The term "naked CDS (Credit Default Swap)" has been tossed around a lot lately, with little to no examination of the etymology of the term. You may have heard of "naked short selling" of stock, and a bit of Google action will tell you that naked short selling is generally illegal. So, you'd be inclined to think that naked CDS must be similar in nature to naked short selling, and inevitably conclude that naked CDS would be illegal but for Wall Street's tentacles. But of course, you'd be wrong.
Naked Short Selling
Naked short selling has nothing to do with being a hedonistic financier. Ordinarily, to short sell a stock, you (i) borrow the stock and then (ii) sell it to someone else. This pair of transactions leaves you with an amount of cash equal to the price of the stock at the time of the sale and an obligation to the deliver stock to the lender at some time in the future. If the price of the stock drops after the sale, you can purchase the stock in the market for less than the price you sold it for, deliver the stock to the lender, and pocket the difference. Fantastic. Naked short selling is very similar, except you never actually borrow the stock. That's right, you sell something you don't actually own. There are circumstances where this wouldn't be much of a problem (e.g., I don't own the stock right now but I will in the next couple of minutes) and we might want to allow the practice to occur. But exactly when the practice is acceptable is beyond the scope of this discussion. The key point is that naked short selling involves the sale of an asset you do not currently own.
Naked CDS
A naked CDS position is a short position that is unhedged by the underlying credit risk. For example, I have a short position on a bond through a CDS but I don't actually own the bond. This means that I profit if the price of CDS protection on the bond increases, which usually means that the underlying bond is more likely to default than when I opened up the CDS trade. Note that I have not sold anything that I don't own. The equivocation between naked CDS and naked short selling stems from the observation that in each case, you don't own the thing in question. Sure, but in the case of a naked CDS position, you're not trying to sell the thing you don't own. It is the sale without current ownership that makes naked short selling problematic in certain contexts. In contrast, in the case of a naked CDS position, you simply enter into a trade expressing a negative view on a credit, that is all.
Naked CDS positions are similar to unhedged puts: buying a put on a stock without actually owning the stock. A put gives you the right to exchange stock for a fixed amount of cash, called the strike price. If the market price goes below strike price, you can go and buy the stock from the market, exercise the put, and pocket the difference between the strike price and the market price. Fantastic. So the more the price of the stock falls, the more you profit. How evil. Of course, no one has a problem with unhedged puts, even though they express a negative view on an asset in almost the same way a naked CDS position does. But don't forget, puts are not part of the "shadow banking system," or whatever other garbage meme is being pumped this week.
Same Same But Different
Pundits also grumble because naked CDS positions are speculative, as are short positions on commodities, such as the price of fuel. But of course, the custom crafted pundit logic applies differently to different markets. For example, in the context of CDS, naked CDS speculators are bad because they magically cause the price of the underlying bond to decrease. But when it comes to commodities, pundits claim that speculators cause the price of the underlying commodity to increase. They hold this to be true despite the fact that both the CDS market and the futures markets are comprised of an equal number of long and short positions, by definition. Moreover, speculators can make money on both the long and the short end of a trade in either market, so why should we assume they consistently choose the "evil side" of the trade? Why markets with such similar characteristics yield such different criticisms is beyond me, but perhaps one day I too will wield the Möbius strip of pundit logic.
OK, maybe not evil. But naked short selling, naked puts and naked CDOs are, for all intents and purposes, no different from betting on the Super Bowl or the Kentucky Derby. Maybe the answer is not to ban these practices outright but to put them on the casino floor where they belong and regulate them the same as other forms of gambling.
Django48
First, "naked CDOs" do not exist. A CDO issues bonds. Second, is buying stock gambling? Is buying a call option gambling? If not, why is buying a put gambling? All investment involves speculation about the future. But speculation can be informed. Gambling cannot be informed because you can't predict the outcome of spinning a wheel with any greater accuracy than I can.
If you "control" the spinning of a wheel via manipulative techniques (naked shorting, flash trades, captured media, regulators and legislators), as the miscreants on Wall Street do, then yes, you can predict the outcome. And very profitably. Check out deepcapture.com.
Kong,
If markets were truly manipulated, why would other sophisticated parties participate? Why would hedge funds take the exact opposite end of a trade that one of your conspirators controls? Derivatives are zero sum games. There's always a loser. If trades were manipulated, idiots might agree to play the game, but how do you explain the fact that these markets are tremendously popular with sophisticated players? I have a theory: you're wrong.
Since you've yet to respond to my post...
It appears that the process is what you're arguing for Mr. Davi, and not the unintended consequences of the actions taken. Does that matter to you? Or is "profit for profit's sake" your only concern?
DD -
There is "gambling" that fulfills a legitimate social purpose (investing) and then there is the other kind.
A CDO is essentially a bet that a particular security will drop in price. If you own the underlying security, that's one thing. If you don't, it's quite another.
Kind of like the difference between taking out a life insurance policy on yourself and taking one out on the life of a complete stranger.
I'm sorry, Mr. Davi, but your logic is flawed.
Taking a short position, be it "naked" or otherwise, on a CDS is different from a short position on commodities. The short position on the CDS drives down the price of the bond that the CDS hedges; and the bond holder loses value not on a commodity, but on actual homes.
The "evil" that is expressly denoted to the naked short position on a CDS as opposed to that on a commodity is the underlying asset involved in the various trade position(s).
The naked short selling that drives down the price of oil (for example), is valuable for the overall economy. Would you ascribe the same pluralistic value to driving down the price of homes? I would hope not.
The outrage that learned people have is not the trading position taken, but the "butterfly effect(s)" of these positions.
Be it a commodity, a home (or a bond based on the a number of homes), each trade effects an asset, and the cumulative effect of those trades affect more than the pockets of the traders.
Dan,
"The short position on the CDS drives down the price of the bond that the CDS hedges; and the bond holder loses value not on a commodity, but on actual homes."
That makes absolutely no sense.
CDS are hedges for assets. Perhaps including in my original post that the CDS' tied to CMO's or CDO's are what I am referring to.
"The 'evil' that is expressly denoted to the naked short position..." Egads! No one was supposed to find out about ISDA subparagraph 666 -- the Expressly Evil Edict. We'll have to retreat to our secret Arctic lair to figure out new ways to screw consumers. This will seriously cut into my mustache twirling and damsel distressing time.
I'm sorry, Mr. Dan, but your language is flawed. Using fancy words only makes you seem smart if you use them correctly.
As to a more substantive (and less snarky) point, you're equivocating price and value. Shorting can only conceivably affect the price of a commodity on a given day, not its underlying value. If markets are even marginally efficient, someone who has shorted something which has a price lower than its value will lose money when the asset's price inevitably lines up with its real value.
Your fixation on housing reveals a real flaw with your argument. Everyone now agrees that the current economic crisis is largely due to wildly overpriced housing. Assuming that you're right that shorting CDOs is currently driving down the price of houses, we would currently be better off if more people had been shorting CDOs over the last decade because housing wouldn't have been so overpriced. Thus, by your own "logic," shorting should be allowed (if not encouraged) in some cases.
You really don't seem to have a problem with shorting (naked or otherwise) per se, but you do have a problem with people driving down the price of houses. So I can only assume that you have access to some sort of secret information that lets you discern which prices should be lowered and which should be raised. But when we appoint you High Priest of Pricing, how will you explain to someone who wants to buy a house why they should be forced to pay more for one?
One, I used the word denote because of the value judgement Mr. Davi placed on the word evil in the article.
Two, I'm not equivocating price and value. Like Dr. Davi, I'm describing the process, but my concern lies with the outcomes that the process creates.
Third, I don't have a problem with the process of trading (short, long, naked, fully vested, etc.), my problem is that your (and "everyone's") assessment that overpriced housing was the cause of the current economic crisis is wrong. The problem didn't stem from consumers, the problem came from the Wall Street traders demanding assets to invest in or products to "play" with. And regulators that did not regulate for no other reason than political ideology.
Like the tech bubble, liquidity was abundant and traders wanted assets to trade. Market makers wanted assets to put the liquidity into, and this time they chose housing. Becuase they did - the trade positions, the complex derivatives, and the eventual saturation of the marketplace for the asset caused this economic crisis. Not overpriced housing.
So your snark aside, do some research and independent thinking, as I have, and see that sometimes "everyone" is wrong.
Lastly, that's why I express concern for the process of trading and Mr. Davi's opinion of it, because until the crisis is decontructed and the causes recognized for their contribution, we are bound to have this problem again.
Dan, as a general rule, you should be wary any time your independent thinking leads you to a conclusion with which everyone else disagrees. For every Einstein there are a million Orly Taitzes and David Ickes.
Why are you so dead-set on the notion that housing wasn't overpriced? If Wall Street can drive the price of housing down, doesn't it stand to reason that they could drive the price of housing up? In fact, every respectable economist agrees with you that Wall Street exacerbated the housing crisis by investing so heavily in housing; they just take the next logical step that this necessarily drove the price of housing up. Of course, Main Street is just as much to blame -- if they hadn't been (literally) willing to buy into the ridiculous notion that housing prices could increase faster than GDP, Wall Street wouldn't have had anywhere to throw all that extra liquidity.
At any rate, I'm not really sure what you're even arguing at this point. If you don't have a problem with puts, how you could have a problem with a product that Dr. Davi has demonstrated is their analogue?
Of course Wall Street drove the housing prices up by funding more and more projects until the market was saturated.
But that was not your original statement. You attributed the current economic crisis to overpriced (or inflated) housing prices ONLY. I was pointing out the the cause while you were restating the problem.
I don't have a problem with puts, I have a problem with Dr. Davi's, and I assume your, conclusion that market trades are "zero sum". Every trade, every positions (put/call), and the assets they are based on has a larger economic consequence - or systemic risk.
Remember economic theory or studying the market in class? I do. And it has always bothered me when people discount or don't not consider that market trades have real world conseqeunces - as Dr. Davi hypothesizes in this article.
As for the Einstein/Taitzes reference, if but all the lemmings go running off a cliff, why should I? Or stated differently, I question everything and think independently becuase the book, Dr. Davi, and you could be wrong (and quite often are).
Also,
The reason the FFIEC prohibits derivatives from traditional banking is the fact that the speculating on assets such as housing inevitably drives up, then down the assets value. Banks that participated in this most recent bubble were, until the crash, investment banks that were not subject to the Council's regulation.
So, the tying of this particular type of speculation to widely sold products is one of the other reasons for the economic crisis.
Simply put, the root of the problem is the 'Commodities Futures Modernization Act of 2000', and the ability to securitize consumer debt.
The question has been asked is the purchasing of stocks gambling? The answer is indeed yes. By allowing the consequences of gambling to extend to consumer debt streams, Wall Street has now put the general public at risk.