Although much attention has been directed at the contribution
made by credit default swaps to the financial crisis, most
discussion has focused on the companies, such as American
International Group, that posted big losses because they sold these
instruments without sufficient due diligence.
Another line of inquiry has not been pursued, however, though it
is of equal, and perhaps greater, significance. That line of
inquiry concerns the way in which the prices of credit default
swaps effect the perceived value of all forms of debt —
corporate bonds, commercial mortgages, home mortgages, and
collateralized debt obligations — and as a result, the
ability of hedge funds manipulators to use credit default swaps in
bear raids on public companies.
If short sellers can manipulate the price of credit default
swaps, they can disrupt those companies whose debt is insured by
the credit default swaps whose prices are manipulated. The
game plan runs as follows: find a company that relies on a layer of
debt that is both permanent, and which rolls over frequently (most
financial firms fit this description). Short sell that
company’s stock. Then manipulate the price of the CDS
upwards, preferably into a spike, as you spread the news of the
skyrocketing CDS price (perhaps with the cooperation of compliant
journalists at, say, CNBC).
Because the CDS is, in essence, an insurance policy on the debt
of the company, the spiking CDS pricing will cause the
company’s lenders to panic and cut off access to credit. As
this happens, the company’s stock will nosedive, thereby
cutting off access to equity capital. Thus suddenly deprived of
credit and equity, the firm collapses, and the hedge fund collects
on its short bets.
Moreover, credit default swap prices are the primary inputs for
important indices (such as the CMBX and the ABX) measuring the
movement of the overall market for commercial and home mortgages.
In the months leading up to the financial crisis of 2008,
short sellers pointed to these indices in order to argue that
investment banks – most notably Bear Stearns and Lehman
Brothers – had overvalued the mortgage debt and property on
their books. Meanwhile, several hedge funds made billions in
profits betting that those indexes would drop.
It should therefore be a matter of some concern that credit
default swap “prices” and the indexes derived from them
are determined almost entirely by a little company with zero
transparency and, it appears probable, a high exposure to influence
from market manipulators. The company is called Markit Group, and
there is every reason to believe that its CDS-driven indices (the
CMBX, the ABX, and several others) are inaccurate, while the credit
default swap “prices” that they publish and which
rock the market are in fact nowhere close to the prices at
which credit default swaps actually trade.
Last year, the media reported that New York Attorney General
Andrew Cuomo had sent subpoenas to Markit Group as part of an
investigation into possible manipulation of credit default swap
prices by short sellers. This investigation, like Mr. Cuomo’s
other investigations into market manipulation, have yielded no
prosecutions.
The Department of Justice is reportedly investigating Markit
Group for anti-trust violations. This investigation (which is
reportedly focused on how Markit Group packages and sells its
information) seems to acknowledge that Market Group has
near-monopolistic control of information about credit default swap
prices. However, if the press reports are correct, the DOJ has not
considered the possible appeal of this monopolistic control to
market manipulators.
Meanwhile, Henry Hu, the director of the Securities and Exchange
Commission’s division of risk, has said that it has been
nearly impossible for the SEC to conduct investigations into any
matter concerning credit default swaps because the commission does
not have access to any data on the trading of CDSs. In itself, this
is a shocking admission. It is all the more shocking when one
considers that the necessary data exists and might be in the hands
of the Markit Group – a black box company based in
London.
A thorough investigation of Markit Group is urgently
required.
Here is what we know so far:
- Markit Group was co-founded by Rony Grushka, Lance Uggla, and
Kevin Gould. Prior to founding Markit Group, Mr. Grushka’s
main line of business was investing in Bulgarian property
developments. He recently resigned from the board of Orchid
Developments Group, an Israeli-invested company based in Sophia,
Bulgaria. Messrs. Uggla and Gould formerly worked for
Toronto-Dominion Bank in Canada.
- Markit Group’s founders also include four hedge funds.
However, Markit Group refuses to disclose the names of those hedge
funds. In response to an inquiry, a Markit Group spokesman said it
was “corporate policy” to keep the names of the hedge
funds secret, but he would not say why Markit Group had such a
policy. It seems worth knowing whether those hedge funds have any
influence over Markit Group’s published information or
indexes, and whether those hedge funds are trading on that
information. It would also be worth knowing whether those hedge
funds or affiliated hedge funds have engaged in short selling of
public companies whose debt and stock prices were profoundly
affected by the information that Markit Group published.
- Goldman Sachs, JP Morgan and several other investment banks
also have ownership stakes in Markit Group. The investment banks
received their stakes in exchange for providing trading data to
Markit Group. It would be worth knowing whether these investment
banks engaged in short selling ahead of Markit Group’s
published indexes and price quotations.
- Markit Group is secretive about how it creates its indexes. In
early 2008, the Wall Street Journal noted that the CMBX simply
“doesn’t make sense” and that Markit
Group’s indexes “might be exaggerating the amount of
distress” in the home and commercial mortgage markets. In
2008, the average prediction for defaults on commercial mortgages
was 2%. The CMBX implied that the default rate could be four times
that level.
- When short seller David Einhorn initiated his famous public
attack on Lehman Brothers, one of his central arguments was that
the CMBX (the index that was likely “exaggerating the amount
of distress”) proved that Lehman had overvalued the
commercial mortgages on its books.
- In March 2008, the Commercial Mortgage Securities Association
sent a letter to Markit Group asking it disclose basic information
about how the CMBX index is created and its daily trading volume.
“The volatility in the CMBX index, caused by short sellers,
distorts the true picture of the value of
commercial-mortgage-backed securities,” the group said in a
statement.
- Markit Group is equally secretive about how it derives its
“prices” for credit default swaps. A spokesman for the
company spent close to one hour talking to Deep Capture. He
did his job well and sounded like he was trying to be helpful. But
he told us as little as possible.
- However, in the course of this conversation, we did learn that
Markit Group’s “prices” are not actual, traded
prices. They are mere quotations. The Markit Group has what it
calls “contributors” – hedge funds and
broker-dealers that provide it with information. Markit Group has a
grand total of 22 “contributors.” Deep Capture
asked Markit Group’s spokesman for the names of these
“contributors.” The spokesman said he would try to find
out the names and call back later. He never called back.
- The 22 “contributors” provide Markit Group with
quotations, and these quotations become the Markit Group’s
“price.” In other words, the “contributors”
can quote any price for a CDS that they choose, regardless of
whether anyone is actually willing to buy the CDS at that price.
Markit Group looks at these quotations. Then it somehow decides
which quotations make the most sense. Then it publishes information
that purports to represent the actual market price of that CDS.
This process is certainly unscientific. And it is ripe for
abuse.
- Consider, for example, the Markit Group “price” for
CDSs insuring the debt of company X. The Markit Group price
strongly suggests that company X is going to default on its debt in
the immediate future. Short sellers eagerly point to the Markit
Group CDS “price” as evidence that company X is doomed.
Panic ensues, and suddenly, company X really is doomed. But the
fact is, nobody ever bought a company X CDS at the price quoted by
Markit Group. Rather, that panic-inducing “price” was,
in effect, pulled out of a hat. Who pulled it out of a hat? That is
matter of immense importance. There are two possible
scenarios:
- The first possible scenario is that the 22
“contributors” report their quotations in good faith.
They should be sending the actual traded price, not just a
quotation, but assume they are just doing what was asked of them.
From these quotations, Markit Group somehow decides what the
“price” should be. It is possible that this decision is
based on some secret formula (which would be worrisome); or it is
possible that Markit Group executives sit around a table debating
what the price should be and take a shot in the dark (which would
be even more worrisome); or it is possible that Markit Group
deliberately chooses the most horrifying price possible in order to
assist the short sellers who are affiliated with its owners (which
would be a matter for the authorities).
- The second possible scenario is that Markit Group acts in good
faith (if not scientifically), but one or more of the 22
“contributors” or their affiliates has an interest in
seeing company X fail. If just one of those
“contributors” sends in an astronomically high
quotation, that could be enough. Markit Group factors the absurd
quotation into its posted “price” and it suddenly
becomes possible to convince the world that company X is about to
default on its debt. Panic ensues, the firm’s layer of
debt dries up, the stock price plunges, and perhaps the
“contributor” or its affiliate make a lot of
money.
- As Deep Capture understands it, CDS quotations suggested
by the 22 “contributors” also help determine the
movement of the CMBX and ABX indexes. The movement of these indexes
did serious damage to the American economy in multiple ways.
The indexes prompted write downs at most of the major banks
and mortgage companies. They were ammunition for short sellers,
like David Einhorn, who claimed that companies had cooked their
books by not writing down to the rock bottom prices suggested by
the Markit Group indexes. They helped precipitate the decline in
prices of mortgage securities, and contributed mightily to the
panic that spread across the markets. A lot of people made a
lot of money as result of those indexes moving downward. So, it is
rather important to know more about how those indexes are
formulated, and if they can be driven by the same people who are
making directional bets on their movements.
Conclusion: Ten years ago, there was no such
thing as a credit default swap. Six years ago, a very small number
of investors traded credit default swaps as hedges against the
long-shot possibility of corporate defaults. Nobody looked to
credit default swaps as reliable indicators of corporate
well-being.
Then, suddenly, there were over $60 trillion in credit default
swaps outstanding. That is, over the course of a few years,
somebody had made over $60 trillion (many times the gross domestic
product) in long shot bets that borrowers would default on their
debt. As this derivative risk marbled through the system, the
trading in credit default swaps was completely opaque. Nobody knew
who bought them, who sold them, or at what price.
But starting in 2001, we knew the “prices” of CDSs.
We knew the “prices” because two Canadians, a developer
of Bulgarian real estate, and four mysterious hedge funds had
founded a small, black-box company in London. That company, the
Markit Group, achieved near-monopolistic power to publicize the
“prices” through its magic process of aggregating
quotation information provided by 22 hedge funds and broker-dealers
who could well have been betting on the downstream effects of
sudden price changes.
These “prices” were not prices in any meaningful
sense of the term. But, suddenly, these “prices”
became perhaps the single most important indicator of corporate
well-being. Assuming that those four hedge funds and the 22
“contributors” (or hedge funds affiliated with them)
bet against public companies, it seems more than possible that
short-sellers got to run the craps table, call the dice, and place
bets, all at the same time.
So perhaps it is not surprising that a lot of long-shot rolls
paid off quite nicely.
Mark Mitchell is a
reporter for DeepCapture.com. He
previously worked as an editorial page writer for The Wall Street
Journal in Europe, a business correspondent for Time magazine
in Asia, and as an assistant managing editor responsible for the
Columbia Journalism Review’s online critique of business
journalism. He holds an MBA from the Kellogg Graduate School of
Management at Northwestern University. Email:
mitch0033@gmail.com