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The piece takes on particular bite given that we've just gone through a very similar episode with Citigroup Inc., right down to the bitching about shorts from Citi CEO Vikram Pandit. The Journal mentions Citi as a firm betting against Morgan Stanley in this episode. The derivative instrument in question, of course, is credit default swaps. The rough linkage goes like this. As fears mounted about Morgan Stanley's viability -- indeed the viability of any remaining "independent" investment bank, including Goldman, Sachs & Co. -- the price of credit default swaps on Morgan Stanley debt mounted higher and higher. The appearance of spiking CDS prices created uncertainty and anxiety, which drove down the stock. Falling share prices then looped back and drove CDS prices even higher. The dual nature of CDSs, as both insurance (or hedging) and as speculative vehicles, drove the prices up, making it all but impossible to separate speculative short selling from simple protection. But by any rational measure, the selling pressures exaggerated the threat to Morgan Stanley's viability. Even Mack admits after the fact -- and after a number of hedge fund clients yanked their assets out after his short-selling charges -- how difficult it is to separate fact from rumor. There is a larger question here, and one touched on by Gordon Crovitz in his column of the same edition of the WSJ. Crovitz does not appear to have read the WSJ reporting, because, focused as he is on the "good" uses of CDSs, he makes the CDS problem from a regulatory perspective seem so much simpler. It's not. It's emblematic of so much that has grown up in finance: instruments that can be used for both speculation and investment, producing real economic gains and gamblers' profits; indeed, instruments that flash good or bad depending on linkages and pathways that suddenly develop under very specific market conditions. Crovitz is right: Too much is made of the notional volumes of CDSs and too little is made of how CDSs have successfully settled, as in the Fannie Mae or Lehman defaults. But CDSs do not exist in isolation. The real challenge for regulation going forward is to gain an understanding of all the potential scenarios and then try to either maximize the good and minimize the bad, or simply limit the damage. That's very difficult, and talking transparency and accountability only takes us a short way down the road. The problem really is not the fact that a CDS is a derivative, it's that unlike traditional insurance, it reprices constantly. In that regard, the CDS market is to insurance what the loan market is to traditional corporate loans. If you believe that the market is all-knowing at all times, then you're biased toward the veracity of the prices the CDS market throws up. If you're skeptical of the market -- and we're entering an age of profound market skepticism -- then you can easily get nostalgic for the not-so-distant past when insurance and credit repriced in a lot more leisurely fashion. - Robert Teitelman See story from The Wall Street Journal Robert Teitelman is the editor in chief of The Deal. Categories Deal Video
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