Dangerous Wall Street Practices Still Possessed of Life

In the initial moments of this blog I stated that there were three things that needed to change in order for the world to definitively leave recession behind:

• The people that led us into recession had to change.
• The institutions that led us into recession had to change.
• The ideas that led us into recession had to change.

While there has been tremendous loss of wealth, many of the people that led us into the Great Recession still remain.  In turn, that means that their ideas are still in place.  One very deadly idea that still exists is the use of the credit default swap to speculate on the creditworthiness of a business.  In this instance I am referring to the Wall Street Journal’s reporting this morning that:

“Banks and hedge funds are trading credit-default swaps, which make payments to holders of General Motors bonds in the event of a default. But GM canceled $40 billion of debt in bankruptcy and has pledged to cut its remaining $4.6 billion bank loan to the bone this year.

That is merely a technicality for the banks and hedge funds that have been actively trading the CDS.”

In other words, those that are trading these securities are betting that GM debt will exist at least while they own the credit default swaps.  In other words, let’s take a derivative instrument, the CDS – so-called because it derives its value from the value of something else – and attach it to something that doesn’t exist.  Effectively this is like you and a friend betting that a couple they know will have a baby when, in fact, that couple has publicly stated that they have no intention of having a baby.  Alternatively, it’s like betting on a cockfight when no cockfight exists…”If there were a cockfight I would bet on that cock.  Okay, I’ll take the other cock, if there’s a cockfight.”

Folks, this is a bad sign.  It means that the survivors on Wall Street have not fully digested one of the lessons of the Great Recession: limit your risk.  Now it may be that the CDS are being traded in limited amounts relative to the overall size of these speculators’ portfolios, but having lived through two large recessions now, I can tell you that it will likely only be a matter of time before bad Wall Street practices are back in full swing.  I don’t consider this to be ethical stewardship of shareholder or investor money and this is one of the reasons that I consider myself a critic of capitalism.  Ugh!

I will continue to watch this issue closely – whether or not the ideas that led us into recession have changed.  If not, then it means that the overall level of secular risk in the stock market is permanently higher.  That means that returns are permanently lower – in the aggregate and over time.

Jason