Posted on 09/23/2008 6:42:35 PM PDT by politicket
Derivatives comprise a whole market of different financial instruments. Unlike the commercial banking industry, or the stock market, the derivatives market is "self-regulated" - primarily by the investment banks.
Credit Default Swaps (CDS's) are one segment of the derivatives market (probably making up about 1/15 of the market). Think of CDS's as bets in Las Vegas. There can be winners, losers, and pushes. The CDS market was valued at around $900 million dollars in 2001 (not actual dollars - but the total amount of "bets"). That grew to over $45 Trillion dollars by 2008 (see the problem here...).
A Credit Default Swap is a contract with a buyer and seller. The seller in this case might be an investment bank - and they "sell" asset-backed (could be mortgage) paper to the buyer. The buyer "wins" when the seller defaults, and the buyer gets the spoils.
Now, to make things more complicated - this is an international market and there can by many entities involved in CDS's for a particular tranche (or bucket of money). You have what are know as "counter-parties". These counter-parties can be greatly affected if something "out of the norm" happens to a particular contract.
So, if Paulson rushes in and starts affecting the CDS market you will see an "unwinding" of contracts all of the planet due to the "counter-party" exposure. It will literally implode on itself.
If Paulson doesn't do anything, then the "bets" that are set to go bad will continue to go bad. Liquidity in our market will be gone and we will enter a depression.
Pick your poison - but I opt for the depression because it will be shorter in duration because market forces will "self-cleanse".
They aren’t greedy high-rollers. They were institutional investors, by and large; the same institutions that your 401k, your pension, your other investments are are tied up with. There’s absolutely nothing wrong with the idea of CDS, CDOs or other derivatives—the purpose is to allocate risk throughout the system. Their quality, however, depends upon accurate assessment of the underlying risk, however. In an inflated housing market caused by the combination of Clinton’s expansion of the Community Reinvestment Act, corresponding changes in how Fannie and Freddie work, and an out-of-control easy money policy by the Fed Reserve under Greenspan, figuring out the real risk in offering CDSs and CDOs was near impossible.
Although a portion of investors were speculators, rather than investors looking to hedge, speculators are IMHO, a minor source of the problem. Most investors were institutional and were hedging against their own investments in mortgages and related instruments. If the CDS contracts cannot be paid, that means that all those institutions will not have a hedge against their other related investments, which means your 401k, your mutual fund, your whatever, will lose value. A lot. Maybe 100%. Something must be done.
/sarcasm
Whatever but I’m still in shock and awe that so many financial gurus, world class economists, CEOs of huge corporations and CFOs the world over and all areas of government, oversight committees, regulators were caught in this debacle for so long. I ain’t got no economics degree but I was taught that 1. There is no free lunch and 2. If it’s too good to be true, it probably isn’t true and 3. You can’t get something for nothing forever. Some simple farm economic theory from my dad who didn’t finish 8th grade.
“It looks like this crisis has been building for a long time.”
That’s correct. Ever since Clinton forced the CRA on the Mortgage Industry in the early to mid ‘90’s.
“What are the chances that the TIMING of this crisis was manufactured for most impact against republicans in this election?”
That is highly unlikely given the complexities to cause a specific timing with all that is involved.
I personally wouldn’t put it past the bastards to have tried it though.
later
I went to Las Vegas. I bet poorly. I am stooopid. Will you give me my money back? No, better yet, I demand that the US taxpayers pay me back. Along with it, please pay the casino owners for their effort for taking my money. That’s about it.
Good explanation, but I am not sure why the Paulson plan would lead to an implosion. The “bets” are between investors and, as I understand it, don’t directly involve the actual debtor. The counterparties are the entities that bet that that debtor will pay (i.e., the seller who sells the contract for payments on the assumption that the debtor will pay) and the buyer who pays a flat fee or makes regular payments, yet bets on the ultimate default. The CDS counterparties are typically entities who are trying to hedge their other investments (usually in the same market or another market with a comparable beta).
That suggests to me, at least, that while the “bailout” (which I think is a really misleading term) might cause CDSs to unravel, the corresponding relief to the underlying instrument (i.e., relief to the original lender of the underlying debt obligation) would balance that out. The goal here is not to save or harm the derivatives market, but simply introduce liquidity to the market. If the derivatives do implode (as they might), it won’t matter so long as the underlying debt obligations are assured to a point and lender are able to provide needed credit to their routine customers (i.e., regular businesses).
Not exactly coincidence, but Greenspan lowered rates in the early to mid 90's for various crises that were mainly created by previous loose money policies. It takes two to tango especially if one of the pair is throwing dollars around.
I’ll try.
Joe Poor gets the mortgage, which the bank resells to someone else (probably Fannie Mae or Freddie Mac). They then bundle it with a bunch of other mortgages, divide it into bonds and sell it off again.
Someone buys the bonds. They get nervous about getting paid back and find someone else who will insure the bond for a premium, just like you pay for car or home insurance. That bond insurance is the credit default swap (CDS).
Confusing, but so far, there’s no real problem.
Now it can get ugly. Other financial firms can build more CDS contracts around that same bond even though none of the parties to those contracts actually own the bond. This part of it is more like a bookie taking bets, think of the two sides of the CDS contract as a bet on a ball game, except team A is the bond defaults and team B is it gets paid on time. There’s no limit to how many of these CDS bets can be created and there’s no organized, regulated market for them.
Now, go back to Joe Poor. He defaults on his mortgage and a few other folks in the same mortgage bundle fall behind. Those payments no longer support the cash flow that goes with the bonds our friends Fannie and Freddie made back in step two or three of this story. The bond goes into default or partial default, triggering payment on the CDS. But remember, the only limit on the amount CDS riding on that bond was how many investors wanted to place bets. So Joe’s $200k mortgage default might have triggered $3 or 4 million of bets.
Repeat thousands of times. I believe the total CDS market is something like $62 trillion - with a T. The CDS market includes corporate bonds, municipals, basically any type of debt instrument out there.
You may have seen the news coverage on the Securities and Exchange Commission halting short stock sales. The news release that isn’t getting so much coverage is that they’ve also launched an investigation into suspected market manipulation involving CDS on corporate debt among other things.
Hopefull some smart Freepers will chime in to correct any mistakes I made.
It wasn't - even though many would like to attach politics to it. This was just pure greed and probably some manipulation. By making it easier for people to get into homes it created an environment where the investment banks were betting that real-estate prices would keep going up for a good long time.
They did for awhile - and then the truth set in.
I'm still not sure that people understand. We are at a point right now where there really is no answer other than to let the market play these bad bets through. We will suffer a mild to major depression because of it because we literally don't have the dollars that could possible pay for the money owed. If the government passes their "plan" then all bets are off. They will start meddling in the CDS market, counter-parties from all over the world will be destroyed, and the financial system of the developed world will face collapse.
There are many that will make fun of the previous statement, but you will also find quite a number of folks here on FR that know exactly what I'm talking about - and it is very, very serious. The government knows it. They're starting to release more info each day as to its seriousness.
Yesterday, the governor of New York stated that the CDS problem was an enormous problem and initiated rules in New York to regulate CDS's as "insurance" beginning in January of next year.
Today, SEC Chairman Christopher Cox stated the extent that the CDS market plays in regards to the financial health of our country and wants 'immediate' regulation.
Unfortunately, it's too late for either of those. Put them in place, but the current climate is here to stay for awhile.
Ask yourself why commercial banks are sitting on their cash right now instead of lending it out. It's because they know what's coming.
The commercial banking system in this country usually keeps $2 billion in reserve each day to cover normal day-to-day withdrawals. It's a good thing they have been keeping the money, because last Wednesday saw withdrawals totaling $114.5 billion.
Each family needs to make sure that they are prepared for this. Not to panic, and not to be anxious for anything - just prepare.
That's a good question, and in a $45 trillion dollar self-regulated betting parlor it is a hard one to answer.
Understand, the SEC, the Fed, and the Treasury have NO IDEA what is in there. And we don't have the years it would take to find it. It's international in scope and it is falling hard.
What 401k? What pension? What investments? I’m just a lowly hand to mouth taxpayer who’s going to work until he dies like a hundred million other lowly hard working taxpayers and I see no reason to allow my tax dollars to be used to repay wall street gambling losses!
Amen. But I dont' see what can be done without counter-parties unwinding like nobody's business.
I read somewhere that back as far as 2005, a penny loss in FNM stock price would cause Citicorp. to lose about 600k, how that works is a bit convoluted but has to do with the credit default swaps, credit lines, and crdit downgrades, the stock price was a symptom not the cause.
The stock price then was 70, now its a buck and change. The investment banks were leveraged anywhere 30 to 70 times.
They collectively now owe more money than exists, probably, so its easy to understand the late unpleasantness.
I am not a conspiratorial-type person and I truly believe that it was just greed that is going to bring this down. But - if I were a conspiratorial person - there is no better way to get rid of the middle class of a society than what they are doing right now.
“It wasn’t - even though many would like to attach politics to it.”
A) you’re right that this has been brewing for a LONG time (and both sides have contributed (going back way before W’s administration - in fact, HE actually tried for several years to get regulation of the two FF’s but always got shot down by senate/congress).
However, B) the timing now is MOST unfortunate, and absolutely IS being used by the Dems in attaching politics to it, albeit with blatant lies. Too bad the public doesn’t know the history or facts, and may just believe sound bytes in the MSM.
That grew to over $45 Trillion dollars by 2008
Good luck to anyone trying to collect.
Either way, it will affect counter-parties down the chain. The problem with the CDS market is that it is so intertwined. There are literally bets upon bets upon bets. When Paulson affects the Mark to Market price of an asset then everything will be thrown off kilter and it will be felt throughout the world's financial systems.
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