More Naked Credit Default Swaps--the Role of Dealers
These post titles should definitely increase the hits on our blog...
I want to add another point to the debate: CDS are often done through dealers, and a naked position for a dealer is different from a naked position for an end-user. A CDS dealer's swaps desk is unlikely to have any long-term stake in the underlying asset. Generally, a swap desk tries to execute perfectly matched swaps so that it will never have any exposure itself to the underlying assets, only counterparty risk. (And dicey counterparties have to post collateral). It isn't always possible to match swaps instantaneously, however, so the dealer will often enter into one swap hoping to find a match soon. Until the dealer finds a match, the dealer has exposure. Moreover, a dealer might be able to get a better price (and hence a bigger cut for itself) if it doles pieces of the swap into the market, rather than trying to move the whole swap position at once. There might not be a lot of market appetite for a $25B swap position except at a steep discount(this goes for CDS as well as other types of swaps), but smaller pieces might be digestible. Dealers tend to try and have everything cleaned up by the end of the quarter, but in between, the short-term exposure could be sizable. If naked CDS were banned without a dealer exception, covered (i.e., not naked) CDS would become quite difficult to arrange and execute.
Complicating this picture is that sometimes a swap dealer decides that the swap is an inherently good position given the price and holds the action itself. This is all by way of saying that CDS go through a dealer market, not a broker market. There might be a case for moving CDS to a broker market, but unless there's sufficient liquidity for the product, that'd be difficult.
To illustrate the role of dealers, consider the Abacus deal. It is usually presented as Goldman Sachs simply arranging a swap between Paulson and the CDO. That's the economic essence of the deal, but not how it worked technically.
The Abacus deal was actually structured as two completely separate swaps. (I think this is what Goldman means when it says it was just a market maker--it means it was a dealer.) Swap 1 was between the CDO and Goldman. Goldman took the short position on the CDS on the underlying CDO assets. Swap 2 was between Goldman and Paulson. These two swaps were separate deals, in that they did not formally reference each other or depend on each other.
In reality, Goldman would never have done Swap 1 with the CDO unless it could hedge its risk in that deal through Swap 2 with Paulson. (Some of this is surmise, as, to my knowledge, only the documentation from Swap 1 is publicly available.) Of course, in the Abacus case, Goldman did not have perfectly matched CDS, and it got screwed (luckily for its sake, as that helps its defense).
The point here, is that dealers play a critical role in the swaps market, and if they happen to have a position in the underlying asset, that is completely by the chance of what an affiliated proprietary investing desk is doing. A naked position by a dealer is different from a naked position for an end-user.
Also, I'm not sure that I'd agree with Stephen that "credit is not a commodity." A bespoke corporate loan is not, but what about when that corporate loan is bundled into a CLO and churned out as securities? Or how about the consumer context, where there are standard form contracts, frequent resales of the debt, and sometimes no collateral involved (e.g., credit card debt)?
[Updated 5/23 at 11:30pm EDT-thx to Wilchy and Marks for corrections]