Skip to comments.FReeper Guide to the REAL economic problem - Credit Derivatives - Lesson 1
Posted on 09/27/2008 1:16:46 PM PDT by politicket
Welcome to Lesson 1 of The Basics of Credit Derivatives.
For this lesson I will be referencing the following article: The Ballooning Credit Derivatives Market: Easing Risk or Making It Worse?, which was published in November 2005 by the Wharton School at the University of Pennsylvania.
My comments will be in Red.
Lets get started:
The Ballooning Credit Derivatives Market: Easing Risk or Making It Worse?
Published: November 02, 2005 in Knowledge@Wharton
When Delphi filed for bankruptcy October 8, investors had to start assessing their losses on more than $2 billion in the auto parts maker's bonds, which have recently traded at around 60% of their face value. As bad as that is, there is more. Looming over the market like an invisible and unpredictable giant is an estimated $25 billion in credit derivatives, a form of insurance whose value is directly linked to the ups and downs of Delphi debt.
This paragraph is referencing the bankruptcy of Delphi Automotive Systems, which was once owned by General Motors and was spun off into its own company in 1999. It also talks about the companys bonds. Think of bonds as debt obligations. Youve probably heard the term corporate bonds before. It is one way that a company can raise capital to accomplish its business it sells bonds to investors, in exchange for money to operate. If the company goes belly-up then the bond holders have a higher pecking order than those investors that may have owned common or preferred stock in the company.
The common and preferred shareholders were completely wiped out in this scenario. The bond holders saw that their investment took a haircut and was now only worth 60% of what they paid for it (worth is based on the liquidation or sale of any company assets).
This paragraph also talks about $25 billion in other debt that is hanging over the market from those that bet that Delphi would not go bankrupt and lost. The way that these investors in the market lost is by participating in the selling of insurance to the bond holders. When Dephi filed for bankruptcy the insurance providers had to make good on the full original worth of the bond. In exchange, the bond holder was to hand over the bond (just like when there is a car wreck and the insurance company pays the value of the car in exchange for the car being delivered to them). One problem with this is that the physical number of insured bonds may have not been enough to give back to the insurance providers if there were more insurance providers than there were bonds. When this happens, the bonds have to be purchased by the buyer of the insurance so that they can give them back to the insurance provider. This would be like you taking out two insurance policies on your car and getting into a wreck. You collect from both policies (highly illegal in the car insurance business) and then both insurance companies want the car in return. You only have one car to give back, so you would have to go BUY a second wrecked car of the exact same type, so that you could give it back to the second insurance company.
In summary, what you need to understand from this paragraph is that there was $25 billion dollars of extra debt in the marketplace because of Delphis bankruptcy without any of those in debt physically holding ANY common stock, preferred stock, or corporate bonds. All that they held were bets.
Clear as mud? Good. Lets move on.
What happens to these complex contracts as the underlying bonds plunge in value? Will ripple effects amplify the Delphi damage, spreading harm to institutional and individual investors who otherwise have no stake in Delphi?
The complex contracts that this paragraph refers to are the insurance contracts between the buyer and seller. The seller has absolutely no physical interest in Delphi, except for the bet that they own regarding whether or not the bond will go into default (i.e. not get paid) This would happen if the cash flow backing the bond was insufficient to meet the bonds terms. This paragraph is asking the question: What happens when there are too many sellers of insurance? What effect might this have on the market (and economy) as a whole? Read on
The Delphi situation points to a broader question: Is the credit derivative market, which grew from next to nothing in the mid-1990s to an estimated $5 trillion at the end of 2004 -- and is perhaps more than twice that size today -- pumping new, poorly-understood risk into the financial markets? Or are these exotic products helping to mitigate the shock from corporate crises, as their proponents claim?
Now were getting to the meat. Remember, this article is from the Wharton School arguably the sharpest minds in the investment community. Theyre basically saying uh oh, what happens as the size of this thing begins to spiral out of control. Notice from the paragraph that what began as next to nothing in the mid 90s was estimated at $5 trillion (of bets) in 2004, and was presumed to be twice that amount at the time this article was written or $10 trillion of bets. In 2007, that figure ballooned to around $62 trillion dollars of bets. Since the beginning of this year, there has been an effort under way to identify bets that would be a wash. They have been destroying these insurance contracts (bets) by doing what is known as a tear-up (you can take that quite literally). As of now, there are assumed to be approximately $54 trillion dollars of bets in the market.
The paragraph also ponders whether it is good to pump new, poorly-understood risk into to financial markets? What happens when there are corporate crises? Does this investment strategy help the situation at that point in time or do great harm? Remember folks, this was written in November, 2005. I want you to write a date down on a piece of paper so that you dont forget it as we continue these lessons July, 2007.
"They're huge, and they have grown very rapidly," said Wharton finance professor Richard J. Herring, describing credit-derivatives products. "In principle, they are redistributing risk," he noted, adding that in the past few years, credit derivatives have helped the financial markets weather storms like the bankruptcies of Enron, WorldCom and Parmalat as well as Argentina's debt default.
It was believed for quite some time that the more credit derivatives in existence, the better. The mindset was something like this: If a catastrophe happened with a particular company, and there had been a huge number of sellers of insurance on the corporate debt, then each insurance seller would only end up paying a little bit of the entire bill.
Heres an illustration: Lets pretend that you go out to dinner with four of your friends. After dinner, the bill comes and immediately somebody asks: Whats the damage? In our story, the damage is $100, so each person takes out $20.00, plus a premium (for the tip) and the dinner is complete. What if only one person brought their wallet? They would have incurred greater harm because there was no redistribution of risk the risk being if you eat our food, you pay our bill.
This all sounds logical, right? Theres no downside, is there?
"Those events would have been sufficient in an earlier era to cause major problems to major banks, and even to precipitate a banking crisis," he said. "But the banks have been fairly robust, and the reason is that someone else is holding the credit risk." However, he added, "What we don't know with any new market is whether something that somebody hasn't quite thought through is going to cause a meltdown."
This paragraph should have you sitting a little straighter in your chair. Finance professor Richard Herring is saying how great credit derivatives are, but stating what has now become painfully obvious. Let me repeat: What we don't know with any new market is whether something that somebody hasn't quite thought through is going to cause a meltdown.
There was something they didnt think through correctly, and it is here, has been here since July, 2007, and will continue rolling forward. Lets move along
In September, the Federal Reserve summoned 14 major banks to a meeting to discuss troubles with the credit-derivatives market. The concern was not that these instruments are intrinsically hazardous. Rather, the Fed worried that the market has grown so quickly that participants cannot keep up with the paperwork. If trades were not processed fast enough, investors could lose confidence in the market and a normal crisis could snowball.
Here was a meeting, with the Federal Reserve and the major banks (the brightest minds in the business) and rather than focus on risk assessment from ballooning credit derivative bets they worried about how to fix the system so that they could handle MORE of them. After all, spreading out the risk was a brilliant strategy or so they thought.
The alarm had been raised earlier in the summer by E. Gerald Corrigan, managing director at The Goldman Sachs Group. As president of the New York Federal Reserve Bank in 1999, he managed the Fed's response to an earlier credit crisis, the collapse of hedge fund Long-Term Capital Management.
Here we learn that E. Gerald Corrigan was the one that wanted the Fed and 14 member banks to get together. He was the one that was concerned that more needed to be done to get more credit derivatives flowing through our economic system and that of the world. Mr. Corrigan, who was once the President of the New York Federal Reserve Bank, was managing director at The Goldman Sachs Group. His boss was the CEO of Goldman Sachs, Hank Paulson our current Treasury Secretary of the United States.
Eric. S. Rosen, managing director and head of North American credit trading at JP Morgan, one of the biggest players in this market, addressed this topic during a panel discussion on sales and trading at the October 14 Wharton Finance Conference. "The Fed is getting worried about the infrastructure," he said. Regulators made it clear at the meeting that "they don't care what your [credit derivative trading] volumes are; you've got to get the system in order." His company is spending $100 million on systems to handle the soaring volume. "I think the Fed has got it right," he noted.
Now, we read that on October 14, 2005, the head of JP Morgans North American operations told a group of high-powered financial executives that the Fed is getting worried about infrastructure. They were also told to not worry about trading volumes ($10 trillion of bets at the time), but to get their process in order, so that they could handle even more bets.
Yes, this is the same JP Morgan that the government has given sweetheart deals to in the takeovers of Bear Stearns and Washington Mutual.
The credit-derivatives market barely existed before the mid-1990s. It developed when new mathematical insights made it possible to set prices for more complex instruments. Market participants were also gaining experience with other forms of derivatives tied to stocks, commodities and currencies. Banks and other lenders and investors were looking for new ways to hedge against risks. And investors such as hedge funds, insurance companies and pension funds were looking for ways to take on risk in hopes of earning higher investment yields.
This paragraph is pretty much self explanatory, except I want to expand on a couple of areas. The original credit derivatives market in the 90s was driven, for the most part, by Investment Consultants that were sincerely looking for a larger return for their client portfolio. Over the years, they have created amazing mathematical formulas that rival the 7 spices of Colonel Sanders recipe in their complexity. There is an incredible amount of competition in the Investment Consulting industry and there has always been pressure to get a leg up on your adversaries.
This paragraph talks about Banks (meaning both commercial and investment) looking for new ways to hedge against risk. Understand that they actually were looking for MORE risk, because it provided MORE return. The problem they faced is that the banking industry is heavily regulated and for a long time they were burdened with managing illiquid assets that only gained a good return. Credit derivatives was their salvation. It allowed them to create hedging strategies where they could actively participate in the high risk high gain marketplace, while still meeting the letter of the law in regulatory requirements.
One last point: Notice how insurance companies and pension funds (yes, your retirement) were getting all tingly about the prospect of taking on more risk. Just like the banks, they had been stuck with conservative investing strategies, and credit derivatives were a thing of beauty to them.
Were almost done with this lesson, hang tight..
The driving force in creating the credit-derivatives market, said Herring, was big banks looking for ways to make assets, such as loan portfolios, more liquid.
One word describes this paragraph GREED! The investment and commercial banks of the entire world put everything at risk so that they could participate with the big boys where it involved risk.
You made it through Lesson One! Still hanging in there?
The next post will be Lesson Two. Well still be covering the same article which will encompass the first 3 lessons.
As economists say, ‘No free lunch,’... except if you can get it from taxpayers, via corporate welfare, which is just a forced wealth transfer - socialism.
Man, oh man, you just wanna punch'um in the mouth, but they're so drunk they probably won't feel it and you don't want to hurt your hand.
I thought they were the big boys, and how can the derivatives be worth several times more than the bonds themselves? The only net loss was the $800 billion on the $2 billion in bonds, since they were still worth 60%.
Thanks. This is going to affect all of the debt since it is suspect too. Anyone living beyond their means is going to get hurt.
bookmark to read later
FR Keyword: moneylist
This can be a high-volume ping list at times.
Thanks for the Ping FRiend! Great explanation...hitting print button NOW.:)
Thanks so much
You should carefully evaluate the "lessons" that you pass along. As a matter of general principle, please consider (and pray about) the proposition that pitchfork populism is a deadly as thoughtless elitism. "Mainstreet" and the farm contributed mightily to the problem by devouring loans that they could not service.
Great analysis, and not to hijack or belittle the thread, but I would like to add that the root of all of our financial troubles is a fractional-reserve banking system / combined with a fiat currency.
This proposed “bailout” is going to skyrocket inflation, the goverment’s secret little tax. The lack of liquidity in the market is just beginning to rear it’s ugly head, so make the appropriate adjustments to a portion of your investments to diversify for such changes.
I watched a lady at the bank today trying to withdraw $33,000 cash. Big bank, main branch, brags about it’s “assets”, beautiful building, huge, open vault right there, only one other customer - they did not have the cash on hand. I could tell her brain could not process why she could not get her cash. I wanted to step in and maybe give her a little clue, but decided against it. Obviously her first run-in with how small the “fraction” really is...
thanks. Look forward to installment 2.
I’ll post here another article about the credit derivatives problem. It should be noted that the proposed bailout bill does nothing to address the problem with derivatives, all it does is buy time. One has got to be fairly certain that the initial $700 Billion bailout is only a down payment on the eventual total of taxpayer $’s that will be required. 3-4 years now we’ve been hearing over and over that the bottom is near and things are going to turn around. Well, they’ve given up on even pretending the bottom is near, but now we are supposed to believe $700 Billion will fix the whole thing. It’s a simple matter to go to the International Bank of Settlements website and see the sum total of outstanding derivatives. It’s a staggering $1,000 Trillion or $1 quadrillion if you prefer.
I’m no economics genius, but I’ve read and learned enough in the past 5 years to realize that the problem with derivatives is that banks/financial institutions that hold them, which I guess is nearly all of them, have to pay out (as in insurance payouts) the “notional” value of the derivative, when the underlying party goes belly up. The fact that they are bond related forces them to be covered way before any shareholder, preferred or otherwise would be made whole.
I don’t think I’ll go on much further, but it’s certain that punks with doctorate degrees in finance thought they could game the system, making huge profits along the way and the derivatives made it all risk free!!
I have no idea how, where or when it ends.
Here’s the article I mentioned in the first sentence above.
I would change "essential" to "fatal". By transferring risk from the assets and payment streams that underlie the original securities to a complex scheme of insurance and arbitrage, they make it impossible to estimate and therefore manage risk.
It describes a CDS as a bet. This is false.
Let me explain first what a CDS is.
It is a contract which states that in the event of a default on a "reference obligation" (which depends on the contract: the reference obligation could be bank indebtedness, corporate bonds, debentures, etc.) of a company, then the buyer of the contract is entitled to a certain payment from the writer (seller) of the contract upon delivery of the reference obligation.
Let me give an example.
Widget Corp issues $100MM senior unsecured bonds. Alice believes that there is a risk of default on these bonds - that Widget will go bankrupt and be unable to pay interest or principal on the bonds. So Alice goes to Bob - a trader who writes CDS - and purchases $10MM of CDS on Widget.
Other investors feel the same as Alice does and Bob eventually writes 200MM of CDS on this 100MM bond issue.
Widget defaults. The bonds trade down to a level where they are selling at 10 cents on the dollar.
Alice decides to cash in her CDS contract. In order to do this, she needs to deliver the reference obligation - she needs to get $10MM face value of Widget bonds so that she can deliver them to Bob, so Bob will be required to pay her the $10MM.
So Alice goes into the open market to buy $10MM face value of Widget bonds at 10 cents on the dollar - in other words $1MM in market value of Widget bonds.
However, there are individuals who hold $200MM of Widget CDS and only $100MM in bonds to fulfill the reference obligation.
This means that CDS holders will bid up the bonds from 10 cents on the dollar up to a higher level until the CDS contract has no more inherent value.
What has this done? It has had the effect of spreading risk much more evenly around the market that would have happened otherwise.
Let's dig deeper for a moment. Why would Alice buy CDS in the first place? Is she a gambler, making a bet? hardly. Alice, like almost all buyers of CDS, is a portfolio manager attempting to use CDS as a tool.
For example, she could be a manager of a convertible arbitrage fund.
many companies issue convertible debt. This is a bond which acts like a normal bond but can be exchanged for a certain number of shares of the company's stock.
So if a company issues a $1000 bond which is convertible into 10 shares of the stock, as long as the stock is below $100 a share and the company's credit is good, the bond will trade in the neighborhood of "par" or its $1000 face value.
However, if the stock shoots up to $150 per share, that bond may trade up to $1500 in the market.
So basically a convertible is a bond that comes with a call option on the stock.
Alice can remove the equity risk to her bond caused by fluctuations (volatility) in the shares by shorting shares of the stock. If she could also remove the credit risk in the bonds by selling short that risk, she would be able to eliminate both the equity and the credit risk in the bond and be able to get a return based solely on the volatility of the stock and the credit.
This is one example of what is known as a "market neutral" strategy.
Well, there is a large market out there for equity options, and there is also a large market out there for credit options (CDS contracts).
They are not normally used by investors as bets, but as risk management tools.
Very few people seem to be worried about the enormous volume of sales of naked equity options (people selling naked calls, for example, as well as far more exotic equity options) but everyone seems to be have fainting spells over naked CDS.
It's irrational and uninformed.
Wrong. Most derivatives are interest rate swaps. Trading a fixed income stream for an adjustable income. In these swaps, no matter what happens, no one is paying out the notional value.
The free market ideologues wants to pretend this crisis is completely the cause of CRA and congress.
It’s simply not true, the CRA contributed to this, but there is no question the greed in the financial sector cause them to run wild with reckless investments.
Why do you object to the term “bet”? All investments are bets. Some are better bets on others. But anything with a risk/reward scenario is a bet.
So I have no problem with referring to CDS as a bet.
A strategy requires skill and a knowledge of probability.
Comparing investment professionals to a drunk tourist at a Vegas craps table may be a cute laugh for the audience, but it's an inaccurate and misleading description.
I agree. The only way a banking system should work is that the bank should keep all the deposits in the vault. 100%! Then, if you wanted to withdraw your money, it would be right there.
“No free lunch,... except if you can get it from taxpayers, via corporate welfare, which is just a forced wealth transfer - socialism.”
The free lunch principle is still in effect under socialism. Oh, sure, they have forced wealth transfers, but they also accidentally starve tens of millions of people. It’s a trade-off.
Everything I have seen to date says that in a bankruptcy, unless there are offsetting derivatives between parties, the derivative becomes fully valued or at it’s notional value. Now, I prefaced my post by saying I’m no financial genius, but perhaps you can steer me to a source regarding derivative value and bankruptcy.
I take it you are an “investment professional”.
Well guess what, all you do is bet. Because in reality, nobody knows what is going to happen. The stock market is just a casino with better odds than the ones in Vegas.
“but there is no question the greed in the financial sector cause them to run wild with reckless investments.”
Foolishness! Everyone in the private and public sector is always greedy. That’s axiomatic. The difference between financial collapse and a growing economy is that greed is channeled into profitable (i.e. productive) enterprises in the latter. What makes credit expansion—and government intervention in the market in general—so destructive is that greedy people have no signals to tell them “Stop! Your greed will not be satisfied by proceeding.”
The mafia is greedy, and it can steal your money with a gun. That’s why we have laws against violent coercion. Bankers can steal your money by expanding the supply of money. That’s why we’re supposed to have laws drawing the line past which banks cannot lend.
“Anyone living beyond their means is going to get hurt.”
Bono can solve that problem.
“there is no question the greed in the financial sector cause them to run wild with reckless investments”
To put my response to this issue less pithily, the reason greedy investors ran wild was because the market was flashing the signal to them that they were earning profits. Bu they weren’t profiting, were they? How could they be so mistaken? Easy credit fooled them. There’s no other explanation. There’s no other reason so many people would make the same mistake in so short a time.
Let's say you bought a CDS (credit default swap) on $10 million of Lehman debt that you paid $120,000 a year for and Lehman defaults, the seller would be liable for the $10,000,000 and you'd have to deliver the $10,000,000 in bonds (now worth much less) to the seller of the CDS.
Most of the contracts allow a cash settlement, so the underlying bonds don't have to change hands.
The vast majority of swaps are interest rate swaps. Fixed rate for adjustable. If I own $10,000,000 in bonds that pay an adjustable coupon but I want the security of a fixed rate, I can enter into a swap so that I give up my adjustable payment and receive a fixed one.
It doesn't matter if I go bankrupt or my bond craters or my counterparty goes belly up, neither party is suddenly liable for the $20,000,000 notional value.
Correct, that’s why the market should be regulated, to a degree. Because with absent adequate laws to limit their behavior, the human tendency is to take advantage of every one for selfish motives.
That doesn’t mean I’m against a free market. A free market does not equal anarchy, the rule of law is essential to the success of a market economy.
“Comparing investment professionals to a drunk tourist at a Vegas craps table may be a cute laugh for the audience, but it’s an inaccurate and misleading description.”
Have you ever heard of professional gamblers? They most certainly weigh the odds. Ultimately, neither investors nor gamblers can see the future.
“That doesnt mean Im against a free market. A free market does not equal anarchy, the rule of law is essential to the success of a market economy.”
Damn right, and the rules governing the lending industry should be no more complicated than other property-right laws.
If you want to describe all activity undertaken without foreknowledge of the future as "betting" - then every job anyone has is "betting" and almost anything anyone every does is a "bet."
In other words, it is a meaningless descriptor when used that vaguely.
Describing financial transactions as "betting" gives the reader exactly zero insight into what is going on, while giving him the illusion that he is gaining insight.
It does no one any good to insist on not thinking clearly about the current financial crisis.
But these are issues of the appropriate management of credit risk. Credit derivatives are like guns: Guns should not be banned because bad actors use them to kill innocent folks.
Well, there is a discrepancy between replacement cost and market cost.
A bottle of water cost what? 5 cents to produce, and $1 on the market.
Let’s say there are 100 million bottles of water in the world and they are all destroyed. What’s the cost of replacing them?
Would it be the market cost of purchasing 100 million bottles? In which case it is $100 million, or would it be the cost of producing 100 million bottles, in which case it’s 5 million.
What about a megaton TNT bomb? There are some weapons that cause such collateral damage when misused that we don’t allow private individuals to own them simply because potential damage is too high for society to bear.
Is the CDS more like a gun or a massive bomb in this scenario?
That's a better analogy in some limited ways, but the implication of this trend in "financial news coverage" is not to compare investment professionals to the cool and unflappable professional gamblers of noir cinema. It is meant to imply a bunch of rubes playing roulette.
The jaded scorn of a green-eyed hipster.
Actually, it gives plenty of insight because it tells the reader what is really going on.
The investment professionals wants to pretend that they have some in depth knowledge about where risks are located, and how much risk there is, that they have everything figured out in nice little formulas that can predict how much money you’re going to make.
They are lying, either to themselves or to the public, they don’t know, their knowledge is woefully inadequate.
Because if they did know, then communism would work. All we we do is just put these professionals in charge of the planned economy and they can allocated financial resources in the economy in the most efficient way possible.
If the reader has no understanding of financial economics before reading the article, the article itself will not give the reader the knowledge needed to make sensible comments.
Lots of good facts there, but I'm not sure how you obtain your conclusion. Once the default risk of some securities is transformed into the default risk of a major CDS counterparty like AIG, then the pricing calculation turns into a govt bailout probability calculation which is indeed what happened.
At the same time the holders of the CDS like Goldman Sachs who used them to speculate on the default crisis as a whole have a economic incentive for particular failures, because the more likely the underlying MBS are to fail, the more GS's CDS for them are worth.
It's a tool for complete financial system failure, not a gun to shoot a specific target, but a building full of gunpowder in the center of the financial district.
The issue is not whether something is dangerous “only when used unwisely”, that is not the criteria. The criteria is when it is used unwisely, what are the potential fallout of such an incident.
If the fallout is mainly localized to the person making the unwise action, then we allow it because the individual bears the risk. But if the fallout engulfs a significant portion of the public as collateral damage, then society has a right to step in.
If you’ve got a ping list, add me. And while we’re at it, cut to the chase. How bad are things going to get?
You said it before I did, see my previous post.
No it doesn't.
I explained how CDS actually works in post 19.
You didn't understand post 19 - all you took away from it is my distaste for the inaccurate use of the word "bet."
You can continue playing that semantic game all you like, but before you can claim that you know what "is really going on" you'll need to be able to comprehend the rest of post 19.
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