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Arbing The Decoupling Between CDS And Out-Of-The-Money Equity Puts In Distressed Names

Tyler Durden's picture




 

In his latest analysis, Goldman credit strategist Charles Himmelberg resumes the firm's party line of claiming the market is overestimating the risk impact of "fat tail" events, because presumably, as Goldman's Javier Pérez de Azpillaga showed previously, even though Spain is insolvent, is facing a massive budget deficit, has a huge debt-roll problem, and has a banking system that is locked out of capital markets, all is good (full report here) and all those who are betting on Europe's demise are about to lose money (how this Eurozone optimism jives with Goldman's recent downgrade of the EURUSD to 1.15 is beyond non-lobotomized comprehension, so we'll just leave it be as yet another fully expected Goldman inconsistency). Yet, as ever so often, inbetween the conflicts of interest, Goldman does tend to provide that occasional piece of useful, actionable information. In this case, Himmelberg has done a very relevant analysis comparing Jump to Default costs for CDS and for out-of-the-money equity puts on distressed public names, and concludes that purchasing CDS provides a far better, lower-costing entry point to hedge against default. As he notes: "Our results show that pricing in the two markets follows the same trend, but that credit protection may be cheaper in many cases." Specifically, anyone wishing to arb the mispricing of credit and equity downside protection would be wise to put on a pair trade basket where one buys CDS/sells OTM Puts in SFI, LIZ, BC, MIR, NYT, and DDS and the inverse (sells CDS/buys OTM Puts) in F, AMR, MGM, TSO, SFD and LEN on a DV01 neutral basis, and wait for risk normalization between equity and credit to lead to a recoupling in the spreads. 

As we have demonstrated in presenting the daily decoupling and subsequent recoupling in the EURJPY-ES pair, technical divergences such as this particular one will likely not persist for long as in this fundamental-less market, any divergence from the norm in technicals is promptly (if with a slight delay) filled in. the For those interested in pursuing this further, here is Himmelberg's elaboration.

Credit default swaps are frequently used by equity investors to hedge the risk of distress across their names, similarly to put options. And if we assume that a stock goes close to zero in case of default, then a CDS can be seen as a zero-strike put option. It is therefore natural to compare the cost of default protection in the two markets (See also “A Simple Robust Link Between American Puts and Credit Insurance”, by P. Carr and L. Wu (2007)). We  acknowledge that
liquidity may be limited in the out-of-the-money puts in some of these names, but we believe the comparisons are valuable to add perspective for investors in each market.

To make the comparison as close as possible, we follow the methodology below:

1. Our analysis considers the universe of HY names with liquid out-of-the money put options of around 1-year maturity, struck lower than 50% of current stock prices

2. We define the gain upon jump-to-default (JTD) for holders of CDS and American equity put protection. We assume bondholders recover around 35-40% upon default, depending on the name, while shareholders lose everything but 5%

3. We compare the former to the cost of the two instruments, using ask prices. For CDS, we use the carry cost, pro-rated until the option’s expiry The resulting information shows the cost per default protection in the two markets  follows a similar pattern. In particular, credit default swaps and puts tend to trade at similar cost, when the puts are out-of-the-money, i.e. close to the theoretical CDS strike (Exhibit 12).

On average, equity options appear to be slightly more expensive than CDS. Partly, the average differential is due to the fact that puts are less out-of-the-money than CDS, and therefore include protection for underperformance scenarios where the company does not necessarily enter default.

However, the strong discrepancies in the analysis where puts are deep out-of-the-money suggest that default protection may be cheaper in credit. A portion of this discrepancy is be driven by wide bid-ask spreads in the options markets (see chart below for more details on our analysis).

Zero Hedge will construct a CIX index in which we will track the relative performance of the proposed pair trade basket, as we are confident that in today's directionless and idealess market, those funds with an access to both CDS and equity will likely be eager to take advantage of this mispricing.That said, we would urge readers with exposure in just one or the other market to not attempt to just put on one side of this trade in anticipation that other "greater fools" will close their side of the trade. That is the surest way blow up your book in no time.

 

 

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Sun, 06/27/2010 - 16:56 | 437100 BumpSkool
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Ill buy the naked OTM puts on their own... mine. If their so over priced I'll fence vs. the OTM calls - because the underlying is NOT going up

Sun, 06/27/2010 - 17:18 | 437138 bob_dabolina
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Does anyone know if you can get BDIY on TOS? Also curious if TED spread is avail, just started using this this plt and was curious if anyone knew.

Sun, 06/27/2010 - 17:17 | 437141 GoldmanSux
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Shouldn't equity put options be relatively more expensive at all times? Why should should this spread change?

Sun, 06/27/2010 - 17:18 | 437143 sheeple
sheeple's picture

risk normalization between equity and credit

 

to arb the mispricing of credit and equity downside protection

 

Rigged market man, that's a rough call

Sun, 06/27/2010 - 17:38 | 437172 Mr Lennon Hendrix
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Truth About Markets USA debuts on GCN!

Max Keiser and Stacy Herbert:

http://www.youtube.com/user/fairinfowar?feature=chclk#p/c/2A2D7BE0AE0DE8...

Sun, 06/27/2010 - 19:19 | 437289 Rusty Shorts
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Jerry Seinfeld introduces Max Keiser at Comic Strip 1978

http://www.youtube.com/watch?v=ShsXiZlMAKw

 

 

Sun, 06/27/2010 - 17:46 | 437184 Wynn
Wynn's picture

Classic ZH. Whip the crowd into a frenzy, then calm things down with some boring CDS piece.

I can't help but wonder ... (assuming) we all meet in the streets one day, will Tyler have a megaphone in his hand, or an iphone?

 

Sun, 06/27/2010 - 19:32 | 437300 Eric Cartman
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The Droid.

Sun, 06/27/2010 - 17:49 | 437189 DoctoRx
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Till CDS are treated as regulated insurance products, they are BS.  Who guarantees payment?  The seller?  AIG? 

HAHAHA

Sun, 06/27/2010 - 18:23 | 437235 Cheeky Bastard
Cheeky Bastard's picture

Unless you can deliver the instrument which underwent a CE, or unless you bought a FixR-CDS/RDS [the second one you want to buy when CPD is over 80% = app. 1950 bps] just to hedge an unnecessary drive up in RRs [see Delphi]; no one; if you buy a defaulted RE [usually in an auction that follows CE shortly] counterparty must make you whole. And you dont need to regulate them, only have a CCP.

But you knew all this; didnt you?

Now; I dont think you actually read the article; you just reacted to the word "CDS" and felt necessary to add that worthless little drivel that is your comment. Nice way to shit in someone else house on someone else work.

What Tyler wrote in this article is not "betting" on a CE [and thus being exposed to a counterparty risk/debt availability]; but arbitraging the cost of CDS and OOTM Puts; but you also knew that; didnt you .... champ?

Sun, 06/27/2010 - 18:47 | 437254 bob_dabolina
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I think the point of what he was trying to say is that the tax payers acted as the counterparty in the case of AIG and until CDS become regulated and this bullshit is allowed to continue with no law than this same problem will happen in the future.

Sun, 06/27/2010 - 18:57 | 437262 Cheeky Bastard
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And how is that on topic with what this article is about 

And the problems in AIG were mostly due to AIG underwriting principles and conducts +  the fact that ALL counterparties were paid 100c/$ when [in LEH case] they should have been paid just a notch above 91.xx [simply because the more debt there is the lower are the RR, and AFAIK LEH debt was not infinite].

Geithner comfortably put RRs aside and made everyone who bought a CDS from AIG whole [regardless if they actually had debt deliverable or not]. I dont think GS and other beneficiaries of FRBNY 08 policies regarding CDS even tried to buy defaulted RE on auctions. 

Sun, 06/27/2010 - 20:23 | 437384 bingocat
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Cheeky,

I don't agree your post should have gotten junked, because the intentions were good. There are far too many worthless "Gee-I-just-gotta-say-something" comments on the boards here. But...

AIG's counterparts did not need to deliver collateral. There had been no CE on the underlyings. I have yet to find someone who can tell me why in law GS and the others should not have gotten 100% as long as there was no default. Apart from default, those with CSAs should be 100% protected (assuming agreement on marks) until default. That's the purpose of a CSA - to make a derivatives counterparty a secured creditor until one side defaults. If there was a default, then what they get is based on the collateral in place vs the reference mark, and where they get out vs that reference mark. But, UNTIL there is a default, it is worth 100%, and in any case, there need be no talk about underlying instruments for delivery (unless the original poster actually has a point about the legality of naked CDS).

What is the significance of the 91.xx number?

 

Sun, 06/27/2010 - 21:39 | 437532 Mercury
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The CDS market is still like the forward contract market in that it is an OTC party-to-counterparty market with no intermediary authority - no?

Equity options are backed by the OCC and the viability of the counterparty isn't really an issue. Might not CDS be cheaper because of a lack of such a uniform guarantee?

Not exactly my area...just askin'  - how do equity options vs. CDS usually trade in distressed or semi-distressed names?

Sun, 06/27/2010 - 22:51 | 437632 bingocat
bingocat's picture

The bilateral CSA (collateral agreement) in place for most OTC CDS trades means that counterparties should not be taking excessive net credit risk of their counterparty in any given transaction.

Equity options are not "backed" by the OCC. The OCC is a clearing system which requires collateral (in the form of margin) to be posted on a daily basis. This is a central clearing system whereas the OTC derivs market is a bilateral netting system (every bank looks at all their open trades with every other counterparty and ends up settling a net amount every day. In the interbank (and broker) market, the number of counterparties is limited. In the bank-to-customer market, this is
a larger list (though a potentially smaller number of transactions). The end result, in "normal times" should be roughly the same. In volatile markets, the OTC market may have the advantage because collateral terms may evolve depending on volatility (whereas the OCC terms don't really).

How equity options vs CDS usually trade in distressed or semi-distressed names is the point of the original thread.

Mon, 06/28/2010 - 01:27 | 437802 Cheeky Bastard
Cheeky Bastard's picture

All true; but you are forgetting one thing; the position moved against AIG position [long REs]; and thus CSA worked in favor of the buyers; not in favor of AIG. Do you really thing AIG had all its positions hedged; please.

This was all much debated about; but we can do it again here. Also we do not know how big % of the OTCs had a CSA attached [since CSA is not a pre-requisite for entering an OTC CDS trade, it is prevalent in use with ISDA, but not a pre-requisite].

My point is every time RE deteriorated in rating etc etc it was AIG who had to put the ever increasing percentages of net-notional as collateral; and that is what brought AIG down. The collateral which AIG did now have.

That still does not guarantee you you will be made whole by not holding the underlying RE [be it synthetic, hybrid, PV; whatever]; and other b-CPs were maid whole when they should have recovered only 80 c/$ not 100c/$. [80 c/$ being calculated by subtracting the average RR x 1 from the value of the bond at the time of issuance; P= 1-[RRavgx1]]. This means where they would usually have a 20c/$ cost and thus only netting a P of 80c/$ they had no recovery costs. Thats my main objective. And if they did preemptively held [as a hedge agains the short CDS position] the RE they netted 1+RRx1; meaning 120 c/$.

The 91.xx is what would your P be if you went trough the whole process of bidding for LEH debt and delivering said debt to the seller of the protection. RR was so low since there was much debt outstanding and was easily available on the secondary market. Most buyers closed the trades before CEs either trough trading the spread or DV01 [think Paulson and ABX [ok, ABX is synthetic, but its the same]] and thus LEH bankruptcy impact on the market was lower than expected [I think around 8B or something in payments]].

So, while CSA should have theoretically mitigate any excessive CP risk; in this case SOLELY because of CSA included in ISDA did AIG went into said death spiral. But yeah, they were idiotic insomuch that they sold insurance on 100$ for every 1$ they actually had [or someting like that; i know the ratio was insane]. They failed because they failed their margin/collateral call when RAs started getting ape-shit with the downgrades. 

But; as you said; this article is not about that; its about OOM equity puts and CDS contracts. Well, all in all a nice discussion; sorry for not being able to respond earlier.

Mon, 06/28/2010 - 05:50 | 437973 bingocat
bingocat's picture

Thanks CB,

I understand the 91.xx now, but it is only relevant post-default.

Don't think I am forgetting anything. AIG hadn't defaulted, and neither had the underlyings. The payments were made to unwind existing live trades between two non-defaulting counterparties on a non-defaulted asset. It matters not whether AIG or anyone else who held risk to the RE, either long or short, had hedged or not, it only matters that the derivatives were unwound before default had been declared because the CSA took care of everything between original reference mark and unwind mark. Anything AFTER default would have been paid off according to the trades being unwound, which means GS would have been "paid off" most of that money because they held the collateral margined correctly up to the mark 2 days before default. Lots of banks hedge counterparty risk for that incremental risk, or explicitly run/count it.

As to use and prevalence, I know of no broker/bank at all, and no hedge fund worth their 2 and 20 (and most who were not), who would have still been involved in open trades with LEH by Q3 2008 without bilateral ISDAs/CSAs (only ones I would ever think about are long calls, because in general, financial system health is positively correlated with asset prices, and by that time, long calls struck many months before were not worth a huge amount).

If all these derivatives had been exchange-listed and cleared, the marks would not have been in question (though if illiquid enough, someone might have been trying to prop them up or push them down) and therefore the margin would have been paid by AIG as well and counterparts would have been "paid out 100%."  GS and others did not get anything they would not have gotten had all the derivs been listed.

AIG went under because of ridiculous bordering on criminally negligent risk-taking at AIG FP in credit asset correlation exposure (especially given their capital base), and what must have been a fundamental disrespect for (or lack of understanding of) mark-to-market risk. They were able to do so because of their credit rating, and the fact that many brokers cut them too much slack (i.e. were willing to take too much credit risk in the early part of the correlation phenomenon). CDS/CDOs were the particular brand of rope they used to hang themselves with. CSAs is simply the nature of the noose (whatever brand you use, even a twisted bedsheet, will have certain effects when you wrap it around your neck and throw yourself off the top floor of 70 Pine or 72 Wall (though it might not have worked at 50 Danbury in Wilton)).

Mon, 06/28/2010 - 06:40 | 438004 Cheeky Bastard
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As to use and prevalence, I know of no broker/bank at all, and no hedge fund worth their 2 and 20 (and most who were not), who would have still been involved in open trades with LEH by Q3 2008 without bilateral ISDAs/CSAs (only ones I would ever think about are long calls, because in general, financial system health is positively correlated with asset prices, and by that time, long calls struck many months before were not worth a huge amount).

 

No no; we fully agree on this; I dont think anyone bought a non-CSA participating billateral OTC CDS not only against LEH; but speaking generally for the market as a whole. I think all post-2005 CDS vintages have CSAs in their structure as an industry standard not something that is non-binding [although it is non-binding; but everyone uses it; now even-more so since rating agencies have shat where they have eaten and rarely are trades structured on the full belief that the assigned rating is representative of the risk involved].

What AIGFP did was first and foremost idiotic [they had 2T net notional insured; and what percentage of that exposure was hedged I dont know; maybe less than 5% and that was mostly hedged via synthetics and hybrids AFAIK [hybrids being 90% synthetic and 10% cash]] and then maybe criminally negligent [although judging by the ost recent court rulling; not even that].

I have long ranted against naked CDS and the negative effects it can have [please just look the volume of the contracts traded for Greece on Thursday and what it did to the spread; ridiculous; but some of us concluded that the most logical explanation for that is that someone who was long either iBoxx or Greek debt participating in iBoxx structure was hedging future movements in yield which will increase [the spread that is] due to Greek debt being removed from the benchmark iBoxx] on borrowing costs; servicing costs, other derivatives etc etc; and the need for a CCP is now stronger than ever; and not only that but a transparent CDS ecosystem which would present all data connected with CDS trading etc etc [please note the ridiculous fact that there is no data available for FixR-CDS, Recovery Default Swaps; which is beyond unexplainable to me].

So we were both right on our own; but just talked about different things [that can happen when you're awake for 3 days straight]. 

Now, before I bid you adieu; please scroll down a bit and read the comment posted by the poster I originally responded to; he seems to have some difficulties understanding some things and he specifically called for your assistance.

Im kinda glad we got this sorted out; It seemd for a second this string of comments could have diverted into a buch of "Fuck you", "No; fuck you" comments; but it didnt. 


Sun, 06/27/2010 - 18:56 | 437261 Sudden Debt
Sudden Debt's picture

Tyler, something new for the European continent to investigate: Starting this week we are expecting heat waves to hit the continent ranging from 34 to 42 degrees celcius. These are going to be one of the worst heatwave this early in the year in 150 years.

Last time these kind of heat waves hit Europe, a very large part of the industry was shut down, construction shut down and a lot of people where put on temp. unemployment. These heat waves cost tens of billions of euro's and this year is expected to be one of the worst ever.

Do you have old records to see what that did to the market before the crisis?

Sun, 06/27/2010 - 19:14 | 437286 Cheeky Bastard
Cheeky Bastard's picture

Watch natural gas trading for a couple of days; thats the commodity which best prices in any big temperature volatilities. If it skyrockets; you bet your ass traders are betting on above-normal temperatures.

It trades on nothing more than weather forecast and supply/demand variables [ok; maybe it trades more on technicals now; but weather and s/d still play a major role]. Industries will need to shut down just to drive down the operating costs; its normal; India did it before the gas market was diversified. 

Sun, 06/27/2010 - 19:45 | 437324 DoctoRx
DoctoRx's picture

My point is in line with Sheeple's comment and and bob_dabolina's interp of my comment that I feel the CDS market is an illegitimate (or rigged per Sheeple) one.  I did read the article.  If as of now CDS is an unregulated OTC market, how does one price in the risk of counterparty failure in comparing/arb-ing protection obtained in a different asset class, that of a plain vanilla equity option traded on a regulated exchange?  I don't believe that options protection purchasers were at risk of non-payment other than the overall risk of terminal failure of the entire financial "system"; is that correct? 

After all, protection is needed most just when the SHTF and the seller of insurance turns into another AIG and maybe next time the govt won't be the Sugar Daddy at 100 cents on the dollar for the seller of protection.

Cheeky:  I don't claim to be a pro on this asset class, that's for sure.  In fact, I don't claim to be a pro on anything financial.  But what did I get wrong?  Further, how easy is it to make Tyler's assumption of 35-40% return of principal after a CE, and what is the sensitivity in either direction to a different assumption?  Especially given perhaps the increased chance that the CE occurs during a crash, when recoveries will be below "fair value"?

Sun, 06/27/2010 - 22:01 | 437573 bingocat
bingocat's picture

The main complaint people can have about the unregulated nature of CDS is that those who do not have the underlying bond to insure against might try to cause the default of a company by buying up so much CDS protection so as to drive up CDS spreads so as to cause panic in the market regarding that company's creditworthiness, thereby "forcing" an otherwise healthy company into wholely undeserved bankruptcy.

This is a real concern. It is, unfortunately, the problem with all markets where an "event" can cause a change in state (i.e. market price affects people's willing to extend short-term credit, company must pay higher prices/worse terms, cannot fund itself short-term, and defaults, even though assets may far outweigh liabilities). However, stock prices can be driven to an event (like Meredith Whitney's, and the govt's "pushing" Citi to convert prefs to common at a low price in order to raise tangible equity - something which should have been avoided because it added nothing to either bondholders (in case of default, prefs are equity) or shareholders (except a whole bunch of new 'friends')). It has happened in currencies (Soros/GBP, SE Asia in 1997, ruble in 1998), gold (removal of gold standard), lumber (lumber futures trading above govt-fixed prices in early 70s causing fixed price break), and any number of other instances.

The question is whether one wants to outlaw going long or short in those markets too...

As to whether they price in the riskof counterparty failure, they do in most cases because they are managed under an ISDA master and a CSA (Collateral Security Agreement). The CSA is what made sure that GS and others "got paid out 100%". The CSA is what makes OTC derivatives much like exchange-traded derivatives - if the price of the underlying moves, then the value of the derivative moves, and the one on the losing side must post collateral to the 'winner' to account for the difference. The calculation happens happens between most counterparties on a daily basis, which means in almost all cases, they are 100% covered in case of counterparty failure at all times. If anything, the risk which is probably not covered is the risk to financial asset prices where a market unwind is required under ISDA. When Lehman was unwound, everything went crazy for a day and I am sure people with multiple unwinds did not expect some of the results they got.

As to the 35-40% recovery ratio, standard CDS contracts assume a RR (recovery ratio) of 40% and pay out default event accordingly. As Cheeky suggested higher up, if you want to make a bet on higher/lower RR, you'd have to enter into a Recovery Swap.

Sun, 06/27/2010 - 20:30 | 437395 RobotTrader
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Sun, 06/27/2010 - 20:30 | 437397 DavidPierre
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Manipulative Gold & Silver Derivative Positions Continue to Grow!

 

 

 The US Treasury’s Office of the Comptroller of the Currency (OCC) has just released the Q1 2010 Bank Derivatives report which can be found here

 

http://www.occ.gov/ftp/release/2010-71a.pdf

 

This report contains more evidence that a flood of paper gold and silver instruments are being used to divert investor capital away from the purchase of the actual physical metals in order to suppress prices. Before looking at gold and silver specifically there are some other very important points to be noted in the report:

 


Key Points


 

  • The notional value of derivatives held by U.S. commercial banks increased $3.6 trillion in the first quarter, or 1.7%, to $216.5 trillion compared to Q4 2009. The notional value increased 7.1% from Q1 2009.

     

     

  • U.S. commercial banks reported trading revenues of $8.3 billion in the first quarter, 15% lower than $9.8 billion of revenue in the first quarter of 2009.

     

     

  • Derivative contracts remain concentrated in interest rate products, which comprise 84% of total derivative notional values. The notional value of credit derivative contracts, at $14.4 trillion, represents 7% of total notionals. Credit derivatives increased by 2.3% during the quarter.

     

     

  • Five large commercial banks represent 97% of the total banking industry notional amounts and 86% of industry net current credit exposure.

     

  •  

    An increase of $3.6 trillion in notional value of derivatives in just 3 months! It sure looks like the banks are working hard to reduce risk and avoid a reoccurrence of the financial meltdown of 2008 that was caused by the failure of Lehman Bros. and AIG due to their monstrously oversized derivatives books! This increase of 3.6 T$ in Q1 is greater than the entire GDP of the US in Q1!

     

    And it also looks like the regulators are working hard to make sure that the risks are not concentrated in a few banks that are "too big to fail" with 5 US banks holding a mere 97% of all banking industry derivatives!

     

    It is ominous that derivative holdings increased 7.1% year-on-year while bank trading revenues decreased 15%. Has the limit of the law of diminishing returns been exceeded?

     

    Let’s have a look at the gold and precious metals derivatives and compare Q1 2010 to Q4 2009:

     

    The Gold derivatives of all maturities increased by 7.8B$ (7.8%) to $107.7 billion. 6.8 B$ of the increase was in the less than one year maturity gold derivatives. JPMorgan Chase increased their gold derivative holdings by 2.1B$ (2.5%) while HSBC increased their gold derivative holdings by a mindboggling 6.1B$ (37.9%). [Note: HSBC holding is inferred as their holding is listed under "other commercial banks" but as JPM and HSBC have traditionally held more than 95% of the precious metals derivatives it is reasonable to infer that the other commercial bank category is almost entirely made up of the HSBC holding].

     

    The increase in gold derivative notional value in Q1 is equivalent to 40% of all gold mined in the world during the quarter.

     

    The precious metals (silver) derivatives of all maturities increased by 0.9B$ (6.9%) to 13.7 B$. The silver derivatives of less than one year maturity increased by 1B$ (8.7%). The holdings of JPM in silver derivatives of all maturities increased 1.7B$ (22%) while those of HSBC decreased by $0.8 billion to 4.25B$ (-15%). The increase in notional value of silver derivatives held by JPM represents approximately 100 million ounces which is 57% of the global production of silver during the quarter.

    The entire notional value of silver derivatives of maturities of less than one year is 12.6B$. This represents 745 million ozs of silver. It is relevant to compare the derivatives that expire in less than one year with the annual global silver production; the notional value is equivalent to 106% of the entire annual global silver production!

     

    Two bullion banks, JPM and HSBC, continue to dominate the precious metals derivatives market with positions that are outrageously oversized compared to the underlying metals markets.

     

    On Friday lawmakers who are negotiating the Financial Reform Bill came to a stunning compromise on a proposal by Senator Blanche Lincoln to ban the banks from trading commodities, equity and credit default swaps.

     

    http://uk.reuters.com/article/idUKN2527340820100625


     

    Under the agreement banks can

     

    QUOTE

    continue to handle foreign exchange, interest rate, gold and silver swaps and to hedge their own risks. Activity in cleared and uncleared commodities, agricultural, energy and equities swaps, and credit would have to move to an affiliate within two years.

    END

     

    It is intriguing to say the least that the banks retain the right to continue to trade derivatives in gold and silver. This is almost a de facto recognition that manipulating the gold and silver markets is a necessary function of the banking industry to keep the dollar Ponzi scheme running. But the manipulators are like King Canute ordering the waves back from the shore. The demand for real physical gold and silver in preference to paper and derivative substitutes is an investment theme that is gaining pace and is approaching like a tsunami. The suppression of gold and silver prices is doomed to fail and, in my opinion, in the very near future.

    Adrian Douglas
    Editor of Market Force Analysis
    Board Member of GATA

    Sun, 06/27/2010 - 20:33 | 437403 bingocat
    bingocat's picture

    "Capital structure arb" of trading waaaaaay OOTM puts vs CDS is an old game which has seen a lot of people get carried out. The main problem is that the players are so different that the correlation between your marks is far lower than it should be given that they both have as their principle component JTD risk. The tradeoff is that if far more people play it, thereby bringing spreads into an semi-arbed state, "spreads" will be a lot tighter.

    As Tyler suggests, going off half-cocked on this is a recipe for disaster. The problem may also be that going off fully-hedged on this is not a lot less dangerous.

    Sun, 06/27/2010 - 22:23 | 437598 RockyRacoon
    RockyRacoon's picture

    My math skills are just not up to it.... thanks anyhow.

    Sounds like a good way to lose a year's worth of sleep.

    Sun, 06/27/2010 - 23:52 | 437707 DoctoRx
    DoctoRx's picture

    Am wondering if Bingocat or anyone else has a comment in response to his comment of 21:51 hours in view of this guest post by Thomas Adams last November at Naked Capitalism:  http://www.nakedcapitalism.com/2009/11/goldmanaig-conspiracy-theories-theres-a-reason-they-wont-go-away.html, one quote from which is:

    I hate to get sucked into the vampire squid line of thinking about Goldman, but the only explanation i can think of for why AIG got rescued and the monolines did not is because Goldman had significant exposure to AIG and did not have exposure to the monolines.

    When it became clear that AIG could face bankruptcy, Goldman’s plan to profit by shorting ABS CDOs was threatened. While they had the collateral posted, thanks to the downgrades, this collateral could be tied up or lost if AIG went bankrupt. This was a real crisis for Goldman – they thought they had outsmarted the subprime market with their ABS CDOs and outsmarted all of the other banks by getting collateral posting from AIG when they got downgraded. But if AIG went away, this strategy would have blown up and cost Goldman billions.

    All of this is essentially factual and based, for the most part, on public information.

    Does this POV affect the Bingocat comment, which includes the following quote:

    As to whether they price in the riskof counterparty failure, they do in most cases because they are managed under an ISDA master and a CSA (Collateral Security Agreement). The CSA is what made sure that GS and others "got paid out 100%". The CSA is what makes OTC derivatives much like exchange-traded derivatives - if the price of the underlying moves, then the value of the derivative moves, and the one on the losing side must post collateral to the 'winner' to account for the difference. The calculation happens happens between most counterparties on a daily basis, which means in almost all cases, they are 100% covered in case of counterparty failure at all times.

    Unlike Bingocat's POV, which clearly comes from a much greater professional knowledge of these instruments than I have, my POV has always been that it was the US Gov's/the Fed's (/Goldman's-Masters of the Universe etc) arbitrary decision to pay AIG counterparties in full, and that in so doing, they committed one of the great financial misdeeds of this century if not of all time.

    So I still wonder if it possible to price in counterparty risk properly given that companies are more likely to default when the entire financial system has gone through a Lehman-AIG fiasco.  I.e., corporate defaults are dependent variables, not random events.

    Separately and FWIW, I endorse Nassim Taleb's recommendation that new CDS be banned as they add nothing but complexity and systemic risk, and our system should be "robustified", using his term.  If a company fails, then it fails.  Adding more entities that share in the pain doesn't change that unfortunate core fact but the whole CDS business is IMHO an unproductive line extension for big finance, utilizing brilliant minds that would be better off doing more useful things.

    Tue, 06/29/2010 - 05:13 | 440416 bingocat
    bingocat's picture

    Thomas Adams does not, apparently, understand how OTC derivatives are unwound and collateral is disposed of. His analysis is incorrect. The collateral is there precisely for times when the counterparty goes bankrupt while owing money to the other counterparty. If it went back to the entity which went bankrupt, it would serve no purpose.

    DoctoRx says...

    my POV has always been that it was the US Gov's/the Fed's (/Goldman's-Masters of the Universe etc) arbitrary decision to pay AIG counterparties in full, and that in so doing, they committed one of the great financial misdeeds of this century if not of all time.

    This opinion is, unfortunately, widespread. Imagine if you had a position on an exchange traded security or derivative, and you sold it for $100 and had the confirmation to prove it. Then the next day, you only get $80 in your account so you call up and they say "well, the guy who bought the other side of your trade was in some kind of financial trouble so we gave him a discount so you only get $80." This is the situation GS would have been in had the government/Treasury/etc stepped in and mandated a forced unwind which delivered less than 100% of what GS was owed. If you had taken your situation to the media and said "that is unfair - expose them for the bastards they are" and their lead article is "Rich DoctoRx complains about not getting paid out 100% on a trade with someone (Company X) who was obviously in trouble and he should have no reasonable expectation of getting paid out because we had to bail out Company X to make sure it did not bring down the system." You would probably be pretty pissed. Why should GS have not demanded 100cts on the dollar?

    The crucial point is that AIG was not in default. If they were in default, they would not have been doing the trade. If they had been short the underlying and not posting margin to the exchange when the position rose, they would have been forced out of their position (like the government forcing AIG out of their trades). Some people say that AIG should not have been saved. That is a separate discussion. It is possible in that case, almost perversely, that GS could have made a profit on AIG's bankruptcy because a) they had some credit hedge against the collateral which AIG had not posted, and b) the proscribed method for unwinds allows counterparts to not unwind everything (i.e. if everyone unwinds in one direction while the bankrupt counterparty cannot unwind the risk in the other direction, then markets tend to unwind in one direction very violently (think May 6th "Flash Crash"), and unwinding counterparts are allowed to not unwind in full (because unwinding in full might push prices down even further) but instead own some of that not-unwound risk at the price of the unwinding; this means they are obliged by the process to beat prices down, in the middle of a panic, and they have the effective right to buy what they want, or not, at the price of the unwind).

    The point that in financial stress situations, corporate defaults are dependent not random is the principle reason why AIG went under.

    So I still wonder if it possible to price in counterparty risk properly given that companies are more likely to default when the entire financial system has gone through a Lehman-AIG fiasco.

    The existing system of CSAs does just that for the world of OTC derivatives. It is generally more flexible than the system of exchange margining. The fact that Entity X may trade against multiple counterparties and not tell any of them what they are doing with the others presents something of a systemic risk, but such would be the same if there were competing exchanges offering marginable risk on the same underlying.

    I am not sure I endorse Nassim Taleb's recommendation that new CDS be banned. CDS, like all derivatives, can be used for nefarious purposes. I personally see no reason why it is OK to take an unhedged short bet on a stock but not on a more senior part of a company's capital structure.

    Mon, 06/28/2010 - 03:23 | 437924 AssFire
    AssFire's picture

    McCrystal's removal was much more about giving Petreaus the total command (in much the same way as Patton was discredited, but very much involved in subsequent operations during WWII). Petreaus is positioned on both sides now; with Iran squarely in the cross hairs. We pulled our missels out of eastern Europe in ... See Moreexchange for the codes to the SAM batteries about a year ago (same thing occurred years ago in Syria years ago when the Israeils attacked their SAM's withot losing 1 plane) . The carrier group is in position, the Black Swan event can only be weeks away.
    We must go to war to repay the financial groups and reduce the ownership of properties (bankruptcies and foreclosures) so that these financial owners have their buying spree of fire sale assets that become available in desperate times.
    They produced this financial crisis just to ramp up the taxes, not for the Wall Street- but now soon for "America's battle against Evil"- all the while positioning themselves on both sides of Iran. The death tax will be re-instated and made retroactive to cover this past year and the taxes will go through the roof for all us "patriots" to pay in the midst of this "Life or Death" BS war. I have not connected all the dots, but I know it is coming soon. The black swan event will be as "believable" as the the 911 BS attacks, but sadly the general populace will be equally as motivated to sign up to fight the good fight (just as they did after the "surprise" attack on Pear Harbor). It makes me sick that without continued economic growth this is the only alternative, but this what is really going on and what will come to pass.
    I am glad I only have daughters- this is pathetic.

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