FReeper Guide to the REAL economic problem - Credit Derivatives - Lesson 2

politicket | 9/27/2008 | Politicket

[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.

[politicket]

For Discussion...

[rabscuttle385]

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[Freedom_Is_Not_Free]

bump for future reading

[combat_boots]

bttt

[politicket]

Ping to Lesson 2...

[kaspergutman]

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.

Thanks for the illuminating commentary. Of course, the "underlying debt" wasn't supposed to "go bad" any more so than accounted for in the models. Three things come to mind:

1. Fraud: A lot of the MBS used for the CDOs may have been created and marketed dishonestly by realtors, appraisers, LO's, bank officers and Wall Street bundlers.

2. Ratings: Even if S&P and Moodys and Fitch acted in good faith rating this stuff (not a sure bet given the incestuous relationship with the IBs, etc.) you can't model fraud.

3. Exchange: Maybe $60 trillion (notional value) of derivatives floating about, but an unregulated and opaque market at best. Getting these instruments on an exchange with rules and transparency might have discouraged excessive risk taking and would at least have kept bankers, Fed chairmen and Treasury officials from fumbling blindly in the dark.

[TASMANIANRED]

bookmark

[politicket]

Getting these instruments on an exchange with rules and transparency might have discouraged excessive risk taking and would at least have kept bankers, Fed chairmen and Treasury officials from fumbling blindly in the dark.

You're correct. But now you see how Paulson will go out after the bailout plan is passed, holding his pail of money, and very likely could do more harm than good if he inadvertently triggers more loan and bond defaults. His mistake of spending a few million too little on a tranche of securities could cause devastating damage in the credit derivatives market.

I believe that a financial tsunami has been unleashed that will swallow up every bit of liquidity that Paulson wants to throw at it. He can buy up billions in loans and it still won't stop the wave.

The market (mainly controlled by investment banks) will be in complete euphoria for awhile this coming week. However, late in the week, or the following week, we will see the credit markets begin to tighten again as companies realize the severity of what was unleashed.

[444Flyer]

Thanks for the Ping. Your ability to communicate this in layman’s terms still amazes me. You need to be on Fox Business. Most of us have learned about 401k investment, mutual funds/CDs and diversifying and these CDSs are WAY over our heads. Up to a few days ago I thought it was all about bad mortgages, but you've been really helpful in helping to paint the real story and bigger picture.:-)

[politicket]

You need to be on Fox Business.

Was that an insult my FRiend? ;-)

[444Flyer]

LOL. No, you should replace the entire bunch of them!:)

[auboy]

I need to learn more before opening my mouth. Thanks for sharing your knowledge and experience!

[444Flyer]

How do you get this message out to our Congress members before they vote us into this Socialistic scheme called the “bailout”. Do you think they know the real storm coming and know the silly bailout will do nothing to prevent it? Why aren't Paulson and Bernanke talking about this?

[politicket]

How do you get this message out to our Congress members before they vote us into this Socialistic scheme called the “bailout”. Do you think they know the real storm coming and know the silly bailout will do nothing to prevent it?

I honestly don't know. I (and a few others) have been hitting this hard for two weeks on Free Republic and folks are just now starting to realize what is happening.

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.

[444Flyer]

It doesn't help that the Congress is being rushed and pressured by the Feds, the President and the media. Who can make an accurate assessment and do any thorough research with that kind of pressure. Dave Ramsey (on Fox Business News;)) had a gentleman by the name of Brian Wesbury, he is the Chief economist for First Trust. He proposed that rather than do a bailout, Congress should temporarily relax accounting rules regarding mark to market accounting. http://www.ftportfolios.com Don't know whether its a good or bad idea, but the point is Congress doesn't have any time to get input from outside consultants who don't have lobbying power and aren't part of the establishment. Everything is being beelined to completion and they have only seen the tip of the iceberg.

[REDWOOD99]

bookmark

[politicket]

He proposed that rather than do a bailout, Congress should temporarily relax accounting rules regarding mark to market accounting.

This would allow a really disastrous situation to get unfathomably disastrous in the derivatives market. There are so many triggers set to go off that changing the accounting rules midstream would be insane.

I like Dave, but he needs to stick to household budgets.

[444Flyer]

I used to play Pick up Sticks when I was a kid. I remember trying to keep my hand from shaking while I carefully lifted those little wooden sticks up one at a time so as not to upset any of the other sticks. One wrong move and you could wreck the whole stack.

It’s hard to contemplate the web derivatives weave through the economy, but it sounds like we are walking on thin ice with any decision or manipulation of the market. Do you think it’s impossible to predict the tipping point or the cause that will send these derivatives crashing down?

Again, thanks for your patient explanations.

[politicket]

Do you think it’s impossible to predict the tipping point or the cause that will send these derivatives crashing down?

They crashed in July 2007. At first it was a snowball at the top of a very tall mountain. As it began rolling it became more massive.
That snowball rolled over some very big companies these last couple of weeks. It's not moving fast, but it's wiping out everything in its way. The bailout money will be consumed quickly and we will be right back where we are, but with a larger snowball.

[TomasUSMC]

How do you get this message out to our Congress members before they vote us into this Socialistic scheme called the “bailout”.
////////////////////////
There is only one language D.C. will understand - THE POWER OF MONEY.

TAKE YOUR MONEY OUT NOW

If Americans make a run on the banks and Market and withdraw a trillion dollars Monday, that will stop the BULLSHEET BAILOUT.

The best way to make sure this doesn't happen again is for PAIN to teach the guilty parties that it is not profitable. They will lose millions individually and in the future they will not take part in these types of tactics.

25billion FORD GMC ..wasn’t enough, need more
30billion BEAR .....wasn’t enough, need more
85billion AIG .....wasn’t enough, need more
138billion LEHMAN...wasn’t enough, need more(they tried to hide that one)
200billion FANNIES...wasn’t enough, need more
770billion WHO ELSE? and no one will ask the question,” Will this be the last dollar we have to spend”? ....
...........Because it won’t be.
Spend $700 billion, 5 percent of our gross domestic product?

THERE WILL BE MORE.

They only understand money.

Kill the Bailout and Shoot it in the head.

The Dow was in much worse shape during the 2000-02, when it went down 36 percent. Today its 24 percent down from its high. -— Its all a big Lie -—

Take your money before the banks do!