Thursday, October 19, 2006

Credit default swaps and other wheels that get greased

Guambat is becoming a more frequent reader of Economonitor, but seems destined to never be able to keep up with his prodigious output.

Just a few of the items he brought to Guambat's attention:

First, in one post Economonitor pointed to this Bloomberg report shining a small beam of light on insider trading in CDSs, which are the financial wheels that make the world go round these days:
Credit-Default Swaps May Incite Regulators Over Insider Trading

While Apollo Management and Texas Pacific Group were in supposedly secret talks to acquire Harrah's Entertainment Inc. for $15.1 billion, the takeover already was a done deal in the market for credit-default swaps.

Seemingly omniscient derivatives traders also determined that Kohlberg Kravis Roberts & Co., Bain Capital LLC, Merrill Lynch & Co. and Thomas Frist would buy HCA Inc. in the weeks before a $33 billion leveraged buyout of the hospital operator was announced. And they did the same thing two weeks before Anadarko Petroleum Corp.'s $21 billion agreement to buy Kerr- McGee Corp. and Western Gas Resources Inc. The debt and equity of these companies barely fluctuated when the price of credit- default swaps based on their bonds climbed as much as 40 percent.

Now that the suspicion of insider trading is increasing, regulators, who have had little to say about imposing rules on the $346 billion of unregistered credit-default swaps, may be forced to increase control over Wall Street's hottest and darkest market.

``In a market that is completely opaque, all sorts of abuses are made easier,'' said Michael Greenberger, former director of trading at the Commodity Futures Trading Commission, which regulates U.S. futures trading. ``The temptation to make money, in a way that would be unacceptable in a regular market, is just too great,'' said Greenberger, a professor at the University of Maryland School of Law in Baltimore.

No one is sure who has oversight of credit-default swaps, financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They're part of the explosion in derivatives, or contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather.

There's more; read the whole report and be the wiser. Also, take a look at this post:

The reintermediation of debt

Henny Sender has a great piece in the Wall Street Journal about how private equity companies, laden with cheap debt, are taking steps to protect themselves from vulture funds ("distressed debt investors") should their companies run into difficulty. Private-equity companies have extremely good relationships with their bank lenders, who lend to many different subsidiary companies and who also get fee income from originating the loans. But those banks do sell their loans, which means the loans can end up in the hands of hedge funds – who can be much nastier in debt renegotiations....

[C]ertain notorious hedge funds are barred by name from voting certain debt instruments. And there's so much liquidity around at the moment that the banks are happy to acquiesce to such conditions.

The hedge funds can still make money on bad credits, of course, by buying default swaps instead of buying the underlying loans. But the workouts might be much easier (and owner-friendly) if they're dominated, as in the old days, by banks rather than by total-return investors.
And this:
Whither the sell side?

Everybody knows that Goldman Sachs is the world's biggest hedge fund, both literally and metaphorically: the venerable house makes vastly more money from trading than it does from banking.

But it turns out that Goldman is not a special case, and that in fact banks which aren't named Goldman Sachs or Morgan Stanley are also becoming indistinguishable from private investment vehicles. Yesterday, Antony Currie of Breaking Views noted that when HCA is taken private, Merrill Lynch will overtake Goldman in terms of private-equity investments on the bank's own balance sheet, with something in the region of $4 billion of its own money invested in the illquid asset class.

Today, Currie's colleague Lauren Silva follows up with an analysis of the weak points within Merrill's spectacular earnings result....

In other words, Merrill might be making money, but it ain't making money from banking. Whither, now, the distinction between buy-side and sell-side?

Do Correlated Positions Pose a Growing Risk to the Banking System?
Hopefully your appetite has duly been whetted and you will follow the links to his posts for the whole picture. This is stuff any financial market participant should have some exposure to.


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