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.
FYI...
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.
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.
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%.
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.
bookmark to read later
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Thanks for the Ping FRiend! Great explanation...hitting print button NOW.:)
Thanks so much
Thank you.
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.
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...
thanks. Look forward to installment 2.
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
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.
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.
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.
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