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CDS For Doomers, Politicians, And The Media

Tyler Durden's picture





 

Submitted by Peter Tchir of TF Capital Markets

CDS for Doomers, Politicians, and the Media

About the only thing that the doom and gloom crowd, the politicians, and the media all agree on is that credit derivatives are evil, unnecessary,  ‘financial weapons of mass destruction’.  With the European Sovereign Debt crisis escalating, the CDS market has once again become a topic of conversation.  Many of the issues related to CDS that are discussed are old, misleading, or plain wrong.  Here is my attempt to address some of the issues that come up most whenever CDS is mentioned:

  • Credit Events
  • Exposures
  • Counterparty Risk
  • Transparency

These are topics that need to be understood in order for investors to make informed decisions.  I am not here to defend CDS as a product, but to try and shed light on the subject so that people don’t react to inaccuracies that cause them to make decisions based on incorrect information.  Since so many journalists still feel that the investing public needs to see the boilerplate language ‘when yields go up, bonds prices, which move in the opposite direction, go down’ this may be an uphill struggle.  But here is my attempt.

Credit Events Are Very Confusing

A Credit Event effectively terminates a CDS contract and locks in a gain for the Buyer of Protection and locks in a loss for the Seller of Protection.  CDS contracts have value prior to a Credit Event and trade regularly and have a mark to market value.  Investors who trade CDS generate P&L from being write or wrong in the direction of spreads on a particular contract.  You do not need a Credit Event for a CDS to have value, but if there is no Credit Event during the life of the contract, then the CDS will expire worthless.  If there is a Credit Event (as determined by the ISDA Credit Derivatives Determinations Committees) then the credit event settlement protocol is followed.

So that is why a Credit Event is important, but what is a Credit Event?  It has nothing to do with the rating agencies.  The rating agencies track defaults, but that is for their own purposes (to show annual default rates and historical ratings transitions, etc).  While the rating agency determinations of defeualt are interesting, they have nothing to do with triggering a Credit Event for CDS.  It is solely determined by the committee based on the 2003 ISDA Credit Derivatives and relevant Supplements.  These can be found at ISDA Bookstore - ISDA Credit Derivatives Definitions, Supplements and Commentaries.  The Committee is comprised of both market makers and investors in an effort to be fair and remove bias from their decisions. 

The Committee has to follow the definitions to determine if a Credit Event has occurred.  It is pretty straightforward for U.S. corporates.  They trade “NR” or “No Restructuring” so the only Credit Events would be applicable are Bankruptcy and Failure to Pay.  These are both pretty straightforward.  Filing for chapter 7 or 11 would clearly trigger a Bankruptcy Credit Event.  Failure to Pay is also pretty self explanatory.  The company must fail to make a payment on an Obligation within the timeframe of any applicable grace period for that Obligation.  The Obligation means Borrowed Money so is meant to cover money the company has borrowed, so as not to get triggered by a company failing to pay a contractor or service provider.  There is a minimum size test so that the Obligation that caused the Credit Event is meaningful.  There is also a requirement that the information is publicly available in order for a Credit Event to be officially triggered.  In spite of some terms like Obligation, Borrowed Money, Publicly Available Information, etc, the Bankruptcy and Failure to Pay Credit Events are pretty straightforward and as far as I know, there has never been a serious dispute over one of these has events has occurred.

European Corporate CDS trades with “MMR” or “Modified Modified Restructuring” and Sovereign CDS trades with Restructuring and Repudiation/Moratorium as Credit Events.  Europe retained a version of the Restructuring Credit Event largely at the insistence of its regulators.  They were unwilling to provide regulatory capital relief for banks that bought protection on an NR basis.  The ‘modified’ element means that if a Restructuring Credit Event occurs then the CDS contract has a limited number of choices of which Obligation to settle against.  It attempts to prevent banks from ‘Restructuring’ a loan by extending the maturity while obtaining collateral and then delivering bonds that had been effectively subordinated on their CDS purchases creating windfall gains.  It is definitely a bit tricky, but the limitations on what can be used in the settlement process of a European Corporate Restructuring Credit Event has limited any controversy.

Full Restructuring and Repudiation/Moratorium Credit Events apply to Sovereign CDS.  Determining a whether a Restructuring Event has occurred still needs to follow the document, but as you can see in this analysis http://tfmarketadvisors.blogspot.com/2011/06/restructuring-credit-event-and.html it is less straightforward to determine whether the conditions were met or not.  Particularly confusing is what was intended for voluntary restructuring.  In any case, for all the noise about whether there will be a Credit Event on Restructuring for Greece, all you need to do is read the definitions included in the link and figure out how it will be interpreted.  The intent of the ISDA contract will play a role. As much as some politicians and bloggers want to make the Credit Event determination a mystery, it is not a mystery.  The outcome may be uncertain as it has to follow the legal document but that is no different than any other trade governed by a contract where sides may choose to dispute it.

It’s Impossible to tell where the Exposures are

The DTCC website provides some very useful overall market data.  You can use this link http://www.dtcc.com/products/derivserv/data_table_i.php?tbid=5 to pull up the top 1000 reference entities.  This is updated weekly.

This site shows what is the Gross Notional and Net Notional outstanding for the Reference Entities with the most CDS outstanding.  It does not give the exposure of any individual institution to a specific name or to CDS as a whole, but knowing how much CDS is outstanding on a reference entity has a lot of practical uses.

For those not familiar with DTCC, it is the Depository Trust and Clearing Corporation.  I believe back in the 90’s it became the primary clearing house for corporate bonds.  Over time they started clearing credit derivatives.  In order for their data to be meaningful, it must encompass the bulk of CDS trades, which I believe it does.  In the 2003-2005 period, the CDS market was plagued by a lack of unsigned confirmations.  The regulators were putting pressure on the industry to clean up the document backlog.  There was real concern both inside and outside of banks that the product had grown too quickly and the systems had not caught up to the volumes.  The fear was turned into action as the auto industry in particular had trouble.  Volumes had spiked, unsigned confirms had grown, but people weren’t as focused on the risk until real fear of defaults gripped the market.  Huge efforts were made to successfully clean up the document backlog and the DTCC played a role in ensuring that the problem of unsigned confirms wouldn’t occur again.  The DTCC started settling CDS trades.  The process had become more formal and it was in everyone’s interest to use the system as no one wanted the risk of unsigned confirmations.  I believe that virtually all single name and index CDS transactions are booked via DTCC at this stage so their data captures virtually the entire market.  I do not know of any significant players who don’t use the system, and cannot think of a reason they wouldn’t, so I am willing to rely on the data from DTCC as fairly all encompassing and would seriously question and CDS notionals outstanding that differ from those reported by DTCC as questionable.

So what do the terms mean?  How can they be interpreted?  This is probably easiest done by working through an example, and given the current news I can’t think of a better Reference Entity than the Hellenic Republic (aka Greece).  As of June 10th the Gross Notional of Hellenic Republic CDS outstanding was $79 billion and the Net Notional was $5 billion.

The Net Notional is the amount of open exposure to a Credit Event on the Reference Entity.  In the case of Greece, there is a total of $5 billion of open exposure.  If a Credit Event occurs the ultimate transfer will be between investors who bought a total of $5 billion of CDS from investors who sold $5 billion of CDS.  With a recovery rate of 50% that means there would be locked in losses of $2.5 billion for the sellers and locked in gains of $2.5 billion for the buyers of protection.  In the grand scheme of how much Greek debt is outstanding, this is a manageable number.

Clearly the Gross Notional is much bigger than the Net Notional.  There are several ways to increase the Gross Notional.  If a market maker/dealer buys $10 million of CDS from one customer and sells $10 million of CDS to another customer, the Net amount reported would be $10 million (since that is the “naked” exposure) and the Gross would be $20 million as there are 2 trades outstanding of $10 million each.  If all trades were so simple you would expect the Gross to Net ratio to be 2:1.  Not all trades are that simple.  At least as common would be for Customer A to buy CDS from Dealer X, and Dealer X to buy from Dealer Y who then buys from Customer B.  You still have a Net of $10 as only customer A and B have naked postions, but now the Gross is $30 since there are 3 trades in the system. 

When a name is active, you will find that the street trades a lot with each other.  This interdealer trading increases the Gross amount outstanding as dealers don’t do assignments or unwinds of old trades on a daily basis. All else being equal, I would expect the ratio of Gross to Net to increase for active names since the street will have high volumes trading amongst themselves while managing risk from providing liquidity to clients.  Gross Notionals like this should not scare investors.  The dealers will have collateral provisions amongst themselves under their ISDA Master Agreements so it would be surprising if any one dealer had too much exposure to another dealer on a single name basis or across the product.  Furthermore, the dealers periodically work on collapsing their trades.  They periodically submit trades to something like trioptima and the clearing corporations to “collapse” trades.  If Dealer A bought from Dealer B who bought from Dealer C, after running a “collapse” methodology, you would only have 1 trade where Dealer A buys from Dealer C.   The size of the institutions and the creditworthiness of them makes this sort of process work effectively.  At times of crisis, say Lehman for example, they would not be included in a way that would force any member to take exposure to them. 

As a Reference Entity becomes distressed, such as Greece, the dealers run these netting/optimization programs more frequently to reduce the number of trades outstanding. 

Isn’t it possible that a hedge fund or some entity stands in the middle of a lot of trades?  If this was the case, I would be more concerned about Gross Notionals being large, but I don’t think it is the case.  Funds have to provide collateral when they do CDS trades.  The amount varies on the Reference Entity and the fund itself, and the ISDA agreements it has in place with dealers.  These collateral provisions are generally much larger when you have sold protection, though some counterparties are required to post collateral when they have bought protection.  At first that might seem strange, but someone who is paying 1400 bps for 5 year Greek CDS could lose a lot of money if it gapped back to even 700 bps.  So a fund would have to post collateral on every trade they wrote protection on, and possibly on trades they bought protection on.  It is not in their interest to tie up so much collateral. It is also not in their interest to take on exposure to multiple counterparties for no good reason other than to have a lot of trades on.  So customers typically do an ‘unwind’ or an ‘assignment’ when they trade out of a position.  If they bought from Dealer A, and then sell back to Dealer A, they would “unwind” the old trade.  There would be no trade in existence anymore which makes sense and is ideal for the entire system as there is no residual counterparty exposure – just like if the client had bought and sold a bond.  If the customer sold to Dealer A and is now buying from Dealer B they would initiate a request for an “Assignment”.  Assuming Dealer A is willing to take Dealer B’s credit risk, and vice versa, the client would “step out” of the transaction and Dealer A would face Dealer B.  That trade would then be put into any future dealer to dealer optimization/netting program.  The process has a high degree of automization and is in everyone’s interest to use since it mitigates counterparty exposure outside of the dealer community.

There is another way to get relatively large Gross notionals compared to Net notionals, and that is when “curve” trades are active on a name.  If a client buys 1 year CDS and sells 5 year CDS they have put on a “curve” trade.  If there is a Credit Event within the 1 year time frame they have no net exposure to the name.  A trade like this would create $20 or $30 of Gross notional depending whether both trades are done with the same dealer but $0 of Net exposure.  The client frequently does both “legs” of the trade with the same dealer because the dealer can charge less collateral so long as the trades are both on.  The client will have some risk based on the price of 1 year CDS versus 5 year CDS, but this is less than the risk of being outright long or short.  If there is a Credit Event and the client has both trades on with 1 dealer, they should collapse at equal value assuming they were done under SNAC protocol which almost all CDS trades have used since it was implemented in April 2009.

So the real exposure to the system is Net Notional as that represents real open positions and Gross Notional can be interesting but should not be viewed as fearfully as it sometimes is as most will be netted at time of Credit Event.

There is hidden Daisy Chain Counterparty Credit Exposure

There still seems to be so much talk about how a Credit Event on one name could have a ripple effect causing counterparties to fail on their obligations.  I think this risk is severely overblown.

The risk of some daisy chain of failure is tied to the Gross and Net Notionals above.  In an ideal and simple world (think exchanges) the Gross Notional would equal the Net Notional.  There would be no one who is merely standing in between trades (except the exchange).  That is not practical as not all clients deal with all dealers, etc, but I think we can quickly show that the risk of a daisy chain collapse is fairly remote.

Lets start with the customers as they are the easiest to analyze.  They will either be short, long, or have some form of curve trade.  They are highly unlikely, due to collateral requirements, to be flat the name with lots of trades on. 

If the client has a curve trade on with one dealer, it should collapse as post a Credit Event all points on the curve should trade to estimated recovery and then to ultimate recovery.  The ISDA Master will ensure this netting occurs so it won’t be the case where cash transfers on one leg but not the other, so no counterparty risk arises from this situation.

If the client has the legs on with two different dealers it is no different than the client being long with one dealer and short with the other dealer.  Those dealers should have appropriate collateral in either case.  It is up to dealers to charge appropriate collateral to clients for the positions they have one with them.  In spite of the hype the dealers have been pretty good at managing their counterparty exposure.  Not only would they have to be under collateralized, but the counterparty would have to post any further money required at time of settlement.  Maybe it is hard for people to believe, but the banks have done a good job of managing exposure to hedge funds.  The only 2 big examples I can think of were LTCM and AIG.  LTCM shocked the markets partly because the banks didn’t realize how much of the same business they did with every dealer and they had negotiated some sweetheart terms in their ISDA’s.  Credit departments became even tougher on hedge funds after LTCM, and in spite of no widespread losses from hedge fund counterparties during the 2008 collapse of credit markets, they have made the terms even more difficult in most cases.  The other problem was AIG FP.  There banks gave too much credit to the high rating and failed to estimate how much collateral would be posted at the worst possible time.  I’m still shocked banks got bailed out by that decision, but my understanding is they are far more careful with even AAA counterparties than they were before.  

I may have more faith than most people that the banks are managing their counterparty exposure to end users well, but my experience is that they have, and there is relatively little evidence pointing to banks having big losses due to mismanaging their end user counterparty credit exposure.

What about the interdealer exposure?  Again, they will net that down through optimization/netting programs.  Right now none of the dealers appear to be in trouble and since most will have small Net positions it is just a matter of money flowing through the chain.  Could someone be sitting on 20 billion of Greece gross exposure?  Sure, but if JPM is, that means they expect the correct amount of money to come in and to pay out the correct amount.  I have addressed why I believe they will collect what is owed from their end user customers and there is no reason to believe they won’t collect what they are owed from the interdealer community.

The daisy chain failure of counterparty after counterparty sounds exciting, but I think that risk is well managed, and to the extent one of the dealers gets in trouble again, the remaining dealers will work around it.  The Fed and every banking analyst was horrified about the prospect of Lehman, as such a large CDS counterparty failing.  In the end, dealers seemed to manage that risk fairly well.  There are few if any stories of banks being devasted by losses resulting from Lehman going away as a CDS counterparty (far more stories of big losses due to owning too many Lehman bonds), and the lawsuits revolving around Lehman’s bankruptcy seem to focus on such “simple” things as repo and which entity Lehman had moved money to/from.  I am not aware of any big CDS lawsuits outstanding.  CDS may sound big and scary but the reality is the losses that hit the market were from traditional problems such as being long bonds and being wrong or having cash tied up in an entity that defaulted where the terms were one sided.  I am not discounting the issue completely but this is should not be the focus of investors trying to analyze the impact of Credit Events.

There is no price transparency

This is a bit tricky.  For the average investor there is limited price transparency, but for the people in the market there is a high degree of price transparency. 

The CDX Indices are quite liquid.  They are quoted on live market in big size all day long by multiple dealers.  At any given time an investor could buy or sell $250 million of IG16 on a ½ bp market and trade $50 million of HY16 on an 1/8 th of a point market.  The liquidity in quiet times is even higher.  That is far more liquid than any other part of the credit markets.  It is highly transparent to the people involved in the credit markets but can be found on the Mark-it Website.  The indices are posted on their home page, but this link can take you to pricing for the 5 year point of most Reference Entities. http://www.markit.com/cds/most_liquid/markit_liquid.shtml

On the single name CDS, the 5 year point is the most useful and accurate.  Generally the more active a name is, and the bigger the market cap of its debt/equity, the more accurate the pricing is.  Just like many high yield bonds, but even some investment grade bonds, are “quote only”, not all CDS quotes are as real.  You can be pretty sure that the 5 year CDS spread on the markit site is close to levels that a CDS trader could execute on.  For more off the run names and smaller high yield names, the price might be more indicative than real (an actual bid or offer could be a bit away or you may have to work an order to execute at those levels rather than demanding the dealer provide liquidity).  Although that sounds scary, the Gross and Net Notionals on those will be small so any impact is minimal and the participants in the market manage around it quite well.

As you move away from the 5 year point, I am not sure where you can get publicly available information on prices.  I use Bloomberg so I haven’t spent time looking, so it may be available and I just haven’t found them.

Shorter dated CDS tends to be less liquid than 5 year and the quoted prices can get wide, but that reflects the binary nature of stressed names more than anything and isn’t dissimilar to the cash bond markets where the liquidity in short dated paper often dries up in times of stress – with memorable exceptions being the day before Bear and the day before Lehman where volumes sky rocketed.

The sort of trades AIG was doing were not transparent, but they have little to do with anything that I have talked about here – single name corporate and sovereign CDS and the associated indices.

Transparency could be better, it might even help outside analysts, but at the same time, the transparency for people in the market is quite good, particularly in the indices and at the 5 year point on the curve. 

Some effort could be made to make the market more transparent, but the same could be said for the corporate bond market.  Corporate bonds themselves are not particularly liquid nor transparent.  Prices on corporate bonds, even with TRACE aren’t that transparent.  All you have to do is look at small lots on TRACE and see the individuals still pay a massive bid/offer on corporate bonds, and if a bond doesn’t TRACE it is hard to find the price.  Some market professionals have argued that TRACE has done little for transparency since individuals don’t seem to notice and professionals already know where bonds are quoted, so all it has really done is make it more difficult to move large positions.

 


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Fri, 06/17/2011 - 19:08 | Link to Comment topcallingtroll
topcallingtroll's picture

Since all the major credit rating agencies are compromised and Dagong is not reliable nor quantitative enough, then CDS and other derivatives such as options are the best way to get a read on the current risk level of a loan.

Sure they are fine one day and not fine the next, just like ratings from agencies, but if you watch the trend, it is much more accurate and timely than "credit watch negative" from a doofus agency.

Watching the options is not a great way to get a read on credit, but it is better than any other way., such as lying sacks of shit like Juncker and Trichet

Fri, 06/17/2011 - 20:01 | Link to Comment iNull
iNull's picture

Depends what kind of options. When too many people try to game near-term options the market usually burns them down. I know. I've tried a few times and learned the hard way. Deep options is another story.

Sat, 06/18/2011 - 12:35 | Link to Comment Kayman
Kayman's picture

CDS is selling insurance without reserves.

When Goldman enlists Hank Paulson to have the American Taxpayer make a bad bet with AIG whole, to the tune of  $13 billion, then it is entirely a fraudulent enterprise.        

 

Fri, 06/17/2011 - 18:57 | Link to Comment JimRogers
JimRogers's picture

after the second logical error i gave up... 

 

happy happy hour td.

Fri, 06/17/2011 - 19:08 | Link to Comment buzzsaw99
buzzsaw99's picture

write, right, meh

Fri, 06/17/2011 - 19:06 | Link to Comment Ecoman11
Ecoman11's picture

I think I've heard enough and ready to move to collapsenet.com.

Fri, 06/17/2011 - 19:09 | Link to Comment topcallingtroll
topcallingtroll's picture

Tyler is the canary in the coal mine.  Best to stay here.

 

He faints a lot, but one of these days it might be for real.

Fri, 06/17/2011 - 20:02 | Link to Comment iNull
iNull's picture

That and Ruppert is smoking way too much weed up in Sebastopol with the patchoulli-tie-dyed crunchies. Late rent or not, Culver City was at least keeping it real for him.

Sat, 06/18/2011 - 08:58 | Link to Comment centerline
centerline's picture

LOL.  That was funny.

Will be right here until the internet goes down... or I can't afford it anymore... or men in black SUVs show up at all ZH'er houses and take us to the special re-education facilities.

Fri, 06/17/2011 - 19:08 | Link to Comment Medea
Medea's picture

Forever Ponzi.

Fri, 06/17/2011 - 19:40 | Link to Comment Long-John-Silver
Long-John-Silver's picture

Pandora, Ponzi, and Nuclear. Once let out of the box there is no putting them back in. 

Fri, 06/17/2011 - 19:05 | Link to Comment Lord Welligton
Lord Welligton's picture

@ Peter Tchir

"As of June 10th the Gross Notional of Hellenic Republic CDS outstanding was $79 billion and the Net Notional was $5 billion."

Can you provide evidnce for that?

 

Fri, 06/17/2011 - 19:10 | Link to Comment TooBearish
TooBearish's picture

Quite good , bravo

Fri, 06/17/2011 - 19:11 | Link to Comment Lord Welligton
Lord Welligton's picture

@ Peter Tchir

"This is a bit tricky.  For the average investor there is limited price transparency, but for the people in the market there is a high degree of price transparency."

Can you provide evidence for that?

Fri, 06/17/2011 - 19:14 | Link to Comment Lord Welligton
Lord Welligton's picture

@ Peter Tchir

"CDS contracts have value prior to a Credit Event and trade regularly and have a mark to market value."

Can you provide evidence for that?

Fri, 06/17/2011 - 19:30 | Link to Comment Noah Vail
Noah Vail's picture

About the only thing that the doom and gloom crowd,

 

Uh, Tyler, ya think that doesn't include you? I mean, really, that was quite the intro.

 

Whoops, I'm sorry, I see you're not the author,well, allow me to continue.

 

I am not here to defend CDS as a product, but to try and shed light on the subject so that people don’t react to inaccuracies that cause them to make decisions based on incorrect information.

 

Yes, and I am from Goldman Sacks and am doing God's work because, God forbid, you should ever attempt to think for yourself. NEVER invest without the advice of an expert like me, an honest to God CFA.

Fri, 06/17/2011 - 19:16 | Link to Comment Lord Welligton
Lord Welligton's picture

@ Peter Tchir

"There still seems to be so much talk about how a Credit Event on one name could have a ripple effect causing counterparties to fail on their obligations.  I think this risk is severely overblown."

Can you provide evidence for that?

 

Fri, 06/17/2011 - 19:36 | Link to Comment Noah Vail
Noah Vail's picture

Did AIG think it was overblown, also? Or Lehman?

Fri, 06/17/2011 - 19:48 | Link to Comment Lord Welligton
Lord Welligton's picture

Now now.

But you know they valued everything for what it was worth.

Just because everyone else thought it was worth less didn't make their Auditors wrong.

It just made them greedy.

Nice fees if you can get them.

Fri, 06/17/2011 - 20:10 | Link to Comment buzzsaw99
buzzsaw99's picture

there will be no daisy chain black swan total meltdown in the financial markets with turbo timmy and ben bernanke backing everything deemed a threat to tbtf bond holders, and i mean everything big is backed by unlimited currency. the evidence is incontrovertible. AIG is a perfect example. There could be ten more AIGs tomorrow and the fed would buy them all. They want to destroy the usa dollar, they want huge fees and bank bonuses. I do not understand your doubt.

Fri, 06/17/2011 - 20:19 | Link to Comment Lord Welligton
Lord Welligton's picture

Well quite.

But is it not time to call a spade a spade.

And just get to hell on with it.

Create €2,000,000,000,000 now and move on.

Why wait?

Fri, 06/17/2011 - 21:02 | Link to Comment buzzsaw99
buzzsaw99's picture

Easy money for them, hard cheese for everyone else.

Fri, 06/17/2011 - 19:22 | Link to Comment Lord Welligton
Lord Welligton's picture

@ Peter Tchir

"This is a bit tricky.  For the average investor there is limited price transparency, but for the people in the market there is a high degree of price transparency. "

"Some effort could be made to make the market more transparent, but the same could be said for the corporate bond market."

There is a "high degree of transparency" BUT "Some effort could be made to make the market more transparent"

You are a dickhead.

What is the Gross value of Greek CDS.

 

 

Fri, 06/17/2011 - 19:23 | Link to Comment Noah Vail
Noah Vail's picture

More advice from the recently renamed stock brokers.

So buy a bridge already.

 

Tyler, I hope you're just funnin' us with this kinda stuff.

Fri, 06/17/2011 - 19:28 | Link to Comment Dapper Dan
Dapper Dan's picture

Tyler, how about an open forum soon?  The last couple of weeks have been grueling. We need time to blow off steam, vent if you will.

Fri, 06/17/2011 - 19:43 | Link to Comment iNull
iNull's picture

It already is an open forum for the most part. One where posters turn any of the topics de jour into their personal hobby horse, be it NWO, immigration, or precious metals. People largely ignore the subject and talk about whatever they want.

Fri, 06/17/2011 - 19:33 | Link to Comment Lord Welligton
Lord Welligton's picture

"The notional dollar value of Greek CDS contracts was last at $76.351 billion. The value has doubled since mid-2009 to more than $85 billion in early April. GRGVCDSV=DT"

http://uk.reuters.com/article/2011/04/29/eu-antitrust-cds-idUKLDE73S12L20110429

"As of June 10th the Gross Notional of Hellenic Republic CDS outstanding was $79 billion and the Net Notional was $5 billion."

Only six billion so far but what's six billion amongst friends.

 

"- Data from the Depository Trust and Clearing Corporation (DTCC) shows that as of April 22 there were 826,029 outstanding euro-denominated CDS contracts with a gross notional value equivalent to $8.322 trillion. TOTEURCDSV=DT

 

- The value of the euro-denominated CDS market is less than that of the U.S. dollar market ($15.58 trillion)."

 

Let's make that trillion.

http://uk.reuters.com/article/2011/04/29/eu-antitrust-cds-idUKLDE73S12L20110429

 

 

Fri, 06/17/2011 - 19:42 | Link to Comment Noah Vail
Noah Vail's picture

You left out this little beauty,

- "Any restructuring that did not affect all holders of the debt would not constitute such a credit event, lawyers say."

Emphasis on LAWYERS SAY.

Which is to say that they can default on some but not others without triggering any default? Horsefeathers. The propa is really getting deep.


Fri, 06/17/2011 - 19:47 | Link to Comment Lord Welligton
Lord Welligton's picture

Agreed.

This is not the Great Recession.

It is the Great Unwind.

Only certain "playas" get fucked.

Fri, 06/17/2011 - 22:27 | Link to Comment XPolemic
XPolemic's picture

Only certain "playas" get fucked.

They are still negotiating which ones that will be, hence the delay.

Sat, 06/18/2011 - 09:08 | Link to Comment centerline
centerline's picture

+1.  There is no "cohesive" group of NWO a-holes with a set plan.  There are all sorts of a-holes and groups of a-holes, mostly making this crap up as they go at this point.  The elite will canabalize themselves the same as they will us, and we will ourselves.  Just a matter of time.  Big players with high stakes making.

Sun, 06/19/2011 - 07:09 | Link to Comment XPolemic
XPolemic's picture

Yep, just lots of different players with lots of different agendas. It's like 10 best friends get stranded on a deserted island with no food. Sooner or later, things aren't so friendly.

 

Sun, 06/26/2011 - 22:41 | Link to Comment forexskin
forexskin's picture

always nice when someone steps way back for a peek at the big picture.

if one of the 10 on the island is a banker, at least the others will not be the last to starve.

The daisy chain failure of counterparty after counterparty sounds exciting, but I think that risk is well managed, and to the extent one of the dealers gets in trouble again, the remaining dealers will work around it.

this is the fundamental assumption, with the greatest consequences in failure. complex system with non-linear dynamics. so DTCC is a know all, tell all CDS market, and will alway be there to clear? (until someone figures out how to game it). choosing to remain sceptical.

Fri, 06/17/2011 - 19:36 | Link to Comment harveywalbinger
harveywalbinger's picture

Lots of interesting discussion of the DTCC here: 

http://www.deepcapture.com/the-story-of-deep-capture-part-2/

Fri, 06/17/2011 - 19:38 | Link to Comment gwar5
gwar5's picture

Thanks for the paper on the dark paper markets. But I can't dance to it so I only give it a 5.  

While CDSs may be fine for normal markets, not so sure it's worth much in times of great upheaval and monetary paradigm shift.

In the LTCM meltdown, among other things, it also came to light that LTCM had oversold to more counterparties than could be redeemed. And LTCM was at the top of the food chain. So, no, they're not managing their risk well and more proof is that the peddlers resolutely refuse any transparency and regulation which means they're still at it. This is the Fraud that Greenspan told Brooksley Born to ignore  --- just months before the LTCM problem.

When counterparty A defaults on counterparty  B, then counterparty B can't pay counterparty C either. All that mark to market debt will become worthless and who is to say anyone will even be accepting USD at that point anyway? That's just one more counterparty risk because it's built on underlying bad loans to a broke country.

 

 

Fri, 06/17/2011 - 19:45 | Link to Comment mcarthur
mcarthur's picture

Thanks for this.  The ability for CDS to spread grief around the world seems to have dawned on the ECB et. al. but not 99% of the population.

Fri, 06/17/2011 - 19:47 | Link to Comment prophet_banker
prophet_banker's picture

  i call this a lie,  -"The DTCC started settling CDS trades. " as in all?; and yet it goes on to claim any CDS traded outside of DTCC aren't real just because they are off of the balance sheet......this article failed to see how naked shorts use CDS for that which they don't own, "place a bet"`- and the bond raiders profit on the way up and down

Fri, 06/17/2011 - 20:28 | Link to Comment oogs66
oogs66's picture

all CDS is off balance sheet, almost all CDS trades are captured by DTCC, there are few if any CDS trades done now that don't go through DTCC so the DTCC data is a very good assessment of the risk outstanding on any given reference entity

 

do you need to own a stock to buy a put?  if CDS should be banned because it places a bet, then shouldn't all options on anything be banned unless you own the underlying?  shouldn't short selling be banned altogether?  people need to get over the hype of CDS if they are going to avoid making dumb decisions.  buying a put in apple is different than buying CDS on AAPL in which way?  other than the put is more likely to pay off :)

Fri, 06/17/2011 - 22:53 | Link to Comment ZeroPower
ZeroPower's picture

almost all CDS trades are captured by DTCC, 

Not totally accurate, plenty of CDSs on sovereigns (think CEE/CIS) never go anywhere near the DTCC system.

We're in agreement on CDSs in general however.

Fri, 06/17/2011 - 19:49 | Link to Comment tgatliff
tgatliff's picture

Let me guess...  Mr. Peter Chachachia trades derivatives for a living, and is unhappy about their possible demise.  Let me shed some light as well...

1) CDS (as well as pretty much all unregulated derivatives) contracts are legalized Fraud, and have effectively blackmail the entire financial system.  

2) They are not "complex".  Having too much fraudulent activity going does not make them complex...  

Fri, 06/17/2011 - 19:49 | Link to Comment Lord Welligton
Lord Welligton's picture

Agreed.

They are not at all complex.

They should be consigned to Las Vegas where they belong.

Sat, 06/18/2011 - 12:50 | Link to Comment Kayman
Kayman's picture

They should be consigned to Las Vegas where they belong.

Agreed.

But in Vegas, if you beat the dealer, the dealer can't call on Hank.

Fri, 06/17/2011 - 20:07 | Link to Comment CrashisOptimistic
CrashisOptimistic's picture

I have suggested from day one that the issue is all about the swaps.

The gross notional is opaque.  The net notionals don't have to be all that meaningful, and there is no european regulation requiring DTCC notification of contracts, though most do.

It's all about the swaps.  There is no way in hell Merkel would cut her own political throat like this had not her banks terrorized her into ensuring they get taxpayer money flowed to them, using Greece as the conduit.

There are two truths to understand here:

1) The politicians and Brussels bureaucrats have one and only one motivation -- the EU (and their consequent benefit/pension packages) must remain intact.  So ANYTHING will be done to make that so.  Money can be printed, politicians can be assasinated, taxes can be looted . . . ANYTHING will be done to keep the juggled balls in the air.

2) NOTHING, absolutely nothing, will change about all this until and unless bullets go through skulls into brains.  People walking in the street are laughable.  General strikes are laughable.  Only snipers on rooftops will change anything.

Sat, 06/18/2011 - 03:15 | Link to Comment Reptil
Reptil's picture

+1 on your points, an tgatliff's.

 

Fri, 06/17/2011 - 20:40 | Link to Comment tom a taxpayer
tom a taxpayer's picture

Thank you, tgatliff, for cutting thru the BS, and speaking truth to power. The CDS were a key part of the 2008 financial crisis that still inflicts high unemployment, foreclosures, depreciated pensions, rape of taxpayers, etc. Congress and the executive branch and the State and Federal prosecutors have done next to nothing about the flagrant fraud...the daylight robbery and financial armageddon of CDSs.

 

Fri, 06/17/2011 - 22:55 | Link to Comment ZeroPower
ZeroPower's picture

Thanks for trolling and adding exactly zero to the conversation at hand.

Fri, 06/17/2011 - 19:54 | Link to Comment XPolemic
XPolemic's picture

I may have more faith than most people that the banks are managing their counterparty exposure to end users well, but my experience is that they have, and there is relatively little evidence pointing to banks having big losses due to mismanaging their end user counterparty credit exposure.

My questions to Peter Tchir after reading the above are these:

Have you ever worked in Risk Management for a Tier 1 bank?

Do you know how counterparty loss-given-default is calculated?

Have you seen a pricing model for credit instruments that uses something other than the "mean time to default" (i.e. the credit rating) for credit event probability in their Monte Carlo simulations?

Do you know if Risk Management perform their own due diligence on counterparties to determine issuer risk on the paper they issue, or simply rely on the credit rating agencies?

Credit Default Swaps are a type of re-insurance. You pass off some of your issuer risk to the re-insurer and pay the premium. If you believe that the premium offered is lower than your internally calculated issuer risk, then you have found an arbitrage opportunity (*cough* Goldman AIG *cough*).

The problem then is, how to manage the issuer risk on the re-insurer, who has obviously mispriced the risk and is due for a gutting? Why, the Federal Government of course! You can count on the good old government as a reinsurer of last resort.

The point most people miss about Credit Default Swaps is that they were initially created as a way to hedge your exposure to investments in emerging markets. Say you want to invest in a Brazillian ethanol producer, buy their bonds for example. The problem is, you know nothing about Brazil, and it's far away and difficult to oversee your investment. That is, it's difficult to price and manage the issuer risk.

What you do know however, is a reliable bank in Brazil, who knows the market, knows the ethanol producer, and can price the issuer risk on your bonds. This same bank has exactly the same problem as you. It wants to manage it's risk on it's investments in the US, a risk that you can price. So you get together, price each issuer risk and swap risks: ergo Credit Default Swap. The difference in risk premium is either settled immediately or on an ongoing basis like a coupon.

Sadly, the best laid plans of any derivative instrument are oft to go awry, and the CDS morphed into a massive blood sucking arbitrage vehicle on those market participants who had no idea how to price the risk on the insurance they were selling.

Fri, 06/17/2011 - 20:22 | Link to Comment oogs66
oogs66's picture

I think they were originally created to hedge the exposure big derivative houses had to japanese banks.  the japanese banks all had the same trades on and all owed the u.s. banks huge amounts on a mark to market basis and the japanese banks were having credit problems on top of it, so a big part of the reason CDS was created was to hedge japanese bank exposure and then as a way to get regulatory capital relief on all their revolver commitments, back when even big money center banks did lots of revolvers.  EM was not a primary motivator behind the birth of CDS as far as I know.

Fri, 06/17/2011 - 21:00 | Link to Comment XPolemic
XPolemic's picture

I am not in the US. In my country, CDS were initially a way of managing exposures to EM. Probably because my country is heavily exposed to those markets. Thank you for your correction on the birth of CDS, I will research more thoroughly. Always learning, always learning.

Heres the thing though: If your MTM counterparty exposure has breached your credit limit, and you think they might default, then you incorrectly calculated your counterparty risk.

If the way to hedge your counterparty risk is to buy insurance against default by creating a new instrument (CDS), then one has to ask who on earth would take the other side of that bet for a premium that was lower than the actual exposure? It either implies that the exposure of the big derivative houses was opaque, or that the people taking those exposures knew something about the credit problems, or a BoJ intervention, and made some free money. Or to put it another way, either the derivative houses got a discount on their risk, or someone else made some free money based on their 'local knowledge'.

The question is, why would you need to create a new credit risk instrument for US and Japanese financial markets when there are already well established risk markets, with deep liquidity, that will take the other side of any position you desire for a price, unless you think that your new instrument will give you a discount on hedging your risk by obscuring it's true exposure. In other words, are CDS an elaborate fraud?

 

Sat, 06/18/2011 - 09:20 | Link to Comment centerline
centerline's picture

The short answer is that it appears so.  "Risk management" is the key phrase here in my opinion.  Although it almost needs to be redefined for purposes of explaining what went wrong in the last banker bubble free-for-all.  Nonetheless, it is the smoking gun in my opinion.

Sat, 06/18/2011 - 12:57 | Link to Comment Kayman
Kayman's picture

" why would you need to create a new credit risk instrument for US and Japanese financial markets "

Because churning and skimming means bonuses. And when there are losses, you assign them to the taxpayers in the home country.

"are CDS an elaborate fraud?"  YES.

 

Tue, 07/26/2011 - 12:23 | Link to Comment Ghordius
Ghordius's picture

Good explanation of how we started.

I prefer the simpler one: CDS is INSURANCE.

Only except in the most extreme free-market ideology that some people "push", we know from history that if anyone can insure your house (not theirs, YOURS) for an amount exceeding it's market value, then your house will eventually BURN.

And if markets know better, why should price discovery of the underlying not be sufficient?

Fri, 06/17/2011 - 19:57 | Link to Comment Atomizer
Atomizer's picture

I'm sure you all heard about this on MSM yesterday. Re-posting door #2 from yesterday, follow the havoc and choas within the central planning community.

www.capmktsreg.org/pdfs/2011.06.16_House_Testimony.pdf

BTW, London Banker won a scrabble game using this word.. Anomie

http://londonbanker.blogspot.com/2011/06/anomie.html

TV Parrot's to use this term in 3,2,1...Anomie.

 

Sat, 06/18/2011 - 02:28 | Link to Comment XPolemic
XPolemic's picture

Thanks for the link on Anomie. I really enjoyed that, especially the insight by Nassim in the comments section.

 

Fri, 06/17/2011 - 19:59 | Link to Comment Illya Kuryakin
Illya Kuryakin's picture

"Since so many journalists still feel that the investing public needs to see the boilerplate language ‘when yields go up, bonds prices, which move in the opposite direction, go up’ this may be an uphill struggle." 

You are already struggling. 


Fri, 06/17/2011 - 20:00 | Link to Comment Manzilla
Manzilla's picture

Holy shit that DTCC site is disturbing if I'm reading it right.(My knowledge is a bit limited here.) Is there $20 trillion floating around there in this type of stuff? Hmmmm, house of cards?

Fri, 06/17/2011 - 21:05 | Link to Comment tom a taxpayer
tom a taxpayer's picture

Maybe CDS are like Las Vegas chips. Lots of money floating round but its in the form of chips, therefore, more like play chips, monopoly money. And here is the best part, if your CDS bets lose, and you screw up the U.S. economy, cause high unemployment, destroy pension funds, cause State and local govts to go bankrupt, don't worry...your CDS bets are protected by the full faith and credit of the U.S. government.

Millions of people will lose their jobs and their families suffer because of your reckless CDS betting, but Uncle Sam will make sure your don't lose a dime...and Uncle Sam will give you a big, fresh stack of taxpayers money to continue your reckless betting.

Fri, 06/17/2011 - 22:08 | Link to Comment vamoose1
vamoose1's picture

except they have no faith and  they  have  no credit

Fri, 06/17/2011 - 21:12 | Link to Comment XPolemic
XPolemic's picture

20 trillion NOTIONAL.

It's a bit like saying 'OMG there is 50 trillion in outstanding life insurance claims, what if we all die at once?'

Well, if we all die at once, there won't be any claimants or any people to pay out the claims anyway. And the same could be said for the world's financial system. Continuing the metaphor, certainly some disaster could take out some of the big insurers, and yes it's effect could be profound and recessionary/depressionary, but both life and the financial system will go on.

Why? Because 51% of the time, it works, and that's pretty much the best you can ask for in any human endeavour. The financial system allocates capital. Period. When it allocates capital well, prosperity ensues, when it allocates capital poorly, you get the opposite effect. But since we are all still here, and the planet has more people eating and living out their lives than ever before, we have to assume that the financial system has got it right at least 51% of the time, because if it had only managed a 49% success rate, I wouldn't be typing these words on history's most complex machine and sending them out over a worldwide, near instantaneous communications network.

 

Fri, 06/17/2011 - 22:01 | Link to Comment Manzilla
Manzilla's picture

Yeah I get that. I forgot to add notional in my reply. It's still a shocking number to look at.

Fri, 06/17/2011 - 22:30 | Link to Comment XPolemic
XPolemic's picture

Oh, when you said "House of cards, hmmmm?" I thought you were implying that the whole 20T would go BOOM all at once.

The nett exposure is probably a lot less than that. Thats the problem with OTC markets (shadow banking), no one really knows what the nett position of the whole system is.

I think the eventual solution to all of this is an increase in trading exchanges for a much wider variety of risk instruments. Move the exposures away from OTC and into the light of market scrutiny. In the Open Source world they say that 'Many eyes make all bugs shallow'. Perhaps if we move away from shadow banking to exchange traded we will find that 'Many eyes make all risks well known'.

 

Fri, 06/17/2011 - 23:13 | Link to Comment ZeroPower
ZeroPower's picture

And right there is the problem with people when bringing up numbers anywhere from $20T to $400T. Its fucking gross. Net it all out, its probably <1% of the gross.

Sat, 06/18/2011 - 00:35 | Link to Comment XPolemic
XPolemic's picture

Net it all out, id say its probably <1% of the gross.

That is almost certainly the form that the coming reset of the world financial system will take. ISDA, central banks, large banks and governments will call a stop to the music, mark everything to the previous day's close/mid/whatever and settle the accounts.

All that remains now in this game of musical chairs is the negotiation on who will lose their seat. Lets just say that negotiations so far have not gone well, so we are likely to see another 3-6 months of can kicking, displays of indignation, carry trade gone wild, quivering lips and debt-ceiling negotiations.

Apart from who gets to keep their seat at the world economic table, the real sticking point of negotiations are this:

1) What happens to the notional value of the Baby Boomer retirement funds?

2) What happens to the ~20-50T worldwide malinvestment in real estate?

3) Can we reverse capital malinvestment and make open markets efficient and transparent again?

On item 1, the politicians stand is that it is non-negotiable.

On item 2, the banks stand is that it is non-negotiable.

On item 3, nobody at the negotiating table really understands item 3.

 

Sat, 06/18/2011 - 13:20 | Link to Comment Kayman
Kayman's picture

ZeroPower

"Net it all out, its probably <1% of the gross."

So... Show me the $4 trillion of reserves. 

How's that Sino Forest thingy going for you guys in Toronto ?

Sat, 06/18/2011 - 19:02 | Link to Comment ZeroPower
ZeroPower's picture

Cant show you but you should comprehend that whoever your counterparty is on the CDS trade, daily MTM rules ensure cash flows (i.e. variation margin) to either party each day. So, these reserves you seek are already balanced out pretty well.

As for Sino Forest - pretty horrible, the company is a clear POS. Is that a hit on our exchanges for allowing TRE to be listed? If so, i guess i should retort back to you with a whole list of chinese RTOs which were on the NAS and SPX.

Sat, 06/18/2011 - 13:11 | Link to Comment Kayman
Kayman's picture

XPolemic

"It's a bit like saying 'OMG there is 50 trillion in outstanding life insurance claims, what if we all die at once?'
 

Let's get a little bit more realistic.  Let's say the death rate doubles from normal and Life Insurance Companies weren't required to have capital in reserve.  Now, that is what the CDS market is like.

" if it had only managed a 49% success rate, I wouldn't be typing these words on history's most complex machine"

I don't know what the "Financial System" had to do with birth of the PC and the internet.  If anything, the "Financial System" stymies the growth of new ideas.

P.S. I would rather be right 49% of the time on the big bets, than 51% of the time on the small ones.  Your example is specious. 

Sun, 06/19/2011 - 07:07 | Link to Comment XPolemic
XPolemic's picture

Let's get a little bit more realistic. 

OK.

Let's say the death rate doubles from normal

You mean without the bureau of statistics, actuaries or life insurance companies noticing?

and Life Insurance Companies weren't required to have capital in reserve. 

Changes to prudential capital requirements are based on mortality tables. Insurance companies are required to report their outstanding claims to prudential authorities, and the mortality table that they used as a base to calculate it.

In order for the prudential captital requirement to stay constant while the mortality rate doubled, you would need to have every actuary of every life insurance company, every prudential authority and every office of births and deaths to miss the change.

If, on the hilariously small chance that every actuary did not notice that the mortality rate had doubled, then yes, that would be the end of the life insurance industry.

Now, that is what the CDS market is like.

Why? Because nobody can calculate a credit rating anymore?

I don't know what the "Financial System" had to do with birth of the PC and the internet.  If anything, the "Financial System" stymies the growth of new ideas.

I guess you don't eat cinamon, or cloves, or tomatoes, potatoes, chilli, or drink tea or coffee. I also assume that you only eat meat once a month, deliver your handwritten mail on horseback, use whale blubber or coal methane for lighting and travel to Europe for vacation on your schooner.

P.S. I would rather be right 49% of the time on the big bets, than 51% of the time on the small ones.  Your example is specious.

So, you are saying that in notional terms, your would rather your return be positive?

Fri, 06/17/2011 - 20:02 | Link to Comment chunga
chunga's picture

Meanwhile...back at home...

Former foreclosure king in trouble with Florida Bar

Kim Miller - Palm Beach Post June 17, 2011

$nip>

The Florida Bar is asking for disciplinary action against South Florida attorney David J. Stern for ignoring a Fifth District Court of Appeal’s order in a foreclosure case where his firm represented SunTrust Bank.

A complaint filed with the Florida Supreme Court Friday charges Stern, whose Plantation-based company was once the largest foreclosure firm in the state, with violating rules of professional conduct and disobeying a court obligation.

Read complaint here

Stern’s attorney, Jeff Tew, said Stern was fired by SunTrust in mid Dec. 2010, before the Feb. 16 order was issued. Also, with 10,000 pieces of mail coming into the floundering law firm every day, Tew said it’s possible the notice went unseen.

Most of Stern’s employees were laid off following the loss of foreclosure business from federal mortgage backers Fannie Mae and Freddie Mac. They cut ties with Stern when questionable business practices were revealed in a state investigation. Stern closed his foreclosure business March 31.

“David is not guilty of any violation of the Bar rules and we will vigorously defend this complaint,” Tew said.

Florida Bar sanctions range from public admonishment to disbarment.

Foreclosure defense attorneys had lukewarm responses to Friday’s complaint, saying it was a trivial concern considering the other issues Stern faces. Former Stern employees allege in sworn statements that foreclosure documents were regularly forged, back dated, and illegally notarized at the firm.

“In the scope of things that he is accused of, this is such a minor matter,” said defense attorney Tom Ice, of Royal Palm Beach-based Ice Legal. “Given everything that’s come out, the fact that this ends up as a complaint is kind of insulting.”

$nip>

Florida's Rip Van Winkle Bar Association is out of order.

Florida's courts are out of order.

Florida's legislature is out of order.

Stern should be criminally prosecuted for Fraudulent Representation. Instead, he'll likely run for Attorney General (and win) with the full backing of the Bar Association, Florida Chamber of Commerce, and The Florida Bankers Association.

Fail. Epic Fail.

We are being taunted. This is nothing more than cover so the Bar Association can continue harassing and intimidating defense attorneys as has been their habit.

We Must Fight Back

Sat, 06/18/2011 - 09:16 | Link to Comment centerline
centerline's picture

Florida has been a regular circus over the last few years for denying people legal rights.  Lots of attorneys, judges and other folks should clearly be in prison.  What is most sad about all of this is the clear example that being made about when the SHTF, don't count on the "system" to be fair... folks need to educate themselves and be prepared.

Fri, 06/17/2011 - 21:44 | Link to Comment YHC-FTSE
YHC-FTSE's picture

The immorality of trading in other people's risk doesn't seem to have been aired here. If you trade in risk, the buyers of the risk have a vested interest in default. There's a good reason why you cannot buy life insurance for somebody and be the beneficiary without their permission, or insure a stranger's car against an accident and get the insurance money if it is totalled. CDS is the exception to this logical rule.

 

Investors in CDS are not speculators, they are vultures waiting for the worst case outcome if honest, or the instigators of global financial disasters if dishonest. Papandreou and IJ partners come immediately to mind, but I'd bet there are a lot more. I don't give a shit if it made a ton of money - I wouldn't touch this with a bargepole.

Sat, 06/18/2011 - 00:36 | Link to Comment narnia
narnia's picture

Regulating a contract between two consenting business interests should be of no concern to the government or anyone outside of those writing the contract.  If someone is foolish enough to allow the coverage of his or her risk to be traded to another party without approval, he or she deserves every ounce of counterparty risk. 

Insurance "regulation" is not the equivalent to some rule of the universe.  Like most other rules contrived by the intellecuals, they are stupid.  If I invest in a start-up and I want to take out a life insurance policy on the CEO, that should be totally within my right.  That has nothing to do with wishing harm.

Sat, 06/18/2011 - 03:40 | Link to Comment Reptil
Reptil's picture

No, they're not the rule of the universe. But the purpose is to make a market transparent, and functional, right? I mean that's in the general interest of the human species. My point is to think bigger and realise the implications of the same rule that allows for you to take out insurance on that CEO.

Standard Oil's 19th century business model? Destroy everything except for your own investment?

On a planetary scale that doesn't make sense. Though it is happening now.

Sat, 06/18/2011 - 17:06 | Link to Comment narnia
narnia's picture

The issues with our financial system are its fiat/debt currency basis, fractional reserve banking, a financial regulatory structure which establishes & directs investment flows to certain assets, a corporate legal structure which decentivizes stewardship & the Greenspan/Bernanke put.  In a free market / true capitalistic / free society, CDS would not be a problem, transparent or not.

The behavior you abhor is only made possible by government intervention.  The government is the only monopoly in a free society.  Here's a good lesson to de-propagandize you:   http://youtu.be/0sxfMjKD_Ao (Rothbard: The Rise & Fall of Monopolies).

 

Sat, 06/18/2011 - 09:03 | Link to Comment YHC-FTSE
YHC-FTSE's picture

"Like most other rules contrived by the intellecuals, they are stupid."

 

Right, so according to you all rules should be made by unlettered morons.

 

OMG. I can't believe anyone would have the gall to post something that is so beneath stupid, I'd have to invent a whole new word to describe it. 

Sat, 06/18/2011 - 12:30 | Link to Comment narnia
narnia's picture

The opposite of writing laws is not writing laws.  Laws written to do anything other than protect life & liberty have unintended consequences.  

I suppose you still have faith in the "intellectuals" who wrote & continue to defend the war on drugs.  

Tue, 07/26/2011 - 12:30 | Link to Comment Ghordius
Ghordius's picture

Let's insure this guy's "Narnia"'s house, life and car for ten billions dollar and spend some pocket money to have him and his stuff liquidated or burnt... ah the profits you can make when all contracts between people are valid and legal without any morality checks!

Perhaps we can push him to bind himself contractually to slavery?

Sat, 06/18/2011 - 13:28 | Link to Comment Kayman
Kayman's picture

"If I invest in a start-up and I want to take out a life insurance policy on the CEO, that should be totally within my right."

It certainly is within your rights. BUT, if your CEO dies and your insurance policy is worthless, then you can go F..K yourself, instead of asking me and my children to pay up on your shitty bet.

CDS are not insurance policies, they are roulette gambles in a bankrupt casino. If the house loses, and you know the house does not have the dough to make good your bet, then you and the house take the loss, not me.

 

Sat, 06/18/2011 - 14:27 | Link to Comment narnia
narnia's picture

Standing for someone's right to trade in CDS is not the same thing as standing for the government bailing out bad CDS bets.  Subsidizing losses is something big socialist governments who try to centrally plan & write all kinds of stupid rules & regulations in the economy do.

Sat, 06/18/2011 - 03:35 | Link to Comment Reptil
Reptil's picture

+1

What happened to the claim of GPap being a traitor and having sold CDS to his family (for peanuts)?

http://hellasfrappe.blogspot.com/2011/06/george-papandreou-accused-of-co...

Buried?!

It seems prudent to solve this, before the "credit event". I assume the prime minister enjoys protection from criminal investigation while he's in function?

Sat, 06/18/2011 - 08:52 | Link to Comment YHC-FTSE
YHC-FTSE's picture

He does indeed.  Greek law (N. 2509/1997 as revised in 2001) makes it impossible to prosecute government ministers while in office. The level of corruption in Greece is infamous - ask any Greek. 

Fri, 06/17/2011 - 21:43 | Link to Comment Arrowflinger
Arrowflinger's picture

At the time of the AIG bail-out, I was reading of almost totally undocumented CDS made whole, some of which were based upon a telephone call.

Were verbal CDS agreements made whole with no documentation?

What was the typical size of such a settlement?

Did financial reform prohibit payment on unconfirmed/inadequately documented CDS?

Heck, when I worked for government decades back, you could not get 50 bucks reimbursed without receipts and an expense voucher filed in triplicate.

Thanks in advance for replies. I realize my understanding of these things is pretty elementary.

 

Fri, 06/17/2011 - 22:50 | Link to Comment XPolemic
XPolemic's picture

At the time of the AIG bail-out, I was reading of almost totally undocumented CDS made whole, some of which were based upon a telephone call.

Got a link? Sounds interesting.

Let's review the making whole of AIGs CDS exposure to Goldman Sachs shall we.

The government, represented by Tim Geithner, Hank Paulson (ex Goldmen) in negotiation with Robert Rubin (ex Goldmen) and Stephen Friedman (ex Goldmen) decided to make Goldman Sachs whole on their CDS position. Once that decision had been made, I think it is largely immaterial what the amount was going to be.

So, if the taxpayer is footing the bill anyway, what's the harm in throwing in a few 'verbal agreement' CDS paper on the already huge rotting, festering pile? I mean, if you are going to pull off the greatest financial fraud in human history, you may as well go all in.

 

Sat, 06/18/2011 - 00:47 | Link to Comment Arrowflinger
Arrowflinger's picture

Well, I found multiple references to the book authored by Gillian Tett, Fools Gold, which apparently refers to 'large numbers' of unconfirmed CDS issued by Bear Stearns. These seem to have been made whole despite the lack of documentation.

The author of the above also references the large number of unconfirmed CDS and seems to be saying that DTCC won't allow lack of confirmation to exist but is at the same time uncertain wheter valid CDS are being written outside of the DTCC umbrella.

A CDS can still be entered into via a telephone call, text message, or even chat message, which means $tens of millions of purely verbal transactions could not only exist before, but that they were likely made good via bail-out or Fed facility.

These damned things should be outlawed under penalty of death.

How we are here, 3 years later, with sovereign debt markets being turned inside out via CDS spreads, NO ADDITIONAL COLLATERAL being posted - that one was always a joke because it was an honor system - with $tens of billions hanging in the balance.

This is still allowed under US financial reform!!!

Insane.

 

 

 

 

 

 

Sat, 06/18/2011 - 01:58 | Link to Comment XPolemic
XPolemic's picture

A CDS can still be entered into via a telephone call, text message, or even chat message, which means $tens of millions of purely verbal transactions could not only exist before, but that they were likely made good via bail-out or Fed facility.

Hmmm, I think the backoffice at almost every major bank would find that assertion ... interesting. While the deal can be made over the phone, contracts should be exchanged as part of settlement, otherwise, how would you ever enforce it? I know in the case of DKs before settlement the trading floor goes to recorded phone conversations, but having an open position without written confirmation (contract), seems .... odd.

On the other hand, there is the joke about the rich oil Sheik, who bought his son Chelsea for his birthday when he loved soccer, and British Airways when he was gaga about aeroplanes, and Lehman Brothers when all he could think about was cowboys ....

 

The author of the above also references the large number of unconfirmed CDS and seems to be saying that DTCC won't allow lack of confirmation to exist but is at the same time uncertain wheter valid CDS are being written outside of the DTCC umbrella.

Yes, well, without a contract exchanged during settlement, the deal technically doesn't exist. The only exception is for instruments that are settled overnight or after the close of trading. There would presumably be some deals sitting on the trading floor that hadn't made it through that process, I can't imagine it was a LARGE number though, unless they were entirely fictional.

How we are here, 3 years later, with sovereign debt markets being turned inside out via CDS spreads, NO ADDITIONAL COLLATERAL being posted - that one was always a joke because it was an honor system - with $tens of billions hanging in the balance.

You obviously don't know the legal problems with collateralization. Assuming you mean collateral of assets rather than cash. Because under ISDA the beneficial owner of the collateral doesn't change, their appears to be no guarantee that you can seize it in the case of a default.

These damned things should be outlawed under penalty of death.

This is still allowed under US financial reform!!!

Insane.

The problem is not the instrument, but the lack of transparency. Personally I believe that the true risk exposure of the underlying asset (or more correctly, it's issuer) has either been occluded, or is just not well understood, otherwise the comparative advantage of purchasing a CDS vs the exposure of an actual default would be pretty close to nil, making the instrument worthless. Perhaps as someone else suggested, that the reason this instrument exists is so market makers can make the bid-ask spread on something that is essentially useless.

 

Sat, 06/18/2011 - 06:59 | Link to Comment Arrowflinger
Arrowflinger's picture

Thanx for your input.

You are exactly right. The phone call should have been followed immediately by a backoffice extension of contract and confirmation. What I read, which were the assertions by this author and others I managed to feret out, was that this process was broken with Bear Stearns.

I would dearly love to see the documentation upon which these $billions were doled out.

Absolutely nothing the Fed/Trashery does or has done can shock me any more.

 

 

 

Sat, 06/18/2011 - 09:27 | Link to Comment chunga
chunga's picture

"The problem is not the instrument, but the lack of transparency."

That's a very good point. In the case of MBS, generally the foreclosing entity objects to document production of the PSA and other agreements because they claim the borrower is not a party and not in privity. However, the OCC lists the borrower as an essenntial party in the securitization process because the performance of the MBS depends on the timely payments made by the borrower. [1]

Color me cynical but I have a suspicion that multiple payoffs were made on a single default transaction based on the assumption pointed out by WB7...that the govt. would be the backstop.

As another poster pointed out - the buyers of the risk had a vested interest in default. Hence the outcome based appraisal, and the disregard for underwriting standards applied at origination.

The more likely the obligation is to default the more profitable it may turn out to be - a very perverted and unhealthy example of the "free market" at work.

[1] Comptroller of the Currency Asset Securitization November 1997

"Got a pen? Just sign here and you're good to go!"

Sat, 06/18/2011 - 13:32 | Link to Comment Kayman
Kayman's picture

Well said.

Daylight robbery.

Fri, 06/17/2011 - 22:02 | Link to Comment JustACitizen
JustACitizen's picture

So - let's say that I have some credit risk on a large portfolio of bonds/MBS/ABS/etc.

I would like to get out of some of that risk - so I am looking for a hedge - presumably it allows me to lock in some portion of my "assumed" profits.

So - I go out and pay some schmo to set up this derivative deal - but now I have to worry about counterparty risk??? The counterparty on my derivative has too much risk - so they in turn lay-off some risk on someone else...

That's great... I suppose this scheme worked much better when everyone was a triple A rated company - with a reputation - like AIG used to have... Let's not forget the good part - the only one that truly gets to "lock in their profits" are the brokers in the middle...

Terrific bit of financial "engineering"... Gawd - I'll bet those idiots running the pension funds must have done an amazing job on the due diligence.

Sat, 06/18/2011 - 00:45 | Link to Comment XPolemic
XPolemic's picture

So - I go out and pay some schmo to set up this derivative deal - but now I have to worry about counterparty risk??? The counterparty on my derivative has too much risk - so they in turn lay-off some risk on someone else...

You almost made it to it's logical conclusion. In over the counter markets, you know your counterparty, but you don't know their counterparty, or their counterparty's counterparty, and so on and so forth, until eventually, the person you are hedging the risk to, is you.

That's great... I suppose this scheme worked much better when everyone was a triple A rated company - with a reputation

Actually, this scheme worked much better when almost every participant traded their risk on open markets. Then the total exposure was much better known, as opposed to the counterparty exposure which is pretty well known, but as we know now, practically useless for risk management and the pricing thereof.

Terrific bit of financial "engineering"... Gawd - I'll bet those idiots running the pension funds must have done an amazing job on the due diligence.

In hindsight, it looks like an elaborate fraud, but one must be careful not to attribute to malice that which can be adequately explained by stupidity. Merton and Scholes genuinely believed they were smarter than the market, and that their model captured all of the market risks. They were wrong of course, but that doesn't mean they were trying to defraud their investors, it just means that they were wrong.

 

Sat, 06/18/2011 - 11:01 | Link to Comment Arrowflinger
Arrowflinger's picture

I disagree. It was fraud.

To believe the securitization model you had to believe that the sum of the transaction was equal to sum of the myriad component parts, dismissing default risk, believing that infinite risk could be made finite by distributing it far and wide, dismissing transaction costs (especially to unwind the damned things) to the point of committing transfer fraud, and ignore the time tested (even IRS recognized) principle that fractionalized ownership decreases marketable asset values.

I have an accounting and auditing background - mostly cash basis - and I realized in Q3 of 2006 that the financial system was destroyed due to the above scenario. I went around interviewing branch managers about mortgages. I was stunned.

I cannot accept that people with decades in banking and finance did not see what scared me stiff in 2006.

Too crooked or too stupid to be in banking. It really is immaterial to me which. They have to be put out of banking forever.

Fri, 06/17/2011 - 22:15 | Link to Comment vamoose1
vamoose1's picture

beautifully  written,   and oddly apologist. did  lloyd  blankfein join this  board. my understanding is  gross derivatives in the world  financial  system  total  1.4  quadrillion, and i did say quadrillion,   with a net  notional  of  600 to  800 trillion.   world annual gnp is  60 trillion,  case closed

Fri, 06/17/2011 - 23:04 | Link to Comment ZeroPower
ZeroPower's picture

Lol. Yes, keep making up numbers. Whatever makes you happy as they are evil, evil contracts. You do realize mom & pop can't speculate in them right?

Fri, 06/17/2011 - 22:29 | Link to Comment Subprime JD
Subprime JD's picture

From the article:

There are several ways to increase the Gross Notional.  If a market maker/dealer buys $10 million of CDS from one customer and sells $10 million of CDS to another customer, the Net amount reported would be $10 million (since that is the “naked” exposure) and the Gross would be $20 million as there are 2 trades outstanding of $10 million each.  If all trades were so simple you would expect the Gross to Net ratio to be 2:1.  Not all trades are that simple.  At least as common would be for Customer A to buy CDS from Dealer X, and Dealer X to buy from Dealer Y who then buys from Customer B.  You still have a Net of $10 as only customer A and B have naked postions, but now the Gross is $30 since there are 3 trades in the system. 

Customer A is naked because he hasnt "sold" any CDS and Customer B is naked because he hasnt "bought" any cds. Also, lets also state that Dealer X has bought CDS from Dealer Y while he sold CDS to customer A. So basically Dealers X and Y are not naked because they have both bought and sold and are therefore hedged. But in the event of a credit event, Customer B would have to fork out 10 billion, with that 10 billion going through the system until Customer A gets paid. Hence the net notional of 10 billion. But what if Customer B is a seller of too much protection and goes bust? Then the dealer Y has to fork out the 10 billion, which also goes through the system until Customer A gets paid.

Makes sense to me. So at what point does gross become net, as tyler has stated numerous times?

Fri, 06/17/2011 - 23:03 | Link to Comment fader107
fader107's picture

CDS is fine. All OTC products are fine. If banks and HF post sufficient MARGIN that is...

Fri, 06/17/2011 - 23:07 | Link to Comment williambanzai7
williambanzai7's picture

The fact that there is no cap on the gross amount of this stuff explains why the whole edifice will stand only if the Fed is prepared to back stop it all in the final analysis, which is obviously what happened.

Those who say it worked seamlessly with Lehman have their heads in a paper bag.

Tnx for posting.

Fri, 06/17/2011 - 23:15 | Link to Comment ZeroPower
ZeroPower's picture

The fact that there is no cap on the gross amount of this stuff 

Where would the cap be, exactly? Would it be on XX amount of gross on an entity? Would it be for all corps, or sovereign? Who would enforce this? How exactly would a cap even reduce implied risk of said entity in such a case? Surely the more amount of bonds protected by a CDS, the better off are bond holders? In which case, shouldn't there be a floor on "this stuff"?

Sat, 06/18/2011 - 09:52 | Link to Comment williambanzai7
williambanzai7's picture

Oh I'm sure bond holders are better off, it's the system I'm worried about.

Fri, 06/17/2011 - 23:49 | Link to Comment dellbalboa
dellbalboa's picture

'' Doom and gloom crowd''

 

 

Quite an introduction there, very charming.

Sat, 06/18/2011 - 09:21 | Link to Comment centerline
centerline's picture

It got my attention!  Of course, if he titled "big, big titties" that would have worked too.  Where's Pladizow today, know that I think about it?

Sat, 06/18/2011 - 00:18 | Link to Comment mcarthur
mcarthur's picture

CDS and all ETFs for that matter will be banned within 10 years.  Shame all markets have to collapse first.  $0.02.  There is no such thing as insurance and the differential between market and underlying liquidity assures this.  You guys never learn.

Sat, 06/18/2011 - 01:33 | Link to Comment XPolemic
XPolemic's picture

There is no such thing as insurance? Oo

I guess a lot of actuaries are about to get a rude surprise. Maybe they can all become chicken sexers.

Sat, 06/18/2011 - 00:48 | Link to Comment Arrowflinger
Arrowflinger's picture

The Fed and Trasherie made CDS, money good, and in so doing put their shitty fiat on the same level as out-of-the-money lotto tickets.

Doom and gloom crowd?

MATH is going to put a real ass whipping on these insane fuckers.

 

 

Sat, 06/18/2011 - 00:53 | Link to Comment Arrowflinger
Arrowflinger's picture

CDS and mark to fiction accounting are the only basis upon which $tens of billions in 401k "guaranteed" "stable investment" "guaranteed" funds remain AAA.

30% of the sheep smelled singed wool already and got their money out.

At some point in this massive run, 401k's are going to run out of liquidity to pay out redemptions and borrowings.

 

Sat, 06/18/2011 - 01:34 | Link to Comment XPolemic
XPolemic's picture

At some point in this massive run, 401k's are going to run out of liquidity to pay out redemptions and borrowings.

I'm calling that day now. November 11th, 2029, the day the last Baby Boomer retires. Until that day, the 'crash' you are expecting will for the most part, proceed from one crisis to the next in painfully slow motion, accompanied by a huge sucking sound.

 

Sat, 06/18/2011 - 02:37 | Link to Comment libelmage
libelmage's picture

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Sat, 06/18/2011 - 03:50 | Link to Comment Reptil
Reptil's picture

Can you explain why? ;-P

TD, IP ban?

Sat, 06/18/2011 - 05:42 | Link to Comment Yen Cross
Yen Cross's picture

 Credit Default Swaps.  Monkey Potus Business.

Sat, 06/18/2011 - 06:38 | Link to Comment swissinv
swissinv's picture

You all get distracted from the real big issue. First, Greece is a small country. Second, credit exposure of OTC derivatives incl. CDS are mitigated by daily remarging / posting collateral. Thus, eventhough you have a chain reaction a good part of credit exposure is already covered. The critical issue is when the collateral is getting impaired used to secure the credit risk of a transaction. And as you know AAA gov. debt securities are high in course for this purpose. Now, imagine the debt ceiling is not increased timely and debt of the biggest economy is getting downgraded!? Chain reaction due to bad collateral is what you have to fear and this goes across all asset classes you have credit exposures.

Sat, 06/18/2011 - 17:53 | Link to Comment oogs66
oogs66's picture

+100  somehow people like to focus on CDS when the real problem is the underlying bonds suck and as you point out, at somepoint the "risk free" collateral being posted may suck.

Sat, 06/18/2011 - 07:02 | Link to Comment EZYJET PILOT
EZYJET PILOT's picture

I don't understand Zerohedge, it seems to be the last bastion of common sense in the financial world, lambasting instruments of financial terrorism like CDS previously, and now suddenly out of the blue a pro banking stooge is given carte blanche to write this load of horse muck, and pretty much with a wave of the wand undo all that I thought zerohedge and Tyler stood for. Disappointing isn't the word! 

Sat, 06/18/2011 - 10:36 | Link to Comment Arrowflinger
Arrowflinger's picture

It is good to hear and consider the opposition POV. I always like to test and retest my theories.

My take is that derivatives remain a threat, especially sovereign debt CDS. How can there be an entity short of a major central bank, creating fiat from nothing to infinity, that can collateralize CDS against a sovereign state?

The bankers just dropped the derivatives regulated in favor of more unregulated ones.

Existing CDS 'wrappers' for 'mortgage-backed' securities in retirement accounts allow these toxic assets to remain in 401k's since they can continue to be marked to fiction. These CDS are like a bandaid on a gangrenous wound.

CDS allowed $trillions in toxic assets to be sold as "money good." That damage has been done and cannot be undone, unless the Fed ALSO bought all the toxic MBS in retirement plans in QE1.

I maintain that it was the fact that every nth CDO was totally fraudulent, especially the squareds and the sythetics, that generated the fees up and down the chain to keep the ponzi running. $billions in fraud kept the 15 to 49 entities behind the securitizations flush with cash, because there wasn't that kind of money in the base transaction.

This is the biggest theft in world history and the top 5 levels of management of the WS firms deserve to be hanged.

 

 

Sat, 06/18/2011 - 17:46 | Link to Comment oogs66
oogs66's picture

CDO's and all these monoline wraps etc, are not the same as corporate or even sovereign CDS.

I don't know why the regulators don't seem to understand it, but they seem to be unwilling to seperate those that could and should be exchange traded and those that should not exist without at least as much, if not more, total regulatory capital held than if the institutions owned the bonds with the same risk.

Sat, 06/18/2011 - 08:54 | Link to Comment Ned Zeppelin
Ned Zeppelin's picture

Thanks for the excellent and well-written article. 

The issue is the creditworthiness of those who may owe the money on a CDS if there is a Credit Event that triggers the contract.  There is no other issue.  The writer has a high degree of confidence that this risk is being properly managed nowadays, and seems to attribute it to the lessons learned from LTCM and AIG.  The only lesson learned from AIG in my book is that the Govt will not allow the CDS house of cards to fall if it means the collapse of foreign and domestic banking institutions if they find themselves on the bad end of a bet with a deadbeat gambler. 

It may well be that the risks are better managed than we think.  Our only true insight into "what might happen," and hence the "doom and gloom" scenario, is the LTCM and AIG debacles, annd in both instances, it went badly.  The taxpayer was forced to backstop the mess.  I have little faith that there is anything different going on right now, and that there is not another AIG lurking in the shadows of the CDS market.  

Sat, 06/18/2011 - 09:12 | Link to Comment Reptil
Reptil's picture

That "backstop the mess" is always presented as the only solution. Over the long run this will not be a solution; moreover it created a false sense of security.

It's not really a solution is it?

Sat, 06/18/2011 - 09:59 | Link to Comment williambanzai7
williambanzai7's picture

You are absolutely right, this pyramid only works if someone is there to back stop it to prevent a total unwind. It was true in 2008 and remains true today.

I'm not saying there is no social utility to these instruments and I am not saying this is the crux of the current crisis, and it is a crisis. However, the scale of the credit derivatives market has created a loose canon on the deck.

Sat, 06/18/2011 - 10:18 | Link to Comment falak pema
falak pema's picture

This may be heresy to a financial trader sight but I want to say it anyway :

WHY IS REGULATION OF CREDIT DERIVATIVE AND SHADOW BANKING MARKETS A DIRTY WORD?

The world needs to disqualify certain types of plays and refocus on the real economy, not on this globalised, financialized, cancer casino/monopoly play. It has to be done, or else we will never leave the central planned, manipulated, pseudo-free market world of today where we go from bubble to bubble, until capitalism dies under its own rubble.

Sat, 06/18/2011 - 10:34 | Link to Comment Arrowflinger
Arrowflinger's picture

They want the 'legal' theft to continue.

Sat, 06/18/2011 - 11:14 | Link to Comment snowball777
snowball777's picture

Ask pick-a-peck-of-pickled-peckers Paulson.

Sat, 06/18/2011 - 10:33 | Link to Comment Mr.Really.Fed.Up
Mr.Really.Fed.Up's picture

The length of this article explaining CDS is reason enough to ban all CDS.

For those who are still working,

why should we have to worry about what the bankers are doing

when we are putting in 8 hours a day making a real contribution to society while the bankers are gambling. Nuts to Phil Graham.

Why should we have to worry about our savings accounts when we are the ones

actually working every day. The move to a financially based society (what was it, 40% of total profits) is insane. We need to manufacture.

This financed based society is insane.

 

Sat, 06/18/2011 - 11:23 | Link to Comment P-K4
P-K4's picture

Another good article on a complex subject but I must admit, I was shocked to see this,

"The Committee is comprised of both market makers and investors in an effort to be fair and remove bias from their decisions."

Based on what has occurred in this financial calamity involving the likes of Dodd, Frank, Dimon, Blankfein et al, I would say all their decisions are self-serving and biased.

Also, with respect to CDS, can't institutions insure against the risk of default on securities they do not own thus adding to the notional amount ?

IMHO, CDS morphed into instruments which allowed banks and governments to take on more debt, thinking the existing "garbage on the books" was covered even if the policy was underwritten by some company who could never afford to pay (e.g. AIG) in the event of a default.

 

 

Sat, 06/18/2011 - 13:04 | Link to Comment oogs66
oogs66's picture

like them or hate them, they are still a part of the market, potentially a big part.  how many times are they mentioned in ZH?  but like everything else, understanding them is a key to making money on this market.  at some point they may go away, but until then it is worth figuring them out as much as possible, ignoring them or making them far better or far worse than they are only leads to wrong investment decisions

Sat, 06/18/2011 - 13:11 | Link to Comment Arrowflinger
Arrowflinger's picture

There is no way to assess and price risk in a mark-to-model accounting world, where the limited real instances of price discovery dictate 70 to 95% losses.

To continue to allow these "markets" to exist when market values are being denied means future bail-outs.

"Misspriced" risk is nothing more than recording ficticious 'profits' now that some other poor bastard has to eat in the future.

Casinos don't get to operate without reserves, neither do insurance companies.

Therein lies the absurdity of CDS markets with no reserve requirements yet available to be bound by a mere phone call. Yeah, each of us can make a phone call and get immediate coverage of a newly purchased car, but those insurors have very real, deep reserves.

The CFMA of 2000 allowed all this and is a travesty. Those who voted for it bear the mark of evil.

 

 

Sat, 06/18/2011 - 17:43 | Link to Comment oogs66
oogs66's picture

single name cds does not really rely on mark to model. it is quoted and traded every day for most of the names. there will be some one of weird ones. Greek CDS is actually more active in volumes than Greek bonds. That still applies for most names. Price discovery is fairly high on single name CDS and extremely high on the indices, including curves.

The true structured products - CDO^2 and CDO's of ABS did rely on mark to model and should be banned. They were largely ways to reduce regulatory capital in the system by taking advantages of loopholes in bank reg cap and insurance reg cap. Price discovery was low.

I think you underestimate the reserve requirements. Other than AIG no counterparty of any significant size failed on any payment related to CDS. Hedge funds and weak financial institutions are forced to collateralize their trades and at some level of exposure even the big banks do.

On the other hand this would all be cleaner if it moved to an exchange!

Sat, 06/18/2011 - 13:21 | Link to Comment jm
jm's picture

Lack of market discipline is clearly the real issue here.  The people that make the mess don't have to clean it up.  This is will end up destroying the CDS market.

The lack of market discipline is obvious with or with out a crisis. 

Just one example: you can get protection on anything with a name, including enterprises that can switch from being a corporation to a state owned enterprise with state backing at the flip of a switch.  How can you assess credit risk on this, much less quote a spread.

More honesty needed. 

Sat, 06/18/2011 - 16:16 | Link to Comment jmc8888
jmc8888's picture

People also have to realize from whose perspective 5 billion (for 1 bank mind you) it is.  From the viewpoint of Greece, 5 billion is a lot.  From our perspective, it isn't.  But even 5 billion multiplied (roughly) the bigger banks in Greece is a lot for Greece to bail out.  This is also, just one section.

Another big question is, what would 'no bailout' do to the chain.  We like to use a situation where people were bailed out, even if lehman wasn't, the rest were. What happens when NONE of them are bailed out?

Plus we all know there's lots of stuff, hidden off-book.  Also 'if' tends to be more like 'when'.

But good read none the less.

Sat, 06/18/2011 - 17:55 | Link to Comment oogs66
oogs66's picture

if (and when) people who lent to Ireland, Portugal and Spain the system will be on verge of collapse, but it will still be 90% from outright stupid lending and only 10% from the world of CDS.

This time, hopefully the governments will let banks fail, and only after failure attempt to pick up the pieces.  Take full ownership, cut the businesses, not get tricked into believing saying mine/yours or mate, or how about them yankees, is worth 7 figures a year.

 

I don't think the governments will have the guts to let it collapse first then pick up the pieces, but maybe they will.  Last time they stepped in and took all the downside, and kept little of the upside, and guess what, it is back to business as usual.  Snide remarks to the Bernank from Jamie about too much regulation?  They too would have been dead without treasury/fed intervention.  If we get another crisis, the government has to let them fail and only pick up the pieces once they are fully in control.

 

But now I need a drink :)

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