Did Wall Street treat CDSs as securities?

It’s worth reading through to the end of Jenny

Anderson’s profile of Tim Geithner today. It’s not just a personal puff-piece

(although it’s that too): there’s also some very good reporting, at the end,

on how Geithner managed to reduce counterparty risk in the CDS market.

In 2004, Mr. Geithner’s staff conducted an extensive review of counterparty

risk. But rather than dump its conclusions on the industry, he chose to stay

behind the scenes while encouraging Mr. Corrigan to reconvene the group. In

January 2005, Mr. Corrigan brought together a group that included some of

the most senior executives on Wall Street. Six months later, the group produced

a report that made 47 recommendations on issues from the very technical to

the philosophical.

Central to the report’s findings were shocking weaknesses in the way

credit derivatives were being assigned and traded around without any sense

of who owned what. The so-called “assignment issue” was simple:

credit derivatives were negotiated by two parties, say JPMorgan and Goldman

Sachs. But banks were “assigning” the contracts out to others

— like hedge funds — without telling each other. It was a little

bit like lending money to a friend who is really rich who in turn lends it

to her deadbeat brother and fails to mention it.

“It violated the first and most sacred principle of banking: know your

counterparty,” Mr. Corrigan said.

In September 2005, Mr. Geithner brought together the so-called 14 families

of Wall Street and told them to fix the problems they had found. They set

goals. Then he raised them. “You want to have a tipping-point dynamic,

where the targets were ambitious enough that they would be forced to put a

lot of resources to work, all together, quickly, otherwise you might not get

traction," he said.

Standards were set, and backlogs came down sharply. One particularly effective

tactic was to collect data from everyone and anonymously distribute it to

the group so that every bank — and that bank’s regulator —

could see how it measured up.

The industry felt triumphant about being part of the solution. It was a classic

“collective action” problem solved: the industry had set an abysmally

low standard and no one would budge for fear of losing business, so someone

had to move everyone.

I’m not sure whether or where this has been reported before, but it’s new to

me, and very interesting – although I’d be interested in whether Wall

Street’s biggest CDS players, such as Deutsche Bank and Goldman Sachs, see the

episode in quite the same way.

What strikes me, from the way that the problem is described, is that CDSs were

being treated as though they were securities, which could be "assigned"

rather than sold. Of course, one of the reasons why Wall Street loves the CDS

market so much is precisely that they are not securities, and therefore

they are subject to much less regulation. But you’d think that Wall Street banks

would at least pay lip service to the distinction, and simply write a new contract

rather than "assigning" an old one.

In fact, that’s a big reason, I’ve always understood, why total notional CDS

outstanding has been rising so quickly – when people trade in and out

of a CDS, they generally write a new contract each time, rather than treating

the CDS as a security. Was that not always the case in the past?

Maybe that practice only became universal after Geithner got involved. In which

case, he can consider himself to some degree responsible for the rise

in total CDSs out there!