Investing Caffeine

Making Safer Asbestos: Einhorn on CDS

November 16, 2009 at 2:00 am 3 comments

David Einhorn, founding hedge fund manager of Greenlight Capital, exploited Credit Default Swaps (CDS) derivative contracts to their fullest in the midst of the financial crisis and now he says any effort to keep them in existence is like making “safer asbestos.” Hypocritical?

As toxic debt devices that profit from credit default triggers, CDSs have created “large correlated and asymmetrical risks,” which have “scared authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay,” according to Einhorn.

The abolishment of the CDS market would have no impact on me (I have never traded a CDS in my life), but in principle Einhorn has no leg to stand on. Just because these unregulated insurance contracts were not properly disclosed or collateralized by American International Group, Inc. (AIG) does not mean a transparent, properly collateralized, central clearing exchange could not be created to efficiently meet the needs of counterparties.

Derivatives Description

Conceptually, a CDS is no different than a derivatives option contract. Take for example a put contract. Like a CDS, a put contract can be purchased as insurance (hedging against price declines on a current holding) or it can be purchased for speculative purposes (profit from future potential price declines if there is no underlying ownership position). All derivatives are structured for hedging or speculation, whether you are talking about options, futures, swaps, or other exotic forms of derivatives (i.e., swaptions). CDSs are no different.

Einhorn is not the first person to disingenuously speak about derivatives. The “do as I say, not as I do” principle holds true for Warren Buffett too. Buffett blasted derivatives as “weapons of mass destruction,” yet he has made billions of dollars (read about Buffett on derivatives) in premiums from writing (selling) multi-year options on various indexes.

Derivatives History

Derivative trading goes as far back as Roman and Greek history when similar contracts were used for crop insurance and shipping purposes. After the Great Depression, the Investment Act of 1934 legitimized options under the watchful eye of the Securities and Exchange Commission (SEC). Subsequently, the Chicago Board Options Exchange (CBOE) began trading listed options in 1973. Since then, the investment banks and other financial players have created derivative products making up many different flavors.

The Solution

How does Einhorn feel about central clearing exchanges?

“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.”

Oh really? If the utility of hedging contracts has been documented for hundreds of years, then why wouldn’t we create a standardized, transparent, adequately capitalized central clearing house for these tools? Whether Einhorn is asking for the eradication of all derivatives, I cannot be sure.  If his extermination comments apply equally to all derivatives, then I guess we’ll just have to shutter entities like the CBOE, which handled 1.19 billion options contracts last year alone. If eliminating speculation was the focal point of Einhorn’s argument, then perhaps regulators could simply raise the reserve requirements for those merely gambling on price declines or default triggers.

In the end, if what Einhorn recommended came to fruition, he would only be throwing the baby out with the bathwater. CDSs, and other derivatives, serve a healthy and useful purpose towards the aim of creating more efficient financial markets. I agree that the AIG flavor of CDSs were like lethal asbestos, so let’s see if we can now replace it with some safer insulation protection.

Read Financial Times Editorial on David Einhorn

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

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Entry filed under: Financial Markets, Trading. Tags: AIG, asbestos, CBOE, CDS, clearing house, contract, Credit Default Swap, David Einhorn, Greenlight Capital, options, put, Warren Buffett.