Posted on 09/27/2008 1:16:46 PM PDT by politicket
Welcome to Lesson 1 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?
Published: November 02, 2005 in Knowledge@Wharton
When Delphi filed for bankruptcy October 8, investors had to start assessing their losses on more than $2 billion in the auto parts maker's bonds, which have recently traded at around 60% of their face value. As bad as that is, there is more. Looming over the market like an invisible and unpredictable giant is an estimated $25 billion in credit derivatives, a form of insurance whose value is directly linked to the ups and downs of Delphi debt.
This paragraph is referencing the bankruptcy of Delphi Automotive Systems, which was once owned by General Motors and was spun off into its own company in 1999. It also talks about the company’s ‘bonds’. Think of bonds as debt obligations. You’ve probably heard the term ‘corporate bonds’ before. It is one way that a company can raise capital to accomplish its business – it sells bonds to investors, in exchange for money to operate. If the company goes belly-up then the bond holders have a higher ‘pecking order’ than those investors that may have owned common or preferred stock in the company.
The common and preferred shareholders were completely wiped out in this scenario. The bond holders saw that their investment took a ‘haircut’ and was now only worth 60% of what they paid for it (worth is based on the liquidation –or sale – of any company assets).
This paragraph also talks about $25 billion in other ‘debt’ that is hanging over the ‘market’ – from those that “bet” that Delphi would not go bankrupt – and lost. The way that these investors in the market lost is by participating in the “selling of insurance” to the bond holders. When Dephi filed for bankruptcy the ‘insurance’ providers had to make good on the full original worth of the bond. In exchange, the bond holder was to hand over the bond (just like when there is a car wreck and the insurance company pays the value of the car – in exchange for the car being delivered to them). One problem with this is that the physical number of insured bonds may have not been enough to ‘give back’ to the ‘insurance’ providers – if there were more insurance providers than there were bonds. When this happens, the bonds have to be purchased by the ‘buyer’ of the insurance so that they can give them back to the insurance provider. This would be like you taking out two insurance policies on your car and getting into a wreck. You collect from both policies (highly illegal in the car insurance business) and then both insurance companies want the car in return. You only have one car to give back, so you would have to go BUY a second wrecked car of the exact same type, so that you could give it back to the second insurance company.
In summary, what you need to understand from this paragraph is that there was $25 billion dollars of ‘extra’ debt in the marketplace because of Delphi’s bankruptcy – without any of those in debt physically holding ANY common stock, preferred stock, or corporate bonds. All that they held were “bets”.
Clear as mud? Good. Let’s move on.
What happens to these complex contracts as the underlying bonds plunge in value? Will ripple effects amplify the Delphi damage, spreading harm to institutional and individual investors who otherwise have no stake in Delphi?
The ‘complex contracts’ that this paragraph refers to are the insurance contracts between the buyer and ‘seller’. The ‘seller’ has absolutely no physical interest in Delphi, except for the “bet” that they own regarding whether or not the bond will go into default (i.e. not get paid) This would happen if the ‘cash flow’ backing the bond was insufficient to meet the bond’s terms. This paragraph is asking the question: “What happens when there are too many ‘sellers’ of insurance? What effect might this have on the market (and economy) as a whole? Read on…
The Delphi situation points to a broader question: Is the credit derivative market, which grew from next to nothing in the mid-1990s to an estimated $5 trillion at the end of 2004 -- and is perhaps more than twice that size today -- pumping new, poorly-understood risk into the financial markets? Or are these exotic products helping to mitigate the shock from corporate crises, as their proponents claim?
Now we’re getting to the ‘meat’. Remember, this article is from the Wharton School – arguably the sharpest minds in the investment community. They’re basically saying – uh oh, what happens as the size of this thing begins to spiral out of control. Notice from the paragraph that what began as ‘next to nothing’ in the mid 90’s was estimated at $5 trillion (of “bets”) in 2004, and was presumed to be ‘twice’ that amount at the time this article was written – or $10 trillion of “bets”. In 2007, that figure ballooned to around $62 trillion dollars of “bets”. Since the beginning of this year, there has been an effort under way to identify “bets” that would be a ‘wash’. They have been destroying these insurance contracts (“bets”) by doing what is known as a “tear-up” (you can take that quite literally). As of now, there are assumed to be approximately $54 trillion dollars of “bets” in the market.
The paragraph also ponders whether it is good to pump ‘new, poorly-understood risk’ into to financial markets? What happens when there are corporate crises? Does this investment strategy help the situation at that point in time – or do great harm? Remember folks, this was written in November, 2005. I want you to write a date down on a piece of paper so that you don’t forget it as we continue these lessons – “July, 2007”.
"They're huge, and they have grown very rapidly," said Wharton finance professor Richard J. Herring, describing credit-derivatives products. "In principle, they are redistributing risk," he noted, adding that in the past few years, credit derivatives have helped the financial markets weather storms like the bankruptcies of Enron, WorldCom and Parmalat as well as Argentina's debt default.
It was believed for quite some time that the more credit derivatives in existence, the better. The mindset was something like this: If a catastrophe happened with a particular company, and there had been a huge number of “sellers” of insurance on the corporate debt, then each insurance seller would only end up paying a ‘little bit’ of the entire bill.
Here’s an illustration: Let’s pretend that you go out to dinner with four of your friends. After dinner, the bill comes and immediately somebody asks: “What’s the damage?” In our story, the ‘damage’ is $100, so each person takes out $20.00, plus a premium (for the tip) and the dinner is complete. What if only one person brought their wallet? They would have incurred greater harm because there was no ‘redistribution of risk’ – the risk being – “if you eat our food, you pay our bill”.
This all sounds logical, right? There’s no downside, is there?
"Those events would have been sufficient in an earlier era to cause major problems to major banks, and even to precipitate a banking crisis," he said. "But the banks have been fairly robust, and the reason is that someone else is holding the credit risk." However, he added, "What we don't know with any new market is whether something that somebody hasn't quite thought through is going to cause a meltdown."
This paragraph should have you sitting a little straighter in your chair. Finance professor Richard Herring is saying how great credit derivatives are, but stating what has now become painfully obvious. Let me repeat: “What we don't know with any new market is whether something that somebody hasn't quite thought through is going to cause a meltdown.”
There was something they didn’t think through correctly, and it is here, has been here since July, 2007, and will continue rolling forward. Let’s move along…
In September, the Federal Reserve summoned 14 major banks to a meeting to discuss troubles with the credit-derivatives market. The concern was not that these instruments are intrinsically hazardous. Rather, the Fed worried that the market has grown so quickly that participants cannot keep up with the paperwork. If trades were not processed fast enough, investors could lose confidence in the market and a normal crisis could snowball.
Here was a meeting, with the Federal Reserve and the major banks (the ‘brightest minds in the business’) and rather than focus on risk assessment from ballooning credit derivative “bets” they worried about how to fix the system so that they could handle MORE of them. After all, spreading out the ‘risk’ was a brilliant strategy – or so they thought.
The alarm had been raised earlier in the summer by E. Gerald Corrigan, managing director at The Goldman Sachs Group. As president of the New York Federal Reserve Bank in 1999, he managed the Fed's response to an earlier credit crisis, the collapse of hedge fund Long-Term Capital Management.
Here we learn that E. Gerald Corrigan was the one that wanted the Fed and 14 member banks to get together. He was the one that was concerned that more needed to be done to get more credit derivatives flowing through our economic system – and that of the world. Mr. Corrigan, who was once the President of the New York Federal Reserve Bank, was managing director at The Goldman Sachs Group. His boss was the CEO of Goldman Sachs, Hank Paulson – our current Treasury Secretary of the United States.
Eric. S. Rosen, managing director and head of North American credit trading at JP Morgan, one of the biggest players in this market, addressed this topic during a panel discussion on sales and trading at the October 14 Wharton Finance Conference. "The Fed is getting worried about the infrastructure," he said. Regulators made it clear at the meeting that "they don't care what your [credit derivative trading] volumes are; you've got to get the system in order." His company is spending $100 million on systems to handle the soaring volume. "I think the Fed has got it right," he noted.
Now, we read that on October 14, 2005, the head of JP Morgan’s North American operations told a group of high-powered financial executives that the “Fed is getting worried about infrastructure”. They were also told to not worry about trading volumes ($10 trillion of “bets” at the time), but to get their process in order, so that they could handle even more “bets”.
Yes, this is the same JP Morgan that the government has given ‘sweetheart’ deals to in the takeovers of Bear Stearns and Washington Mutual.
The credit-derivatives market barely existed before the mid-1990s. It developed when new mathematical insights made it possible to set prices for more complex instruments. Market participants were also gaining experience with other forms of derivatives tied to stocks, commodities and currencies. Banks and other lenders and investors were looking for new ways to hedge against risks. And investors such as hedge funds, insurance companies and pension funds were looking for ways to take on risk in hopes of earning higher investment yields.
This paragraph is pretty much self explanatory, except I want to expand on a couple of areas. The original credit derivatives market in the 90’s was driven, for the most part, by Investment Consultants that were sincerely looking for a larger return for their client portfolio. Over the years, they have created amazing mathematical formulas that rival the 7 spices of Colonel Sanders recipe in their complexity. There is an incredible amount of competition in the Investment Consulting industry – and there has always been pressure to get a “leg up” on your “adversaries”.
This paragraph talks about Banks (meaning both commercial and investment) looking for new ways to hedge against risk. Understand that they actually were looking for MORE risk, because it provided MORE return. The problem they faced is that the banking industry is heavily regulated and for a long time they were ‘burdened’ with managing illiquid assets that only gained a ‘good’ return. Credit derivatives was their salvation. It allowed them to create hedging strategies where they could actively participate in the “high risk – high gain” marketplace, while still ‘meeting’ the letter of the law in regulatory requirements.
One last point: Notice how insurance companies and pension funds (yes, your retirement) were getting all ‘tingly’ about the prospect of taking on more risk. Just like the banks, they had been stuck with conservative investing strategies, and credit derivatives were a thing of beauty to them.
We’re almost done with this lesson, hang tight..
The driving force in creating the credit-derivatives market, said Herring, was big banks looking for ways to make assets, such as loan portfolios, more liquid.
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.
You made it through Lesson One! Still hanging in there?
The next post will be Lesson Two. We’ll still be covering the same article – which will encompass the first 3 lessons.
Is this the real reason banks are going under? Since bets start with loans, was there incentive to make subprime loans even knowing they'd default?
This is all very confusing to me & I have been trying to make sense of this...up front sorry for length of this & it’s lack of clarity.
So would it be better to have not bailed AIG and let all the banks and investment companies go bankrupt—I ask this sincerely as I am wondering if then banks, credit unions that have none of these CDSs would emerge the winners—last man standing so to speak—I mean if govt bails out the companies that have these, then we are all on hook for trillions from what I read? What is US to do file chapter 11 to get out from them?
However, if a company or insurer (whoever is responsible for paying on the CDSs)of cannot pay on the value of the company debts or the “insurance policy” against insurance debt because they are bankrupt, then the liability would be limited wouldn’t it. Ex. We had a lifetime health club membership...well the health club went belly up & there were so many creditors that there simply were not enough assets to satisfy everyone’s claims—like trying to get blood from a turnip...not gonna happen. However, if the someone else had been writing policies against the health club ever going bankrupt, then they would be out lots of money—there were many unhappy campers. So the insurance company goes out of business too—but if the government is not involved in backing up the health club or the insurer of the health club, then wouldn’t only the holders of the health club memberships, the and the owners of insurance be sad out of luck?...of course there will be a lot of sad, fat health club members and owners of insurance feeling the pain, but only those who were involved as opposed to my whole community being on hook for bailing everyone out.
In other words, would the Armagedon that Paulsen forcast w/o bailout be less severe than the armagedon that might face our government if we are insuring all of them—I am sure we would be liable for some of the government insured stuff, but perhaps fewer...
Seems there has to be a way to save the country from this...please clarify. Thx!
Isn't the problem here the degree of leverage here? Am I correct in thinking that in your example the Widget bonds are leveraged 2:1? That is that there have been 200MM in CDS for 100MM in bonds. When Widget goes bankrupt it's going to be like musical chairs and a bunch of somebodies - indeed half the total investment in the CDS are going to be unable to get the bonds and get no return. I read that some of these large firms are leveraged by 40:1 and up to 80:1. If I am looking at this when a highly leveraged CDS goes, a lot of the investors lose.
Now, is this not precisely what they signed up for when they bought this crap? Shouldn't they just take their losses and learn from their mistakes?
Where I get angry is when there is real abuse and big piles of this stinking mess are tranched and then these pieces are further split and bundled and all of a sudden you have some real stinkers is SPVs that ratings that are far higher than their real risk. Here the investors lose but the bundlers and the raters have committed fraud. Should we not see lots of these wise-guys pay some hefty fines and do some significant jail time?
Please correct any misconceptions you detect. I want to understand this properly and that means quantitatively.
I honesty don't know. My mind is still churning all of the possibilities.
I am not a conspiratorial person by nature. I try to look at the economic signs and understand the movement of the money and trades. But one thing REALLY bothers me:
The credit derivatives problem began increasing on a HUGE scale beginning in 2004-2005. The Fed was the head cheerleader, and Goldman Sachs and JP Morgan were holding the cheerleader up on their shoulders for all the investment community to see.
I was IN the investment consulting arena at the time. I know for a fact what investment 'strategies' they were devising.
Here's my conspiracy theory - and then I'll get back to being sane again....if 'someone' wanted to get rid of the middle class in this country then this is sure the way to go about it. </tinfoil>
Sigh....I feel better now...
...
Not a bad example, so what happened to the money? With the MBS, there are defaults and there were profits skimmed off the top when the securities were created. But those numbers are roughly 10's of billions and billions respectively, yet the writeoffs are 100's of billions and will be trillions before it is over. The answer to the missing money is that it never existed.
The stock market in 2000 is another good example, everyone's shares were worth trillions, but that was paper wealth, not real wealth. In the case of your gym, while you put your hard-earned wealth into the membership, your neighbor may have put it on their credit card, paid off the credit card with a home equity loan, gone underwater on the house, and defaulted on the loans. That's the nature of a credit bubble, it is the predominance of paper wealth over capital.
As credit creates leverage (your neighbor using the paper value of his house to obtain loans), credit bubble contraction causes deleveraging. In the case of your neighbor who owes more than the house is worth, the bank takes the house, auctions it for half price, then takes other money owed from your neighbor's other assets like bank accounts. Let's say another neighbor uses his 100k HELOC from bank1 for downpayment on a property downtown and borrows 900k from bank2. The market turns down and his house is underwater. Bank1 takes the house and sells at a loss, just enough to pay the primary mortgage but not the HELOC.
Now the guy owes 100k to bank1 and 900k to bank2. Bank2 decides the guy is a poor credit risk and calls in the loan. The property sells for 800k in a fire sale. Now the guy owes 100k to bank1 and 100k to bank2. But what's this? He has 200k in membership deposits, guess who gets that money? There is potentially real money that disappeared, not just credit.
The problem is worse with derivatives. Money cannot be created from thin air without dangerous leverage. At least with banks and other institutions, the regulators can enforce risk and reserve requirements. For AIG, the State of NY regulated their insurance business and enforced requirements on reserves based on risk. But once AIG got into the business of CDS, the regulators were completely ineffective. They approved the business but AFAIK, did not perform any independent risk analysis. That meant that AIG could create and book profits on income streams that would not exist in a downturn. At that point, the income stream would disappear and they would owe whatever the default losses were.
In your health club case the "real money" is your own membership as you point out. In the case of AIG, the real money is the reserves for their other insurance business and the collateral for a large amount in loans (about a trillion). Your own health club payment was real, not borrowed, it came from your earnings and was spent on consumption. Your neighbor's payment was not, it was borrowed and because the money is gone, he can't get it back to use to keep his house. That where deleveraging creates a ripple effect in the economy.
In the case of AIG's trillion in loans, a lot of that is in the form of securities owned by other financial and nonfinancial entities, used to leverage other loans or provide collateral for economic activities. Some of those securities could be owned by the health club neighbor who wakes up one morning and finds that his AIG bonds are worthless. Then he gets a phone call from the bank.
Thanks for the explanation. Yikes!! It is still very confusing—like a spider web—all over whole country :(
still not sure even House Republicans are addressing this....Hope so
Thanks. I've sometimes felt that a George Sorose type mind would be able to use this new product (derivatives) in dangerous way because so few would understood abuse of the product.
On the other hand, most free market outcomes are based on money moving from the impatient to the patient - and this might be no different. The destruction of the middle class might be an unintentional consequence of a more "perfect" market.
Is Paulson going back to Goldman when he leaves the Administration?
Bullshit. Not essential.
Meanwhile, House Republicans won a major victory, persuading negotiators to include a provision that would require the Treasury Department to create a federal insurance program that would guarantee banks and other firms against loss from any troubled asset, the official said.
The first paragraph is good, letting judges monkey with mortgages is a great way to tank the value of the securities resting on them. The second paragraph is more ominous. Insurance might seem like a cheaper alternative to bailouts in the short run, but in the long run it just perpetuates the moral hazard that got us here in the first place.
The moral hazard here will from the knowledge that the govt will bail out a related company to save on insurance payouts. In other words another AIG will be saved for $40B so the govt can avoid paying 80B in insurance when the company defaults completely.
The real problems with the bailout and that provision are that it solves nothing in terms of reducing the credit bubble that will destroy us, and now we will use up even more of the fed's good credit rating in propping up our sick financial industry. As a result the dollar will go down (maybe not right away but inevitably) and the interest rate demanded for Treasuries will go up (although Bernanke has promised to prevent that by using monetary inflation).
I don't think it will matter. In a financial market this messy, there's plenty of ways to get the pudding.
not essential, and actually fatal.
The mix is explosive.
* * *
Comparing the complexity of derivative contracts to Col Sanders recipe is not quite right. The contracts -- see Warren Buffet's comments -- can often be too inscrutable to value, thus can only trade in an environment of implicit fraud. The Colonel's recipe is a top secret mix of 11 herbs and spices. People have made guesses at it, and good guesses, but the exact recipe is still a top secret.
Derivatives often are worse --- not only are they confections of ad-hoc mixes of securities and events and tabulated valuations and probabilities -- they can have accidental or deliberate omissions or mistakes. A cookbook recipe of 7 or 11 ingredients is simple. A derivative's mix of formulas and schedules is more than seven come eleven -- it is as if someone shredded the cookbook and someone else who wasn't themselves a particularly good cook pasted the shreds back in some hopeful order.
Could you please go into more detail as to the kind of naked short you are referring to?
Thanks ... great work!
Sorry....my poor attempt at injecting a little humor into a very sobering writeup.
Geez I really wish I had finished MBA program tho I am not sure they even had these instruments & paper back in the day when Earth crust was cooling and no VCRs invented yet.
So you are saying that by Bailing out AIG, we are avoiding the Credit Default Receipts from being exercised thereby saving money, but can’t bail everyone out & get crushed from these Credit default insurance-type policies because they are so leveraged—so much debt leveraged on for each dollar or original assets?
So where do we run? where do we hide?
That's not what the comparison was. I used to trade options, and I've worked with people who trade commodities and indexes -- they themselves say they are "putting a bet" on the market.
And I also know professional gamblers. They don't drink on the job.
And I've known investment professional to go out for a liquid lunch.
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