FReeper Guide to the REAL economic problem - Credit Derivatives - Lesson 3

Politicket | 9/28/2008 | politicket

[politicket]

Welcome to Lesson 3 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

Short Squeeze

Rosen estimated there are $25 billion in credit derivatives riding on $2 billion in Delphi bonds. Just as any catastrophe triggers insurance claims, Delphi's problems mean credit default swap sellers owe payments to the buyers who took out the insurance. Many contracts require the insured party to turn the underlying bonds over to the insurer when the payment is received, much as an insurance company may take possession of a wrecked car upon paying a claim.

When Delphi went bankrupt it had its own books to deal with. Of course, the common shareholders lost everything. The preferred shareholders probably lost everything. The bond holders took a big ‘haircut’ on their bonds – meaning they were still high enough on the totem pole to get some of the liquidated assets. In addition to this entire mess, there was another $25 billion of money owed in the market that had nothing to do with Delphi – other than the fact it was betting on whether Delphi would continue to exist as a viable concern. The ‘insurers’ of the various Credit Default Swaps owed the ‘buyers’ of the CDS’s. In return, the ‘buyers’ had to provide the ‘insurers’ with the bond that was being insured.

Insured parties that don't have the bonds in their portfolios can buy them through the market to satisfy this obligation. But because of leveraging, there may not be enough bonds to go around. The escalating demand can cause a short squeeze, Rosen said, that would drive up the bonds' price and cause spiraling expenses for those desperate to get the bonds, possibly forcing them to sell other assets to come up with more cash.

What happens when the buyer of insurance doesn’t have possession of the insured item? In most circumstances that person goes to jail. In the financial industry that person has to go out onto the open market and buy the insured item – in this case a bond. But what if the buyer goes out to buy a bond in good faith and finds that none exist – because a bunch of other people had to go buy bonds to cover their insurance claim? It will drive up the price of the bond because of the supply and demand model. When there is a short supply of something then the price for that item tends to go up. If the price goes up high enough then the insurance buyer might have to liquidate some of their other possessions in order to raise the capital needed for the bond purchase.

The solution, according to Rosen, is likely to be a push by regulators to allow the obligations to be settled with cash payments instead of physical bond transfers. The topic has been the subject of frequent meetings between participants and regulators since the Delphi bankruptcy filing. The talks are aimed at how the payments should be figured, Rosen adds. Some participants, such as hedge funds, oppose cash settlement because they got into this market for the very purpose of obtaining bonds at fire sale prices, hoping to profit when a squeeze or recovery drove the bond prices back up. Asked if the issue can be resolved before a short squeeze begins, Rosen answered, "I think that's a great question, and I don't know the answer."

If a bond insurance buyer could just pay the current ‘haircut’ price of the bond to the insurer in cash then there would never be a ‘shortage of bonds’ problem – and the bond wouldn’t get ‘squeezed’ by availability, causing the price to escalate. Good idea right? Not so fast. What about the ‘other’ investors that might be ‘hedging a bet’ that bond prices would increase. They would be left out in the cold. The hedging folks actually WANT other people to get hurt so that they can profit handsomely.

Although the Delphi situation is testing the resiliency of the credit-derivatives market, Rosen argues that the system actually has grown stronger in the past few years. Leverage is not as excessive as it was at the time of the Enron collapse, and dealers have better systems for tracking the value of collateral on which credit derivatives prices are based.

This paragraph may have been true when this article was written in November 2005, but it is laughable now. Leverages are now huge, and the tracking of collateral is pretty much worthless due to the real-estate implosion and the ‘mark to market’ rule stating that the market must use ‘current’ pricing of any asset.

Herring, however, points out that this is a very opaque market, since credit derivatives are not traded in a centralized marketplace like stocks. It is therefore not clear where all the risks lie.

The last sentence of this paragraph seems obvious now. Most of the risks that are now steamrolling our economy are based on being the ‘seller’ of insurance for far too many credit derivatives. Also, the investor leveraging their risk to insure sometimes hundreds of times the value of the underlying debt obligation has created a scenario that is seeing total collapse of major financial institutions.

In some respects, these derivatives amount to a zero-sum game: risk is neither created nor destroyed; it is simply shifted from one player to another. But although the overall level of risk stays the same, credit derivatives allow it to be concentrated in the hands of participants willing to shoulder lots of it in hopes of attaining outsized gains. This is why credit derivatives have become so popular with hedge funds.

This paragraph is a very important point. Just like in Las Vegas, there are always winners and losers with a derivatives contract. So the idea of $64 trillion dollars of “bets” means that somebody is going to come out way ahead. There are a number of combined “bets” that are “washes” and cancel each other out. These are sometimes seen and the related contracts are torn up. The investment community got on the wrong side, as ‘sellers’, of a huge number of mortgage-related “bets”. When the housing bubble popped they were out on a limb – owing more money than they had in assets – a lot more money.

One last point on this paragraph. The author calls derivatives a ‘zero-sum’ game – meaning that for every loser there will always be a winner. Conceptually, that is correct – but remember – they’re not betting with real dollars, they’re betting with ‘pretend’ dollars. The dollars only become real when the debt needs to be paid out. My point in saying this is that in ‘real dollars’ this is not a zero-sum game. If the buyer of insurance wins, and the seller of insurance loses and can’t afford to pay the debt, then the ‘zero’ effect fails. It is no longer a 1 to 1 event.

Hedge-fund investors take their chances with their eyes open, and nobody else cares much if some of them get burned. But ripple effects do sometimes swamp the innocent, too. That was the big worry when Long-Term Capital Management's bets went sour.

This paragraph is talking about the complex hedging strategies that many investment firms and Investment Consultants make without any concern or consideration of the other ‘players’. If they misplayed their “bet” then the inter-related nature of many CDS contracts would harm otherwise innocent investors. We now have a situation where greed was so rampant that it generated more than a ripple. It generated a tsunami.

According to Ramaswamy, it is unlikely that trouble related to a single company like Delphi will spill over to the broad markets, but he said it would be worrisome if a large number of companies ran into serious difficulties. And Rosen noted there is a lot of dry tinder on the forest floor -- a mushrooming issuance of low-rated, high-risk debt. "I will be shocked if we don't see a significant rise in default rates over the next 18 months," he said.

OK folks – this is the paragraph that we need to look at carefully. Professor Ramaswamy mentioned a very large rise of defaults over the next 18 months. This article was written in November 2005. It is my belief that the housing bubble popped in July 2007 (20 months from the date of the article). He also talks about it being ‘worrisome’ when a lot of companies begin to fail – especially with all the issuance of low-rated high-risk debt (like mortgage and credit card, especially CDO’s). These ‘smart’ people in the investment community had no idea what would happen with this new form of investing when the market turned against their strategies.

If that happens, it will be easier to determine whether credit derivatives are making the world a safer place -- or a more dangerous one.

I think that the last month has pretty well answered the question in the last paragraph.

Congratulations on finishing Lesson Three! We are now done analyzing this particular title.

The next post will be Lesson Four, where we discuss ‘Special Purpose Vehicles’ (SPV’s) – a way for banks to make extra money, and get themselves into a lot of trouble.

[politicket]

For discussion...

[politicket]

Lesson 1 can be found here: Lesson 1

Lesson 2 can be found here: Lesson 2

[GOP_Raider]

Pinging myself for later

[FreedomHammer]

reading the third in the series.

[bruinbirdman]

Forbes knew this was coming last August? That's when these complex transactions were first being discussen on FR.

Smart institutional traders knew enough to convert their bonuses and gains to commodities, cash, etc? And then it didn't matter if the company went bust. They could lose the value of company shares they owned because they were cashing out as the company went broke?

Hank Blankberg makes $10M a year and buys gold, art and real estate while running his company into the ground. He also gets $10M in company stock options. Insiders only know the house of cards. The stock price is solid. For three years he makes $10 and $10. Then, in six months, the company goes bust. He is up $30M. What does he care about the stock price.

yitbos

[ThePythonicCow]

The September 29th issue of Crosscurrents, a subscription ($189/year) newsletter by Alan M. Newman, available at Crosscurrents, has the best explanation of Credit Default Swaps that I've seen. Alan has been warning about the systemic risks that such derivatives present since shortly after the crash of 1987.

This current issue of Crosscurrents clearly describes what CDSs are, their (massive) growth over the last decade, and both their total notional value over the years and how much loss risk they present to the worlds finances.

Alan believes that a complete collapse will (probably) be avoided, but markets remain volatile and difficult to trade. That conclusion won't sound too surprising to most of us; he backs it up with some informative analysis.

[DaveTesla]

Good GOD!

Cant any one make an honest living anymore?

Or are they all at the race track.

And it's credit card coming around the stretch with
mortgage in the rear....

[ThePythonicCow]

The author calls derivatives a ‘zero-sum’ game

But the author then went on to explain that he meant this was a zero-sum game in terms of the total risk. Derivatives do not create or destroy risk; they just move it about, obscure it and entangle more companies in it.

The risk of individual failure goes down, but the risk of systemic failure increases. One for all and all for one; the principle of the conservation of energy, applied to aggregate risk.

There is a serious secondary affect which makes this misleading, however.

As each individual decision maker feels less personal risk, each such maker starts making more rash decisions, betting more, leveraging more, on less certain information. This apparent "safer" environment leads to increasing the total amount of risk in the system.

Since individual failure is for most practical purposes designed out of the system, the total level of risk in the system rises, exponentially, until there is an undeniable systemic failure.

Precluding individual failure increases aggregate system risk, and ensures an even greater systemic failure.

[ThePythonicCow]

And it's your credit card coming around the stretch with my mortgage in the rear.

These scoundrels are playing with our money, and our children's money, and our grandchildren's money, not theirs.

I don't mind when my bum of a brother-in-law gambles away his rent money, but when he takes my money at gun point (as will the IRS gladly do, if I don't voluntarily pay up) then that annoys me.

[DaveTesla]

Me too.

[EasySt]

Is it time, then, for our country to take back its money from the Money Masters?

The Money Masters - How International Bankers Gained Control of America - 215 min - Mar 27, 2007
http://video.google.ca/videoplay?docid=-515319560256183936

Money As Debt - 47 min - Feb 12, 2007
http://video.google.com/videoplay?docid=-9050474362583451279

“Whoever controls the volume of money in our country is absolute master of all industry and commerce…when you realize that the entire system is very easily controlled, one way or another, by a few powerful men at the top, you will not have to be told how periods of inflation and depression originate.”

~James Garfield,
20th President
Assassinated, 1881

I wish our congress critters could all be held down and forced to watch these two videos, kinda like in Clockwork Orange... (No, they don't recommend going back to a gold standard.)

[ThePythonicCow]

Is it time, then, for our country to take back its money from the Money Masters?

It's been time, since 1913.

The problem is, Presidents seem to find assassination an unpleasant event. And our representatives are ... well I guess this is supposed to be a family forum, isn't it.

[PGalt]

Thanks. Educational, informative post and thread.

[sergeantdave]

Bottom line - How many beans and bullets do we need to buy before spring?

[RochesterFan]

Derivatives do not create or destroy risk; they just move it about, obscure it and entangle more companies in it.

Very well put. And precisely why the Paulson Plan fails miserably. The Paulson Plan does not address this fundamental issue. Many of us have been imploring our representatives to include these items, best summarized by Karl Denninger

The solution is simple, it is elegant, and it will work.

1. Force all off-balance sheet "assets" back onto the balance sheet, and force the valuation models and identification of individual assets out of Level 3 and into 10Qs and 10Ks. Do it now. [Denninger calls this 'transparent balance sheets']
2. Force all OTC derivatives [i.e. credit default swaps] onto a regulated exchange similar to that used by listed options in the equity markets. This permanently defuses the derivatives time bomb. Give market participants 90 days; any that are not listed in 90 days are declared void; let the participants sue each other if they can't prove capital adequacy.
3. Force leverage by all institutions to no more than 12:1. The SEC intentionally dropped broker/dealer leverage limits in 2004; prior to that date 12:1 was the limit. Every firm that has failed had double or more the leverage of that former 12:1 limit. Enact this with a six month time limit and require 1/6th of the excess taken down monthly.

Once 1-3 are put in place then send in the OTS and OCC examiners and look at every financial institution in the United States. All who are insolvent and unable to raise private capital immediately are forced through receivership where the debt is converted to equity and existing equity is wiped out. With the CDS monster caged the systemic risk is removed, the bondholders provide the cushion for recapitalization (as it should be) and the restructured firm emerges with no debt while the former bondholders are now the owners (of the equity) in the resulting firm.

Sadly, our pleas were ignored and we got sold a $700B pile of stinking crap. If there were profit to be made, investors would be lining up to buy this stuff. Instead, Treasury will have to print money to buy this stuff, driving the dollar lower and raising inflation.

[Toddsterpatriot]

In some respects, these derivatives amount to a zero-sum game: risk is neither created nor destroyed; it is simply shifted from one player to another.

Sounds vaguely familiar.

One last point on this paragraph. The author calls derivatives a ‘zero-sum’ game – meaning that for every loser there will always be a winner. Conceptually, that is correct – but remember – they’re not betting with real dollars, they’re betting with ‘pretend’ dollars. The dollars only become real when the debt needs to be paid out.

Okay. If you say so.

My point in saying this is that in ‘real dollars’ this is not a zero-sum game.

LOL!

If the buyer of insurance wins, and the seller of insurance loses and can’t afford to pay the debt, then the ‘zero’ effect fails.

If I bet $10 on a baseball game and I win, the loser gives me $10. Zero sum. If the loser doesn't pay me anything, still zero sum.

Now, if I was counting on that $10 to pay my mortgage, I might be screwed, but that doesn't change the fact that the bet itself was zero sum.

[Mase]

How exactly do I get in on this betting with pretend dollars instead of real dollars? I want some of that action so I won't have to worry about losing my kneecaps -- or at least my house and any other assets I own. How does that work?

[Toddsterpatriot]

How exactly do I get in on this betting with pretend dollars instead of real dollars?

Fiat dollars are pretend, gold dollars are real.

[expat_panama]

If the buyer of insurance wins, and the seller of insurance loses and can’t afford to pay the debt, then the ‘zero’ effect fails. It is no longer a 1 to 1 event

.

Sounds like we're talking about 'counterparty risk' --the danger that the other guy may fink out.  No problem, when we buy insurance to cover the fact that we might die, we can also buy insurance on the insurance.  Then we can also buy insurance on the insurance on the ....

Before we get carried away with all this 'winners and losers' talk, let's not forget that if I don't die and I forfiet my insurance gains, then I'm not at all disappointed.   Any talk about losing out on CDR's etc. has to be coupled with the fact that when purchased as a hedge, it was the goal all along to 'lose' money on the 'asset'.

[politicket]

If I bet $10 on a baseball game and I win, the loser gives me $10. Zero sum. If the loser doesn't pay me anything, still zero sum. Now, if I was counting on that $10 to pay my mortgage, I might be screwed, but that doesn't change the fact that the bet itself was zero sum.

Faulty logic and spoken like someone wanting to protect the "soundness" of the derivatives system.