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

Politicket | 9/27/2008 | Politicket

[politicket]

Praying that this will assist my fellow FReepers in understanding the real issues before us.

[politicket]

FYI...

[4Liberty]

As economists say, ‘No free lunch,’... except if you can get it from taxpayers, via corporate welfare, which is just a forced wealth transfer - socialism.

[norraad]

Yeah, well I see it as I'm just driving along minding my own when here's a rich guy who just crashed his car drunk driving and want's to trade me his bottle for my car.

Man, oh man, you just wanna punch'um in the mouth, but they're so drunk they probably won't feel it and you don't want to hurt your hand.

[Moonman62]

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.

I thought they were the big boys, and how can the derivatives be worth several times more than the bonds themselves? The only net loss was the $800 billion on the $2 billion in bonds, since they were still worth 60%.

[freekitty]

Thanks. This is going to affect all of the debt since it is suspect too. Anyone living beyond their means is going to get hurt.

[lonevoice]

bookmark to read later

[combat_boots]

bttt

[rabscuttle385]

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[Cacique]

btt

[444Flyer]

Thanks for the Ping FRiend! Great explanation...hitting print button NOW.:)

[cowtowney]

Thanks so much

[TASMANIANRED]

Thank you.

[Warlord]

Credit derivatives are nothing but a means to transfer default risk. 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.

You should carefully evaluate the "lessons" that you pass along. As a matter of general principle, please consider (and pray about) the proposition that pitchfork populism is a deadly as thoughtless elitism. "Mainstreet" and the farm contributed mightily to the problem by devouring loans that they could not service.

[cliniclinical]

Great analysis, and not to hijack or belittle the thread, but I would like to add that the root of all of our financial troubles is a fractional-reserve banking system / combined with a fiat currency.

This proposed “bailout” is going to skyrocket inflation, the goverment’s secret little tax. The lack of liquidity in the market is just beginning to rear it’s ugly head, so make the appropriate adjustments to a portion of your investments to diversify for such changes.

I watched a lady at the bank today trying to withdraw $33,000 cash. Big bank, main branch, brags about it’s “assets”, beautiful building, huge, open vault right there, only one other customer - they did not have the cash on hand. I could tell her brain could not process why she could not get her cash. I wanted to step in and maybe give her a little clue, but decided against it. Obviously her first run-in with how small the “fraction” really is...

[AndyJackson]

thanks. Look forward to installment 2.

[jsh3180]

I’ll post here another article about the credit derivatives problem. It should be noted that the proposed bailout bill does nothing to address the problem with derivatives, all it does is buy time. One has got to be fairly certain that the initial $700 Billion bailout is only a down payment on the eventual total of taxpayer $’s that will be required. 3-4 years now we’ve been hearing over and over that the bottom is near and things are going to turn around. Well, they’ve given up on even pretending the bottom is near, but now we are supposed to believe $700 Billion will fix the whole thing. It’s a simple matter to go to the International Bank of Settlements website and see the sum total of outstanding derivatives. It’s a staggering $1,000 Trillion or $1 quadrillion if you prefer.
I’m no economics genius, but I’ve read and learned enough in the past 5 years to realize that the problem with derivatives is that banks/financial institutions that hold them, which I guess is nearly all of them, have to pay out (as in insurance payouts) the “notional” value of the derivative, when the underlying party goes belly up. The fact that they are bond related forces them to be covered way before any shareholder, preferred or otherwise would be made whole.
I don’t think I’ll go on much further, but it’s certain that punks with doctorate degrees in finance thought they could game the system, making huge profits along the way and the derivatives made it all risk free!!
I have no idea how, where or when it ends.
Here’s the article I mentioned in the first sentence above.

http://www.financialsense.com/Market/wrapup.htm

[palmer]

Credit derivatives in and of themselves are essential to modern financial economics.

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.

[wideawake]

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.

Let me explain first what a CDS is.

It is a contract which states that in the event of a default on a "reference obligation" (which depends on the contract: the reference obligation could be bank indebtedness, corporate bonds, debentures, etc.) of a company, then the buyer of the contract is entitled to a certain payment from the writer (seller) of the contract upon delivery of the reference obligation.

Let me give an example.

Widget Corp issues $100MM senior unsecured bonds. Alice believes that there is a risk of default on these bonds - that Widget will go bankrupt and be unable to pay interest or principal on the bonds. So Alice goes to Bob - a trader who writes CDS - and purchases $10MM of CDS on Widget.

Other investors feel the same as Alice does and Bob eventually writes 200MM of CDS on this 100MM bond issue.

Widget defaults. The bonds trade down to a level where they are selling at 10 cents on the dollar.

Alice decides to cash in her CDS contract. In order to do this, she needs to deliver the reference obligation - she needs to get $10MM face value of Widget bonds so that she can deliver them to Bob, so Bob will be required to pay her the $10MM.

So Alice goes into the open market to buy $10MM face value of Widget bonds at 10 cents on the dollar - in other words $1MM in market value of Widget bonds.

However, there are individuals who hold $200MM of Widget CDS and only $100MM in bonds to fulfill the reference obligation.

This means that CDS holders will bid up the bonds from 10 cents on the dollar up to a higher level until the CDS contract has no more inherent value.

What has this done? It has had the effect of spreading risk much more evenly around the market that would have happened otherwise.

Let's dig deeper for a moment. Why would Alice buy CDS in the first place? Is she a gambler, making a bet? hardly. Alice, like almost all buyers of CDS, is a portfolio manager attempting to use CDS as a tool.

For example, she could be a manager of a convertible arbitrage fund.

many companies issue convertible debt. This is a bond which acts like a normal bond but can be exchanged for a certain number of shares of the company's stock.

So if a company issues a $1000 bond which is convertible into 10 shares of the stock, as long as the stock is below $100 a share and the company's credit is good, the bond will trade in the neighborhood of "par" or its $1000 face value.

However, if the stock shoots up to $150 per share, that bond may trade up to $1500 in the market.

So basically a convertible is a bond that comes with a call option on the stock.

Alice can remove the equity risk to her bond caused by fluctuations (volatility) in the shares by shorting shares of the stock. If she could also remove the credit risk in the bonds by selling short that risk, she would be able to eliminate both the equity and the credit risk in the bond and be able to get a return based solely on the volatility of the stock and the credit.

This is one example of what is known as a "market neutral" strategy.

Well, there is a large market out there for equity options, and there is also a large market out there for credit options (CDS contracts).

They are not normally used by investors as bets, but as risk management tools.

Very few people seem to be worried about the enormous volume of sales of naked equity options (people selling naked calls, for example, as well as far more exotic equity options) but everyone seems to be have fainting spells over naked CDS.

It's irrational and uninformed.

[Toddsterpatriot]

have to pay out (as in insurance payouts) the “notional” value of the derivative, when the underlying party goes belly up.

Wrong. Most derivatives are interest rate swaps. Trading a fixed income stream for an adjustable income. In these swaps, no matter what happens, no one is paying out the notional value.