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

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

[jas3]

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.

Your assertion that Credit Default Swaps are zero sum would only be correct if, in fact, all counterparties were solvent in the event of a series of credit defaults. However, what we will most likely see is that hundreds of counterparties wrote hundreds of billions if not trillions of notional value of CDSes with entirely inadequate capital.

So if/when we start to see significant defaults, the debt that banks and financial institutions carried on their books at par by virtue of their CDSes will have to be written down to market. That could be a very very financially painful process, and it certainly could tank an economy if the collateral effect of various large CDS writers going under was to effectively render BoA, Merrill, Citi, and a few other large banks insolvent.

CDSes have been a shadown means of engineering massive leverage in the US economy. If we have a series of large defaults, the market will not cancel itself out. The buyer of the CDS will find that he was never insured in the first place, and the seller will lose what little capital he posted.

It is actually quite similar to the housing market where the value of falling homes don't enrich anyone else. In fact the problem in both markets was created by too much leverage. In the same way that mortgage originators and applicants lied in stated income loan documents and borrowed up to 100% (and more) of their homes' values, which created a bubble....Credit Default Swaps require surprisingly little collateral to write. Because collateral requirements are so low in a standard ISDA agreement, one can put up $10 and write a guarantee on $100 of debt.

Even worse, the insured can now pair his debt and swap together at a brokerage and lever that up tremendously as well.

There is far more leverage at work in US financial markets that is widely assumed, and the consequences of that are very disconcerting.

jas3

[Southack]

Nope.

If a counterparty can’t pay, then the original party simply didn’t make a profit.

That’s a far cry from someone taking money out of your bank account, physically.

[jas3]

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.

Well....debt is not a bad thing when it is used responsively. I'm even a big fan of high yield debt (aka Junk Bonds). And in ranking Governments, Consumers, and Corporations as to their ability to repay their net debt, I'm worried least about Corporations.

CDSes were a great invention and they could in theory be used to reduce net risk in our economy. Unfortunately, because swap agreements are generally written with so litle collateral required of counterparties, and accounting rules are written to assume that swap counterparties are solvent, there is a huge arbitrage that has ensured the growth of the CDS market. I fear that it will not end well as a chain reaction of defaulting counterparties puts our largest financial institutions into insolvency.

jas3

[jas3]

Please see post #21.

jas3

[Toddsterpatriot]

So if/when we start to see significant defaults, the debt that banks and financial institutions carried on their books at par by virtue of their CDSes will have to be written down to market.

For sure. The loser will have losses, the defaulter will have gains. Still zero sum. The losses may cause panics and loss of liquidity, but the swaps themselves are zero sum.

[Southack]

"I fear that it will not end well as a chain reaction of defaulting counterparties puts our largest financial institutions into insolvency."

That's silly. That's like fearing that insurance companies failing to pay auto claims would cause every car owner to become insolvent.

First, only the car owners who actually had wrecks would be impacted, and Second, they'd only be insolvent if they went out to buy a new car beyond their means once they learned of the non-payment by the failed insurance party.

Same with credit default swaps. Only the holders of cds's who likewise held losing bond investments would even notice defaults...and the problem there would be that their primary bond investments lost money in the first place.

Pretending that there was some great CDS failure to pay would simply mean that the money-losers found out that they were uninsured all along. Hardly the end of the financial world.

The actual bonds would still be worth *something*, and the money to buy those bonds was paid out long ago...so unless the institution holding the bonds was already insolvent, their cash flow position would remain solvent (read: unchanged)...and they could in fact sell the money-losing bonds for *something* in order to actually **improve** their current cash flow (the opposite of insolvency).

[jas3]

Nope.

If a counterparty can’t pay, then the original party simply didn’t make a profit.

That’s a far cry from someone taking money out of your bank account, physically.

Unfortunately it is not that simple. A CDS allows a debt holder to lever against his debt instrument. Let's use as an example, Bank of America (BoA). Let's say that BoA has $100 in capital in 2004 and decided to buy a GM bond for $98 and a credit default swap for $2.

In 2006 and 2007 GM's credit deteriorates and the market value of the GM bond goes to $65. However GM has not yet defaulted and continues to pay interest timely of (let's say) 5% per annum.

BoA has a recorded a 5% gain each year on its GM holding in 2005, 2006, and 2007.

By virtue of the swap, the loss in value of $33 of the GM debt is not recorded on BoA's books.

The 2005, 2006, and 2007 gains have already been recorded. You write that BoA simply didn't make a profit....but the profits have already been recorded for three years running.

Now here we are in 2008. Let's say GM does default, the value of their debt goes to $10, and the counterpary disappears.

BoA's original capital was $100, it made say $20 in interest, and also made money on it's commercial loans. However, now it must write down the value of the swap to zero and the value of the GM debt to $10.

For you to suggest that the original party didn't make a profit misses the point. Those profits have been recorded already for several years. The danger of the CDS market locking up and of massive defaults in US debt markets is EXACTLY that the original parties will have to recognize that the profits the ALREADY recorded were fictional. For you to pretend that the consequences of that are not dire is folly.

And if you happen to hold common stock in BoA or have more than the FDIC guaranteed $100K in a BoA account, then the consequences are identical to someone taking money out of your bank account physically.

jas3

p.s. In this example, we didn't even discuss the knock on effects of BoA having to pull in its lending to reflect that it's capital base has just shrunk by more than 50%. And that's the single biggest problem in a credit crunch...the capacity of lenders contracts incredibly...and THAT can bring whole economies to their knees.

[jas3]

For sure. The loser will have losses, the defaulter will have gains. Still zero sum. The losses may cause panics and loss of liquidity, but the swaps themselves are zero sum.

Swaps are NOT zero sum. They are SUPPOSED to be zero sum, but the whole point of the NYT article is that they will not be zero sum in any stress environment.

Example: You give me $2 to insure your $100 GM bond. I give you a piece of paper that says "GM CDS Swap" on it. GM defaults. I also default because I wrote $100 million GM CDS pieces of paper with only $2 million of capital.

You get back maybe $1 if you are lucky. Your bond goes to 10% of face so you have lost $90 there for a total loss of $91.

Insurance is only zero sum if the insurer can pay out the claim.

jas3

[Southack]

"but the swaps themselves are zero sum."

Yup. That's why the NY Times can scream that there are "$45 Trillion in credit default swaps oustanding!"

Because there are $22.5 Trillion worth of wagers that interest rates will go up, and $22.5 Trillion worth of wagers that interest rates will go down...for one way to look at it (or $45 Trillion in wagers, with half betting rates go up, the other half betting rates go down).

Zero sum.

If rates stay the same, then no money is exchanged (other than nominal fees). If rates go up enough to cause one Credit swap to go up $1 Million, then the other guy has to pay a Million Dollars. One makes a million, the other loses it.

Net impact to the national economy: $0. Sure, a million Dollars changed hands, but it all stayed inside our national economy.

Zero sum.

One guy defaults...then he saves a million and the other guy doesn't get to make a million.

Net impact to the national economy: $0.

Zero sum.

Tough to bankrupt the whole national economy that way!

[jas3]

Pretending that there was some great CDS failure to pay would simply mean that the money-losers found out that they were uninsured all along. Hardly the end of the financial world.

I take it you are not very familiar with financial accounting. There is not a single top 5 US commercial bank or brokerage that would be solvent under Tier 1 capital rules if they had to recognize today that their swaps were valueless, which you for some reason think is no big deal. That's the whole problem with the monolines going bust too.

The entire net capital of US commercial and investment banks is at risk.

jas3

[Toddsterpatriot]

Swaps are NOT zero sum.

Say we bet $100 on the Cub's season opener. Is that zero sum?

but the whole point of the NYT article is that they will not be zero sum

The NYT is wrong.

Your bond goes to 10% of face so you have lost $90 there for a total loss of $91.

I lost $90 because my bond lost $90. You gained $90 because you didn't pay me the $90 you owe.

[Southack]

Nope. It’s still zero sum.

One guy defaults means that no money changes hands. That’s zero sum.

Or...one guy wins a million and the other guy pays a million. That’s likewise zero sum because the national economy still has that million Dollars...it simply changed bank accounts.

Credit Default Swaps add no value; they take away no value. They are zero sum.

[Toddsterpatriot]

Like I said, don’t bother with logic. Panic!!!!

[jas3]

You gained $90 because you didn't pay me the $90 you owe.

Hahahahah...that's rich. So where can I spend this $90 that I didn't pay you, since I'm now bankrupt too?

jas3

[Southack]

Nope. All that is at risk is the premium to purchase new insurance.

The old insurer defaulted. Big deal. You just pay a new premium for new insurance. Problem solved.

[jas3]

Credit Default Swaps add no value; they take away no value. They are zero sum.

They are only zero sum if you can collect on them.

jas3

[Southack]

A Credit Default Swap is just like a bet on a baseball game.

You bet the the Cubs will win. I bet that they will lose.

If you win and I pay, then the bet was zero sum because the national economy has the same amount of money in it.

Ditto if I default on the bet.

Same again if I win and you pay or don’t pay.

It’s all zero sum.

[jas3]

The old insurer defaulted. Big deal. You just pay a new premium for new insurance. Problem solved.

But you've lost 50% of your net worth in the default of the old insurer. That is a very big deal if you happen to be an investor in the company that for years has been reporting earnings based upon the presumed solvency of their CDS counterparties. And it is also a very big deal if you are a lender by trade, such as a commercial bank or an investment bank, which now has to call in 50% of your outstanding loans in order to meet Basel solvency requirements.

I don't think you understand the consequences of a counterparty failure.

jas3

[Southack]

"They are only zero sum if you can collect on them."

Nope. They are zero sum regardless of outcome. Your ability to pay merely impacts where money moves or not, but the fact that the same amount of money remains in the national economy means that the deal was and is zero sum.

[Toddsterpatriot]

Hahahahah...that's rich.

And true.

So where can I spend this $90 that I didn't pay you, since I'm now bankrupt too?

You have a gain of $90. I didn't say you had $90.

If your bank allows you to write off some of your debt, you have to declare that as income.