Credit Default Swaps and Financial WMDs
Gretchen Morgenson's NYT article yesterday offered a good primer about Credit Default Swaps (CDS):
Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.
Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.
As the graphics explain, counter-party risk is an ever present factor.
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click for larger graphics
graphic courtesy of NYT
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What's truly astonishing is the size of this market: The market for these
securities is enormous. Since 2000, it has ballooned from $900 billion
to more than $45.5 trillion — bigger than the US equity markets, US Treasuries, and Mortgage Securities -- COMBINED.
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click for larger graphics
graphic courtesy of NYT
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CDS are thinly traded, have huge counter-party risk, are difficult to analyze, and are unreguylated insurance products. This leadsme to this money quote:
"As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in."
Sounds kinda familiar . . .
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Source:
Arcane Market Is Next to Face Big Credit Test
GRETCHEN MORGENSON
NYT, February 17, 2008
http://www.nytimes.com/2008/02/17/business/17swap.html
Monday, February 18, 2008 | 07:34 AM | Permalink
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Comments
Credit default swap is analogous to Captive insurance. Both are mostly unregulated and under capitalized. Hey Vermont lawyers, are ya covered?
Posted by: AGG | Feb 18, 2008 7:56:56 AM
This was the first article I read that actually explained what the payouts were when Delphi defaulted on its debt and there were CDS for ten times the face value of the bonds. Those holding the CDSs, but no bonds, got about $.35 per dollar. ouch.
Barry had a post a week or so ago, "Bear Stearns Makes $1 Billion Bet on Subprime Market Decline." They bought already expensive CDSs assuming they would increase in value AND pay out at par. This bet is a lousy one, even if subprime does tank further, just because of the potential payouts.
Posted by: Bob_in_MA | Feb 18, 2008 9:00:46 AM
"Send in the clowns, there has to be clowns," this all can't be real... These insraments, like the cdo's et. al., were created by intelligent people right? Or I guess intelligents is as subjective here as the prices paid for the underlying instraments...problem is no one can look at these from "both sides now, from in and out, etc"...wow!
Would one of you truly intelligent people out there tell me how this cannot lead to another very scarry "social unrest amongst the natives," situation??? The kind that resembles head clubing, book burning, and kill the intelligensia?
Posted by: JustinTheSkeptic | Feb 18, 2008 9:01:31 AM
And lets just assume for a moment that the global economy can bail this situation out at present, what stops it from morphing into something even bigger several years from now? You have to guess that the greed of man will make this problem worse down the road. jmho
Posted by: JustinTheSkeptic | Feb 18, 2008 9:07:31 AM
According to Wikipedia, the intelligentsia is defined as the "social class of people engaged in complex mental and creative labor directed to the development and dissemination of culture, encompassing intellectuals and social groups close to them (e.g., artists and school teachers)."
This group is about as far removed from Wall Street financiers as you're going to get, and as such are among the last who will be subjected to "head clubing" by the outraged natives.
Posted by: bluestatedon | Feb 18, 2008 9:14:12 AM
A wise old Hetman of the Cossacks once said 'put your faith in your sword, and your sword in the Poles.'
I suggest we do that to the counter parties except we don't know who they are!
The guys who wrote the insurance did so with a completely blank checkbook. There ARE no reserves. Anyone who thinks otherwise also believes their Feddiebear can save them from the boogyman.
Posted by: Ross | Feb 18, 2008 9:49:39 AM
bluestatedon,
Tell that to all the scientist, artist, and professors, who were forced to march to their deaths, in Germany, Poland, Russia, Burma, China, etc....
Posted by: JustinTheSkeptic | Feb 18, 2008 9:58:30 AM
That large numbers of the so-called intelligentsia disappeared in Germany, Poland, Russia, Burma, Cambodia, etc. is a lamentable historical fact, but it doesn't mean there's any chance of it happening here. Our political and social culture is so different from all of those countries in so many ways that our school teachers and artists don't have to worry much about being placed in re-education camps as a result of a systemic economic collapse. That's not to minimize the chaos that would attend such a collapse, but I don't think pogroms of the intelligentsia are in the cards.
does not mean it will happen here. We'd have to have a complete and thorough collapse of society in all ways, in combination with the institution of a radical fascist or socialist regime coming to power.
Posted by: bluestatedon | Feb 18, 2008 10:20:06 AM
That $45 trillion number is kind of misleading b/c that's notional value not the Net exposure of the parties involved...Although, counter party default risk is always there...
Posted by: SINGER | Feb 18, 2008 10:32:08 AM
bluestatedon, agreed.
Posted by: JustinTheSkeptic | Feb 18, 2008 10:45:46 AM
There will still be a winner and a loser for each trade. Unfortunately, the gullible investor will probably be the loser. Sometimes the bad guy wins.
I guess if you want to pick the pocket of a worldly investor, you need to use something that sounds complicated, new, and a sure thing that only a few select people can take advantage of. History abounds with stories of people who thought they were too smart by half, and gullible fools who fell for the lies of a corporate psychopath.
Posted by: cinefoz | Feb 18, 2008 10:54:17 AM
The lawyers for the monolines knew how to put lipstick on a pig, like every good lawyer should.
Hey, monolines don't write CDS on CDOs, they write "financial guarantee insurance policies" and now the insurance regulators are on their case.
Posted by: Carmen | Feb 18, 2008 10:55:46 AM
intelligentsia? what intelligentsia? inflation has been at work for decades in that realm and the roundup would be a considerable disappointment of mostly beleagured holders of large student loans; a little jail time to get out from under those obligations would probably be welcomed. god knows the product financed was vastly over-priced.
Posted by: rexl | Feb 18, 2008 11:06:48 AM
So, no one knows exactly how large the actual credit default market is, nobody knows who now owns or is providing the "insurance", there are no reserve pools to cover defaults or losses, but according to Easy Al derivatives have been a boon to the financial markets. Why would anyone say this is not a gigantic fraud. Who's going to finally open up the storage tank and find no oil?
Posted by: larry | Feb 18, 2008 11:14:27 AM
Barry, have we discussed Auction Rate Securities, and what they mean for thousands of businesses?
Off the top of my head we have had issues with a drug company, 3M and Texas Instruments, but this is the tip of the iceberg. Having to mark them as investments as oppsed to a cash equivalent is gonna be a real BE-ATCH for everyone. Then again they say it's contained so why worry?
From CFO dated 2005. Who could of known though:
Auction-Rate Securities: Hold That Gavel
The securities--long-term bonds that act like short-term debt--have often helped treasurers squeeze out added return on corporate cash balances. But a bevy of woes is making it tougher to embrace the cash-management tool.
Marie Leone, CFO.com | US
April 25, 2005
Posted by: SPECTRE of Deflation | Feb 18, 2008 11:37:01 AM
It appears that a huge fraction of the activity in the financial markets has consisted of variations on the theme of selling naked puts, an "investment" strategy which well deserves its classical description: "Picking up nickels in front of steamrollers."
The genius of the bankers and hedge fund managers has been to devise ways to render the steamrollers temporarily invisible and send other people out to pick up the nickels -- while getting those people to pay them huge, non-refundable fees for the privilege.
Posted by: jm | Feb 18, 2008 11:38:11 AM
Financial WMDs? Another apt term would be the greed bomb. I can see the Laffer crowd astride this monster like Slim Pickens in Dr. Strangelove yelling Yeehaa Yeehaa!
Posted by: twistytop | Feb 18, 2008 11:39:21 AM
That $45 trillion number is kind of misleading b/c that's notional value not the Net exposure of the parties involved...Although, counter party default risk is always there...
Posted by: SINGER | Feb 18, 2008 10:32:08 AM
bluestatedon, agreed.
Posted by: JustinTheSkeptic | Feb 18, 2008 10:45:46 AM
Don't you need a counterparty willing and able to pay on the losing bet for it to be notional? If there is no counterparty, you are royally screwed.
Posted by: SPECTRE of Deflation | Feb 18, 2008 11:40:06 AM
Participants in the credit default swap market have argued against insurance-type regulation since the swaps are not technically "insurance". While the credit default swap transfers a risk, it entitles the covered party to a defined notional amount upon occurrence of a given event; unlike insurance, which indemnifies the insured for actual losses, the credit default swap entitles the covered party to the notional amount, regardless of actual losses. And the covered party in a swap knows full well that the counter-party is not a fully capitalized regulated insurance company.
AGG's analogy to captive insurance is on point. Most captive insurance shifts risk in the same way that a party moves liabilities of its books by dumping them into a Cayman SPV, i.e., it's illusory. As a tax attorney, I've been perplexed that Congress permits captive insurance to be treated as insurance for tax purposes.
Posted by: Terminator_X | Feb 18, 2008 11:44:14 AM
The money is spent boys and girls. We are left with debt. Anyone who believes that this is a zero sum game will have his or her head handed to them. The bank have blown through their reserves. We are being financed through the TAF.
Posted by: SPECTRE of Deflation | Feb 18, 2008 11:47:08 AM
More about the domino effect:
Monolines and credit default swaps.
http://www.bloomberg.com/apps/news?pid=20601103&sid=aRgbDoRUoSM8&refer=us
Posted by: Steelduck | Feb 18, 2008 11:51:22 AM
Watching Christine and Mike on CNBC. 53 years old and $680,000 in debt. Our grandparents are rolling in their graves. Didn't anyone really listen to their Grandparent's stories when they were growing up, or did the "Me" Generation just think they were smarter than everyone else who had come before them? Jackasses!
Send us your debt confessions per CNBC. Unfrigging real.
Posted by: SPECTRE of Deflation | Feb 18, 2008 11:58:03 AM
“President George W. Bush has bestowed on his intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations. Notice of the development came in a brief entry in the Federal Register, dated May 5, 2006, that was opaque to the untrained eye.”
This in an article I just read relating to JP Morgan's more than twice the exposer of citi's derivitives...and the annoucement to do away with certain government statistics. "Oh my, what might the world do if this woven web becomes a financial death bed?
Better hope our fighting men and women respect the judgment of our leaders? Also, who's to say that after other countries who have had the time to wittness our quagmires in both Vietnam, and Iraq, might not find severing our world dominance appealing? Could the stability of your democracy possibly be in question? Or would the other world members see no benefit in our demise?
Posted by: JustinTheSkeptic | Feb 18, 2008 11:59:53 AM
Yes, jm, selling naked puts. And the money manager collects his 2 and 20 (or more) up front based on some pretty large nickels. And the "investors" in his hedge fund are left to be run over by the steamroller. To whom the money manager eventually says
"sorry I f****d up" as in Friday's power point.
Posted by: Tom Durff | Feb 18, 2008 12:09:56 PM
A lot of talk these days about the size of the CDS market and a nice NYT chart. However, I would be more interested in a net-credit-exposure number reduced by dealer-books offset rather than looking at the number of total CDS's contracted. Any regulator out there with an idea about this number? Guenter http://www.highyieldblog.com
Posted by: Günter Leitold | Feb 18, 2008 12:10:45 PM
