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

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

[Southack]

"But you've lost 50% of your net worth in the default of the old insurer."

Nope. I simply have to pay a new insurer a new premium. At that point it's like I've always had insurance.

So all that is at stake is the premium for new insurance.

[jas3]

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

What if my not paying you the bet shrinks your capital base by requiring you (a large money center bank) to recognize losses and to call in 50% of your loans outstanding to prevent seizure by the banking regulators. Would you still classify the bet as zero sum? Would you still think that the national economy has the same "amount of money in it"?

I don't think you understand how credit is created and what the effects of recognized losses are to banks.

jas3

[jas3]

"But you've lost 50% of your net worth in the default of the old insurer."

Nope. I simply have to pay a new insurer a new premium. At that point it's like I've always had insurance.

So all that is at stake is the premium for new insurance.

I think you forget that the insurance was put in place to protect the value of your asset, which was a GM bond. That bond has now defaulted, which is why you lost 50% of your net worth.

Your insurance already proved to be worthless, which is why you've lost your net worth.

Who is going to write you a credit default swap on a bond that is already in default?

jas3

[jas3]

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

You are hillarious. Under what scenario do you think that a defaulting counterparty will have any income at all to declare to a tax authority? Counterparties default because they cease to exist.

jas3

[Toddsterpatriot]

You are hillarious.

And correct.

Under what scenario do you think that a defaulting counterparty will have any income at all to declare to a tax authority?

Doesn't matter.

Counterparties default because they cease to exist.

So what?

If B of A writes off $100,000 on your defaulted mortgage, they claim a $100,000 loss. You claim a $100,000 gain. Zero sum. Just like swaps.

[jas3]

Wrong....if ABC Hedge Fund goes out of business, they don’t claim a gain...and they don’t actually gain anything.

The swap counterparty never had the protection, so they bear the full brunt of the loss.

In the example, BoA would have a HUGE hit to their capital, which would have a severe impact on US credit markets.

Swap counterparty failure is NOT zero sum. Swap counterparties delivering IS zero sum.

jas3

[Southack]

"Who is going to write you a credit default swap on a bond that is already in default?"

You are confusing financial instruments.

A bond insurer guarantees that monthly/annual/term interest payments are made.

If I want my bond to have a high rating, then I pay for that bond insurance. If that bond insurer won't/can't pay, then I have to pay, or I have to sell the bond at a loss, or I have to find a new insurer and pay a new premium.

However, the above (finding a new insurer) is *only* going to be problematic (read: pricey) for a bond in default.

For all of my performing bonds, getting a new insurer is a snap.

And since all of my bonds aren't in default, the problem is trivialized down to simply paying a new insurance premium.

The other financial instrument is a credit default swap. This is a zero sum financial instrument that lets me bet on the direction of interest rates. For instance, I might have a large adjustable rate loan, so I would bet that interest rates go up. If they do go up, then I make money on my CDO bet (which will offset the rise in my adjustable rate interest).

Or I could just place a bet that interest rates will go up. Doesn't matter. If they go up, then someone owes me money. If they go down, then I owe someone else money proportional to the change in interest rates.

Zero sum. But quite different from bond insurance that merely guarantees interest payments.

[RinaseaofDs]

CDS’s are basically giant side bets, correct? One guy thinks they’ll default, the other guy doesn’t. They wait. The company tanks, one guy pays the holder of the Swap.

[jas3]

You are confusing financial instruments.

No, I am not. You don't understand the difference between an interest rate swap and a credit default swap. CDSes are very similar to the guarantees that monolines like ABK and MBI provide. Also, your last sentence is wrong. Monlines guarantee the timely payment of both interest and principal.

You are wrong that credit default insurance is zero sum - WHEN ONE PARTY DOES NOT ACTUALLY PAY.

jas3

[Southack]

"I think you forget that the insurance was put in place to protect the value of your asset, which was a GM bond. That bond has now defaulted, which is why you lost 50% of your net worth."

Nope.

If the insurer defaults anywhere in the world on any insurance, then you are simply going to drop their insurance coverage and purchase new insurance for all of your bonds.

And if a bond defaults, then the insurance kicks in to make the interest payments.

But to lose 50% of your net worth, you'd have to have your insurer fail, you'd then have to fail to get new insurance, and then while you were uninsured most of your bonds would have to default.

So it's not a single point of failure. Just a bond insurer going belly up is not a problem (beyond irking you that you have to dig money out of your own pocket to purchase new insurance).

Likewise, a bond in default is not a problem by itself so long as you have viable insurance.

Both the bond and the insurance would have to fail to present a financial problem to you (of any magnitude of note). And here's the kicker: you can control when a bond fails by making the premium payments from your own pocket for a period of time.

So there is plenty of time to reinsure.

Which means: all that is at *risk* is you having to make a new bond insurance premium payment). You'd certainly choose to do that rather than write down your bond holdings by 50%!

[jas3]

CDS’s are basically giant side bets, correct? One guy thinks they’ll default, the other guy doesn’t. They wait. The company tanks, one guy pays the holder of the Swap.

CDSes were originally hedges for people who owned debt of the underlying company. Because the market is so large with respect to the underlying debt, it is correct to note that most CDS buyers are speculators. And it is also correct to note that if the underlying company defaults, the CDS writer is supposed to pay the holder.

The problem is that many of the people who thought they had protection by purchasing CDSes will soon find out that their counterparties are insolvent. Some people in this thread seem to think that is not a problem. It is analagous to losing your home in a tornado and then finding out that your insurer can't pay out claims.

jas3

[Southack]

"You don't understand the difference between an interest rate swap and a credit default swap."

Please educate me.

[ex-Texan]

Arcane Market Is Next to Face Big Credit Test: Means $ 45.5 Trillion in Exotic Debt

Exotic derivatives manufactured by Wall Street are a huge, unregulated Debt Bomb. Where is the Congress when you need them? Playing get rich quick games and campaign finance bingo with wealthy special interests i.e. Big Money Bag Men.

Play Clickity, click, click . . . ?

This $ 45.5 Trillion might be the Debt Bomb which will sink the U.S. economy. . . .

Many thanks to M. Espinola for the graphics !

[Toddsterpatriot]

Wrong....if ABC Hedge Fund goes out of business, they don’t claim a gain...and they don’t actually gain anything.

They may go out of business, but they gained whatever they owed you and didn't actually pay you. Their net losses may still be huge, but that doesn't change the fact that their dealing with you was zero sum.

In the example, BoA would have a HUGE hit to their capital, which would have a severe impact on US credit markets.

Absolutely!

Swap counterparty failure is NOT zero sum.

Never said it was. Let me repeat what I said in post #25, "The losses may cause panics and loss of liquidity, but the swaps themselves are zero sum"

Swap counterparties delivering IS zero sum.

Not delivering is also zero sum. Glad you finally figured that out.

[Southack]

"It is analagous to losing your home in a tornado and then finding out that your insurer can't pay out claims."

Yes, and that's zero sum.

If the insurer pays for your $500,000 home loss, then $500k moved between two banks accounts. Your insurer lost it, and you gained it.

The insurer then has a $500k loss and you then have a $500k gain.

That's zero sum.

If the insurer doesn't pay your claim, then the insurer paid $0 and you received $0. That too is zero sum.

The same money stayed in the national economy. Zero sum.

[Toddsterpatriot]

Here come the clowns. LOL!

[Toddsterpatriot]

CDS’s are basically giant side bets, correct? One guy thinks they’ll default, the other guy doesn’t.

Exactly. Zero sum bets.

[jas3]

"I think you forget that the insurance was put in place to protect the value of your asset, which was a GM bond. That bond has now defaulted, which is why you lost 50% of your net worth."

Nope.

Wow..your post is factually incorrect in so many places and speaks to your complete ignorance of CDS markets that I don't know where to begin. So let's start here: YUP. You lost your net worth because your bond defaulted. Saying NOPE doesn't change that fact.

If the insurer defaults anywhere in the world on any insurance, then you are simply going to drop their insurance coverage and purchase new insurance for all of your bonds.

That is not possible. Once the value of your GM bond went from 100 to 10 upon default, you can't buy insurance that it won't default. What you are suggesting is akin to trying to buy fire insurance on your house AFTER it has already burnt to the ground. Who will sell you fire insurance after a fire? Who will sell you credit default insurance after a default?

And if a bond defaults, then the insurance kicks in to make the interest payments.

Wrong. Your credit default swap counterparty DEFAULTED HIMSELF. The whole point of the CDS mess is that many counterparties do not have the capacity to pay in the event of actual defaults. There is nobody to step in to make the interest payments or to return your principal. You will have to work out your debt and will be getting 10 cents on your dollar.

But to lose 50% of your net worth, you'd have to have your insurer fail, you'd then have to fail to get new insurance, and then while you were uninsured most of your bonds would have to default.

Wrong again. You won't find out that your insurer failed until AFTER the loss. Most people don't know that their insurer was poorly capitalized until AFTER the stress event (hurricane). In the example we are using, we are talking about only ONE bond and ONE company defaulting. But the effects are the same on large swaths of defaults, such as those facing home builders or financials.

So it's not a single point of failure. Just a bond insurer going belly up is not a problem (beyond irking you that you have to dig money out of your own pocket to purchase new insurance).

It is exactly a single point of failure. Investors do not typically buy CDSes on one instrument from several CDS providers. And, my god, you are out of your mind if you think a bond insurer going belly up is not a problem. Were you sleeping during the ACA default? Do you have any idea what the repurcussions were to banks that thought they had monoline insurance? And do you have any idea what the repurcussions were to the credit markets? Have you even the first clue what will happen when ABK and MBI go under, are seized by New York State, or are split in two?

Likewise, a bond in default is not a problem by itself so long as you have viable insurance.

Did you even read the article? The whole point is that investors who THINK they have viable insurance do not.

Both the bond and the insurance would have to fail to present a financial problem to you (of any magnitude of note).

Yes, and that is exactly what is happening now !!!!

And here's the kicker: you can control when a bond fails by making the premium payments from your own pocket for a period of time.

What in the world are you talking about? No investor can control when a bond fails.

So there is plenty of time to reinsure.

Reinsure? You've got no idea what you are talking about. Investors don't control when bonds fail, and when they generally realize that their counterparty can't pay, it is too late.

Which means: all that is at *risk* is you having to make a new bond insurance premium payment). You'd certainly choose to do that rather than write down your bond holdings by 50%!

That's ridiculous. Even if you could purchase a credit default swap on a defaulted instrument, it would cost you the full 50% that you would have to write down.

Do you have even the first idea what you are writing about? Have you even ever read an ISDA?

jas3

[jas3]

"You don't understand the difference between an interest rate swap and a credit default swap."

Please educate me.

No. There are plenty of good sites for you to go educate yourself. Posting at Free Republic is hardly the most efficient way for you to learn about swaps.

But do yourself and the rest of us a favor. Please do not post as though you are an authority on swaps, when you don't have even the most cursory knowledge on the topic. You are contributing far more heat than light.

jas3

[Pelham]

Mish has a good piece on CDS as well. 45 trillion in CDS I believe he said.