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.
OK, that clarifies. I was misinformed. Thanks!
I'm a FReeper with an opinion... ;-)
I also run my own company as a business analyst for the financial community. I do not have a 'degree' or 'certification' in investment consulting, so take all I say as 'food for thought' and nothing else.
I spent the last seven years working in the Investment Consulting industry, specifically in the area of administering CIMA (Certified Investment Management Analyst) designations. Most of the investment professionals that obtain this designation are CEO's, VP's, and other highly experienced consultants from across the nation, and spanning many countries.
I learned a lot during those seven years and have formed my opinions based on that knowledge. Nothing more. Nothing less.
So....don't go sell your 401k because you think I told you to. :-)
For example?
For the case of CDS's on MBS's, you just wait for the next recession.
Sounds easy. Makes you wonder why anyone would sell a CDS, seeing as you think it's a guaranteed winner.
I agree. My point was that greed drove it.
I saw this relevant description on the following site:
http://biglizards.net/blog/archives/2008/09/democrats_try_t_1.html
Let’s jump back 18 months. I spent several letters going over how subprime mortgages were sold and then securitized. Let’s quickly review. Huge Investment Bank (HIB) would encourage mortgage banks all over the country to make home loans, often providing the capital, and then HIB would purchase these loans and package them into large securities called Residential Mortgage Backed Securities or RMBS. They would take loans from different mortgage banks and different regions. They generally grouped the loans together as to their initial quality as in prime mortgages, ALT-A and the now infamous subprime mortgages. They also grouped together second lien loans, which were the loans generally made to get 100% financing or cash-out financing as home owners borrowed against the equity in their homes.
Typically, a RMBS would be sliced into anywhere from 5 to 15 different pieces called tranches. They would go to the ratings agencies, who would give them a series of ratings on the various tranches, and who actually had a hand in saying what the size of each tranche could be. The top or senior level tranche had the rights to get paid back first in the event there was a problem with some of the underlying loans. That tranche was typically rated AAA. Then the next tranche would be rated AA and so on down to junk level. The lowest level was called the equity level, and this lowest level would take the first losses. For that risk, they also got any residual funds if everyone paid. The lower levels paid very high yields for the risk they took.
Then, since it was hard to sell some of the lower levels of these securities, HIB would take a lot of the lower level tranches and put them into another security called a Collateralized Debt Obligation or CDO. And yes, they sliced them up into tranches and went to the rating agencies and got them rated. The highest tranche was typically again AAA. Through the alchemy of finance, HIB took subprime mortgages and turned 96% (give or take a few points depending on the CDO) of them into AAA bonds. At the time, I compared it with taking nuclear waste and turning it into gold. Clever trick when you can do it, and everyone, from mortgage broker to investment bankers was paid handsomely to dance at the party.
I'll give a prime example - National City Bank. It is my opinion that they are about to go belly-up, really soon. Yet, if you look at their books they are well capitalized. They're going belly-up because they played in the sandbox and got burned.
And the numbers are hidden from the investor whose is about to lose their shirt.
A “naked short” position in an asset simply means you owe something which you do not own. Many people, including people who carp about naked stock shorts, have “naked short” positions in U.S. dollars, in so far as such people owe more dollars than the dollar value of the assets they own. The risk of a “naked short” position is that the price of the asset goes up before the debt is settled. Then, repayment is made with something more valuable (adjusted for time) than that which was borrowed.
For example, take your common student. He takes out a big loan when the dollar is weak to pay for worthless (assumed) educational services (the next bubble). Over the years, say the dollar strengthens. The hidden cost to the student, beyond the interest, is difference in value, adjusted for time, of the relatively dear dollars that he must use to repay the loan. Educational services are used in this example to represent a usage of funds for something that does not hedge the short position in dollars.
That's all it is. Nothing sinister.
“Why doesn’t everyone wait until I post the last two lessons based on the article, and then make a determination of the whole?”
Do you really thing that these lessons will present anything new? Perhaps, but very likely not.
It's a winner as long as you can defer the day of reckoning to the point where the problem is so big that a government bailout is required to avoid a total collapse.
Something like the S&L crisis. People were making lots of money right up to the point of systemic failure.
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.
Not to be rude, but you're free to visit other threads at any time...
There were several offers because Bob’s stock price got down in low single digits. The reason the stock price dropped is that investors have learned from previous Fed interventions that they are out of luck, so if there’s any chance of it, they withdraw their equity.
So you’re not going to tell me how to cause IBM to fail, to make my CDS profitable?
profit: http://www.financialsense.com/fsu/editorials/amerman/2008/0917.html
That and the political appointee of the now disgraced former governor of New York said it was ok to do it.
These guys got junk bonds onto institutions books as AAA assets
And Mike Milken got into a lot of trouble for far less.
Keep posting that silly link. LOL!
One big problem about naked shorts is it allows more shares to e sold than actually physically exist.
Every chance that you give me.
I was talking MBS’s, you’re the one who did the bait and switch to talking about IBM debt.
Toddster likes to argue perfect world examples like wideawake’s post 19. The concept of taking the profit and running doesn’t exist in his world.
Also see palmer’s link from post #93, which shows how it can be done.
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