It looks like the Federal Reserve is back at it providing leaks to the press, and as usual it sheds a negative light on the banks. I’m all for higher capital requirements but the rules have to be clear.
It’s silly to come up with these fictional “stress tests” scenarios, where one group argues that their hypothetical simulation is better than the other group’s hypothetical simulation. I also don’t mind regulation but it is disappointing to see that many of the most significant problems don’t get dealt with. For instance there has been no substantive change in the CDS market, even though the perceived risks and ambiguities of that market, have caused panic and disorder for the last several years. These are illiquid securities that can be manipulated tremendously having catastrophic consequences for the funding needs of both companies and countries, Even worse many of these contracts don’t trade on exchanges which is why so many people are close to having a panic attack from ISDA’s announcement today that Greece’s restructuring constitutes a default, thereby triggering the CDS. Many institutions use this market to hedge risk but due to the lack of transparency everyone prepares for the worst.
Even though the banks and other financial institutions are lobbying to preserve this market I feel it is very shortsighted, in that these companies trade at fractions of book value primarily because of the perceived ambiguity of their balance sheets, largely due to the CDS market. This can be corrected by putting all CDS on an exchange, and I’d like to see them only used as a hedge as opposed to a destructive speculation instrument. For just a few million, Hedge Funds can bet on the collapse of hundreds of millions of government debt. Due to the lack of liquidity these spreads can easily widen causing bonds to drop increasing the borrowing rate for the targeted debtor. In many cases this becomes a self-fulfilling prophecy.