Rorech/Negrin victory, Part I

The Securities and Exchange Commission's case against Jon-Paul Rorech of Deutsche Bank and Renato Negrin of the Millennium hedge fund -- a case that the Manhattan federal court derailed Friday -- attracted a good deal of attention when it was first filed, in May 2009.

Here is the Reuters coverage from that time, for example.

The man-bites-dog reason for the interest is that this was the first insider trading case involving what had only then become a headline-worthy sort of instrument in the mainstream media, credit default swaps (CDS). In this case, the CDSs' were bets for or against the solvency of a Dutch media company, VNU, which was a client of Deutsche Bank.

The case was a test of a new theory of jurisdiction for the SEC based upon the Commodity Futures Modernization Act of 2000, which extended the SEC's enforcement authority to "securities-based swap agreement[s]."

Here's an analysis that Law360 did in August.

Those of you who have a PACER subscription can read Judge Koeltl's decision dismissing the case Friday. Be assured, there is no charge for viewing opinions. But be warned, this one is 122 pages long.

The Wall Street Journal this morning has headlned it on p. C1 (the prime real estate for real finance wonks -- let the 'casual reader' look to A1!): "SEC Loss Shows Difficulty of Insider Cases," with the byline to Kara Scannell.

Frankly, I think that headline itself exhibits exactly the wrong emphasis. (Scannell of course can't be blamed for the headline.) We shouldn't worry about the costs imposed upon the poor SEC as it brings tricky enforcement actions pushing the boundaries of its jurisdiction. They'll be all right, the world is full of porn whereby they can console themselves. We should be concerned, rather, by the individuals whose lives are disrupted by the very act of bringing such a case. Courtroom vindication a year later doesn't give you that year of your life back.

The court conducted a non-jury trial of the case from April 7 to April 28 of this year. It has now issued its findings of fact and of law.

The only good news from the pro-enforcement point of view (never my own) is that the court agreed with the SEC about what Congress had meant to do with that CFMA language I quoted above. Koeltl writes, "[The] CDSs at issue in this case are security-based swap agreements for the purposes of section 206B of the Gramm-Leach-Bliley Act and are subject to 10(b)'s antifraud provisions...."

The bad news for enforcers? He didn't buy anything else they tried to sell him.

I hope to come back to this tomorrow.

The blunderer who is Ben

Curiouser and curiouser. In Sunday's New York Times, 'economics' columnist Ben Stein comes out against speculative portion of the CDS market.

This kind of stance is one of those bonehead simplifications of a complicated subject that appeal to people who want to think they are sophisticated without having to do a lot of wonkish reading. You know. People like ... Ben Stein.

Here's a link to his column for those of you with a subscription to the NYT.

And here is the bit that has provoked my ire:

ADD A RULE Don’t allow speculators with no insurable interest to buy credit-default swaps on bonds.

When used properly, these instruments can function as a legitimate kind of insurance. Yes, if you are a real buyer of the bonds of a given company, you should be able to buy insurance. But you shouldn’t if you are just a shark circling prey, bringing blood into the water.

Allowing speculators to buy C.D.S.’s merely to bet against a firm in difficulty just blasts the prices of bonds, kills the balance sheets of banks, insurers and hedge funds, and throws fear into the system.

First, it is absurd to try to draw a sharp distinction between the "legitimate insurance" use of a CDS and the illegitimate speculative use. Those speculators provide precious liquidity for the market. If you have GM bonds in your portfolio, and you want to buy default protection, you'll be glad that there are counterparties in the market willing to sell protection to you. And part of the reason there will be such counterparties in the market is that there are speculators to whom they can sell. The speculators, in other words, increase the size of the overall pool, making life easier for the hedgers who need to wade into it.

Second, on any CDS contract, whether hedging or speculative, there is a winner as well as a loser. If a hedge fund makes a speculative bet that GM will fail, it is because and to the extent that somnebody else -- typically, a bank or insurance company -- has made a speculative bet that it will survive for the life of the contract. Stein doesn't even explain: which side of that bet is the public policy problem? Which side is the "shark," which side is the "prey"? If the protection is sold too cheaply, the bank has taken a foolish position. But on that same presumption, the hedge fund has made a wise decision. The outcome isn't going to "killl the balance sheet" of them both.

Third, in more general terms, why shouldn't we expect that a liquid market in CDS will cause prices, i.e. spreads, to move to an equilibrium that won't represent a foolish decision on either side?

There are some necessary changes in the CDS marketplace. Central clearing and settlement would be a good idea, and some standardization of product is probably necessary to make that happen. Such developments are underway. But Stein blunders right through all of that, cognizant of none of the real issues because he just wants somebody -- the SEC? the CFTC/ Treasury? Congress? it doesn't really matter -- he just wants somebody to "add a rule".