Did Wall Street treat CDSs as securities?

It's worth reading through to the end of Jenny Anderson's profile of Tim Geithner today. It's not just a personal puff-piece (although it's that too): there's also some very good reporting, at the end, on how Geithner managed to reduce counterparty risk in the CDS market.

In 2004, Mr. Geithner’s staff conducted an extensive review of counterparty risk. But rather than dump its conclusions on the industry, he chose to stay behind the scenes while encouraging Mr. Corrigan to reconvene the group. In January 2005, Mr. Corrigan brought together a group that included some of the most senior executives on Wall Street. Six months later, the group produced a report that made 47 recommendations on issues from the very technical to the philosophical.
Central to the report’s findings were shocking weaknesses in the way credit derivatives were being assigned and traded around without any sense of who owned what. The so-called “assignment issue” was simple: credit derivatives were negotiated by two parties, say JPMorgan and Goldman Sachs. But banks were “assigning” the contracts out to others — like hedge funds — without telling each other. It was a little bit like lending money to a friend who is really rich who in turn lends it to her deadbeat brother and fails to mention it.
“It violated the first and most sacred principle of banking: know your counterparty,” Mr. Corrigan said.
In September 2005, Mr. Geithner brought together the so-called 14 families of Wall Street and told them to fix the problems they had found. They set goals. Then he raised them. “You want to have a tipping-point dynamic, where the targets were ambitious enough that they would be forced to put a lot of resources to work, all together, quickly, otherwise you might not get traction," he said.
Standards were set, and backlogs came down sharply. One particularly effective tactic was to collect data from everyone and anonymously distribute it to the group so that every bank — and that bank’s regulator — could see how it measured up.
The industry felt triumphant about being part of the solution. It was a classic “collective action” problem solved: the industry had set an abysmally low standard and no one would budge for fear of losing business, so someone had to move everyone.

I'm not sure whether or where this has been reported before, but it's new to me, and very interesting – although I'd be interested in whether Wall Street's biggest CDS players, such as Deutsche Bank and Goldman Sachs, see the episode in quite the same way.

What strikes me, from the way that the problem is described, is that CDSs were being treated as though they were securities, which could be "assigned" rather than sold. Of course, one of the reasons why Wall Street loves the CDS market so much is precisely that they are not securities, and therefore they are subject to much less regulation. But you'd think that Wall Street banks would at least pay lip service to the distinction, and simply write a new contract rather than "assigning" an old one.

In fact, that's a big reason, I've always understood, why total notional CDS outstanding has been rising so quickly – when people trade in and out of a CDS, they generally write a new contract each time, rather than treating the CDS as a security. Was that not always the case in the past?

Maybe that practice only became universal after Geithner got involved. In which case, he can consider himself to some degree responsible for the rise in total CDSs out there!

Posted by Felix at 9:43 EST

Comments

What most baffles me is that the terms -- is this correct? -- allowed for assignment without notification (or even consent) of the counterparty. The comparison to relending money seems inadequate; I would think in a typical "relending" situation as described, the person in the middle would still be on the hook if the person to whom they relent the money defaulted.

Posted by: dWj at 20:32 EST, February 09, 2007