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

Politicket | 9/27/2008 | Politicket

[Moonman62]

Fed interventions that they are out of luck, so if there’s any chance of it, they withdraw their equity.

So it's not much of a "bailout" is it? And certainly not free money.

[PapaBear3625]

The concept of taking the profit and running doesn’t exist in his world.

It's like having a deal where you have a 99% chance of making $1million, but a 1% chance of losing $1billion. Most likely, you win. And if you lose, you don't HAVE a $billion, so you walk away.

[Warlord]

“One big problem about naked shorts is it allows more shares to e sold than actually physically exist.”

This isn’t a real problem as settlement may be made in cash. The only issues relate to credit risk. Market participants take steps to mitigate credit risk but it’s always something to consider.

[Toddsterpatriot]

Still didn't clear up your confusion about how CDS work.

Why would your "assumption" about default risk give you a profit? I'd think the market price would be a better measure.

[Toddsterpatriot]

You’re talking about CDS. They trade those on IBM, or didn’t you know that?

[palmer]

It is exactly a bailout for the CDS holders like Goldman Sachs. The Fed didn’t have much concern for shareholders of AIG, like previous cases, but they did not want the CDS that Goldman holds against AIG to be defaulted upon in a liquidation of AIG.

[Toddsterpatriot]

I’ve been laughing at that link for a while.

[Toddsterpatriot]

So now you’ve gone from arguing that buying a CDS is a sure money maker to arguing that selling a CDS is a sure money maker. That’s funny.

[PapaBear3625]

The main assumption that issuers could make at the start of the game, was that the default-triggering recession would not be for a few years. In those years, they could rack up a lot of bonuses and commissions.

It was a situation where, by taking the risks, the best that could happen is that they would make $millions, the worst that could happen is that they would have to look for new jobs, and the most likely scenario was that they would make millions and then have to look for new jobs.

[palmer]

The article (not perfect for sure) simply points out that the original sale of the CDS generates profits based on “assumptions”. It also points out that the market price is driven both by the desire for profits and the assumptions, in that the rosier you make your assumptions, the lower you can make your price at a constant profit (or the higher profit at a constant price).

[Warlord]

“You may not think so, but if you look through the thread you will find at least a few people who are very interested in them.”

There is nothing new in the first lesson. That's objective fact. That doesn't mean that the lesson is unworthy of posting. Nevertheless, I concede that my interest in the thread is not the lesson as much as dealing with the idea that somehow the lessons (if the first is indicative of the series) make any sort of case against the general use of derivatives.

[palmer]

any sort of case against the general use of derivatives

Privatized profits, socialized risks. If that's obvious from recent history, then you would need to provide an alternative explanation for the bailouts of derivative counterparties like AIG.

[politicket]

Nevertheless, I concede that my interest in the thread is not the lesson as much as dealing with the idea that somehow the lessons (if the first is indicative of the series) make any sort of case against the general use of derivatives.

Stay tuned for the rest of the Lessons (next one coming in a little while).

I'm not arguing against CDS's, nor combining and using them in CDO's. I'm saying that they can be, and were, abused heavily - without consideration being taken of the downside. That downside is about to bury us financially.

[Moonman62]

But in a previous post you said it was “Bob” who got a bailout and that “Bob” was AIG. Now I’m confused. I never did figure out who “Alice” was.

[PapaBear3625]

This isn’t a real problem as settlement may be made in cash.

Oh there is INDEED a real problem.

I incorporate PapaBear Inc and issue 1000 shares, which palmer buys and holds. You naked sell 1000 shares to Toddsterpatriot. You then sell another thousand shares to freeandfreezing. There are now 3,000 shares in circulation of a company which only has 1000 shares. You start seeing the problem?

[palmer]

Post 19

[PapaBear3625]

So now you’ve gone from arguing that buying a CDS is a sure money maker to arguing that selling a CDS is a sure money maker. That’s funny.

I've done neither. I'm saying that CDS's can be used to provide an illusion of solvency, for long enough that people can walk away with a lot of money before the house of cards falls down.

[Toddsterpatriot]

The article (not perfect for sure) simply points out that the original sale of the CDS generates profits based on “assumptions”.

Well, first of all, you'd be paid $1.2 million a year for 10 years. So if you assume you're going to lose $10 million, you're posting a loss for the first 8.33 years. Maybe in year 9 you can book your "profit"?

It also points out that the market price is driven both by the desire for profits and the assumptions

Well duh.

in that the rosier you make your assumptions, the lower you can make your price at a constant profit (or the higher profit at a constant price).

Assumptions don't pay the bills. You can assume all you want but if the CDS you sold for $1.2 million a year starts trading at $2 million a year, I suspect you'll be booking a loss.

[Toddsterpatriot]

I'm saying that CDS's can be used to provide an illusion of solvency, for long enough that people can walk away with a lot of money before the house of cards falls down.

By buying them or selling them?

[palmer]

It depends on whether you “book” the loss or not. In AIG’s case it was better not to even in the face of imminent defaults. But the market knew better and drove down the stock price. So perhaps your free market really worked after all? Well, then there was a bailout.