Capital Markets

Cox: Default Swaps Are Naked Shorts

In prepared testimony that he will deliver to the Senate this morning, the SEC chairman will call for Congress to give his agency authority over sw...
Tim ReasonSeptember 23, 2008

Credit default swaps, potentially the next domino to fall in the ongoing financial crisis, are the debt equivalent of naked shorts on stocks, according to the chairman of the Securities and Exchange Commission.

In prepared testimony that he will deliver before the Senate Banking Committee this morning, SEC chairman Christopher Cox equated the sale of the unregulated bond derivatives with naked short selling and called on Congress to give his agency authority to regulate the derivatives.

“Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS,” said Cox. “Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can ‘naked short’ the debt of companies without restriction.”

Equating credit default swaps on corporate bonds with short selling of corporate stocks will resonate on Capitol Hill, where short selling, particularly naked short selling, has come under fire for purportedly driving down the stocks of financial institutions and undermining public confidence. The SEC has a partial ban in place on naked short selling and also temporarily limited short selling of 799 financial stocks in response to the financial crisis.

Credit default swaps — the unregulated derivatives that are supposed to offer their buyers a payout if the company against which they’re written defaults or goes bankrupt — were, until recently, hailed by many as a valuable financial innovation. In fact, the notional value of credit-default swaps soared to some $62.2 trillion in 2007 from $34.4 trillion in 2006, according to the International Swaps and Derivatives Association.

But the bankruptcy of Lehman Brothers, a major issuer of credit default swaps, combined with the government takeover of AIG, which had covered more than $440 billion in bonds with credit default swaps, has raised serious concerns about the default of the default swaps themselves.

The Financial Accounting Standards Board voted last month to push forward with a disclosure requirement aimed at helping investors get a better read on the financial instruments, rejecting recommendations by its own staff and many in the financial industry that the provision be delayed. Under the rule every derivative — or group of similar derivatives — the seller must disclose the nature of the instrument (term, reasons for entering into the contract, and current status of the payment/performance risk); the maximum potential amount of future payments the seller is required to make under the contract terms; the fair value of the derivative; and the nature of any recourse provisions that would allow the seller to recover the amount it pays out — such as collateral pledged or assets held by third parties that the seller has the right to liquidate.

The new rule will be effective for fiscal years ending after November 15, 2008. That means that investors may have a much clearer picture of the credit default swap market by February of next year, when calendar-year companies begin releasing their year-end results. But that may not be soon enough.

Indeed, during the August meeting in which FASB voted to issue the new disclosure rule, board member Thomas Linsmeier was adamant about acting sooner rather than later. “In this market, with the credit crisis, two or three months may be a big deal” in terms of investor disclosures, he said.