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, 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.