Arcane Market Is Next to Face Big Credit Test (credit default swaps)

New York Times ^ | Feb 17, 2008 | Gretchen Morgenson

[Southack]

"Then explain why the Japanese were unable to do so in the 1990s. "

They used a different approach because they didn't want real-estate speculation to resume its earlier insanity there.

You'll note that they didn't have soup lines and mass homeless, either. They found an in-between path.

[jas3]

Have you shoved them into their bankruptcy graves while they are still breathing?!

Since debtor's prisons were abolished, creditors do not have the option of shoving debtors into a grave. While you are trying to be funny, you deflect the fact that creditors are pretty much stuck in most cases when debtors walk on their loans. Pretending that there is some funny solution doesn't advance the ball or help recognize the gravity of the problem.

Send them to jail for insurance fraud if they can’t pay what they charged to insure, though. Methinks they’ll “find” some assets to sell to obtain the money to pay their claims if the alternative is real jail time for frail white-collar crooks.

You "thinks" incorrectly. Radian and MGIC have no assets left. I concur that monoline insurers and PMI firms were pushing a fraud on consumers, but putting the management or shareholders in jail can't make money that doesn't exists appear. The loss ratios will exceed 500% of premiums. Where do you pretend the money to pay losses will come from?

jas3

[Southack]

"The $75 Billion in losses comes directly from the net worth of US banks. Monoline failures will destroy a significant percentage of their remaining capital."

Nope. A bond insurer failing could mean that a bank writes off paper gains...or that a bank reports a paper loss...or that a bank pay a new insurance premium to a new monoline...but none of that "destroys" actual capital.

Could it mean that a bank has to sell existing bonds in order to raise short-term cash flow? Yes. But that would *increase* actual capital on hand at the expense of a paper write-down in net wealth.

Or could it mean that a bank *can't* sell some bonds because they aren't insured, thus having to keep the bonds to term? Yes again, but that means that the bank makes *all* of the money from the bond over the long-term, at the expense of short-term cash-flow...hardly the end of the world.

[jas3]

They used a different approach because they didn't want real-estate speculation to resume its earlier insanity there.

No...they used the same approach the US tried to us. The problem is that in an INSOLVENCY crisis, it is not possible to inflate the currency. All asset bubble pops lead to DEFLATION. And that's exactly what we'll have here.

You'll note that they didn't have soup lines and mass homeless, either. They found an in-between path.

You'll note that I have never suggested that there will be soup lines or mass homeless. Those, BTW, are not the criteria for determining if the United States has entered a credit crisis.

Also, we are far worse off now than the Japanese ever were in the 90s.

jas3

[jas3]

"The $75 Billion in losses comes directly from the net worth of US banks. Monoline failures will destroy a significant percentage of their remaining capital."

Nope. A bond insurer failing could mean that a bank writes off paper gains...or that a bank reports a paper loss...or that a bank pay a new insurance premium to a new monoline...but none of that "destroys" actual capital.

WRONG!

OMG..that is so stupid. Many US banks have kept loans on their books at par and refuse to recognize market values because these loans are "insured" by a monoline which mispriced the risk at issue. When the insurers later fail for having mispriced too much risk, the banks are required to recognize losses that have already happened on their debt instruments. Not just paper losses, but actual defaults. The capital has already been destroyed; the banks have just not recognized it yet.

Could it mean that a bank has to sell existing bonds in order to raise short-term cash flow? Yes. But that would *increase* actual capital on hand at the expense of a paper write-down in net wealth.

When a bank has to write down assets, it is also required to call in loans and divest other loans to keep its capital ratios within regulatory requirements. Every dollar writedown = ten dollars in loans called in, not renewed, or assets sold to raise cash. That is the type of contagion that leads to spiraling collapses in asset prices.

Or could it mean that a bank *can't* sell some bonds because they aren't insured, thus having to keep the bonds to term? Yes again, but that means that the bank makes *all* of the money from the bond over the long-term, at the expense of short-term cash-flow...hardly the end of the world.

Dude, the bonds are trading below par because they are likely to default. The CMOs that trade at 23 cents on the dollar trade there because there is no chance the owner will get all his principal back.

I don't know what world you live in, but in the REAL world, when a bank has to write down assets that has huge and immediate economic effects that are very negative.

jas3

[JasonC]

A credit default swap is just a mutually agreed bet on the possibility of an original borrower not being able to pay.

If the only use ever made of them were that people who lent to the original borrower, bought one, and others connected to the borrowing company or the bond issuance act (the original borrower's banker, e.g.), then it would be a straightforward form of financial insurance. But there is no such restriction, and in practice others bet on whether companies will pay their debts, without being lenders to them.

Just as there need not be any relation between the size of all bets on a given horse to win the Derby and the size of the "purse" the winning horse will get, there can be any amount of money bet among any number of counterparties, on the question "will Delphi Automative pay its debts, or default on them?"

In practice, the distinction between hedging and just speculating on the matter gets murkier. More mixed.

Say Merrill is underwriting a Delphi bond issue. Some of Merrill's customers would be willing to lend to Delphi, only if they can insure themselves against the risk of Delphi defaulting. Maybe for the whole amount, maybe for just portion of it, to limit their downside if things go badly. Suppose Merrill itself agrees to sell them this insurance by entering a credit default swap with them.

Ok, first step and simple enough. Instead of the lenders being on the hook if Delphi can't pay, Merrill is. For the amounts it insured. OK, so what is Merrill going to do about this? Does it really want to be in the "Delphi can pay" business? Or did it just want to move the new bonds it was creating, and the swaps helped do it?

Assuming the latter, Merrill looks around for someone else who wants to be in the "Delphi can pay" betting business - say, ABC Bermudan Insurance. And Merrill buys a second credit default swap from them. Now Merrill owns the right to be paid by ABC-BI if and only if Delphi can't pay - and Merrill has promised to pay the lender if Delphi can't. As far as Merrill is concerned, it now doesn't give a darn whether Delphi can pay - or so it thinks. Instead of Merrill insuring payment, ABC-BI is.

Except, Merrill is still on the hook if both (1) Delphi can't pay and (2) ABC-BI can't pay, either.

As for dealing in the bonds themselves, the accounting identity is - what the bonds actually pay, and what one set of the credit default swaps have to pay, added together, always equals the amount Delphi *promised* to pay. No matter what happens. You can own the bonds or sell them short. You can own a swap or have promised to pay one. Mix and match to hedge your risks, or bet the same way if you prefer.

The complexity comes from the fact that swaps are counter-party specific. They don't "clear" by transfer. In the case above, it isn't that ABC-BI has promised to pay the original lenders if Delphi can't. ABC-BI hasn't promised the original lender, it has promised Merrill. And Merrill hasn't promised to pass along whatever ABC-BI actually manages to pay to it, it has promised the original lender to pay whatever Delphi didn't, of what Delphi originally promised.

That is why the amounts outstanding can climb far above the original value - along with outright speculation by "outside" parties, to be sure.

So, imagine a chain of 10-12 counterparties each passing the buck along. One loss will require one payment by the guy at the end of the chain, and if he makes that successfully, it can pass up the whole chain and satisfy all of the swaps in turn, liquidating each one. No problem. But if instead the end party fails, someone farther up the chain has to pay. Who? The first guy who can, the others failing.

Also, others might fail not because they aren't paid on Delhi, but because they lost too much in mortgages or weren't paid on a New Century Finacial default or what-have-you. Bankrupts don't pay their debts, and they don't "sign" each one separately and pay most while defaulting on others. No blood in stones, if they can't pay they can't pay, regardless of what caused that to come about.

We say, credit risk is counterparty-specific.

What many people in the market would like to do, is liquidate cross swaps. Merrill would like to hand over its claim on ABC-BI to the lender it sold the original swap to, and say "here, collect from him, I'm out". If the original lender considered ABC-BI at least as likely to pay as Merrill, it would have no objection, and the overall position could be simplified. But if they consider Merrill much more likely to be able to pay them - from other assets entirely - then they might not be willing to take a ABC-BI IOU in place of a Merrill IOU - even if both are promises to pay the same amount of money, at the same time, if the same event happens.

So cross-trades don't "clear", they hang around forever like luggage. Until either Delphi pays in full at maturity, or defaults before maturity.

Does that help? Or is it as clear as mud? lol.

[Southack]

"OMG..that is so stupid. Many US banks have kept loans on their books at par and refuse to recognize market values because these loans are "insured" by a monoline which mispriced the risk at issue. When the insurers later fail for having mispriced too much risk, the banks are required to recognize losses that have already happened on their debt instruments. Not just paper losses, but actual defaults. The capital has already been destroyed; the banks have just not recognized it yet."

Nope. "Capital" is the cash physically inside your bank vault. All the rest is bookkeeping...paper numbers.

Your physical cash inside your bank vault isn't destroyed just because an insurer of a bond/note (said bond/note may even be making its interest payments still) defaults.

[jas3]

Nope. "Capital" is the cash physically inside your bank vault. All the rest is bookkeeping...paper numbers.

Very little "capital" is actually physical CASH. And very few of United States dollars are actually in physical paper form. Your definition of capital is dead wrong. And therein lies the problem. You understand so little of economics that you are incapable of grasping how banks create and destroy capital. Therefore you are unable to see the destruction of capital as having any negative economic effects.

Your physical cash inside your bank vault isn't destroyed just because an insurer of a bond/note (said bond/note may even be making its interest payments still) defaults.

Physical cash is not even relevant to this discussion.

jas3

[Southack]

And yet, the difference in your estimate for recovery to my estimate is a mere 9 months.

Let’s meet back here in November and see who’s right.

[jas3]

And yet, the difference in your estimate for recovery to my estimate is a mere 9 months.

Let’s meet back here in November and see who’s right.

It is not the difference in time that is so relevant. It is the destruction in capital. The events of 9/11 lasted only a few days before recovery began, but it destroyed a tremendous amount of capital.

The issue with this recession and credit crisis is less the length and more the depth.

I think my estimate may be light. I'm an optimist at heart. Lastly, you continue to be wrong about capital formation and the notion that bank writedowns and loss of capital has no economic effect. I suggest you read up on some basic economics between now and November.

jas3

[Southack]

Feel free to post your prediction of the depth of our current crisis between now and the end of the estimated length of the current crisis...so that we can look back at that time to verify which of us was more correct than the other.

[Southack]

Still waiting for your prediction of the depth...

In the meantime, Citigroup, Wachovia, and UBS have put together a large cash infusion “bailout” for Ambac that should be public Monday morning...insuring that the monoline keeps its AAA credit rating.

[Don Joe]

---

"Except that you paid the premiums and lost your house. You probably won't consider that to be zero sum. And the national economy just lost $500,000 in asset value from the housing stock."

The loss of your house is independent. The economy suffers the same whether you were insured or not.

What changes if you are insured is that *you* come out whole should the insurance company pay...but then the insurance company has a loss for the amount that they paid.

The insurance itself is zero sum; what the insurance company pays may well go to you, but that same money remains in the national economy. It just moved from their bank account into yours.

And that's a net "zero sum."

---

In other words, if you're on your way to pay your insurance premium, and on the way to the agent, a mugger sticks you up, and takes your money, you lose your policy, since you couldn't make the payment -- and, you lose your house when the hurricane hits it -- but, since the mugger had your money in his pocket, and used it to buy a few rocks of crack, "that same money remains in the national economy," so no harm, no foul, and quitcher bitchin.

And, if there should be a national wave of muggings, causing massive losses, no problem, since "that same money remains in the national economy."

And if a bunch of embezzlement results in the insurance companies going belly-up, unable to pay out on the policies that remained in effect, it's no problem, because "that same money remains in the national economy."

And if we're all walking around with barrels held up by rope suspenders, learning how to say "Yes, sir" in Chinese, well, that's no problem too, because there'll always be someone with a stake in convincing you there's no problem.

What I'd like to know, though, are who these "no problem" folks are, and what their stake is. Are they "last man standing" types, desperately casting about for "the greater fool" so that they can affect a soft landing? Are they "paid-to-post" types (hey, a guy has to pay for his sphagetti-O's)?

Or are they garden variety recreational bullshitters, who live to troll?

[Don Joe]

I think my estimate may be light. I'm an optimist at heart. Lastly, you continue to be wrong about capital formation and the notion that bank writedowns and loss of capital has no economic effect. I suggest you read up on some basic economics between now and November.

Oh, c'mon now.

Next, I suppose you'll have us believing that the so-called "crash" of '29 actually harmed the economy? *guffaw*!! (After all, the "same money" did remain "in the national economy," so clearly, there was no real problem. Zero sum, my good man, zero sum. Tut tut!)

BTW, I'm starting a new type of credit counseling service. It consists of coaching the clients on explaining to the creditors that there's no real problem, since "that same money remains in the national economy" and therefore, there's no reason to continue harassing them.

The way I see it, even if all the lenders go out of business, there'll be no actual impact on the nation, since "that same money remains in the national economy."

Simple math. Why can't these fools see it? Zero sum, how much easier does it get?

[Don Joe]

Seriousy, though... I've been sick like a dog for going on three weeks or so. I come up for air and what do I see? Is this place really going to the dogs? Is lunacy really holding court? Are the vast majority of people who read without posting really seeing this twaddle, this feel-good propaganda, this "go back to sleep, nothing to see here" as the country seems to be poised to give the fall of the Weimar Republic a -- to "coin" a phrase -- a run for the money?

OK, the ship is sinking, but it's no big deal. The water was there already. Inside the hull, outside the hull, it all balances out in the end. Not one drop less -- or more -- than at the start.