Wall Street’s Latest Magic Trick: Imaginary Prices for Non-Existent Products

Remember the JPMorgan “London whale” trades in which $5 billion went up in smoke? The fiasco happened on a trade that involved placing bets on something known as a credit default swap index (CDX), produced by a company called Markit.

In a nutshell, a CDX reflects the cost of buying protection against credit risk on big companies. Banks and hedge funds like them because they get to speculate on the creditworthiness of American companies. Bond fund managers like them because they allow them to hedge risks in their portfolio.

But CDS trading has tanked because many folks really don’t want to do this kind of high-risk business in a crappy economy. In fact, trading is so meager that right now it’s hard to scrape together enough names to make up a 100-company index.

So what does Wall Street do? Poof! It’s pulling a market from thin air. Markit is adding companies to an index that no bank has written credit default swaps on.  

According to the Financial Times:

“Wall Street financial engineers have devised a new way to combat declining trading in the credit derivatives market – they are revamping an index to add financial instruments that do not exist.”

It seems that Markit, along with derivatives traders, is betting by adding CIT Group, Charter Communications and Calpine Corp to the index, banks will be forced to write credit default swaps on these three companies. In other words, Markit is trying to conjure a market to pump up CDX trading by acting like there is one.

This is extremely creepy. What does an index of prices mean when it reflects prices that are not real for financial instruments that do not exist?  The situation sounds uncomfortably reminiscent of LIBOR, the interest rate that banks charge each other for loans, which, it was lately discovered, has been rigged by Barclays and other banks.

We've already had a whale of tale with the JP Morgan disaster. But this one sounds even fishier.

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