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

Politicket | 9/27/2008 | Politicket

[palmer]

The ideal world sounds nice, but you should add few real world scenarios. Bob issues CDS on BuggywhipCorpX and BuggywhipCorpY. Both default due to an unforeseen inventions, Bob only expected one or the other to default and Bob runs out of money. Govt bails Bob out.

Bob uses his "AAA" from other parts of his business to obtain credit lines for the CDS. Sam wants to compete with Bob but with his more expensive credit lines, Sam changes his default assumptions and offers the same or better price for his CDS as Bob (there are no regulations on them). Sam ultimately defaults on the CDS he issued.

Bob prices CDS assuming there would not be a recession. Alice thinks there will be recession and buys lots of Bob's and other issuers' CDS as a speculative investment. In one case there is a recession, Bob is out of money, govt bails him out. In another case there is no recession, but Alice is unable to pay her CDS obligations and Bob is forced to write them off leading Alice to default on her obligations in a systemic meltdown.

[palmer]

Systemic risk is an issue for the regulators of the institution.

An appointee of the governor of NY??

[PapaBear3625]

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.

No, it's not greed, it's criminality. And I'll explain why.

One feature of pay and bonuses for executives and traders is that, once it is paid, you are not required to give it back if things crash in the following year, and you cannot be assessed a negative bonus.

So if an executive can take an action which pumps up profits this year, and so qualifies for a $10M bonus, but this action creates a crash the following year, the executive still retains his bonus.

Executives have no incentive to look long term, to look beyond the end of their expected stay at the firm. Executives have lots of incentives to make sure this quarter is good, by whatever means necessary. So it turns into a game of "delay the crash as long as possible, and grab as much money as you can, for as long as you can".

[PapaBear3625]

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.

Warlord had it right, from the executives' viewpoints.

Derivatives allow executives to conceal the true financial condition of their firms, so that they can claim their bonuses and stock options.

[palmer]

http://www.financialsense.com/fsu/editorials/amerman/2008/0917.html

[PapaBear3625]

I thought they were the big boys, and how can the derivatives be worth several times more than the bonds themselves?

Suppose I buy insurance on the full value of your house from Insurance company A. Then I buy insurance on your house from Insurance Company B. If your house burns down, then I make double the value of your house.

But doing this will put me in jail, because it creates an incentive to burn down your house.

It's a similar deal with CDS's. they created a financial incentive to burn down our economy.

[Toddsterpatriot]

It's a similar deal with CDS's.

So you buy a CDS on some IBM debt. How do you burn down the house of IBM?

[VOA]

bump for later read

[politicket]

and how can the derivatives be worth several times more than the bonds themselves?

Because many 'insurers' sell 'insurance' on the bonds (between party's that don't even issue or own the bonds), so when the bond defauts it can pay out many times the face value of the underlying bond.

[politicket]

The problem is not “credit derivatives,” but the failure of institutions to manage adequately exposure to such risk. Credit derivatives in and of themselves are essential to modern financial economics.

I completely agree with you. This current economic problem is based on the greed of the entities that wielded otherwise useful tools very, very unwisely - and past a danger point.

My intent in these lessons is not to cast down credit derivatives - it is to educate the public that the issue about to bring down our economy is centered around the great misuse of credit derivatives.

[Moonman62]

So, how exactly would the government bail Bob out?

[4Liberty]

As an economist, “shorting stock” transactions seem irrational.

As I heard them explained, you promise to sell someone a stock you don’t yet have - but only if the price is later LOW, when you buy it (to then give to them).

Why wouldn’t the FIRST person simply buy it, at the LOW price you are planning to buy it at?

Why would the first person even MAKE such a deal?

Please explain - thanks.

[palmer]

By preventing the market from taking Bob over and selling some assets and defaulting on others. There were several offers for “Bob” aka AIG, but the govt overrode them and forced Bob to take a bridge loan and stay in business.

[palmer]

There is no first person. To short naked, you sell some stock you don’t have. Your brokerage puts the money in your account and notes that you are on the hook for some shares. Time passes, the price drops, you buy some shares and relieve your obligation. Or, time passes, the price rises, the brokerage makes a margin call which forces you to buy the shares to relieve your obligation.

[politicket]

This article may be from the Wharton School, and it may be edited or excerpted in some way, but it does not give a clear explanation of what a credit default swap is. It describes a CDS as a bet. This is false.

You need to read the WHOLE lesson (bad student... ;-)). If you did, then you would have learned that the referenced article is broken down into 3 lessons. The second lesson is all about Credit Default Swaps.

Stay tuned...

[PapaBear3625]

So you buy a CDS on some IBM debt. How do you burn down the house of IBM?

If you have enough CDS's, more than the value of IBM, you could do lots of things to make IBM fail.

For the case of CDS's on MBS's, you just wait for the next recession.

[politicket]

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.

Why doesn't everyone wait until I post the last two lessons based on the article, and then make a determination of the whole?

[Moonman62]

If there were several offers for Bob, how come his stock price got down in the low single digits?

[concentric circles]

Thanks for posting. It’s hard to imagine gambling on such a large scale.

[politicket]

And while we’re at it, cut to the chase. How bad are things going to get?

I don't have the answer to that one.

If I'm correct, and the current bailout plan passes, then you will see euphoria in the market for 3 - 5 days. It will then be followed by the credit market beginning to seize up again - and the general public won't have a clue what is going on.