CDS and Market-Based Resolution, II

Since I’m seeing Chris Papagianis’ CDS proposal mentioned some more (by Matt Continetti, for instance), it’s worth pushing back on it a little bit more in light of Goldman’s recent activity.

I am a person who is skeptical that the financial market prices always and everywhere and at all times reflect some sort of inherent value, and as such I’m reluctant to give huge amount of regulatory power over to it. So consider Christopher Papagianis suggestion at Economics 21 (my original comments are here). Chris:

In the Hart and Zingales framework, once the CDS spread rises above a pre-specified “critical threshold,” the regulator would force the institution in question to issue equity (offer new stock for sale) until the CDS spread moves back below the threshold…CDS spreads, by contrast, are perfectly correlated with market participants’ collective view of the probability of default…having the regulator demand that the institution issue new equity, the debt of the institution could automatically convert into equity.

And let’s go to the original Hart and Zingales piece for a little more how to work it in practice:

If the trigger were to be set off by a too-high CDS price, the regulator would be required to carry out a “stress test” on the financial institution to determine if it is indeed at risk. In a stress test, regulators use sophisticated algorithms to run “what if” scenarios that examine whether a financial institution has sufficient assets to survive serious financial shocks. A stress test should precede any other action, so that extraneous panic is not allowed to bring down financial institutions unnecessarily. If, for instance, a few significant hedge funds or other investors lost confidence in a bank on the basis of a rumor or misperception about its strength, and began to buy credit default swaps as protection against its failure, the CDS price would rise and might trigger regulatory action. It is important that the regulator first test the validity of the concern before acting on it.

Their target number is at 100 bps to begin actions.

So according to markit commentary, Goldman’s CDS hit at peak at 140bps, and currently is closing around 125 bps, 35 bps wider from yesterday.

So, should we begin resolution powers against Goldman? Forcing it to issue equity out of debt? Hart/Zingales says we should initiate a stress test, but could you even imagine how much of a political nightmare that would be right now with SEC investigations ongoing?

And here’s the question: let’s say there would probably be a mean reversion back to the previous CDS number without resolution authority. But in this new world, who would bring it down to 99bps knowing that at 100bps everything changes? Remember at 100bps you’ve initiating something that has a reasonable chance of death spiraling into a big payout.

It may also be a good time to revisit some of the problems of these types of instruments/resolution authority regimes brought up by the FT and Gillian Tett, with the CoCo as the “nuclear warhead in the capital structure. He thought that if the bank approached the trigger, everyone would pull out and that looming conversion would cause more fear than reassurance. ”

Things to consider when you are hoping that the market will take care of the problems we have with regulators – the market introduces a whole new world of problems, some that might even be worse than the current stuff we are dealing with.

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3 Responses to CDS and Market-Based Resolution, II

  1. Anjon Roy says:

    Great points

    It seems the CDS markets, even if they were put onto an exchange, could still easily be subject to “artificial runs”, or be used to induce runs on an institution. I suppose the proponents of this proposals would argue that this mechanism could be naturally self-correcting, but the history of currency and financial crises suggest that the opposite might be true – self fulfilling instead of self correcting! Perhaps in “normal times” this is not the case, but in panic-crisis times (when you most need a tested resolution framework), open market prices can become self-fulfilling momentum / “death spirals”, especially when combined with a “RED LINE” number such as 100bps (or whatever number one chooses for the spread). . The Magenetar and Paulson/Goldman trade on Abacus are good examples of how market prices can easily be manipulated.

    At the end of the day, combining hard numbers with open market trading prices is the worst of both worlds, because it leaves regulators and bank risk managersand the broader resolution process disconnected from true fundamentals.

    Moreover, I’m attracted to the idea of hard numbers, as suggested by Kansas Fed Chair Hoenig, Krugman, Simon Johnson, and probably yourself too. However, those hard numbers should be tied to balance sheet fundamentals on asset quality, liquidity mis-match, leverage, capital quality, etc. It should NOT be based on open market (Casino) prices.

  2. erdosfan says:

    100 bps is a ridiculous, and uninformed threshold. Almost all investment grade credits trade around 100 bps. High yield trades around 500 bps.

  3. @erdosfan: I think the point is that major financial institutions’ debt should be considerably safer than other investment grade credits and in particular “high yield trade”.

    But I have another problem with Papagianis’ suggestion. If the 100 pt trigger would convert debt to equity, and therefore lower the risk of default, then why would anyone buy CDS over 100 pts before the trigger has been triggered? They are assured of the price falling after the debt equity conversion. If the trigger was in place, then the market price would be “sticky” around and just under 100 pts, until the market believed that the conversion of debt to equity wasn’t enough, then the price would go over 100 pts, the trigger would be triggered, it wouldn’t be enough and the bank would still go bust.

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