Posted on 02/17/2008 5:52:04 PM PST by 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.
(Excerpt) Read more at nytimes.com ...
http://www.nytimes.com/2008/02/17/business/17swap.html?_r=3&ex=1360904400&en&oref=slogin
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.
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
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...
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
permalink to Mish’s article: http://globaleconomicanalysis.blogspot.com/2008/02/shadows-of-cds-market.html
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).
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...
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.
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.
The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion
I’am sure obama can CHANGE D A T.
http://investorsinsight.com/thoughts_va.aspx?EditionID=640
John Mauldin does a great job of explaining monolines, cdo’s, and cds’s.
Suppose a house burned down and ten different "owners" show up to collect the insurance settlement (each claiming 100% ownership).
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.
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.
#16
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.
Don't try logic. The notional values are huge, therefore we are doomed!
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