Where Pricing Anomalies Abound

Barrons (subscription ^ | March 7, 2009 | Michael Santoli

[CutePuppy]

Credit-default-swap traders may need a shorter leash.

LIQUIDATION. A GOOD SOAKING. PLENTY OF TEARS. It is real wet out there in the markets.

Given all the known big-picture reasons for this drenching, does it makes sense to continue enabling the folks who make and sell umbrellas to force it to rain at will? The people with a stake in umbrella prices who are able to trigger a downpour are the traders who bid up credit-default swaps on individual companies, whether they own their debt or not, and short the stock.

In combination, these actions feed signals into the market that companies are at risk of default -- often true, sometimes not, never a certainty. The mix of ballooning CDS premiums and collapsing share prices is a factor that can force credit agencies to issue debt downgrades, make real creditors nervous and scare would-be "real money" buyers away from the shares and bonds of the affected companies.

The results are some alarming pricing relationships. A Merrill Lynch analyst Friday noted it was more costly to protect oneself from the possibility of a default by Berkshire Hathaway (ticker: BRKA) than one by Vietnam. And General Electric (GE) CDS prices outstripped those of Russia -- a country that a dozen years ago actually did default on its foreign debt.

This is all legal, thanks to a law a few years ago exempting CDS from "bucket shop" laws that ban gambling on security prices indirectly. And, as New York State Insurance Superintendent Eric Dinallo testified in Congress last week, one likely reason they aren't termed credit-default "insurance" is that using that term would trigger state regulation and higher capital requirements for the underwriters, making the swaps expensive hedging instruments.

.....

[CutePuppy]

This is a subscription publication, but this article is very much worth reading for those who want to understand how the companies and overall markets are being crippled through the use of generally legitimate and otherwise useful quasi-financial "insurance" instruments. Most libraries and news stands should have this issue by Monday, it's in the "Streetwise" section.

The truth is trickling out about the use of CDSs as a "shorting" instrument, instead of insurance it was supposed to be, especially in conjunction with outright, often "naked", shorting of companies' stock, and how it helped lead to deliberate and indiscriminate destruction of capital and spreading of fear, which are feeding on each other.

[ari-freedom]

first let’s put Obama, Dodd and barney Frank on a very very short leash.

[CutePuppy]

Another article from Barron's November 15, 2008 issue - FR post Defusing the Credit-Default Swap Bomb

[CutePuppy]

And have them and few of their influential friends take a long walk on a short plank...

[Vet_6780]

Naked CDS is the $60 trillion black swan that flies under the radar.

Even though it has been reported over and over for years as the base cause of the credit crunch, nobody understands it including Obama. Obfuscation is the best stealth.

Meanwhile. the federal reserve system continues its death spiral.

[expatpat]

Yes, the size of the CDS problem dwarfs the size of the mortgage problem itself because the CDSs were used for gambling and speculation far beyond investment in the mortgage securities themselves — AIG took the wrong end of the swaps.......

[CutePuppy]

Yep, no sane insurer would underwrite a $100 worth of assets with $600 worth of insurance. Besides making no business sense, it also creates perverse incentives. CDSs are sort of like viatical contracts of the 80s and 90s.

Theoretically, an unlimited amount of credit-default swaps can be written and bought on any issuer, and there are incentives for buyers to make companies look sickly. If an investor buys a troubled issuer's deeply discounted corporate debt that has little chance of trading again at face value, and then buys CDS as protection, the investor could essentially want the issuer to default so the swaps pay off to the max.

Says Tony Dwyer, a strategist at FTN Equity Capital Markets: "You have turned the buyer of stressed corporate debt from a buyer incentivized to make the company better and worth more, to a buyer with the goal of default. If the total cost of buying a bond and insuring it to par is less than par, it creates an arbitrage that ultimately destroys capital."

In particular, John Paulson and his friends made a bundle on CDSs - http://www.freerepublic.com/focus/f-news/2186519/posts?page=36#36

[expatpat]

Yes, he did, because he was one of the few people to both see that the whole thing was a crock, and act on it.

[CutePuppy]

Yes, seeing “that the whole thing was a crock” was not that difficult, many people saw that. He was one of the few who understood how to exploit the loophole and gathered enough capital and had the wherewithal to invest in the instruments which would do the most damage and maximize the profit when the stinking crock eventually broke.

Many people went bust trying to act on it too early, either using too short term contracts, or without enough capital and having to cut losses. Paulson himself started getting into CDS since 2005, when they were extremely cheap.