Posted on 09/30/2008 1:33:18 PM PDT by BGHater
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:
http://www.daveramsey.com/etc/fed_bailout/3_steps_to_change_the_nations_future_10928.htmlc?ictid=sml
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.
LOL!!!
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.
Sigh...
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:
Bear Stearns
Fannie Mae
Freddie Mac
Lehman Brothers
AIG
Merrill Lynch
Washington Mutual
Wachovia
National City Bank
I'll be waiting...
I never said that.
I'll be waiting...
Uh-huh.
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.
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