The Real Reason

The smokescreen will just get thicker and thicker as the discussion of financial reform proceeds.

The real goal for the dealers, of course, is to protect profits that arise from customers not knowing as much as the dealers know.  For that reason, we should expect that any compromise includes substantial carve-outs for “custom” deals in the swaps market that keeps pricing hidden away.

This Bloomberg article should give us a clue.

As I think back to the organizational meetings I had when setting up a bond-oriented hedge fund myself, my colleagues and I came to the conclusion that Bear Stearns and Lehman were by far the leaders in servicing bond managers, but more on that later.

As I said when Bear Stearns was gifted to JP Morgan with a $29 billion non-recourse credit line from the taxpayer, the real value was the Prime Broker business the Bear had with its hedge fund customers.

There was a balanced  book of over-the-counter CDS contracts that would eventually need to be unwound, and the Prime Broker was going to be in the position of setting the prices.

To make it easy, imagine that book was a trillion dollars (it was more).  Imagine also that there was a bid/offer spread of two points (it was more).  So that makes the eventual take equal to half of the bid/offer applied to the entire book of business, or at least 1% of a trillion dollars.  That’s $10 billion in profit.  Now you see why I call it a gift when JP Morgan put $1 billion at risk alongside the taxpayer’s $29 billion.  We’ll ignore for the time being the $2 billion or so per year of carry profit thrown off by the portfolio.

The only option available to a customer that didn’t like the price they were given by their original counterparty was to attempt to find another counterparty willing to enter a newly originated contract with equal and opposite terms.  That way the customer would have no exposure on the swap any more, except that they would have the counterparty exposure to both counterparties for the life of the contract.  Oops.  For mortgage bonds, that exposure extended out for as much as 30 years.

In 2007, of course, the fixed-income hedge fund Prime Broker business had exploded, with huge Credit Default Swap positions being taken on by the Dealers and their hedge fund customers.

The place where the business was the most opaque was the “single name” CDS.  You could get into a position, but you might not like the price of getting out.

We were treated to daily lists of “OWIC’s” or Offers Wanted in Competition.  There was a huge appetite to open up these positions, but nobody seemed to be thinking what would happen if the market needed at some point to close them down.

Even the publicly-available indices of CDS had very wide bid/offer levels, so that selling at the offer was as much as a 10% profit over buying at the bid.

If you look at the market commentary during the early days of the ABX (subprime CDS bond index) discussion, you’ll see that the dealers were positioning it as a way they and others could offer a “more liquid” and “transparent” means of hedging. That was true, at least compared to the single-name business.

So now we know that Paulson and Co. did most of their business with single-name CDS, at least until the business was already rolling over for its final dive into the ground, roughly the time of the infamous ABACUS 2007-2A1.

How much could their friendly Prime Brokers take?  My guess is plenty.  After all, paying $15 million to arrange a big block (some reports say $1 billion) was a good deal.  Compare that to a bond market that regularly quotes bonds in 32nds and 64ths of a percent.  One and a half percent is basically unheard of.

Look again at the numbers in the Bloomberg article.  To let customers buy and sell stocks in large blocks without actually buying or selling in the markets, the European equity swap dealers made roughly ten times the fees they made raising new equity.  Yikes!  And I thought 5% commissions on a IPO were a lot!

So watch the exceptions and carve-outs.  That will tell you how successful the Dealers are in protecting their informational advantage over their customers.

I’ll go so far as to say this:  We will probably seen transparency and efficiency only in the parts of the market the Dealers need to hedge their own positions.

To see proof of how this works, just look at the futures markets.  Among the most efficient (and super-levered) markets in the world are the ones where you can buy or sell S&P futures or positions in US Treasury bonds.  That’s the stuff the Dealers need to manage their own risk, and they make sure they get a good deal with miniscule bid/offer spreads when they are the customer.  They also require tiny amounts of capital to enter those positions. Leverage and efficiency, writ large.

For that reason, given the significance of the swap markets, I expect to see the Dealers throw their support behind very efficient and transparent markets in a selection of “plain vanilla” swaps and CDS.

Just enough for them to manage their overall exposures while they continue to negotiate hugely innefficient one-off deals with their customers and keep those from being disclosed.

Just my opinion, but it would be a win-win for the Dealers.  Note that they’ll say it’s a win-win for Dealers and customers.  They just won’t tell you that they will be the biggest customers on the part of the market that becomes efficient.



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