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

Politicket | 9/27/2008 | Politicket

[Toddsterpatriot]

It depends on whether you “book” the loss or not.

Like I said before, you don't need to trade CDS if you're going to commit accounting fraud.

[palmer]

Like I said before, the CDS business of AIG was regulated by a political appointee of a now disgraced liberal former governor. And as Papabear has pointed out, the people creating this mess had large incentives to be dishonest.

[politicket]

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.

Bingo..

[murphE]

Thank-you for this.

[Toddsterpatriot]

And as Papabear has pointed out, the people creating this mess had large incentives to be dishonest.

He said you could earn a guaranteed profit by buying CDS and burning down the economy. I think we can ignore his "thoughts" about CDS.

[palmer]

Sure. He later changed that to burn down MBS which is at least plausible. I’ve changed things I’ve written before too.

[Toddsterpatriot]

So buy a CDS on some MBS. How do you make that set of MBS more likely to go into default?

[palmer]

Short sell the insurer (e.g. MBIA)

[Kackikat]

Last Week on CNBC they were talking about the “auctions” of Freddie Mac and Fannie Mae “CDS.s” or credit deriviatives, that was being set up to dispose of them. We should get in writing that banks the government helps must do the same, and since that company has those auctions already in place, it could do the banks derivatives...??? Only 3-4 banks hold the most of those CDS (credit default swaps)...but more than 10 X that number do hold them.
They fear that if they do not ‘do something’ to slow down the runs on moneymarkets, annuities or other savings, this will bomb big time. There are National Security Issues here.

[Warlord]

You describe a synthetic sale of equity. A synthetic sale of 2000 PapaBear Inc. equity shares does not result in an additional 2000 equity shares in PapaBear issued and outstanding. It's just a contract the value of which is a function of the price of PapaBear equity which may be settled physically or cash with a notional of 2000 equity shares. Under the contract that you describe, the only problems are (i) the credit risk presented to counterparties if the share price goes up or (ii) the credit risk present to me if the share price goes down. The moral to the story is that settlement may always be made in cash and that the only problem is counterparty credit risk. I thing the flaw in your argument is that you confuse notional with actual. The notional in a derivative is nothing more than a value against which payoffs are determined.

[Moonman62]

So “Bob” is really Goldman Sachs, not AIG?

[palmer]

Bob is AIG, but the bailout was really for Alice (Goldman Sachs) because they had the most to lose from the breakup or bankruptcy of AIG. The bailout was a bridge loan forced by the government in place of private offers.

[keats5]

LOL. Now THAT I understood.

[victim soul]

thanks

[Kackikat]

CDS-credit default swaps are known as a credit “derivative”, and a type of “specialized insurance” used by debt holders to Hedge or insure against a default...HE$$ yes it’s a bet.

[Moonman62]

I did a Google search on what you said and I found an article saying AIG forced the Fed's hand, not the other way around. Can you help me find a source that shows AIG, "Bob" was forced to take the loan? Thanks.

A potentially market-rattling bankruptcy filing by American International Group (AIG Quote - Cramer on AIG - Stock Picks) forced federal officials to reverse course and pursue a costly bailout of the insurance giant late Tuesday.

AIG will receive an $85 billion bridge loan from the Federal Reserve aimed at keeping the giant insurer out of bankruptcy and preventing the acceleration of a world credit crisis.

[palmer]

By Sept, AIG was not in a good position, their share price plummeted far below the book value of their extensive assets (unrelated to CDS). They rejected a offers from buyout firms (see http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=a7owyQQ3Nxks) because they knew that would simply lead to a huge profit from chopping up the company, defaulting on the CDS stuff and selling the good stuff. So, according the article, they approached the Fed.

To say "Bob" was forced to take the loan from the Fed, you need to look at the big picture. The only reason that AIG stock price could have gotten so far below book value is the threat of Fed intervention. As has been shown since last January with Bear, the shareholders always lose when the Fed takes over which is unfortunate because it robs companies like AIG of needed and deserved capital.

[GOPJ]

Please add me to your ping list. Thanks.

[Tempest]

Good thread.

[GOPJ]

If we do the $700 Billion bailout, doesn’t the game start up again?