Skip to comments.The $55 trillion question[Credit Default Swaps]
Posted on 09/30/2008 1:33:18 PM PDT by BGHater
The financial crisis has put a spotlight on the obscure world of credit default swaps - which trade in a vast, unregulated market that most people haven't heard of and even fewer understand. Will this be the next disaster?
If Hieronymus Bosch were alive today to paint a triptych called "The Garden of Mortgage Delights," we'd recognize most of the characters in the bacchanalia and its hellish aftermath. Looming largest, of course, would be the Luciferian figures of Greed and Excessive Debt. Scurrying throughout would be the Wall Street bankers who turned these burgeoning debts into exotic securities with tangled structures and soporific acronyms - CDO, MBS, ABS - that concealed the dangers within. Needless to say, we'd see the smooth-tongued emissaries of the credit-rating agencies assuring people that assets of lead could indeed be transformed into investments of gold. Finally, somewhere past the feckless Fannie Mae executives and the dozing politicians, one final figure would lurk in the shadows: a hulking and barely recognizable monster known as Credit Default Swaps.
(Excerpt) Read more at money.cnn.com ...
This is why the bailout really needed to be defeated: it did nothing to address the credit default swaps problem.
But perhaps nothing can, short of a depression.
Nobody whines about equity options.
My fingers are aching from the number of times that I've typed this same comment to folks.
Since the underlying nature of fractional reserve banking is leverage, it is extremely important that lenders carefully assess borrower credit risk.
Take away prudent lending policies, and everything built on top of the house of cards is a hair trigger away from financial meltdown.
Like what we are seeing right now.
But the times they don't.....watch out below!
You might try your idea with:
(and I haven't even touched on Europe...or Germany....or...)
Rather than cry ‘fire’, someone needs to explain this in terms people can understand. (That means a 2 minute byte)
If we were able to survive without CDS’ before 2000, why can’t we now? It’s not like going without a microwave or without a TV. Most of us don’t have CDS’s living in our backyard that we have to feed or anything.
If they were created out of nothing, I’m okay with them going back to where they came from.
Any time before three weeks ago.
ESPECIALLY, try and find a message delivered while he was at Goldman Sachs.
How many trucks would it take to carry a trillion dollars in currency?.. (in say, twentys, or even hundreds)
Hell would be frozen over before any appreciable portion of these lawsuits came to fruition resulting in any movement of funds.
Probably an unworkable idea but hey...it sure would be good for the market in the short term.
Remember the MIPS that brought down Enron? Goldman Sachs created it to fool the IRS. The were “Monthly Income Preferred Stock” but all they really were was a way to sell debt to a subsidiary in order to interchangeably turn debt to equity and vice versa, and claim special tax benefits on both sides based on the structure of the subsidiary.
Anyway - that took down Enron. Now we have these CDS. It’s just unbelievable that people can be allowed to “bet” against homeowners and mortgage baskets etc. It’s asking for trouble - sell loans to people with bad credit, then bet against them being able to pay the loan under the guise of selling “insurance”.
Who the hell thinks this crap up?
I think you'd be amazed.
A stack of one trillion 20 dollar bills would weigh more than 50,000 tons.
Assuming that you are using a standard 48 foot box on a tractor-trailer with a cargo capacity of 22 tons, you'd need almost 2500 rigs to haul that load.
I'd opt for a check.
until the company on which the "bet" is made defaults. Then the holder of the swap stands to gain an enormous amount of money and can be expected to try to collect.
That is one part of why they are not as toxic as they seem - they will, most of them, never reach that 5X trillion point of settlement. Not being a player in these esoteric financial instruments leaves most of us with a loss to explain why not, but everyone I have spoken to on this with more knowledge than me says that's true.
The other part is that even when they will need to come to a settlement, most of them are NOT based on toxic sub-prime or otherwise foreclosing mortgages, and therefore even if they settle the underlying original asset values (discounted for risk in the algorithms calculating the swap) - mortgage and or insurance revenues quite frequently - will still hold true most frequently.
Of course if some people WANT to create a depression psychology, knowing that economic expectations share as much value in determining economic behavior as does an actual paycheck, bank account and distance between income and expenses, then if they can be successful in that process, it does not matter what the material values of the economy are, they'll get a depression.
Company A issues a bond.
Company B places a bet that Company A will default on the bond.
Company C takes B's bet and similar bets from lots of other companies.
Company C books enormous profits on the business.
Company A defaults on the Bond.
Company B is rich.
Company C is up the creek.
Very timely article. This dark and dingy market desperately needs a little sunshine.
Devious greedy people who know how to use leverage to term a stupid idea into a bonanze as long as nothing goes wrong too quickly before they can get out with billions in their pockets. The people betting on the downturn were not necessarily the bad actors here. It was the people selling the insurance, knowing they could never pay it, and prices that were way too low.
Company B is rich.
Company C is up the creek.
Or, Company C has taken so many bad bets that it is unable to make good on the claim, and files for bankruptcy. Then:
Company A is up the creek (it must be since it defaulted on the original bond)
Company B is up the creek (no payment possible from C) and
Company C is up the creek also since it's now in bankruptcy from misjudging the level of risk on all the bets it made.
Company C takes B's bet and similar bets from lots of other companies.
Goes a long way towards explaining the downside market impact of CDS'. Unlike normal insurance, where the loss on the insured asset is limited to the asset value itself, the exposure of Company C is more like the exposure of a bookie - limited only by the number of bets they took.
There is a better way. Revise the tax code treatment of income from CDS contracts. Make the recipient of any payment caused by a default event covered by a CDS liable for an income tax on the payment -- on an accrual basis. Require the payer of such a CDS to deposit the tax due with the Treasury before paying the counterparty. In the event that the payer can't live up to his obligation, require the recipient to cover the tax shortfall. Set the tax rate high enough, and CDS contracts will miraculously be unwound all over the world - without requiring either party to pay anything to each other.
Another damper on the problem would be to legislate a fee on the outstanding value of the contracts, payable quarterly to the Treasury. Set the fee high enough and you'll see the volume of outstanding CDS' drop overnight. Also, this would instantly generate visibility into who holds what, and what the amounts are. Why that could be page one of Form CDS-2008.
If there are 55 trillion dollars in swaps outstanding, then a fee of say .3% per quarter generates revenue of 660 billion dollars per year - money which would allow the Treasury to cut taxes, or reduce the debt, or whatever. At least until all the CDS' magically disappeared.
Have you seen this? Dave Ramsey was on Neil Cavuto’s show today, and he has posted a plan on his website that is common sense driven and doesn’t cost $700b. Here’s the link:
He told Neil that the website had taken 100,000 hits since posting at 3PM, and that it was finding it’s way to Washington.
But in order to collect, he needs to have two things: the swap contract and the reference obligation.
How does he get the latter, without which he cannot collect?
The answer may surprise you.
Why don't you educate me?
I think that I already know your answer, and why that answer exists.
Remember, give me hard data.
I have witnessed these transactions on TRACE.
This is due to the following factors:
(1) If you want to collect on an individual CDS contract you need to be in possession of defaulted bonds to deliver to your counterparty. If there are more CDS holders than bondholders, then the demand for the bonds rises well above zero.
(2) Many of the sellers of CDS contracts are naturally long the underlying bonds they sell CDS to finance their inventory - therefore a CDS contract holder will often find themselves trying to buy bonds from the person who sold them the CDS contract in order to satisfy the CDS contract.
(3) Most holders of CDS contracts do not hold individual CDS contracts, but have bought index contracts. For index contracts you do not have to deliver bonds, but you only get a certain number of index points for each default - not par on your index contract.
(4) For the riskier paper, CDS contracts trade in the secondary market at higher and higher prices as they change hands - the original CDS on AIG may have been purchased for 150 basis points. By the time default was near, people were buying them for 40 full points.
In sum, there turns out to be no free lunch - the notional amount of CDS out there, and the actual amount due on any given day is probably in the neighborhood of 10000:1.
Not to mention that many CDS contracts stretch out to a period of as long as 30 years.
Of course they are!
Look here FRiend...you challenge me on my CDS statements - which are backed up by insignicant people like the Governor of New York and the SEC Chairman - then I ask you for proof of your rebuttal - and you give me this?
Let me give you a little 'edumacating':
Bonds are really high on the pecking order when it comes to insolvent companies. Of course they're going to have some residual value.
Do you really think Governor Patterson and Christopher Cox have traded distressed debt?
That they would actually be more knowledgeable than someone who has?
Bonds are really high on the pecking order when it comes to insolvent companies. Of course they're going to have some residual value. Sigh...
Your typical plain vanilla corporate bonds (i.e. senior or senior subordinated holdco unsecured debentures) are not that high in "the pecking order", smart guy.
They come before preferred stock and common equity and warrants in a workout, but they come after: taxes, mechanics' liens, A/R facilities, letters of credit, trade claims, capital lease obligations, first lien bank obligations, second lien indebtedness, operating company debt and of course debtor-in-possession facilities.
In many bankruptcies the holders of corporate bonds are either wiped to zero or are given warrants with strike prices so high that they are worth practically zero.
In a financial company bankruptcy - which typically involves enormous amounts of debt that are structurally senior to corporate bonds and an asset base that consists mostly of troubled loans - bonds rarely recover a cent.
I should be sighing: I gave you a detailed breakdown of the mechanics of the CDS market and your response was that Governor Patterson is really scared of CDS.
And you will continue to spread the same FUD regarding CDS despite the fact that I have given you the real deal.
You have given me nothing my FRiend.
As our fellow readers will attest, you specifically stated that very few CDS contracts are settled.
I want you to give me hard proof of your assertation as it applies to these failed institutions:
National City Bank
I'll be waiting...
I never said that.
I'll be waiting...
The fact that bonds for a number of these companies are still quoted and traded, even though the conditions exist for CDS settlement, shows that a substantial number of contracts did not settle - otherwise there would be no reason to quote or trade the bonds.
And I have given you a number of market-based reasons for why a market would be.
Reasons which apparently you cannot understand or discuss intelligently.
Your sky-is-falling scenario of utter collapse is not borne out by actual trading activity in the secondary markets.
"Of the above named companies, do you know how many CDS contracts have actually settled, and for what amount they settled? The answer may surprise you."
Ok, wideawake, surprise me....I'm waiting.
Let's say that the 'reference obligation' is a bond for the sake of discussion.
The CDS buyers that do not have a bond to give back to the insurer will need to buy one from the open market. If there is short supply then it will drive the bond price up - to the point where the buyer may need to sell assets to free up capital. It causes a short squeeze for the buyer.
As you deduced from my explanatory post, there was indeed a short squeeze and it continues.
However, rather than sell assets to buy the underlying of the contract, a lot of managers have decided to simply take the loss on some positions and only settle others.
In much the same way, a equity derivatives manager might decide to allow an option to expire unexercised rather than sell assets that are more valuable than the exercised option which would have a lower rate of total return than the assets he would have to sell.
In this way, risk is spread much more diffusely.
Someone like Phil Gramm.
Somebody who realizes that treasury hedges don’t always correlate to portfolio risk.
I understand. I'm not arguing that CDS's are bad, as they were originally intended to work. I'm saying that the broad leverage of them and the underlying mortgage bubble burst have caused enormous losses to be realized (either on the books or via transactions) on both sides of the CDS. Insurers got killed due to the leverage. Buyers got hurt (but not killed) by the exercise of a CDS contract for which they did not own the underlying security.
The commercial banks are now getting hammered by participating in highly leveraged CMO's that didn't have the support base that they thought.
If this becomes the plan, they need to hold off implementation for three months. In the meanwhile, I’ll stop paying my mortgage so I can get the 6% fixed w/o the back fees.
Why are we bailing out irresponsible people?
Respectfully, that is why they are more toxic than they seem. Derivitives, credit default swaps,....whatever term the bankers use to deceive the public with.....are inocuous as long as their notional values remain notional. The danger comes quickly as a company defaults and makes a demand on the derivitive contract. Like Lehman's Bros. it happend literally in a matter of hours. This caused AIG (largest insurer in the world) to declare their inablility to live up to their agreement (default) to pay Lehmans. That caused the Federal REserve (think about that....the Federal Reserve went in and injected 85 billion dollars in AIG, 20 of which went to Paulsons buddies at Goldman, in order to stop the immediate cascade of failures on Sept 16. That began the meltdown. Now, where in the Federal Reserve Act of 1913 did Mr.Bernanke get authority to 'give' 85 billion to an insurance company? That is not in their charter. He did it anyway, and noone asked the question. Bernanke gave the money because he knew that Sept.16 would have been the date which the economy cascaded into what is referrd to as a meltdown.
The meltdown has been slowed only temporarily. The only way out for Mr.Bernanke is to monitize the debt. There is no other way, except to allow everything to decay to destruction. Sorry to sound so bleak, but it has already started and it cannot be stopped. All debts will be paid, mostly in the currency of pain and loss.
That data may be available on the website of the Bank of International Settlements.
They were caused by writedowns on portfolios of CDOs - very different instruments.
whatever term the bankers use to deceive the public with
Just because you're not clear on the difference between these contracts and structures doesn't mean that anyone intends to deceive anyone in naming them.
"Credit default swap" is a succinct and accurate description of the instrument.
“Derivitives, credit default swaps,....whatever term the bankers use to deceive the public with.....are inocuous as long as their notional values remain notional. The danger comes quickly as a company defaults and makes a demand on the derivitive contract.”
True, I think, but:
Correct me if I am wrong, but I also think that your scenario is only true when the rate of “default” is extremely out of wack with the discounted risk of default that was built into the cost/price of the derivative at origination and such defaults were occurring on a volume/scale among a whole class of those derivatives AT THE SAME TIME; that an entire class was in question.
What does that right now is the burst of the real estate market bubble and the as yet, unsettled - where will it land (bottom) - housing market that sits at the foundation of the mortgage market; which does not produce a demand that derivatives so based MUST be settled, now, but if demanded to be settled now, then at what “value”; and, until this afternoon, ANY auditors operating under FASB would demand that value be “mark to market”. Some may view today’s SEC rule change as implying the “failure” at Lehman may not have been so large if its “derivatives” had not been needed to be assessed until tomorrow morning.
That was the point which I was trying to make. Derivitives have been around for over 20 years. You and I have known little or nothing about them. That is because, like Options, or Insurance, they usually expire worthless. But the notional values are so staggering that if even one large entity is triggered (ie.Lehmans) it begins to destabilize IMMEDIATELY other buisnesses associated with the company who sold the derivitive (ie. AIG). AIG has its buisness in EVERY LARGE BANK IN THE WORLD!!!!!!!! To stop the flames Bernanke broke the law and gave AIG $85 billion IMMEDIATELY. If he had not done this, the entire banking world would have immedialtely destabilized. As it was only the 4th largest US Bank on Sept.16 failed. Think....The CEO of Lehman got up that morning, not knowning of impending doom of his company. By 1PM Lehman was no more. Billions of dollars in assets disappeared. DISAPPEARED. Common stockholders, preferred stockholders...not sure about the Bondholders....up in smoke. So now, the Fed got in the buisness on Sept 16 of underwriting insurance for banks by buying 79.9% of AIG. That is the story of which books will be writtten. PhDs will write their dissertations on Sept.16. Movies will be made about what happened in those few hours. This will be remembered as distinctly as 9-11 or Black Tuesday October 29, 1929. It is that remarkable.
You make too much good sense - any chance anybody in DC is listening to ideas like yours?
I am not so sure how the Feds role with AIG will play out in the long run.
Separated from the one AIG unit that wrote most of its derivatives, the overwhelming rest of AIG, including its underwriting business, is very sound, and very profitable.
I don’t think the Fed is going to, directly, manage or direct any of AIGs units, but they will give a large dose of high-level financial direction; but, I think that too will not be permanent and will change whenever any “bailout” is finalized. Eventually, and that means as soon as possible, AIG needs to rejoin the fully private business world.
Do you find it odd that the Federal Reserve allowed Lehman to fail and AIG had to be saved?
I don’t know enough to see any conspiracy in it.
I do know that the scale of the reach and complexity of AIG, world wide, makes Lehman look like Payless Shoe Stores by comparison; maybe that had something to do with a difference in actions taken.
I also noticed that no sooner had Lehman filed for bancruptcy, Barclays was able to buy all of certain segments of Lehman, which local papers say will mean most of Lehman’s former NY employees will just have a new employer, not new jobs.
Which also pleads the question, why not simply bankruptcy for many of these other outfits?, instead of bailout.
If it won’t hurt the U.S. Treasury to buy “the toxic assets” for pennies on the dollar, and hold them until more favorable markets prevail, then why can’t consortiums of private investors buy the ailing Wall Street houses holding the “toxic assets” on the same basis, with the possibility of selling the toxic cum bargain assets later as the Treasury will?
I find that hard to believe. If true, the CEO of Lehman must beincredibly stupid. The fact is these folks knew it was coming. They have depended on their contacts and behind the scenes machinations with the Congress and the Fed. Reserve to save them. Now they have found looting $700 billion from the American People isn't that easy.
Per wideawake, it seems that the CDS play a reasonable, if not valuable (from a social perspective), role in ‘normal times.’ However, we are faced with a tsunami of defaults in mortgage-backed securities that might overwhelm the capacity of protection sellers to gain control of the underlying securities - bankruptcy might be their better business decision.
It seems a matter of scale, and as said, that scale may be abnormally large as well as highly unexpected (or at least ignored while we let the good times roll).
Henry Paulson, while at Goldman Sachs, was apparently involved, present with the creation of every type of derivative known to man....therefore, the most credentialed person to serve as US Treas Sec. The first hedge fund, in London, was estb by a Goldman Sachs person who went to London to begin the experiment ...the rest is history. Goldman Sachs is at the epicenter of the derivative world. Lehman later took on the mantle of having the greatest involvement with credit default swaps. All the bad stuff strangling the world was an American invention, augmented by all the central banks of the industrialized world jumping in.
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