Posted on 09/27/2008 9:05:01 PM PDT by politicket
Lesson 1 can be found here: Lesson 1
Welcome to Lesson 2 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.
Let’s get started:
The Ballooning Credit Derivatives Market: Easing Risk or Making It Worse? (continued) Published: November 02, 2005 in Knowledge@Wharton
Credit Default Swaps
Credit derivatives are contracts that go up or down to track the fortunes of underlying corporate debt, such as bonds the company has issued or loans it has taken out. Typically, the company is not involved in the credit derivatives contract, which usually involves the bond holder or lender paying a fee to shift risk to a third party.
A company that issues bonds usually has no connection to a Credit Default Swap, which is basically an insurance policy (like your auto insurance) that the face-value of the bond will be paid back to the bondholder by the insurance company, in the event of a default on the bond. Just like most any insurance policy, the buyer of the insurance (bondholder) pays a premium to the seller of the insurance. Pretty simple stuff. Let’s go on…
"The market for credit derivatives is mostly dominated by credit default swaps (CDS)," said Wharton finance professor Krishna Ramaswamy. He described them as "an 'insurance' contract in which the buyer of protection pays a periodic and ongoing premium in exchange for a payment from the protection seller when a well-defined event is triggered...."
Again, this paragraph is pretty self-explanatory. Usually, the ‘well-defined event’ would be a cash flow event to where the bond defaulted, or possibly went into partial default. As stated previously, the bondholder pays an insurance premium on a periodic basis to maintain the insurance coverage.
A typical buyer is a bond owner or lender who is expecting to receive payments from the corporate borrower. The CDS can protect that income stream or offset any decline in the value of the bond or loan the buyer owns. Like an insurance claim, the payment is triggered if, for example, the bond issuer goes bankrupt, fails to make its debt payments, restructures its debt or suffers a rating downgrade. In the U.S., these contracts typically run for five- or 10-year periods, and they provide protection in blocks of $10 million to $20 million.
A bond is a debt obligation, as is a loan. A corporation is obligated to meet the terms of its debts. This paragraph is again referencing the insurance nature of the CDS, and it mentions some of the ways that an insurance claim can be triggered. You can also see that these insurance contracts typically provide coverage for a pretty long time, and work in fairly large blocks (in other words, you wouldn’t buy bond insurance on an individual bond that you bought for your grandchild).
Once a CDS is created, it can be traded in the secondary market, much the way bundles of mortgages are traded as collateralized mortgage obligations. Its price will rise or fall as the market assesses the health of the underlying corporate debt. Thus, the risk of a company defaulting on its debt obligations can easily be passed to investors willing to shoulder it. "The system is actually more stable because of these mechanisms," Ramaswamy said. "The losses...are best borne by a wider pool of investors, each holding a diversified basket of these obligations."
This paragraph is the reason that I call credit derivatives, and specifically Credit Default Swaps, “bets”. The underlying function of the CDS is just straight insurance coverage, but now we start getting into the ways that they have been abused. The secondary market, OTC (Over-the-Counter), etc. provides a means of “betting” on whether a company is going to be able to meet its debt obligations. More on this soon… It is believed that ‘spreading the risk’ to a bunch of ‘insurers’ would greatly lessen the risk to any one ‘insurer’, should a given company default on their bonds, loans, or other debt obligations. Sounds like pretty solid thought. You wouldn’t think that anything could be wrong with that logic.
In recent years, many credit default swaps have been assembled into baskets and traded as indexes, much the way stocks can be traded through S&P 500 index funds. This allows investors to use credit default swaps to bet on broad changes in credit markets -- betting that default rates will rise or fall, for example.
This describes another way that investors can participate in a wide-range of Credit Default Swaps. A group of CDS’s are gathered together into what is called an ‘index’ (just like the S&P 500 is an index of companies), and the investor is able to buy shares on the group as a whole. This helps to lessen the investor risk, since the bankruptcy of any one ‘index’ company can be somewhat offset by the remaining ‘healthy’ index companies.
With a CDS, an investor can focus a bet on credit risk, while an investment in a bond or loan entails a much broader assortment of risks -- credit risk, interest-rate risk and currency risk, for example. Credit derivatives also can be used for shorting and hedging strategies. All of that is much more difficult for investors trading in actual bonds and loans.
This paragraph is a very important one to understand. If an investor were to invest in a ‘physical’ piece of paper (a bond, stock, loan, etc.) then there are a myriad of things that the investor would need to heavily consider – because a default on the debt obligation would go directly against them. With a CDS, the main focus is just on the credit risk of the company that the CDS represents. It is a “bet” as to whether the company will be solvent or insolvent over the performance period of the underlying debt obligation. Also, without getting into too many complexities, CDS’s are very liquid when traded in the secondary markets; whereas, company bonds and loans are highly illiquid and cannot be “hedged” as easily. Think of the phrase ‘Hedge your bets’. It’s basically a way of investing where you take a risk, but you also take some form of opposing risk in order to protect you if your first risk goes bad. You need assets that are fairly ‘liquid’ in nature to do this effectively. CDS’s have that as one of their strong points.
Banks are both the biggest buyers of CDS protection and the biggest sellers, using them to reduce their risk exposure to companies to whom they have lent money, thus reducing the capital needed to satisfy regulatory requirements. Other big buyers are securities firms and hedge funds, while re-insurers, insurers and securities firms are the other large sellers.
This is another extremely important paragraph to read, and to understand. Banks (stodgy, conservative, put your down payment on the table) have jumped at the opportunity to use CDS derivatives. They can buy insurance to protect themselves from loans they have given out, and they can also sell insurance, while getting the premiums, to protect other entities against loss. This, in turn, has enabled banks to use the ‘liquidity’ afforded by CDS’s for investments that they otherwise couldn’t have made under regulatory rules. They are able to keep less ‘reserves’ because of the CDS insurance that is in place to protect them. It works great, when it’s used properly and without greed.
In recent years credit default swaps have been bundled together to create collateralized debt obligations (CDOs). Typically, a CDO contains swaps from more than 100 companies. Once put together, the CDO is sliced into several tranches, which are then sold separately. At one extreme is the high-risk, high-yield slice. Owners of these get a disproportionately large share of the income flowing into the CDO. But they also are first to suffer the losses from any companies that default. At the other extreme is a safe, low-yield tranche, with one or two other tranches occupying the middle.
Here is another area where deceit can rule the day. And your thinking cap is going to have to be on tight. Let’s start back at the beginning a little bit:
Joe buys a house, the mortgage loan gets sold up the chain (let’s pretend like it ends up at Fannie Mae). The loan is bundled with a bunch of other loans of the same type (i.e. prime, Alt-a, subprime). Each particular bundle is divided into “tranches” (buckets of ‘stuff’ having approximately the same credit risk). These tranches are rated and sold to the bond market. The best tranche out of a bundle of mortgages is considered “Senior”, meaning it gets paid back first if the ‘bundle’ goes bad, and is usually rated ‘Aaa’. The rest of the tranches are rated and ranked based on their credit risk, from best to worst.
The top tranches are usually easy to sell in the bond market, but the bottom level tranches are difficult, because they are pretty much junk. So, how to fix this problem?
Sometimes, the bottom level tranches are gathered together into what is known as a “Collateralized Debt Obligation” or CDO. This CDO itself is split into a series of tranches, rated, and sold to the bond market. The CDO has its OWN Senior-level tranche, that is often rated ‘Aaa’ since it is the best tranche of the CDO. The other CDO tranches are rated from best to worst underneath the Senior tranche.
So what just happened? Junk level securities were just magically made into ‘Aaa’ rated bonds in the CDO’s Senior-level tranche.
Also notice that any income flowing into the CDO is mainly absorbed by the LOWEST level tranche, since it is taking the highest risk – and therefore gets the highest reward. If the CDO goes belly-up then the Senior-level tranche (which gets the least income while the CDO is healthy) gets paid first, and then on down the line.
The CDO market has mushroomed in the past few years as investors hunted for higher yields than they could get with more traditional interest-paying investments. Last year, an estimated $1.2 trillion in risk was transferred to investors through CDOs.
You can see by this paragraph that CDO’s are being, and have been, heavily used. They offer an attractive higher yield (remember, they were at the bottom part of the original mortgage bundle), but also have the highest risk associated with them (even though many of them are rated ‘Aaa’ due to the ‘interesting’ way in which they were created). You also see that in 2004, one year before this article was written, there was $1.2 trillion of risk assumed by those who invested in CDO’s. That dollar number has mushroomed exponentially since that time.
Another key feature of credit derivatives: leverage. The value of credit derivatives can greatly exceed the value of the debt they are based on. That is because the entity that buys credit insurance does not actually have to own the bonds or loans it is insuring.
Have you ever taken out car insurance on your neighbor’s car? How about house insurance on the guy you saw at the store yesterday? What if you had 1,000 people decide to take out life insurance on you? Would you feel a little paranoid? Maybe lock yourself in your house while heavily armed?
This is the equivalent of what is going on with credit derivatives. You can take out (‘buy’) insurance on debt obligations that you don’t own. And since many, many entities can do the exact same thing it creates a great big leverage factor if that underlying debt obligation goes bad. The seller(s) of the insurance now needs to pay up to a whole bunch of buyers.
You are now through Lesson Two! Wipe that glazed look from your eyes…
The next post will be Lesson Three, where we discuss ‘Short Squeezes’ – and no – that’s not giving your wife a quick hug!. We’ll still be covering the same article – which encompasses the first 3 lessons.
When I think of “crash” I’m thinking of the snowball finally hitting the bottom of the hill and obliterating everything. Bringing the whole market down with it. Any idea where the bottom of the hill is? I keep hearing the word “correction” from all these yahoos on T.V.. It makes me laugh now.
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??!?!?!?! I was nodding my head and not too worried until I read this line. That's insane. It's like being able to take out auto insurance on a car owned by a guy you don't like, and getting paid if he crashes because you cut his brake lines. And to make things even better, you have a nice handy CDO label of cars whose brake lines are already cut!
It is clear as mud that our 'representatives' knew that they could play the system to the tune of trillions and the only thing that put a halt on their greed was the proverbial well runnin dry...ie worthless paper...
sad fact is that the well has been essentially dry for a very long time, and I believe the smoke & mirrors couldve ran for much longer had it not been for an empty suit needing a bounce...
to me it doesnt really look like theres any 'real' value in the market, all bubble, no solid, unless you can 'bundle' ALL the property in the country to cover it...
premeditated, treasonous thievery by 'elected' scum, all of which need to be stripped of every RED cent they stole and buried under the prison...
I don't know. They are either foolish, blinded, or in on the whole deal. I'm beginning to feel the latter.
Your article is pretty good, but it's when you start calling people greedy and insinuating conspiracy that you lose me.
That is, you seem to be attacking the philosophy underlying the creation & operation of the derivatives markets. If so, then it appears you are blaming "greed" & advocating greater regulation; isn't this what Barney Frank and other Dems are claiming?
The real issue isn't the derivatives markets - they should be allowed to operate in any legal manner as they choose - these are PRIVATE contracts.
The real issue was government involvement in lighting an inflationary fire. They achieved that by dictating to private markets that they abandon traditional lending principles in favor of public policy driven mandates.
You understand how the markets operates, but you're either waiting for Part 3 to reveal the true driver, or don't care to address this issue.
Yes, private legal entities should definitely be allowed to engage in private legal markets.
That is, you seem to be attacking the philosophy underlying the creation & operation of the derivatives markets. If so, then it appears you are blaming "greed" & advocating greater regulation; isn't this what Barney Frank and other Dems are claiming?
I have no problem with the original intent of Credit Derivative Swaps. I do start having a problem when investors are able to buy insurance on something that they don't even own and have no root financial stake in.
The real issue isn't the derivatives markets - they should be allowed to operate in any legal manner as they choose - these are PRIVATE contracts.
I see where you're going, but I don't agree with it. You're saying that the "fuse" was mishandled - which I agree, but the fact that CDS's had the type of potential downside that we're now seeing should have raised enormous red flags - and it didn't. CDS's have a very bad side when they're misused, so we can't discount that they're a defective financial instrument in that way.
The real issue was government involvement in lighting an inflationary fire. They achieved that by dictating to private markets that they abandon traditional lending principles in favor of public policy driven mandates.
That is what acted as the 'fuse' and it was insane to do. But the dynamite that the fuse is attached to is what will bring us, and the world economies, down.
You understand how the markets operates, but you're either waiting for Part 3 to reveal the true driver, or don't care to address this issue.
I have revealed the true driver - Credit Derivative Swaps. Lesson 3 will touch on what happens when there is a 'short squeeze' on a CDS.
You keep wanting to make the fuse the same as the explosive. Realize that a bunch of bad mortgages is not what is going to bring down our economy. We could clean up that specific problem with about $300 billion - which is the exact size of the bill that Bush signed on July 30, 2008 - and which takes effect in a few days on October 1st.
Now you're understanding. And we're being lied to by Bush, Bernanke, and Paulson (and I voted for Bush both times).
So it appears you agree with Barney Frank, and that it was unregulated Wall St greed that got us to this point.
I, and many, many others, believe the underlying premise of the derivatives market is valid: to spread risk & increase liquidity. The problem is that core financial principles were based on faulty economic fundamentals which had been corrupted by poor public policy decisions.
We both agree that there needs to be a bailout; we only differ on the reasons. I think 'we' are collectively responsible because it was 'we' who allowed DC to disrupt an efficient market. If 'we' hadn't engaged in this behavior, we wouldn't be seeing a freeze up in the normal derivatives pricing mechanism.
“Why aren’t Paulson and Bernanke talking about this?”
“I don’t know. They are either foolish, blinded, or in on the whole deal. I’m beginning to feel the latter”
We are way down river.
They had to know.
“...the dynamite that the fuse is attached to is what will bring us, and the world economies, down”
Okay, how far down will we fall...look into the economic crystal ball you have...roll out how and how soon this is going to trickle down.
How soon will the Swiss start yodeling a different tune?
Do you like to put words in people's mouth. It sure seems like it.
There is blame to go around. My one and only point is that the CDS market is the train that is about to run us over. CDS's obviously have a downside risk, albeit one made with poor investment decisions and wholesale greed, and should be re-analyzed. For instance, there should be a ban on buying and selling insurance on an underlying security that you have no direct financial interest in. I can't do it with my neighbors house, the market should not be able to do it with my bonds.
I, and many, many others, believe the underlying premise of the derivatives market is valid: to spread risk & increase liquidity. The problem is that core financial principles were based on faulty economic fundamentals which had been corrupted by poor public policy decisions.
The underlying premise of CDS's are valid, up to a point. The entirety of the risk factors was not completely thought out - duh! and the value of CDS's as a proper financial instrument should be looked at again. Insurance on underlying securities should be limited to those having direct financial ownership.
We both agree that there needs to be a bailout; we only differ on the reasons. I think 'we' are collectively responsible because it was 'we' who allowed DC to disrupt an efficient market. If 'we' hadn't engaged in this behavior, we wouldn't be seeing a freeze up in the normal derivatives pricing mechanism.
I have no clue where you got this idea from. I've only posted about 500 times that this bailout plan is ridiculous and could actually do more harm than good.
I agree.
Just speculation on my part - based on the data before me:
The G7 countries will all go through economic depressions with bouts of spiraling inflation. I say "depression" because of all of the cooked books that will need to be sorted through, and the respective companies will need to "fall" to their proper level (many which will be insolvency).
I expect the ball to pick up speed by this week, or the end of next week at the latest.
Watch the movement of money between banks. 1-month LIBOR is a good indicator. Also watch the rates on 30-day US T-bills. If the rate approaches 0 then the money market is completely locked up.
If the bailout plan passes then you will see the stock market surge for 3 - 5 days. Liquidity in the overall market will probably loosen a little during this time.
Keep watching the movement of money immediately after the Dow settles down. If it begins to tighten again then our economy will be going down within a matter of days to a week after that.
Just my opinion...I could be completely wrong.
getting informed.
Hi ya Teach. Please ping me when part 3 is up and running.:)
(It’ll take my mind off the garbage I’m watching on C-Span.)
Ping.
Ping.
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