FReeper Guide to the REAL economic problem - Credit Derivatives - Lesson 1

Politicket | 9/27/2008 | Politicket

[PapaBear3625]

If we do the $700 Billion bailout, doesn’t the game start up again?

Yep. It's called "moral hazard". If this situation does not end up with everybody who touched derivatives losing their shirts, to the extent that the next smart young guy who brings up the subject of derivatives trading being immediately fired, then we will have this happen again.

Yes, derivatives are fun, and can potentially produce high returns. But no institution upon which the financial system depends, like banks and insurance companies, may be allowed ever again to be associated with them.

[PapaBear3625]

From my understanding a “naked short” is borrowing a stock that one does not own and immediately selling the stock, thus leaving one with a “naked” short position on the stock.

Ok, now I understand how we got off the rails. You are describing a regular short sale, where the seller borrows the shares he is selling. A "naked short" is where you sell shares that you plain do not have, and potentially may not be able to cover.

[GOPJ]

Yep. It's called "moral hazard".

And the loan machine will start up too.

All those homeowners who haven't made a payment in a year or two will be foreclosed and their homes sold. Bets will be placed by the derivative folks and the game starts up.

Except when they need to be bailed out in a year, the US will be broke - we'll be third world for a hundred years.

[GOPJ]

ping

[supercat]

Credit derivatives in and of themselves are essential to modern financial economics.

The term "credit derivative" encompasses many types of instruments, which may be used in many different ways. A lot of problems in today's marketplace are a result of credit default swaps (a specific type of derivative). Credit default swaps are somewhat like insurance, but without any effort to control some major moral hazards associated with both buyers and sellers. While financial "insurance" may be useful, I see no legitimate market use for a form of insurance that includes no check against fraud.

Imagine what would happen if it were legal to buy fire insurance on any property, without regard for insurable interest, and there was no way for companies to find out what other companies had written policies, nor any rule against multiple pay-outs.

If such insurance purchases were legal, insurance-fraud arson would be far more lucrative than it is today. After all, today's rules limit recovery to the actual value lost. If one could buy multiple independent policies, though, one could collect multiple times the value of the destroyed property.

Meanwhile, sellers of 'insurance' may have a perverse incentive to offer maximize the correlation of the insured risk. If the big one hits, they pay pennies on the dollar; if it doesn't hit, they lose nothing.

[FreedomHammer]

more study and action items.

[Huck]

Are you familiar with James J. Puplava’s writings over at financialsense.com?

http://www.financialsense.com/series2/rogue.html

I used to read his columns back around 2000, when I knew even less than I know now. It seems like he had the whole thing nailed years ago.

[AlanGreenSpam]

Wideawake: Great description... Thanks!

Question though... You said, “Other investors feel the same as Alice does and Bob eventually writes 200MM of CDS on this 100MM bond issue.”

Wouldn’t there only be a one-to-one mapping between the amount of actual bond issue (100MM) and the amount of CDS “open interest” (to use stock option parlance)?

In other words, why would there be a market for more CDS’s than there is bond issuance? Wouldn’t only people buying the bonds want this kind of insurance?

Or is it like the stock options market where you might simply have bettors who think there is a good chance that Widget Inc. will go belly up?

Thanks in advance for your response...

[wideawake]

Wouldn’t there only be a one-to-one mapping between the amount of actual bond issue (100MM) and the amount of CDS “open interest” (to use stock option parlance)?

Excellent question and excellent guesses.

No one-to-one map and one reason why is this:

Companies often have more than one kind of debt.

In order to get your CDS contract paid you need to deliver the face amount of a "reference obligation" - so a CDS holder can deliver the notes we described, or he could deliver another piece of debt - say a participation in the company's bank loans. This is because the CDS contract does not name specific bond issues - any piece of debt that has the same ranking in the company's capital structure is a "reference obligation."

Or is it like the stock options market where you might simply have bettors who think there is a good chance that Widget Inc. will go belly up?

That is the second reason exactly. Some people sell CDS because they think a credit is going to improve, others buy because they think it will deteriorate.

[444Flyer]

Ping.