A Blind Hog and a Turnip

An old boss of mine used to talk about how even a blind hog could find a turnip once in awhile. I think this is an apt comparison to the latest coming out of the Treasury. I think they finally got something right:

The vast majority of complex and opaque over-the-counter derivatives must be traded on centralized clearinghouses, the Treasury Department recommended on Wednesday as part of its regulatory reform effort for exotic financial products.

"As part of our comprehensive reform effort, we are laying out a framework for oversight for the derivatives markets," Treasury Secretary Timothy Geithner said.

I've pounded Geithner for months but on this I think he's correct. Derivatives create an layer of risk and complication to the market that is very difficult for the average investor to understand or price into their investment decisions.

The Treasury, the Securities and Exchange Commission and the Commodity Futures Trading Commission proposed having standardized credit default swaps and most derivatives traded through clearinghouses. The government regulators made a host of other recommendations, however legislation would need to be crafted by Congress for the Treasury proposal to become a reality.

Traders could also be required to keep capital in reserves to cover losses. Specifically, the proposal also calls for derivatives dealers to maintain conservative capital standards, tougher risk controls and proposes new business conduct guidelines.

The parts I like are the trading desk, which will give transparency to the pricing of these securities and the requirement to keep capital in reserve to cover losses. Both of those would have gone a long way to preventing the melt down we saw happen last fall.

I'll hammer Geithner will glee every time he screws up, and I still think he's a clown, but this time he got it right.

Credit Default Swaps and Short Selling: A Deadly Combination

Much of our financial meltdown is due to the dangerous combination of "credit default swaps" and the absence of an uptick rule for short selling and no enforcement of the naked short selling rule by the SEC. Put all that together and you have the both the motivation and ability to destroy a company for profit.

A "credit default swap" is a quasi (but unregulated) insurance policy whereby I contract with an insurance company to pay a certain stream of money for coverage in case a third party (call them Company A) might go into default on their credit. If Company A does not go into default, I just pay the premium on my coverage, the insurance company pockets the premiums and everything continues on until the contract is completed. If Company A does go into default, then I cash in the contract and the insurance company pays me the specified amount of coverage that I paid for.

But here is the rub. I do not even have to have an insurable interest in Company A, I do not have to own any stock or have any financial relationship with Company A whatsoever in order to buy a credit default swap on them. I can buy one on any entity I want to, if I'm willing to pay the premium. If you think about it, this is the equivalent of calling up your bookie and making a propositional bet on some outcome of the local basketball game. Taking it one step further, once I buy the credit default swap, I have an big motivation to do anything I can to help Company A go into default, because that is how I get paid off. So how do I help Company A into default? By short selling the daylights out of them.

OK? So, now imagine being able to short sell Company A's stock with no "uptick rule" and with "naked short selling" overlay, the currently unfettered ability to short sell stocks into this picture. What do you get? Lehman Brothers going belly up:

The biggest bankruptcy in history might have been avoided if Wall Street had been prevented from practicing one of its darkest arts.

As Lehman Brothers Holdings Inc. struggled to survive last year, as many as 32.8 million shares in the company were sold and not delivered to buyers on time as of Sept. 11, according to data compiled by the Securities and Exchange Commission and Bloomberg. That was a more than 57-fold increase over the prior year’s peak of 567,518 failed trades on July 30.

The SEC has linked such so-called fails-to-deliver to naked short selling, a strategy that can be used to manipulate markets. A fail-to-deliver is a trade that doesn’t settle within three days.

“We had another word for this in Brooklyn,” said Harvey Pitt, a former SEC chairman. “The word was ‘fraud.’”

In other words, I can short sell a stock into oblivion, forcing down their credit ratings, which then makes creditors call for more collateral or have their credit lines get canceled. I can also call up brokers and reporters and spread negative rumors about the company and get a whisper campaign going against them. So the stock price slides, it then hits pre-set "sell" orders and more selling happens and you have the downward death spiral happen. And then I get paid off on my credit default swap plus I make a nice profit on my short selling escapades.

I make it coming and going, but I destroy a company in the process and throw the market into a turmoil.

A lot of the rebound in the market the last week or so has been due to short sellers covering their positions now that Congress is talking about reinstalling the uptick rule, which will discourage short selling. Conversely, a lot of the sudden drop in the market Friday afternoon (yes, there was profit taking as well) was due to the short sellers taking short positions for the weekend cause Congress had left for the weekend and they knew an uptick rule would not be put in place before next week.

I'm not saying that the economy is not in bad shape. But what I'm saying is that the credit default swap situation, combined with the current ability to destroy companies through unlimited short selling, has created a free-fire zone in which companies can be financially destroyed for profit. This has contributed significantly to the downturn.

Before the market can rebound fully, we need the uptick rule installed, the naked short selling prohibition enforced and credit default swaps have to be regulated like any other insurance policy. Currently, companies writing credit default swaps did not even have to set aside assets to cover the exposure.

And in the mean time, The Messiah has time to go on late night talk shows and make bad jokes.

Yes we can!