Posted on 09/22/2008 3:07:35 AM PDT by TigerLikesRooster
Default Swaps May Be Next In Credit Crisis
Ultimate Moral Hazard Looms in the Markets
By JULIE SATOW, Staff Reporter of the Sun | September 22, 2008
The biggest Wall Street story most Americans haven't yet heard of is the $62 trillion unregulated credit default swaps market.
Here is one scenario: A hedge fund buys insurance in case a company defaults on its bonds — a so-called credit default swap — when the hedge fund doesn't necessarily own the bonds. Then it immediately shorts the stock, driving down the company's share price, leading to a downgrade, and eventually triggering a default. It is the ultimate moral hazard, like taking out fire insurance for a home you don't own: There is an obvious motivation to set the house on fire and collect the insurance.
Meanwhile, that same hedge fund may also be issuing its own credit default swaps, where it promises to cover a company's bonds if it defaults, in exchange for the buyer of the swap paying out a premium. The premium is paid out in regular intervals, much like an insurance premium, and is a simple means for the hedge fund to generate additional income. This is especially true because the hedge fund does not have to put aside any capital to cover the swaps it is writing. Riskier still, no bond has to actually be delivered to settle the swap in case of a default.
(Excerpt) Read more at nysun.com ...
Ping!
If you can short a stock enough to drive it into default, you don’t need to be involved with its credit swaps to begin with.
You’d just profit from driving the company you’re short into default.
Gonna have to find another way to make the sky fall...
I guess I just don't get it. What are they going to do with the dozen or so houses that are now in foreclosure?
I am against regulation for the most part. But it is clear that banks, hedge funds and others will drag down the economy for their own personal short-term gains. We have to stop letting that happen.
Short-sales are a good example. Why Cox et al allowed for the removal of short-sale restrictions is beyond me given the potential for massive moral hazard problems.
The same goes for allowing banks to do whatever they want, even when regulated by MBA students. Throw in the government interfering with the free market and we destroyed our economy by promising everyone free goods. Too much debt, no ability to pay.
We need Teddy Roosevelt again! Even the Republicans can conspire to screw the economy and taxpayers leading to a systemic collapse.
Why aren’t we prosecuting Raines, Johnson, Morzillo and others that created this mess? And the banks CEOs, CFOs, etc? Democrat or Republican? Why do we keep electing “give away the story” Dems and Repubs?
Bread and circuses.
Don't we have enough real problems to worry about right now without listening to journalists who are making up more?
The criticism of short-sales is that funds can conspire to drive a stock down in price (one of the reasons that we put short-sales restrictions on the books in the first place). E.g. Schumer can tell his friends to short IndyMac, then announce that IndyMac is in severe trouble. Buffett could do the same with Fannie and Freddie. It becomes a virtual freefall.
Credit default swaps. Another seemingly simple risk management tool that blew out of control and is part of our financial house of cards. Suppose that I own the bonds of Corporation X. I try to reduce my risk exposure in these bonds by entering into a credit default swap. A CDS is like an insurance policy when the counter party (the entity you entered into the swap with) pays you the difference between par value and the value of the bond in a credit event. So, you are supposed to be protected against the company defaulting on its debt.
What happens if the counterparty defaults on its swap obligations? Suddenly, you took on all these risks, THOUGHT you were hedged out and now you are fully exposed to risk .... and probably don’t have enough equity to cover the losses.
This happened to me on Wall Street when during a crisis when we had to unwind our swaps. Think of it like this. You have fire insurance, auto insurance, life insurance, health insurance and theft insurance. And the insurance company goes out of business. Even worse, because the insurance industry is so bad, you can’t new insurance. Even worse, your spouse and child are sick and you just lost your job.
That is sort of where we are today.
Part of the problem is regulation of the wrong kind - congressional rules that force financial institutions to make bad business decisions to further politicians' PC agenda.
As a tradeoff, congress weakened other controls so businesses wouldn't squawk.
Another problem is that our government let Fannie and Freddie become too large and also failed to apply anti-trust laws to other financial institutions. So we saw a constant parade of mergers, takeovers, buyouts until we are now told these businesses are too large to allow them to fail.
The solution to both problems is obvious but don't expect the government to actually do anything.
While this bailout is going on the same businesses wuill bo doing the same things that got us in this jam.
They will probably need another taxpayer bailout before we even pay this one off.
$62T—I don’t like the sound of that. Given our Government’s perchant for wanting to guarantee everything lately, I wouldn’t put it past ‘em to take that on too.
Fury at $2.5bn bonus for Lehman's New York staff
$521,000: The average pay of Goldman Sachs employees and that includes secretaries
You are right. This is so kooky. If the company was basicaly healthy, others would BUY, BUY, BUY and laugh at the morons shorting the stock, all the way to the bank.
Patrick Byrne, the CEO of Overstock.com might disagree with you.
There is one element that has not been discussed in this whole financial drama.
Millions of home-sellers made ENORMOUS profits during the housing boom - flipping $100k dwellings for $200K+? The capital gains tax on home sale profits were changed or eliminated (good thing) - driving selling into the stratosphere.
Where were those *profit proceeds* invested?????
That guy has at least one loose screw.
How many are going to prison and for how long???
.
IMO, we need a good depression. The prices for everything, other than eggs and green beans, so to speak, are inflated way beyond real worth.
If only such a depression could depress the cost of government. If it can’t do that, then never mind.
IMHO this is the absolute root of the problem and starts with Carter and his Community Revitalization Act that essentially forced the mortgage to make bad loans to minorities. More changes to the CVA instituted by Clinton continued to exacerbate the situation and made it even easier for minorities to scream racism when they didn't get a loan because they had a 480 credit rating. Basic common sense economic 101 policy - You can't lend money to people who can't pay it back...period!
Again...IMHO...the government created a bad situation for the lending institutions and they had to find a way around it. Everyone knew from the very beginning that these policies where bad but Wall Street being Wall Street created a window of huge opportunity with CDS and the investment banks ran it in the ground.
So who's really to blame...the greedy banks that capitalized on BAD economic policy or the government for creating the bad economic policy in the first place and then turning a blind eye to what the banks had to do to comply?
How do CDS’s compare to conventional credit insurance from regulated, properly capitalized companies?
Isn’t the credit risk already priced into the interest rate on the underlying debt obligation?
What is the point of CDS’s in the marketplace when (a) risk is priced into the interest rate (b) conventional credit insurance is already available and (c) the debt can be sold at a discount?
GM max’ed out it’s credit card last week. At the rate they are bleeding cash, I’m guessing they are next in line at the trough. And if they line up, Ford will bully it’s way into the line as well.
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