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The New Face of Equity Derivatives
Minyanville ^ | 9/25/2008 | Darol Ryan

Posted on 09/25/2008 12:03:02 PM PDT by politicket

Excerpt...

1. Counter-party risk has risen dramatically and is the most significant. ISDAs have to be renegotiated (especially in light of the market disruptions like short-selling). Credit lines have to be reviewed with almost every client. Risk officers are preventing larger trades from being completed and demanding higher collateral levels from clients. Most important are the huge risks of counter-parties blowing up and not being able to pay their obligations.

...

(Excerpt) Read more at minyanville.com ...


TOPICS: Business/Economy; Front Page News; Government
KEYWORDS: bailout; cds; derivatives; economy; financialcrisis
Derivatives...derivatives...derivatives.

That is where the focus should be - and it's not.

1 posted on 09/25/2008 12:03:03 PM PDT by politicket
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To: politicket
True, and there's no solution on the table to that problem. When there is one, I will welcome the discussion.

"OMGWTF!! We gotta buy up all the s--t loans, right away" is - shall we say - failing to address the issue?

2 posted on 09/25/2008 12:11:19 PM PDT by Notary Sojac (I'll back the bailout if Angelo Mozilo lets me borrow his Lamborghini on Saturday nights.)
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To: Notary Sojac
"OMGWTF!! We gotta buy up all the s--t loans, right away" is - shall we say - failing to address the issue?

I've been working hard for days to get folks to understand this. At lot of people get a glazed look in their eyes when you mention derivatives because of the complicated nature of them.

This bailout plan - no matter what the size - is not going to free up liquidity in the market. The market institutions are not stupid and they don't trust anyone else's balance sheet. Therefore, they will continue to "hoard" their money.

It's a good thing that the commercial banks did this last week. Normally, commercial banks keep a total of around $2 billion on reserve each day to meet the nation's banking withdrawal's. Last Wednesday, there were $114.5 billion of withdrawals that took place.

The Dow is going to go hog-wild for a few days to a week. Then it will turn down. I'm forecasting (my opinion) that it will hit 8,600 and possibly get to 7,000.

3 posted on 09/25/2008 12:22:08 PM PDT by politicket (Palin-tology: (n) - The science of kicking Barack Obambi's butt!)
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To: politicket
Great minds think alike!! I've already planned to leave what is left of my stock-based 401K money there until about three days after the bailout is signed.

And you know what? If you take the DJ from where it was in about 1995, and project a historical growth rate forward from then till now (ignoring the increases of the funny-money asset bubble era) you get to right about -

8,000.

4 posted on 09/25/2008 12:49:16 PM PDT by Notary Sojac (I'll back the bailout if Angelo Mozilo lets me borrow his Lamborghini on Saturday nights.)
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To: Notary Sojac

Don’t forget about undershoot


5 posted on 09/25/2008 3:09:32 PM PDT by palmer (Some third party malcontents don't like Palin because she is a true conservative)
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To: politicket
That is where the focus should be - and it's not.

Right now a lot of businesses have a lot of assets on their books that are backed in some measure by funny money (e.g. CDSs). Without any way of knowing what those assets are worth, there's no way of knowing what businesses are solvent. It's no wonder that nobody wants to lend money in such an environment.

The only way I can see to restore liquidity is to have the CDS market come down to realistic valuations. Some CDS assets will be worth face value. Some will be worth $0.10 on the dollar. Some will be worth $1 per $million. The only way to get a realistic valuation in such a marketplace is to liquidate it.

Actually, the matter of whether the CDS market should come down isn't really a question. The CDS market is going to come down no matter what we do. The only questions are whether it comes down this month or a few years from now, and how much damage it will do in the process. Trying to bail out the mortgage mess without tackling the CDS issue first will simply allow more wealth to be swallowed up by the CDS money pit.

Bringing down the house of CarDS will cause a lot of businesses to become overtly insolvent. On the other hand, a market where some businesses find themselves overtly insolvent is better than one where nobody knows who's solvent and who isn't. Further, even those businesses that are revealed to be insolvent may be better shape after that revelation than before. Someone who has just filed bankruptcy won't be considered a good credit risk, but will be much less bad than someone who's on the verge of filing.

Politically, what needs to happen is for GWB to do a controlled demolition after November 5. If that were done, I think the markets would recover far better than they will from the infusion of capital.

6 posted on 09/25/2008 3:41:40 PM PDT by supercat
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To: supercat
Politically, what needs to happen is for GWB to do a controlled demolition after November 5. If that were done, I think the markets would recover far better than they will from the infusion of capital.

I don't see where we have until November 5th, based on market fundamentals and the illiquidity going on.

The G7 have been pumping hundreds of billions of dollars into the international market the last few weeks, trying to get some form of liquidity to take place. Nobody is budging. We are worse off right now than we were last Wednesday and Thursday. And I believed then that we would have a bank run on Friday.

The only thing holding all of this together right now is that the American public doesn't even understand what the problem is. They are focused on Republican -vs- Democrat, on overpaid executives of investment banks, and on bums owning homes. Once they realize what is truly going on then the game will be over. Period.

There has been a process in place all of this year to "bring down" the betting pool of the CDS market. They have basically been identying "wash" bets where nobody would be a winner and doing "tear-ups" on the contracts. This has succeeded in bringing the CDS betting pool down to about $54 trillion instead of $62 trillion.

We have run out of time. We need to pass immediate legislation banning CDS contracts on bond insurance. That is what Congress should be doing right now, instead of wasting their time figuring out whether to use a 5 gallon or 10 gallon bucket to bail out the Titanic. This won't fix our immediate crisis, but it will help our chidrens futures.

7 posted on 09/25/2008 4:43:38 PM PDT by politicket (Palin-tology: (n) - The science of kicking Barack Obambi's butt!)
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To: politicket
Since my previous post on this topic got wiped out (and many others), I'll bring this example up again.

There's a good article from Wharton here 2005 on Delphi that shows the magnitude of the leverage that derivatives put into the market. The problematic issue is that so many funds own some of these instruments - so the exposure to mainstreet (us) is significant.

When Delphi filed for bankruptcy October 8, investors had to start assessing their losses on more than $2 billion in the auto parts maker's bonds, which have recently traded at around 60% of their face value. As bad as that is, there is more. Looming over the market like an invisible and unpredictable giant is an estimated $25 billion in credit derivatives, a form of insurance whose value is directly linked to the ups and downs of Delphi debt.

So, a $2 billion loss triggers an obligation of $25 billion in credit derivatives - for a total impact of $27 billion!

In recent years, many credit default swaps have been assembled into baskets and traded as indexes, much the way stocks can be traded through S&P 500 index funds. This allows investors to use credit default swaps to bet on broad changes in credit markets -- betting that default rates will rise or fall, for example.Banks are both the biggest buyers of CDS protection and the biggest sellers, using them to reduce their risk exposure to companies to whom they have lent money, thus reducing the capital needed to satisfy regulatory requirements. Other big buyers are securities firms and hedge funds, while re-insurers, insurers and securities firms are the other large sellers.

In recent years credit default swaps have been bundled together to create collateralized debt obligations (CDOs). Typically, a CDO contains swaps from more than 100 companies. Once put together, the CDO is sliced into a several tranches, which are then sold separately. At one extreme is the high-risk, high-yield slice. Owners of these get a disproportionately large share of the income flowing into the CDO. But they also are first to suffer the losses from any companies that default. At the other extreme is a safe, low-yield tranche, with one or two other tranches occupying the middle.

Short Squeeze

Rosen estimated there are $25 billion in credit derivatives riding on $2 billion in Delphi bonds. Just as any catastrophe triggers insurance claims, Delphi's problems mean credit default swap sellers owe payments to the buyers who took out the insurance. Many contracts require the insured party to turn the underlying bonds over to the insurer when the payment is received, much as an insurance company may take possession of a wrecked car upon paying a claim.

Insured parties that don't have the bonds in their portfolios can buy them through the market to satisfy this obligation. But because of leveraging, there may not be enough bonds to go around. The escalating demand can cause a short squeeze, Rosen said, that would drive up the bonds' price and cause spiraling expenses for those desperate to get the bonds, possibly forcing them to sell other assets to come up with more cash.

Hedge-fund investors take their chances with their eyes open, and nobody else cares much if some of them get burned. But ripple effects do sometimes swamp the innocent, too. That was the big worry when Long-Term Capital Management's bets went sour.

According to Ramaswamy, it is unlikely that trouble related to a single company like Delphi will spill over to the broad markets, but he said it would be worrisome if a large number of companies ran into serious difficulties. And Rosen noted there is a lot of dry tinder on the forest floor -- a mushrooming issuance of low-rated, high-risk debt. "I will be shocked if we don't see a significant rise in default rates over the next 18 months," he said.

8 posted on 09/25/2008 5:10:18 PM PDT by uncommonsense
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To: politicket

I’ve bailed on my 401K mutual funds that were in the money and I was going to ride out the storm on those under water (thankfully not too bad). Some that I held were international and bond funds. Are you fleeing to cash? We can take this off line...


9 posted on 09/25/2008 5:17:11 PM PDT by uncommonsense
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To: uncommonsense
This post, my FRiend, earns you the Free Republic Post of the Month award.

It is my sincere wish that every citizen in our country could read your post and understand its implications fully.

It is so sad to drive by the restaurants this evening and see the parking lots full as people charge their way into oblivion - without having a clue what is about to hit them.

10 posted on 09/25/2008 5:19:03 PM PDT by politicket (Palin-tology: (n) - The science of kicking Barack Obambi's butt!)
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To: uncommonsense
Are you fleeing to cash?

I went completely to cash last December, 2007.

Since then, I have bought some silver as a hedge against the currency inflation.

11 posted on 09/25/2008 5:20:52 PM PDT by politicket (Palin-tology: (n) - The science of kicking Barack Obambi's butt!)
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To: uncommonsense
Are you fleeing to cash?

I went completely to cash last December, 2007.

Since then, I have bought some silver as a hedge against the currency inflation.

12 posted on 09/25/2008 5:21:19 PM PDT by politicket (Palin-tology: (n) - The science of kicking Barack Obambi's butt!)
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To: politicket
I don't see where we have until November 5th, based on market fundamentals and the illiquidity going on.

If a bailout of $10B would get us to November 6, that might be money well spent, though admittedly the ethical dilemmas posed by such an approach would be rather nasty. Probably better to do things earlier, but boy is it going to be touch politically.

The only solution I can see for McCain, and I don't know if he'd have the acting skills to pay it off, would be for McCain to mimic the reporter in Castle of Cagliostro and "discover" some monstrous level of malfeasance (that he already knew about to a significant extent, and tried to warn people of). Come out and tell people that their money has been stolen by crooks who were sheltered and enabled by every Democrat on the Senate and opposed by every Republican on the Senate.

Major bombshell. If McCain could pull it off, the Democrats would be toast, as they deserve to be. Even the welfare-class people who would be happy to see a middle-class person assaulted by a street thug would probably not be happy at the Democrats' allowing middle class people to be robbed by greedy bazillionaires.

Tough to pull off. But the essentially-straight-party-line vote on the 1995 bill might make it work.

13 posted on 09/25/2008 7:43:58 PM PDT by supercat
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