Home -> Law Blog Directory -> Legal Commentary Blogs -> Economics of Contempt

Legal Commentary

: Economics of Contempt

House Bill Limiting CDS Speculation

By Anonymous

I was working on other things this week, so I didn't get a chance to comment on Rep. Collin Peterson's draft bill aimed at limiting speculation in credit default swaps (CDS). The bill is poorly drafted, to say the least. The operative language appears in Section 16, entitled "Limitation on Eligibility to Purchase A Credit Default Swap":

It shall be unlawful for any person to enter into a credit default swap unless the person would experience financial loss if an event that is the subject of the credit default swap occurs.

Where to start? First of all, contrary to media accounts, the bill does not require protection buyers to own the underlying bond. It simply provides that when the parties enter into a CDS, the protection buyer must be in a position to "experience financial loss" if a credit event occurs. Essentially, the protection buyer has to have exposure to the reference entity. Owning stock in the reference entity would almost certainly satisfy this requirement. In fact, owning an ETF that tracks the reference entity's stock would probably satisfy this requirement as currently written. (I'm sure lawyers could push this requirement even further too, and could conceivably define away its effect entirely. Not me personally, of course, but other, less public-spirited lawyers.)

Second, the bill actually requires the protection seller to also be in a position to "experience financial loss" if a credit event occurs. This makes no sense whatsoever. It would be like requiring a fire insurance company to be a co-owner of all the houses it insures.

Third, the requirement that the parties be in a position to experience financial loss upon the occurrence of a credit event only applies at the time the CDS is entered into?that is, on the "trade date." After the trade date, then, the parties would no longer have to have exposure to the reference entity. So presumably, both parties could just borrow a few shares of common stock in the reference entity, execute the CDS, and then return the stock to the lenders. That would appear to be legal under the current language, amazingly enough.

It's not entirely clear what Rep. Peterson actually wanted to accomplish with this bill. I assume he wanted the bill to ban so-called "naked CDS," since that's more or less what the expert witnesses discussed in the hearings Peterson held on the proposed bill this week. Of course, the reality is that Peterson was just grandstanding?he gets his name in the headlines by proposing absurdly draconian legislation aimed at everyone's favorite villain, credit default swaps, knowing full well that his bill stands no chance of ever becoming law. He gets to look like a principled regulator standing up to Big Bad Wall Street, without, you know, actually having to stand up to Wall Street. Peterson has already backed off his original proposal now that his turn in the spotlight is over, claiming that his ban on CDS speculators would only apply when the SEC bans short-sales. "It would blink on and off based on what the SEC does," Peterson said yesterday. This is what Congressmen do with their time.

Full post as published by Economics of Contempt on February 05, 2009 (boomark / email).