Arcane Market Is Next to Face Big Credit Test (credit default swaps)

New York Times ^ | Feb 17, 2008 | Gretchen Morgenson

[Travis McGee]

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term. Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts. The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market. No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.

[Travis McGee]

Read pages 1, 2 and 3 at the link.

http://www.nytimes.com/2008/02/17/business/17swap.html?_r=3&ex=1360904400&en&oref=slogin

[Travis McGee]

As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.

“This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.”

Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.

In late 2005, at the urging of the Federal Reserve Bank of New York, market participants agreed to advise their trading partners in a swap when they assigned contracts to others. But it is unclear how closely participants adhere to this practice.

It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim.

[SandRat]

Read pages 1, 2 and 3 at the link.

http://www.nytimes.com/2008/02/17/business/17swap.html?_r=3&ex=1360904400&en&oref=slogin

[2banana]

For example, when Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company’s debt exceeded the value of underlying bonds tenfold. Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt.

Market participants worked out an auction system where settlements of Delphi contracts could be made even if the bonds could not be physically delivered. This arrangement was done at just over 36 cents on the dollar; so buyers of protection on Delphi who did not have the bonds received $366.25 for every $1,000 in coverage they had bought. Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond.

I am still not quite tracking all of this...

[Travis McGee]

Mish Shedlock dissects the meaning of this quite arcane NYT article over here today:Shadows of the CDS Market

[jiggyboy]

Well if that’s the next test, then last week AIG was one of the flunkers:

http://www.freerepublic.com/focus/f-news/1968991/posts

[jiggyboy]

permalink to Mish’s article: http://globaleconomicanalysis.blogspot.com/2008/02/shadows-of-cds-market.html

[nicmarlo]

Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.

I believe that Paul Kanjorski, Chairman of the Senate Committee, addressed this very problem (and used the word "greed") during the hearing the other day (it's during the last hour of the tape).

[2banana]

Banks and brokerages are unwilling to commit capital and who can blame them?

No one knows what anything is really worth because there is no market at all for some of these securities.

Banks and brokerage houses are afraid of a downgrade of Ambac and MBIA because it might require as much as $200 Billion more in capital to be raised.

Mark to fantasy models have too much stuff on the books at unrealistic prices.

No one trusts the ratings put out by Moody's, Fitch, and the S&P.

Fears of counterparty failures are in everyone's minds. Credit default swaps are going to blow sky high. If 10% of credit default swaps blow up, it would wipe out $4.5 trillion in capital. A mere 1% hit would wipe out $450 billion. We don't know when, but we do know the fuse is lit.

Helps some...now I need a bunker to crawl into...

[jwalsh07]

The insurance shoe is gonna drop sooner or later. And when it does the DOW will contract another couple or three thousand points. JMHO of course.

[Freedom_Is_Not_Free]

Fascinating but scary read. Leverage is causing catastrophic losses. Where will this end? It is not looking pretty. It is looking downright scary to me. I can’t imagine a full-fledged, wide spread banking collapse but the cows are coming home and it looks like a bunch of companies are going to find it easier to just throw up their hands and say “I quit” than to try to survive all of the massive losses.

It is like seeing capital being vaporized by the billion before your eyes. Just going up in smoke.

[TomasUSMC]

The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion

---

oK SOOOO divided by 300 million that come out to 150 thousand per american.????

I’am sure obama can CHANGE D A T.

[sheana]

http://investorsinsight.com/thoughts_va.aspx?EditionID=640

John Mauldin does a great job of explaining monolines, cdo’s, and cds’s.

[Moonman62]

I think it means that people collected insurance on Delphi bonds who never actually owned them.

Suppose a house burned down and ten different "owners" show up to collect the insurance settlement (each claiming 100% ownership).

[Neidermeyer]

But 16 percent were created to protect holders of collateralized debt obligations, complex pools of bonds that have recently experienced problems because of mortgage holdings.

There is no exchange where these insurance contracts trade, and their prices are not reported to the public. Because of this, institutions typically value them based on computer models rather than prices set by the market.

Neither are the participants overseen by regulators verifying that the parties to the transactions can meet their obligations.

The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks’ books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.

[Southack]

Credit Default Swaps are a zero sum game. They can’t tank an economy, much to the NY Times’ chagrin, because when one guy loses a Million Dollars on a swap, the other guy makes it.

The entire market cancels itself out when viewed in national economic terms. It’s entirely different from the housing market, where homes going down fail to make someone else that much richer.

[Southack]

#16

[CodeToad]

Holy crap! This scheme is just begging, “Take my money!”

Sad that our nation’s corporations run on credit and not profits such that this market segment even exists.

[jas3]

I think it means that people collected insurance on Delphi bonds who never actually owned them.

Suppose a house burned down and ten different "owners" show up to collect the insurance settlement (each claiming 100% ownership).

That's a poor analogy because there would be 10 different insurance companies all of whom would have known up front that the "insureds" probably didn't own the house.

jas3

[Toddsterpatriot]

Credit Default Swaps are a zero sum game.

Don't try logic. The notional values are huge, therefore we are doomed!

[jas3]

Credit Default Swaps are a zero sum game. They can’t tank an economy, much to the NY Times’ chagrin, because when one guy loses a Million Dollars on a swap, the other guy makes it.

The entire market cancels itself out when viewed in national economic terms. It’s entirely different from the housing market, where homes going down fail to make someone else that much richer.

Your assertion that Credit Default Swaps are zero sum would only be correct if, in fact, all counterparties were solvent in the event of a series of credit defaults. However, what we will most likely see is that hundreds of counterparties wrote hundreds of billions if not trillions of notional value of CDSes with entirely inadequate capital.

So if/when we start to see significant defaults, the debt that banks and financial institutions carried on their books at par by virtue of their CDSes will have to be written down to market. That could be a very very financially painful process, and it certainly could tank an economy if the collateral effect of various large CDS writers going under was to effectively render BoA, Merrill, Citi, and a few other large banks insolvent.

CDSes have been a shadown means of engineering massive leverage in the US economy. If we have a series of large defaults, the market will not cancel itself out. The buyer of the CDS will find that he was never insured in the first place, and the seller will lose what little capital he posted.

It is actually quite similar to the housing market where the value of falling homes don't enrich anyone else. In fact the problem in both markets was created by too much leverage. In the same way that mortgage originators and applicants lied in stated income loan documents and borrowed up to 100% (and more) of their homes' values, which created a bubble....Credit Default Swaps require surprisingly little collateral to write. Because collateral requirements are so low in a standard ISDA agreement, one can put up $10 and write a guarantee on $100 of debt.

Even worse, the insured can now pair his debt and swap together at a brokerage and lever that up tremendously as well.

There is far more leverage at work in US financial markets that is widely assumed, and the consequences of that are very disconcerting.

jas3

[Southack]

Nope.

If a counterparty can’t pay, then the original party simply didn’t make a profit.

That’s a far cry from someone taking money out of your bank account, physically.

[jas3]

Holy crap! This scheme is just begging, “Take my money!”

Sad that our nation’s corporations run on credit and not profits such that this market segment even exists.

Well....debt is not a bad thing when it is used responsively. I'm even a big fan of high yield debt (aka Junk Bonds). And in ranking Governments, Consumers, and Corporations as to their ability to repay their net debt, I'm worried least about Corporations.

CDSes were a great invention and they could in theory be used to reduce net risk in our economy. Unfortunately, because swap agreements are generally written with so litle collateral required of counterparties, and accounting rules are written to assume that swap counterparties are solvent, there is a huge arbitrage that has ensured the growth of the CDS market. I fear that it will not end well as a chain reaction of defaulting counterparties puts our largest financial institutions into insolvency.

jas3

[jas3]

Please see post #21.

jas3

[Toddsterpatriot]

So if/when we start to see significant defaults, the debt that banks and financial institutions carried on their books at par by virtue of their CDSes will have to be written down to market.

For sure. The loser will have losses, the defaulter will have gains. Still zero sum. The losses may cause panics and loss of liquidity, but the swaps themselves are zero sum.

[Southack]

"I fear that it will not end well as a chain reaction of defaulting counterparties puts our largest financial institutions into insolvency."

That's silly. That's like fearing that insurance companies failing to pay auto claims would cause every car owner to become insolvent.

First, only the car owners who actually had wrecks would be impacted, and Second, they'd only be insolvent if they went out to buy a new car beyond their means once they learned of the non-payment by the failed insurance party.

Same with credit default swaps. Only the holders of cds's who likewise held losing bond investments would even notice defaults...and the problem there would be that their primary bond investments lost money in the first place.

Pretending that there was some great CDS failure to pay would simply mean that the money-losers found out that they were uninsured all along. Hardly the end of the financial world.

The actual bonds would still be worth *something*, and the money to buy those bonds was paid out long ago...so unless the institution holding the bonds was already insolvent, their cash flow position would remain solvent (read: unchanged)...and they could in fact sell the money-losing bonds for *something* in order to actually **improve** their current cash flow (the opposite of insolvency).

[jas3]

Nope.

If a counterparty can’t pay, then the original party simply didn’t make a profit.

That’s a far cry from someone taking money out of your bank account, physically.

Unfortunately it is not that simple. A CDS allows a debt holder to lever against his debt instrument. Let's use as an example, Bank of America (BoA). Let's say that BoA has $100 in capital in 2004 and decided to buy a GM bond for $98 and a credit default swap for $2.

In 2006 and 2007 GM's credit deteriorates and the market value of the GM bond goes to $65. However GM has not yet defaulted and continues to pay interest timely of (let's say) 5% per annum.

BoA has a recorded a 5% gain each year on its GM holding in 2005, 2006, and 2007.

By virtue of the swap, the loss in value of $33 of the GM debt is not recorded on BoA's books.

The 2005, 2006, and 2007 gains have already been recorded. You write that BoA simply didn't make a profit....but the profits have already been recorded for three years running.

Now here we are in 2008. Let's say GM does default, the value of their debt goes to $10, and the counterpary disappears.

BoA's original capital was $100, it made say $20 in interest, and also made money on it's commercial loans. However, now it must write down the value of the swap to zero and the value of the GM debt to $10.

For you to suggest that the original party didn't make a profit misses the point. Those profits have been recorded already for several years. The danger of the CDS market locking up and of massive defaults in US debt markets is EXACTLY that the original parties will have to recognize that the profits the ALREADY recorded were fictional. For you to pretend that the consequences of that are not dire is folly.

And if you happen to hold common stock in BoA or have more than the FDIC guaranteed $100K in a BoA account, then the consequences are identical to someone taking money out of your bank account physically.

jas3

p.s. In this example, we didn't even discuss the knock on effects of BoA having to pull in its lending to reflect that it's capital base has just shrunk by more than 50%. And that's the single biggest problem in a credit crunch...the capacity of lenders contracts incredibly...and THAT can bring whole economies to their knees.

[jas3]

For sure. The loser will have losses, the defaulter will have gains. Still zero sum. The losses may cause panics and loss of liquidity, but the swaps themselves are zero sum.

Swaps are NOT zero sum. They are SUPPOSED to be zero sum, but the whole point of the NYT article is that they will not be zero sum in any stress environment.

Example: You give me $2 to insure your $100 GM bond. I give you a piece of paper that says "GM CDS Swap" on it. GM defaults. I also default because I wrote $100 million GM CDS pieces of paper with only $2 million of capital.

You get back maybe $1 if you are lucky. Your bond goes to 10% of face so you have lost $90 there for a total loss of $91.

Insurance is only zero sum if the insurer can pay out the claim.

jas3

[Southack]

"but the swaps themselves are zero sum."

Yup. That's why the NY Times can scream that there are "$45 Trillion in credit default swaps oustanding!"

Because there are $22.5 Trillion worth of wagers that interest rates will go up, and $22.5 Trillion worth of wagers that interest rates will go down...for one way to look at it (or $45 Trillion in wagers, with half betting rates go up, the other half betting rates go down).

Zero sum.

If rates stay the same, then no money is exchanged (other than nominal fees). If rates go up enough to cause one Credit swap to go up $1 Million, then the other guy has to pay a Million Dollars. One makes a million, the other loses it.

Net impact to the national economy: $0. Sure, a million Dollars changed hands, but it all stayed inside our national economy.

Zero sum.

One guy defaults...then he saves a million and the other guy doesn't get to make a million.

Net impact to the national economy: $0.

Zero sum.

Tough to bankrupt the whole national economy that way!

[jas3]

Pretending that there was some great CDS failure to pay would simply mean that the money-losers found out that they were uninsured all along. Hardly the end of the financial world.

I take it you are not very familiar with financial accounting. There is not a single top 5 US commercial bank or brokerage that would be solvent under Tier 1 capital rules if they had to recognize today that their swaps were valueless, which you for some reason think is no big deal. That's the whole problem with the monolines going bust too.

The entire net capital of US commercial and investment banks is at risk.

jas3

[Toddsterpatriot]

Swaps are NOT zero sum.

Say we bet $100 on the Cub's season opener. Is that zero sum?

but the whole point of the NYT article is that they will not be zero sum

The NYT is wrong.

Your bond goes to 10% of face so you have lost $90 there for a total loss of $91.

I lost $90 because my bond lost $90. You gained $90 because you didn't pay me the $90 you owe.

[Southack]

Nope. It’s still zero sum.

One guy defaults means that no money changes hands. That’s zero sum.

Or...one guy wins a million and the other guy pays a million. That’s likewise zero sum because the national economy still has that million Dollars...it simply changed bank accounts.

Credit Default Swaps add no value; they take away no value. They are zero sum.

[Toddsterpatriot]

Like I said, don’t bother with logic. Panic!!!!

[jas3]

You gained $90 because you didn't pay me the $90 you owe.

Hahahahah...that's rich. So where can I spend this $90 that I didn't pay you, since I'm now bankrupt too?

jas3

[Southack]

Nope. All that is at risk is the premium to purchase new insurance.

The old insurer defaulted. Big deal. You just pay a new premium for new insurance. Problem solved.

[jas3]

Credit Default Swaps add no value; they take away no value. They are zero sum.

They are only zero sum if you can collect on them.

jas3

[Southack]

A Credit Default Swap is just like a bet on a baseball game.

You bet the the Cubs will win. I bet that they will lose.

If you win and I pay, then the bet was zero sum because the national economy has the same amount of money in it.

Ditto if I default on the bet.

Same again if I win and you pay or don’t pay.

It’s all zero sum.

[jas3]

The old insurer defaulted. Big deal. You just pay a new premium for new insurance. Problem solved.

But you've lost 50% of your net worth in the default of the old insurer. That is a very big deal if you happen to be an investor in the company that for years has been reporting earnings based upon the presumed solvency of their CDS counterparties. And it is also a very big deal if you are a lender by trade, such as a commercial bank or an investment bank, which now has to call in 50% of your outstanding loans in order to meet Basel solvency requirements.

I don't think you understand the consequences of a counterparty failure.

jas3

[Southack]

"They are only zero sum if you can collect on them."

Nope. They are zero sum regardless of outcome. Your ability to pay merely impacts where money moves or not, but the fact that the same amount of money remains in the national economy means that the deal was and is zero sum.

[Toddsterpatriot]

Hahahahah...that's rich.

And true.

So where can I spend this $90 that I didn't pay you, since I'm now bankrupt too?

You have a gain of $90. I didn't say you had $90.

If your bank allows you to write off some of your debt, you have to declare that as income.

[Southack]

"But you've lost 50% of your net worth in the default of the old insurer."

Nope. I simply have to pay a new insurer a new premium. At that point it's like I've always had insurance.

So all that is at stake is the premium for new insurance.

[jas3]

If you win and I pay, then the bet was zero sum because the national economy has the same amount of money in it..

What if my not paying you the bet shrinks your capital base by requiring you (a large money center bank) to recognize losses and to call in 50% of your loans outstanding to prevent seizure by the banking regulators. Would you still classify the bet as zero sum? Would you still think that the national economy has the same "amount of money in it"?

I don't think you understand how credit is created and what the effects of recognized losses are to banks.

jas3

[jas3]

"But you've lost 50% of your net worth in the default of the old insurer."

Nope. I simply have to pay a new insurer a new premium. At that point it's like I've always had insurance.

So all that is at stake is the premium for new insurance.

I think you forget that the insurance was put in place to protect the value of your asset, which was a GM bond. That bond has now defaulted, which is why you lost 50% of your net worth.

Your insurance already proved to be worthless, which is why you've lost your net worth.

Who is going to write you a credit default swap on a bond that is already in default?

jas3

[jas3]

If your bank allows you to write off some of your debt, you have to declare that as income.

You are hillarious. Under what scenario do you think that a defaulting counterparty will have any income at all to declare to a tax authority? Counterparties default because they cease to exist.

jas3

[Toddsterpatriot]

You are hillarious.

And correct.

Under what scenario do you think that a defaulting counterparty will have any income at all to declare to a tax authority?

Doesn't matter.

Counterparties default because they cease to exist.

So what?

If B of A writes off $100,000 on your defaulted mortgage, they claim a $100,000 loss. You claim a $100,000 gain. Zero sum. Just like swaps.

[jas3]

Wrong....if ABC Hedge Fund goes out of business, they don’t claim a gain...and they don’t actually gain anything.

The swap counterparty never had the protection, so they bear the full brunt of the loss.

In the example, BoA would have a HUGE hit to their capital, which would have a severe impact on US credit markets.

Swap counterparty failure is NOT zero sum. Swap counterparties delivering IS zero sum.

jas3

[Southack]

"Who is going to write you a credit default swap on a bond that is already in default?"

You are confusing financial instruments.

A bond insurer guarantees that monthly/annual/term interest payments are made.

If I want my bond to have a high rating, then I pay for that bond insurance. If that bond insurer won't/can't pay, then I have to pay, or I have to sell the bond at a loss, or I have to find a new insurer and pay a new premium.

However, the above (finding a new insurer) is *only* going to be problematic (read: pricey) for a bond in default.

For all of my performing bonds, getting a new insurer is a snap.

And since all of my bonds aren't in default, the problem is trivialized down to simply paying a new insurance premium.

The other financial instrument is a credit default swap. This is a zero sum financial instrument that lets me bet on the direction of interest rates. For instance, I might have a large adjustable rate loan, so I would bet that interest rates go up. If they do go up, then I make money on my CDO bet (which will offset the rise in my adjustable rate interest).

Or I could just place a bet that interest rates will go up. Doesn't matter. If they go up, then someone owes me money. If they go down, then I owe someone else money proportional to the change in interest rates.

Zero sum. But quite different from bond insurance that merely guarantees interest payments.

[RinaseaofDs]

CDS’s are basically giant side bets, correct? One guy thinks they’ll default, the other guy doesn’t. They wait. The company tanks, one guy pays the holder of the Swap.

[jas3]

You are confusing financial instruments.

No, I am not. You don't understand the difference between an interest rate swap and a credit default swap. CDSes are very similar to the guarantees that monolines like ABK and MBI provide. Also, your last sentence is wrong. Monlines guarantee the timely payment of both interest and principal.

You are wrong that credit default insurance is zero sum - WHEN ONE PARTY DOES NOT ACTUALLY PAY.

jas3

[Southack]

"I think you forget that the insurance was put in place to protect the value of your asset, which was a GM bond. That bond has now defaulted, which is why you lost 50% of your net worth."

Nope.

If the insurer defaults anywhere in the world on any insurance, then you are simply going to drop their insurance coverage and purchase new insurance for all of your bonds.

And if a bond defaults, then the insurance kicks in to make the interest payments.

But to lose 50% of your net worth, you'd have to have your insurer fail, you'd then have to fail to get new insurance, and then while you were uninsured most of your bonds would have to default.

So it's not a single point of failure. Just a bond insurer going belly up is not a problem (beyond irking you that you have to dig money out of your own pocket to purchase new insurance).

Likewise, a bond in default is not a problem by itself so long as you have viable insurance.

Both the bond and the insurance would have to fail to present a financial problem to you (of any magnitude of note). And here's the kicker: you can control when a bond fails by making the premium payments from your own pocket for a period of time.

So there is plenty of time to reinsure.

Which means: all that is at *risk* is you having to make a new bond insurance premium payment). You'd certainly choose to do that rather than write down your bond holdings by 50%!