David Einhorn is without question an exceptionally bright man and a very astute investor. However, the latest message being delivered from his bully pulpit, proposing a ban on credit default swaps (CDS), is misguided at best and dangerous at worst. Are his motives for putting forth this radical view pure, or perhaps informed by the complexity of being an equity investor in a world where the entire capital structure can be sliced, diced and priced? I have no idea. But banning CDSs is akin to banning Twitter. Are there some negative outcomes associated with using each of these tools? Sure. But do their overall benefits outweigh their costs? I believe so.
Here are a few extracts from Henny Sender’s Financial Times’ story on Mr. Einhorn’s Letter to Investors:
“I think that trying to make safer credit default swaps is like trying to make safer asbestos,” he writes in a recent letter to investors, adding that CDSs create “large, correlated and asymmetrical risks” having “scared the authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay”.
CDSs are “anti-social”, he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company. This strategy became prevalent in recent years and remains so, as holders of these so-called “basis packages” buy both the debt itself and protection on that debt through CDSs, meaning they receive compensation if the company defaults or restructures. These investors “have an incentive to use their position as bondholders to force bankruptcy, triggering payments on their CDS rather than negotiate out of court restructurings or covenant amendments with their creditors”, Mr Einhorn says.
“The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialised risk by moving the counterparty risk from the private sector to a newly created too big to fail entity,” he notes.
That’s because it is almost impossible to adequately capitalise against such developments. “There is no way a clearing house could demand enough collateral,” he says. “The market can be so big and discontinuous that it is very hard to figure out the correct amount of collateral.”
The crux of Mr. Einhorn’s argument is that CDSs, by their nature, are negative tools, e.g., the holder wants the company to do poorly, and will do things to hasten this fact, and that merely putting CDSs on exchanges won’t solve the larger problem of taxpayer support for “too large to fail” institutions.
Are CDS negative tools? Sure. Is shorting stock a negative tool? Certainly. The ability to go long and short creates what I call “positive stress,” e.g., it’s stressful, but it keeps managements’ focused and penalizes poor corporate decision-making. They both provide essential checks-and-balances in the financial system, provided they are not used fraudulently. The mere fact that an instrument is “anti-social” is no reason to ban its use: Mr. Einhorn knows this. And while he might argue that shorting a stock doesn’t have as direct an impact on a company’s need to enter bankruptcy, it might be that a poorly run company should be in bankruptcy with its assets better deployed by others. Also, the CDS market has been a kind of early detection system for the equity markets, providing a leading indicator of corporate woes before this information has been fully priced into stock prices. Taking away this kind of information hurts everyone, including Mr. Einhorn. And if bankruptcy laws need to be brought up-to-date to reflect the fact that a multi-trillion CDS market has emerged, then so be it. But to merely toss out the information value associated with the CDS market is ludicrous. In fact, I’d argue that the market should be bigger, more transparent and more liquid, which gets to Mr. Einhorn’s second point.
Clearinghouses are not a panacea, according to Mr. Einhorn, because the CDS market is too big, their price movements too discontinuous and collateral requirements too difficult to quantify, invariably leading to private profits and socialized costs. One word: Garbage. Think about it this way. As one moves down the capital structure, from senior debt to junior debt to equity, price volatility and discontinuity goes up. Why? Leverage and the hierarchy of claims. A company’s equity price can move all over the place while its senior debt trades in a narrow range. It stands to reason, therefore, that CDS should have price movements more stable, e.g., less discontinuous, than equity prices. Do stock prices gap? Yes. Can CDS prices gap? Yes. But because of the seniority of their underlying in the capital structure they should gap less frequently and less violently than stock prices. Yet Mr. Einhorn doesn’t want to ban equity trading. What would become of his hedge fund?? The issue is one of liquidity and transparency. Discontinuity comes from opaqueness and thin trading volumes, both of which can be addressed through an exchange mechanism. And this is directly related to the collateral question. As the market becomes more liquid and more continuous, collateral requirements will be increasingly easy to set, far easier than they are today through the daisy-chain of over-the-counter margining arrangements. So at the end of the day, I find Mr. Einhorn’s arguments specious and likely self-serving.
As a rule, turning back the clock of innovation is almost never a good thing, and it isn’t here, either. Better to harness it and use it prudently than to pretend it simply doesn’t exist. Mr. Einhorn knows better, which is why this whole meme makes me very curious…