The SEC announced that it is considering reinstating short sale rules, but that won’t do any good if credit default swaps remain unregulated. It is no surprise that banks and hedge funds are on opposite sides of the short selling issue, according to the NYT.

Hedge funds and big pension funds argue that short-selling is vital to modern markets. Such trading not only enables investors to hedge their risks but also to ferret out weak companies or, as in the case of Enron, outright frauds.

But many banks, whose stocks came under attack last autumn, maintain that unfettered short-selling is dangerous. The shorts, their argument goes, helped bring down Bear Stearns and Lehman Brothers last year.

The merits of this argument lie with those who would limit short selling. Short selling in the absence of limits may well have played a role in the demise of Lehman Bros. and Bear Stearns. The American Bankers Association says so, but that doesn’t necessarily make the argument wrong. I don’t think that limits would have salvaged much, but they would have made for a more orderly market.

The bigger problem is that credit default swaps play make it possible for traders to short bonds, in fact, this is touted as one of its great benefits. It even works in the muni bond markets.

When short sales increase, or the price of protection through credit default swaps increases, it makes it look like there is a broad market belief that company is in deep financial straits. When people start doubting the financial stability of the company, that will drive its stock down faster than a bear raid.

As of today, there are only 5,281 live CDSs on Citigroup, and 11,104 on Bank of America. (This link is not permanent.) That isn’t a lot of contracts to make up a real market. Many of the contracts are held as hedges, so a few trades by speculators can easily move the market.

In the municipal bond market, moves in the CDS market can drive up interest rates for cities and states, to the massive detriment of taxpayers. Market participants don’t have to have any skin in the game when it comes to credit default swaps, they can simply gamble, and since the muni bond CDS market is really thin, a few bets can sway pricing. As an example, DTCC reports that the total number of live CDSs on the State of California is 185.

The Obama administration doesn’t have any intention of regulating the CDS market in any realistic way. In that case,why bother changing the short sale rules if credit default swaps can be used more effectively to accomplish the same purposes?

“The government wants a confidence measure right now, and that’s all this is,” said Lawrence E. Harris, a former S.E.C. chief economist.

Traders, he said, will simply find ways to circumvent the rule, but the commission probably will make the move if only to deflect outside pressure.

“Every crisis requires action,” he said. “It’s not worth fighting over.”

Everybody’s a cynic.

Well not everybody. I know we can do stuff to fix this mess, but only if we keep the financial elites from crushing real reform.

masaccio

masaccio

I read a lot of books.

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