This is a piece that has been sitting in my draft folder for some time. But reading the article by Soros in yesterday’s WSJ gave me the necessary kick to finish it off. So read Gremlins first then his piece on CDS, bear raids and regulation.

Gremlins

Gremlins was a classic movie released in 1984. Most of you will be familiar with the plot. A man desperate for a Christmas present for his son manages to buy an exceptionally cute fluffy animal called Mogwai from a mysterious Chinese trader. But attached to the sale are conditions. It must be kept away from bright light, it must never be fed after midnight and most important of all it must never be exposed to water.

Of course all these events happen and a host of evil creatures are spawned. Result? Chaos.

And this brings me to CDS.

When CDS were first invented the idea was simple - to give lenders some insurance on loans or securities. A perfectly reasonable idea, in fact quite cute just like Mogwai.

What CDS looked like when they began:

Unfortunately they morphed into a super traded beast. Instead of being the equivalent of buying fire insurance on your own home they allowed everyone else to bet on the probability that your house would burn down. With that it was naive to believe that there were no arsonists out there.

As the market grew at an exponential pace one got CDOs and CDOs squared based on packages of credit default swaps and even stranger investments. Moreover CDS effectively gave everyone a get out of jail free card. Credit analysis became less rigorous as the concept of the biggest fool came to dominate.

Ultimately CDS gave the credit boom a super steroid injection, driving excesses to new extremes. Unfortunately the majority of participants, and by that I mean banks, investors and regulators had failed to realise that their cute, lovely little Mogwai had not only got soaking wet but had gorged after midnight. When the bubble burst the reality was that CDS had come to look like this - worse still they became a key tool in financial arsonists’ destruction kits. Exempt from short selling restrictions, it can be argued that it was the CDS markets that ultimately lead to the dramatic deaths of Lehman, Bear Stearns and others.

And what they became:

Some will, no doubt, feel that this comparison is unfair. But the majority of those are likely to have their careers intimately related to CDS and turkeys don’t vote for Christmas. Nevertheless, I have little doubt that if CDS were invented today they would probably be banned.

Looking ahead I believe that CDS is a market in terminal decline. As regulation increases, along with disclosure requirements and CDS exposures are forced on to exchanges the market will become increasingly hounded. Turnover will steadily fall. Investors will shy away from them as liquidity shrinks and so on. As they do, a return to the more disciplined approach of proper analysis and making a more simple decision of whether to buy something or not, or make a loan, will gather pace. After all what was so wrong with that approach in the first place?

Ultimately just like in Gremlins, the sun will shine.

Good Luck,
PPG