Skip to comments.Defusing the Credit-Default Swap Bomb
Posted on 11/16/2008 1:49:44 PM PST by CutePuppy
AS THE GLOBAL CREDIT CRISIS GRINDS ON WITHOUT seeming relief, worries grow that a mishap in the once obscure credit-default swap market could trigger an even more lethal financial meltdown. .....
It's easy to understand why credit-default swaps, which have been called financial weapons of mass destruction, can engender hysteria. These quasi-insurance policies allow buyers to insure all manner of debt instruments, including corporate and sovereign-nation bonds, various bond indexes and securitizations, against any credit losses from defaults. Demand for them grew explosively during the past decade's credit boom. According to the International Swaps & Derivatives Association, or ISDA, the outstanding "notional" value of debt insured by these swaps soared from under $1 trillion in late 2000 to a peak around $62 trillion at the end of 2007.
The sheer reported size of the market, many multiples of the actual total value of corporate, mortgage and government debt outstanding, has led many to conclude that a lot of folks who don't even own the underlying debt are buying the swap insurance as cheap lottery tickets to bet on the demise of some debt issuers. The swaps are default-insurance policies, and their prices rise when it appears that the issuer of the stock or bond being insured is in trouble. Swaps thus have become handy tools for short sellers seeking to drive down the prices of equity or debt securities by convincing investors that the issuers are going belly up. New York Attorney General Andrew Cuomo and the U.S. Attorney's office in Manhattan are investigating whether shorts artificially drove up swap prices by reporting bogus trades that were never completed, in order to push down the prices of stocks they were short, particularly financial issues.
(Excerpt) Read more at online.barrons.com ...
It shows how easy it was for some short-sellers hedge funds to exploit the potential of this derivative financial instrument to manipulate financial system - already frail and overextended by government mandates and guarantees (CRA and GSEs Fannie and Freddie etc.) and by onset of delation in the real estate sector - and cause financial destruction and worldwide crisis, starting with rumours that brought down Bear Stearns first and later triggered even bigger chain reaction with the fall of Lehman and AIG.
Also, article shows the real size of total CDS market, and how recent reforms and other measures, already taken by the industry along with Treasury and Fed's "swift actions" is now allowing reasonably orderly unwind of the CDS crisis.
*Subscription required, use the library if you have to.
only stronger economic growth can solve this problem
Soros was up on Capitol Hill just last week testifying before one of the committees holding hearings about the economy.
He looked like some kind of new horror straight out of a “Hellraiser” movie, or another one of those giant bugs from “Men in Black” wearing a baggy, ill-fitting Soros-suit...
Link only takes me to the first page, how do I read the rest?
So you think it’s unfair for someone who knows what a cesspool we have created with these toxic debts to make a principled bet on the appropriate credit default swaps? Shirt selling is only a signal of what is wrong, not a cause.
A CDS is essentially a bet, just like betting on horses or pro-hockey and should be treated like betting regulatory-wise. If you buy or take out a CDS on a mortage you actually OWN, then it could be considered an insurance. Once you start taking out swaps on stuff someone else owns, it’s not a financial instrument any longer.
it’s like shooting the messenger
Ping, follow up to comments in previous threads:
http://www.freerepublic.com/focus/news/2103586/posts?page=64#64 - TenthAmendmentChampion, you might appreciate this... some details and timeline on Cassano’s contribution to bringing down the “House of Hank”. As Smokin’ Joe said in the next link, “No tinfoil needed”...
http://www.freerepublic.com/focus/news/2131629/posts?page=41#41 - Smokin’ Joe, I think you’ll appreciate this if you haven’t seen already.
This is very readable article, it clearly lays out what was involved and how much more was in store. Can be used as part of good educational material from a credible financial publication, even for financially challenged who keep asking “what’s going on?”
Where did it all go wrong, Blanche?
Why didn't they crash the Clintons' re-election hopes back then? :)
CDS’s sound like taking out a life insurance policy on your wife and then loosening the brake lines on her car.
I’ll just say that there is a huge difference between insurance and betting / gambling. Also, activity that surrounded short-selling in financial industry is like hurting the horse before the race and then betting against it. Remember the fraud around the original “viaticals insurance” industry? BTW, it’s being repackaged now into “life settlements”, and Warren Buffett is one of the principals of “mainstreaming” it.
Not to mention the sheer size and consequences of the “bets” outside of horse racing industry vs financial industry / system which by necessity and by definition must be leveraged to make any profit. Leverage kills on the way down, simply by feeding on itself like avalanche and in the process liquidating standbys in other markets that are not leveraged or had nothing to do with original issues.
It’s like saying that pimple is a signal that something is wrong, then infecting it with small pox virus.
While there is a value in short-selling strategy (like “collars” etc.), it should not become the instrument of deliberate value destruction.
I don’t believe there is a solution—at least until the system gets flushed of these toxic instruments, and in order for that to happen, we’ll need to endure another “Great Depression”. DJIA at 2,000, etc
These instruments are as potentially bad as advertised. And the fact that they occur over-the-counter via an ISDA means they are both hard to value and illiquid. The notional value estimated size numbers are accurate as well.
True and the results of the meeting of the G-20 was that these will be regulated. Since they are not worth spit. I would say ending them would be the best. I think that what will be the outcome from the democrats.
For practical purposes, it is almost impossible to differentiate “gambling” from “investing.” The characteristics of each are so much in common that they are for all intents and purposes the same.
While you might view credit default swaps as “gambling”, somebody who has a position in mortgage securities would view it as a “hedge.” Unless you can figure out a way to divine investor’s intentions in advance, you will never be able to differentiate between the two.
One thing I don’t get is that the journalists and pols keep talking of the total CDS liability as though they could all go wrong at once to the tune of so many trillions of dollars? But aren’t a lot of the “bets” or hedges on opposite sides of the same potential event, so that when some have to pay out others benefit? I’m not saying there’s not a huge problem, I don’t know, but I keep hearing it described as though all of the CDS market could have to be paid off and that doesn’t seem plausible.
True, but I was not talking about "gambling" vs "investing", I was talking about "betting" vs "insurance", which is what CDS started out and were supposed to be (an insurance), but were transformed to be exactly opposite. And the article talks about short-sellers against financial institutions which have been weakened by leveraging due to real-estate inflation caused in part by government rules and demands and encouragement of questionable loans, not the banks buying CDS as an insurance against their CDOs. So let's not get these mixed up.
Also, As I said, short-selling as a "hedge" / insurance has its uses, but insurance is well defined as non-leveraged "covered sell" against your own position - none of this has been the case with CDS, and the the sheer growth and size of the market in latter stages that dwarfed the value of underlying real-estate loans market by several magnitudes makes it abundantly clear. You essentially had more money (in fact, in multiples) and people vested in quick and substantial destruction of value, than in growth or flat or orderly deflation of it that had relatively little consequences to economy. That usually leads to at best, unethical, and more often, illegal "practices", some of which I already described and which are well understood.
And it's very easy "to divine investors intentions in advance", the article itself describes it and those who played by the rules of "matching" CDOs and CDSs, i.e. "market-neutral" long and short positions using CDS as an "insurance" not a "bet".
Here's how Soros and some others have used short-selling, with rumors and inside information from political class:
You Lose, Soros Wins
Market has recovered when Cox put in place rules prohibiting short sales against the financials, that is very telling in itself. These institutions might have failed eventually, but we would not have the financial crisis of these proportions and global credit freeze (LIBOR and TED spreads) if it were not accelerated by short-selling and their tactics betting on the destruction of financial system.
$10T of underlying real-estate mortgage market, "insured" by $62T of CDS. Makes one think, eh? And short-selling that accelerated financials downfall was against financial institutions that were leveraged with CDOs or CDSs themselves, not through CDSs directly.
It’s a subscription publication of WSJ. Most with subscription to WSJ.com also have access to Barrons. The libraries and news stands should have this edition now or by tomorrow, at the latest. This one is worthwhile to make an effort to read.
We don't need more regulation, there's plenty already. Just call CDS's for what they are: it's a form of gambling and whoever wants to issue them better have a gaming license. And you better believe the casinos will be a lot better at setting the odds than the investment bankers. Added benefit is that anyone who tries to unduly influence the market will get their knee-caps shot off by angry bookmakers. Problem solved, everybody wins.