RCM Reprint: Karl Denninger on CDS and the Vicious Cycle

RCM Comment: The following explanation, while a little esoteric, offers unparalleled insight into a major component of the credit crisis:

Karl Denninger-

I buy a CDS on GE (a few weeks ago) for a couple hundred basis points ($200,000 per $10 million)The SELLER of that CDS protects against possibly having to pay by shorting whatever he can against that short credit position. This means he buys PUTs, he shorts the common, he does whatever he needs to in order to lay off that risk. He does this because if GE goes bankrupt their stock would presumably go to zero; therefore, if he has a potential $10 million exposure on the CDS he will short $10 million face value of the common stock, or buy enough PUTs to pay him $10 million if the stock goes to zero.

The PUT writer (assuming he buys PUTs), being a market-maker, will in turn short the common to lay off the risk as well. This hammers the stock price which then reflects into the pricing models for the CDS, driving them higher.This cycle repeats; unfortunately credit rating models include market cap as one of their inputs, which causes a credit downgrade (eventually.) That in turn adds more pressure. This cycle is repeated until the company is destroyed.

Why is this not a problem with options and straight short sales? Because with both straight short sales and PUT purchases the short side is required to post margin every night, and if the price goes the wrong way they get an immediate margin call and are required to buy that position back at a loss. That in turn puts pressure UPWARDS on share price and arrests the slide. As such the people selling short (whether stock or listed options) do not dare short in unlimited amounts, because if they get caught on the wrong side of a squeeze they are dead.

The enforcement of risk against the people betting on a bankruptcy through regulated instruments puts a natural limit on their activity and prevents an unwarranted "death spiral".

But in the CDS world there is no mark-to-market margin supervision, because there is no central counterparty supervising exposure and demanding it. As a consequence it is only the counterparty and the written document that can demand collateral posting and usually that is either on an infrequent schedule (monthly, quarterly, annually or on an "event") or in some cases not at all provided the writer maintains some specific credit rating criteria themselves!

Without nightly margin supervision on CDS short positions these vehicles have turned into the means to launch monstrous focused attacks on specific companies; the buyer has limited risk and virtually unlimited reward.

This is exactly like me buying fire insurance on your house, and in addition I can name the amount of insurance I want to buy, even exceeding the house's value!How nervous will you get if I buy $10 million in "fire insurance" against your $100,000 bungalow and then start stacking up gasoline cans in my driveway?As a direct and proximate cause of this ability to distort the market it becomes possible to create self-fulfilling prophecies almost on demand, with the people doing it profiting handsomely - at the expense of American workers and otherwise-sound companies.This form of exploitation of the market must stop.