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Reading Between The Lines Of David Einhorn's Attack On CDS

Tyler Durden's picture




 

The $26.5 trillion (gross notional) CDS market is under siege. Or such is the latest news from the formerly pervasive (ab)user of CDS trading strategies, David Einhorn. In an op-ed in the FT, Einhorn states "I think that trying to make safer credit default swaps is like trying
to make safer asbestos,” he writes in a recent letter to investors,
adding that CDSs create “large, correlated and asymmetrical risks”
having “scared the authorities into spending hundreds of billions of
taxpayer money to prevent speculators who made bad bets from having to
pay." His full opinion can be found here, while for an extended blame session on CDS we refer readers to his complete VIC speech we posted earlier.

We agree with Mr. Einhorn's cautionary perspective in principle: his warning that CDS has a feedback loop quality, and a negative convexity nature courtesy of a much increased correlation among various assets, is quite obvious to anyone who has traded or is familiar with the product. Which Mr. Einhorn undoubtedly is, having made hundreds of millions precisely courtesy of leveraged bets using CDS. The "about face" coming now from the Greenlight founder is surprising, although we have some thoughts that explain it.

Some other arguments he presents:

CDSs are “anti-social”, he goes on, because those who buy credit
insurance often have an incentive to see companies fail. Rather than
merely hedging their risks, they are actively hoping to profit from the
demise of a target company. This strategy became prevalent in recent
years and remains so, as holders of these so-called “basis packages”
buy both the debt itself and protection on that debt through CDSs,
meaning they receive compensation if the company defaults or
restructures. These investors “have an incentive to use their position
as bondholders to force bankruptcy, triggering payments on their CDS
rather than negotiate out of court restructurings or covenant
amendments with their creditors”, Mr Einhorn says.

Yet one could have made the same claim about derivative holders of any other asset class: options (equity derivatives) are of course not spared from this, neither are interest rate or FX swaps. What is unique about CDS, Einhorn claims, is that it provides a synthetic (and very liquid) way for stakeholders higher in the capital structure to influence restructuring/reorganization negotiations in a worst case scenario. Is that bad? Not at all.

Ultimately, the strongest bargaining position on the table wins. If CDS is part of a pre- or post-facto basis trade (we are not sure one can attribute ethics to a trading strategy), where a corporate raider loads up on billions of evil CDS and buys bonds only after the cash product trades down to the low single digits in order to have a blocking stake in any prepack or Chapter 11 free-fall discussions: well, that's just the way the free market is. After all, this is simply yet another way to express the conviction of one's beliefs. This is a strategy rumored to have been used widely by Carl Icahn in the early part of 2009 on numerous distressed corporate names. Again - what is wrong with that? Remember, with derivatives buys and sells are matched. For every CDS that Icahn (or Einhorn is his less idealistic days) or whoever buys on company X, someone has to sell it to him at a price that both agree on. And last time we checked, nobody holds a gun to the head of Prime Broker Y (which may or may not have an immediate risk pass thru with "AIG Z", although these days more likely not) to sell these CDS at a price that is determined at arms length negotiations. A first year analyst can do a waterfall analysis and determine what the equivalent bond recovery is, contingent on a CDS level of XYZ bps. Then that same analyst can express a directional bet on the underlying asset value - and if he/she can find someone in the marketplace to take the opposite side of that bet, it will happen: after all that's what free markets are all about (and we are not talking about HFT in CDS, although the irony is that now that a clearinghouse is much more tangible, rumors are swirling that several entities have already expressed an interest in developing High Frequency Trading strategies for CDS. Letting a TBTF hedge fund loose on something like that, where momentum alone would determine risk levels, would truly be the end of the financial world as we know it).

Where CDS opponents do have an argument is when the "raider" is either backstopped by the government, too big to fail, or has a massive economy of scale when it comes to CDS accumulation/hedging capacity. But that is a different discussion altogether, one that gets mixed up in otherwise rational observations of the (f)utility of the CDS market.

And at the end of the day, does CDS really have such a huge cataclysmic capacity? According to DTCC data, net notional exposure for single names is about $1.4 trillion, while index and index tranches add another $1.2 trillion in net risk, for a total of $2.6 trillion. This is about one tenth the total amount that has been backstopped by the US government currently, as Obama attempts to fool the investing public that things in the financial world are once again ok. So if the entire market were to collapse, and assuming DTCC is not misrepresenting netting, a complete implosion of every single CDS contract would only add another $3 trillion to the financial bailout package. That's about 30% of the budget deficit over the next 10 years. Financial Armageddon? Hardly. We already experienced the first and most powerful nuclear bomb when AIG blew up, and when gross CDS notional collapsed from $65 trillion to far less than half. Ironically, the CDS market can somehow police itself best (even when aberrant sinkholes of risk like AIG are bailed out) contrary to what CDS haters would want you to believe.

Ironically, how US CDS can be trading as tight as it is, is a mystery: perhaps Mr. Einhorn should consider the amusing ramifications of a US basis trade in which China decides to bring America to its knees via CDS (already being long and strong the cash leg). Wait, advocates would say that can't happen cause it is a "special situation" as the US can never default. Alas, that is the whole problem with derivatives: everything is a special situation of a special situation (or eventually becomes one, and when it does, it makes someone very rich, and someone else, poor). Truly, where one person finds fault, another finds opportunity. Some can gripe about put options in the same way, others: about Interest Rate and FX swaps.

The bottom line is: in every trade there is a buyer and a seller. What needs to happen is the risk skew has to be eliminated and everyone has to be on equal footing. If an AIG or Goldman is aware that they can sell CDS in a company X all the way to zero because if the bet goes against them, they will be "rescued" by a moral hazard encouraging Federal Reserve. In doing so they will squeeze the natural market to a point where enough opposite bets emerge in order to arrive at some imbalanced equilibrium. The imbalance would disappear if Goldman were to realize that it has the same risk/return profile as a Carl Icahn or any other CDS player. If you want to have an efficient CDS market, remove the government backstops of its core players: AIG some years ago, which was more an implicit understanding of their TBTF status, and Goldman Sachs and all the TBTF banks currently, courtesy of explicit guarantees by the government. That is the first and critical step to making CDS trading sensible.

Even with a myriad of cons, CDS has its pros. Credit Default Swaps provide the most liquid and effective mechanism to express a directional bias. With equity volumes ransacked courtesy of HFT systems and various algos that have taken the equity market to unsustainable valuations all with the administration-backstopped desire to provide the "image" to the retail public (and their 401(k) holdings) that things are ok, it is next to impossible to hedge positions for the downside, as every equity short gets run over (courtesy of the Fed), and purchased puts expire worthless: in essence the equity market is broken from a hedging perspective. This only leaves fixed income as some semblance of providing a hedging opportunity. This of course excludes cash bonds (good luck finding borrow to offset long bonds anywhere even close to 1:1), thus leaving asset managers with only CDS as a natural hedge to any and every risk imaginable: from corporate, to duration, to interest rate, to counterparty.

All those who would see CDS extinguished, should consider that without this most liquid product, there will practically be no way to express bearish opinions on the most critical part of the  capital structure. And as we live in a valuation vacuum and true enterprise values are well below the equity tranche for the bulk of corporations (yet above 0, we hope), CDS is precisely the principal and only way to express a valuation bias for such time as the Fed decides to stop fighting the market and tightens (which may or may not happen in our lifetimes). Absent CDS, we will revert to the day when the mutual funds could only go directionally long, and when selling begins, look out below with no natural bids on the way down. A CDS ban is to the fixed income market, as a shorting ban is to equities (and a much more dangerous version of an uptick rule which the SEC is once again curiously investigating. Apparently S%P 1,100 is not enough for Larry Summers).

The best outcome for all involved is not seeking a ban of all CDS transactions (well, maybe it is, although it is as impractical and, well, futile, as crusades get) but an exponential increase in transparency of everything related to the product. Even with all the recent so-called opacity removing measures, we challenge Barney Frank to show us one free, open, and public venue where we can find what the bid-ask spread on Goldman Sachs CDS (1 through 10 year) is at any one moment during the day (a 15 minute delay work just as well). It simply does not exist, unless, of course, one is a wealthy client of QuoteVision, MarkIt, or one of the many investment banks that blast out CDS levels every time they print or are looking for naturals. Talk about a two-tiered market. Furthermore, a centralized clearing system would be a tremendous improvement as that may be the only way to aggregate this data (which would allow a much more efficient CDS market, than merely one which can be used and abused by a select cadre of hedge funds and investment banks). Of course, due to the immediate margin compression for the broker dealers that this increased informational efficiency would translate to, one can expect even a clearinghouse not be a realistic outcome for many, many years. And lastly, why not just open CDS to retail participation as well? If Joe Sixpack is allowed to trade in equities, cash bonds, and options, let him trade in CDS as well. If collateral needs to be posted in order to do so, fine. But open the CDS market up to everyone: why should it be the plaything of the rich and famous, while 99% of the investing population is unable to participate, and thus have no say whatsoever in what appear to be such "high level" CDS-banning negotiations.

Lastly, CDS opponents seem to forget that there are daily actual physical collateral netting arrangements at the end of every single day between OTC counterparties in any given CDS trade. Thus, the threat of a massive imbalance in the market would result in a liquidity impact of net positions only from the time it opens (around 6 am domestically although CDS are traded 24/7 courtesy of the market being open somewhere in the world all the time) to the point intraday when there is a risk flaring event. Everything prior to any given day will have been squared out and neatly tucked away under lock and key. As such, the CDS trading risk is far more contained than the informational surprise courtesy of assumptions about a bank's balance sheet which usually hide7 hundreds of billions more in mismarked assets that the entire CDS market netted. In other words, if every single bank's assets were to be marked to a realistic market, the fall out would be far, far worse than the abovementioned $2.6 trillion in net notional risk arising out of CDS. And likely orders of magnitude worse. Yet the two are, of course, intertwined: with all assets now trading as one major class (we refer readers to recent charts of implied correlations), a sudden and dramatic reversal would likely also have a disastrous impact, but not because of CDS (although the former would not help), as all market players rush for the exits. At this point, as Zero Hedge has long been warning, not even printing another $23 trillion in actual dollars (printing, not mere guarantees) won't save the financial system.

And while Einhorn is discussing banning CDS, why is nobody more concerned about the $1.2 quadrillion in interest rate exchange traded and OTC swaps currently in circulation? The IR market is simply the latest and greatest bandwagon idea out there, leveraged to the nth degree. If you want an Armageddon scenario, look no further than this. The cataclysm scenario that nobody is contemplated, simply because it is simply so improbable (where have we seen this before?), is what would happen when there is a black swan event at the core of the fiat monetary system: be it a failed US auction, or a parabolic move in the price of gold. At that point, watch for $1.2 quadrillion in interest rate bets to politely (or not) line up in front of the single file exit door of the burning theater. This begs the question: who has "sold" this incomprehensible amount of IR protection, and has bet the ranch, city, country, and basically all of capitalism, that a black swan in the IR arena will never happen? If you want to find your next AIG, find the answer to this question. Which is why, if one is dead set on banning CDS, one should also ban IR swaps, and virtually all derivative products, as all these asset classes reinforce one another. But the problem is that all derivatives do, when one gets down to it, is provide a monetary equivalent for the global lack of assets, as the globalized economy has gotten far too big for its own good. Fiat banking hard at work.

Remember the liquidity pyramid?

As the graphic shows, derivatives account for 1,000% of world GDP, in essence allowing the world to believe fiat money is worth something only courtesy of financial sleight of hand which involved derivatives and securitizations. Yet all those calling for an end to CDS also have to realize that due to CDS intertwined nature, the world fiat system would need to do away with all derivatives (not just CDS), and when you do that you basically eliminate the other hybrid asset classes: securitizations being chief among them. What this would leave us with is a liquidity pyramid which ends with bank loans, which are much more manageable and whose risk can be controlled. It would also leave the world with a fiat currency system, which would lose about 10x of its value overnight, thereby leading to an instantaneous and global unwind of fiat money, and rolling waves of domestically denominated hyperinflation. A spectacular race to the bottom of the asset pyramid. And who will rather commit suicide than see that happen: why the Federal Reserve of course.

Which brings us full circle: an attack on CDS is an attack on excess liquidity, which is an attack on the global asset/liability imbalance (as world GDP and otherwise output has no chance of catching up with the liquidity that is currently available), which is an attack on fiat money, which is an attack on the perpetually low price of gold (because if and when derivatives and securitizations are done away with and tangible assets regain their true value, gold would go up by at least the same magnitude that fiat currencies are devalued), which is an attack on the heart of our broken financial system itself, and, an attack on the Federal Reserve, the Fractional and Central Banking System in principle. Well done David.

We hope Einhorn is successful in bringing more people to understand not just what the risk implications of CDS are (while also demonstrating the positive value that they do in fact provide in a rigged and broken capital market), but also what the underlying thematic subject of his attack really is: a busted fiat system. In essence, David believes in a fresh start. So do we, because on a long enough timeline...

 

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Sat, 11/07/2009 - 15:14 | 123515 Anonymous
Anonymous's picture

umm. we were giving 500000 mortgages to people with no jobs and at that time there was no backstop from the government.

Sat, 11/07/2009 - 18:33 | 123602 anynonmous
anynonmous's picture

edit (redundant)

Warren (all in bet on America) Buffet sees CDS profit of $1.44 billion in the third quarter

http://www.bloomberg.com/apps/news?pid=20601087&sid=aZ7k46r1Ylqs&pos=3

Sun, 11/08/2009 - 11:29 | 123867 Jim B
Jim B's picture

Quote from NY Times article "Mr. Buffett was just as scathing on the subject of derivatives, which he had likened to weapons of mass destruction long before they started eviscerating the balance sheets of banks around the world."

Did I miss something, or WB doing the do as I say......

Sat, 11/07/2009 - 15:26 | 123524 Anonymous
Anonymous's picture

Absolutely brilliant analysis.

Sat, 11/07/2009 - 16:13 | 123556 DiverCity
DiverCity's picture

Second that!

Sat, 11/07/2009 - 17:58 | 123608 Careless Whisper
Careless Whisper's picture

$500 Ta Ta Trillion in CDS and they net out to a $2 Trillion exposure? Yeah right.

Apparently Einhorn struck a nerve.

The spreads on the CDS are too lucrative for the Squid to give up.

"Banks" which are hedge funds in practice, shouldn't be trading CDS with taxpayer backed funds.

 

Sun, 11/08/2009 - 11:24 | 123865 Jim B
Jim B's picture

"Banks" which are hedge funds in practice, shouldn't be trading CDS with taxpayer backed funds.

+1000

Sat, 11/07/2009 - 15:28 | 123527 Unscarred
Unscarred's picture

Great article.  I like your perspective, TD.  One question: what would the the most likely scenario (and subsequent probability- guess that doesn't matter any more, though) that we see a significant interest rate swap disruption on par with the credit pinch in late September '08?

Sat, 11/07/2009 - 15:30 | 123531 Anonymous
Anonymous's picture

Is it any coincidence Einhorn is long an excessive amount of gold?

Sat, 11/07/2009 - 16:38 | 123569 Missing_Link
Missing_Link's picture

So are a lot of smart people.  Like John Paulson.

Sat, 11/07/2009 - 17:31 | 123593 deadhead
deadhead's picture

anybody know if JP bailed out on the bac or rf positions?  thanks in advance

Sun, 11/08/2009 - 10:46 | 123848 chumbawamba
chumbawamba's picture

And like Chumbawamba.

And I happen to be Chumbawamba.

Thu, 11/12/2009 - 01:33 | 128067 Missing_Link
Missing_Link's picture

Grow the fuck up.

Sat, 11/07/2009 - 15:46 | 123543 Anonymous
Anonymous's picture

Listen to this guy...make a good point on china/gold...and it removes the intervention component from West.

Pierre Lassonde is one of the living legends of the mining and resource world with over 35 years of experience. He was able to build up and successfully merge Franco Nevada into Newmont Mining in what was In this interview Pierre discusses the gold bull market, the Indian Central Bank purchase of gold, competitive currency devaluations, the Dow/Gold Ratio, the undervaluation of mining shares, junior mining shares, the oil market, future consolidation in the mining sector and more.

http://tinyurl.com/yzfvqts

Sat, 11/07/2009 - 19:50 | 123649 Spitzer
Spitzer's picture

I am doing what ever Pierre Lassonde is doing.I trust his 35 years of  experinence. His royalty company has no debt and a current and quick ratio of 26.

Sat, 11/07/2009 - 15:50 | 123544 Anonymous
Anonymous's picture

Great insight. The fact that we have seen almost incessant derisking in DTCC data since the March lows and yet spreads have compressed says something perhaps about the largest CDS market makers willingness to soak up risk with little thought to downside (apparently). The fact that GS and others can write protection knowing that if all ends badly, the government is there leaves many CDS traders 'nervous' to enter anything but arb or RV trades...

Sat, 11/07/2009 - 16:09 | 123553 sgt_doom
sgt_doom's picture

Frigging brilliant, TD, absolutely frigging brilliant!!

You had me going for awhile there; I was beginning to believe in Santa Claus, his Elves, Tinkerbell AND Godzilla.

But the culmination of your brilliant blog/article/exposition brought forth a "Holy Mother of Godzilla!!

So, fundamentally, credit derivatives are, or have been and can be, modelled as a financial virus and controlled by specific parties.

Which more than a few now believe to be the thinking behind their original design.

Interesting....very interesting.....

(Although full credit should go to economist Paul Craig Roberts - not Einhorn - who brought up these very points quite some time ago.)

Although I did happen to see a recent article where Terri Duhon (creater or the BISTRO when at JPMorgan) did still believe CDSes were neat!

Sat, 11/07/2009 - 16:13 | 123555 pinkboxtrader
pinkboxtrader's picture

bit of an (un)intentional derail here but does anyone have any compelling readings as to why derivatives are a good thing? (theoretical basis) what do they facilitate that isn't otherwise possible? ie. why is the answer not simply reducing risk asset exposure instead of entering a 'hedge' contract? reducing exposure is a 100% perfect hedge and reduces systematic transaction costs. what am i missing here?

i used to think financial engineering was for the sake of real businesses to offload risks unrelated to their core competencies, but with the 'buy stocks as USD weakens because of repatriation of foreign sales' theme i see that currency hedging by legitimate business isn't nearly as comprehensive as i once thought. (why purchase the insurance when you can speculate on a downtrending USD as an exporter of tractors!?!)

Sat, 11/07/2009 - 16:23 | 123561 Pizza Delivery Man
Pizza Delivery Man's picture

"reducing exposure is a 100% perfect hedge and reduces systematic transaction costs"

Why buy insurance on your car when you can just get a cheaper car?

 

Sun, 11/08/2009 - 11:28 | 123866 Anonymous
Anonymous's picture

Why indeed! If you can afford to replace the hardware, then as long as you have too few "available " assets you can leave the liability costs to be socialized. It's the new norm!

Sat, 11/07/2009 - 17:07 | 123580 Anonymous
Anonymous's picture

How does, say, anairline reduce its exposure? It needs x thousand gallons of jet fuel. Enter a long-term contract and you risk falling prices, so you want to hedge. Buy on the spot market and you risk rising prices, so you want to hedge. The analysis is the same for most parties that enter into derivatives. Not all, but most.

Sun, 11/08/2009 - 14:43 | 123978 sgt_doom
sgt_doom's picture

"..does anyone have any compelling readings as to why derivatives are a good thing.."

Anything published by JPMorgan Chase, Goldman Sachs, Morgan Stanley and the Fed will make that "compelling" argument.

And truly, what they facilitate are debt-financed billionaires, and that cannot be repeated enough times --- especially as we know what happens to their debt!

Sat, 11/07/2009 - 17:18 | 123586 lizzy36
lizzy36's picture

That was a very illuminating Tyler.  Thanks. 

Question:did you ever discover who has taken AIG's place on the street @ the chief seller of CDS?

Sat, 11/07/2009 - 17:35 | 123597 Printfaster
Printfaster's picture

My money is on the Fed and its agents.

No other way to explain the yield curve versus the implied risk.   The US Treasury cannot pay its bills.  Why on earth can they get the ridiculous yields that they do?  Someone is pressing on the levers, and no bank other than the Fed could be holding those levers.  Unfortunately, the CDSs have no CUSIP numbers.

Rather like the Wizard of Oz behind the curtain.

 

Sun, 11/08/2009 - 14:46 | 123981 sgt_doom
sgt_doom's picture

Agreed, Herr Printfaster, with JPMorgan Chase, Goldman Sachs, Morgan Stanley trailing behind, and Deutsche Bank and Credit Suisse bringing up the rear.....

Sat, 11/07/2009 - 17:27 | 123591 unemployed
unemployed's picture

 Totally agree with your comment TD,  "why is nobody more concerned about the $1.2 quadrillion in interest rate exchange traded and OTC swaps currently in circulation"    There should be some case studies published about what the market manipulators have done with all the different swaps.  Just as the naked short,  buy puts and bonds and CDS on the bear target is a well known strategy,  there must be similar ones in the interest rate and FORex worlds.

 Wished you had a few more words for the opaqueness and complexity of the swaps.  Evidently there are lot of seller and buyers who did not hire that "first year analyst"  and or also missed some of the salient valuing features and possible valuation changing events.

 Before the end of the day,  mortgage securitization valuations were all flawed.  So I disagree with your thinking that CDS valuations are accurate despite the effect of the daily collateral postings.

Sat, 11/07/2009 - 17:56 | 123610 bruiserND
bruiserND's picture

 One of the most scholarly & important macro economic / finance articles of our lifetime.

 

 

FALL OF THE REPUBLIC, parts 1 & 2.

  To view online:  http://www.youtube.com/watch?v=VebOTc-7shU  
Sat, 11/07/2009 - 20:05 | 123654 Spitzer
Spitzer's picture

hahaha fuck that video, its a joke. So nothing is ever going to go wrong with the plans of these so called globalists ?

Sat, 11/07/2009 - 21:11 | 123673 bruiserND
bruiserND's picture

Ashley Dupre thinks youre  stupid because you left a paper trail.

She also said your pecker is little & limp .

Nothing has gone wrong with their cram down plans for a decade so why should they go bad now?

Near a million have watched the 2 hour video.

 

 

Sun, 11/08/2009 - 05:43 | 123786 Apocalypse Now
Apocalypse Now's picture

Hahaha - Nice

"We are grateful to the Washington Post, The New York Times, Time Magazine and other great publications whose directors have attended our meetings and respected their promises of discretion for almost forty years. It would have been impossible for us to develop our plan for the world if we had been subjected to the lights of publicity during those years. But, the world is now more sophisticated and prepared to march towards a world government. The supranational sovereignty of an intellectual elite and world bankers is surely preferable to the national auto-determination practiced in past centuries." -- David Rockefeller

How would the folks here at ZH like a supranational sovereignty of an intellectual elite and world bankers?  There are times I have wished both the population and selected leaders were smarter, and I can appreciate the allure of eliminating the need for war or WMD by placing agenda compliant leaders throughout the world subserviant through the banking control system (trillions in derivatives & debt), but would his selection of agenda subserviant elite and world bankers make the world a better place?

These people appear to be heirarchical, close minded, dominating, authoritarian, population control genocidal, and controlling - the opposite of a freedom loving people.  They will most assuredly impede our pursuit of life, liberty, and the pursuit of happiness and the bill of rights stands in their way.  They want to rule the world, including you and your body - they can exercise that control through the state (subserviant politicians placed for obedience) or any concentrated power base - all the small and medium sized businesses are inefficient for a heirarchial command and control structure, but the big corporations, GSE's, and governments fit into this structure. 

Check out this short Twilight Zone clip http://www.youtube.com/watch?v=_b9aNclVopk

Sun, 11/08/2009 - 00:15 | 123732 Anonymous
Anonymous's picture

Scholarly? Perhaps for the Primary School crowd. Virtually every comment by every interviewee is "They control everything blah blah blah", and "Their plan is to control everything blah blah blah". Then "back it up" with an out of context comment accompanied with a dramatic background score. Oh, and make sure to show a few smiling faces of the elite so as to make it seem they are laughing at YOU.

This sort of yellow journalism has an audience among those who never stray far from home, and who would be scared and confused if they did. I'd love to see one of those Cabal gatherings with the Rothschilds sitting at the same table as Li Kai Shing and the Mori's and Carlos Salim and the Ambani brothers (on opposite sides, of course) plus Soros and Steve Cohen and the Makhtoum's and al-Thani's and Khalifa's and al-Rajhi's and Putin ....etc. No doubt they're all just the best of buddies.

Very silly.

Sun, 11/08/2009 - 13:02 | 123923 bruiserND
bruiserND's picture

I refered to Tyler Durdens article as scholarly.

The video addressed "motive & "intent" which no one has investigated, held hearings or been convicted.

 "There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." -Ludwig Von Mises

Sat, 11/07/2009 - 19:05 | 123624 george
george's picture

I have been enlightened time and time again by reading your blog.

Sat, 11/07/2009 - 18:47 | 123629 Fish Gone Bad
Fish Gone Bad's picture

Einhorn is my idol.  Anyone who can beat up a girl, in this case the alpha female of wall street, is A-OK in my book.  </humor>

 

Sat, 11/07/2009 - 19:20 | 123639 putbuyer
putbuyer's picture

If you ever needed to justify why ZeroHedge is it! - enough said.

Sat, 11/07/2009 - 20:15 | 123656 buzzsaw99
buzzsaw99's picture

Selling insurance against interest rates going higher is not what I'd call risky. I'd be selling it myself if I thought I could get away with it. How much moreso for those in the know who are also too big to fail? No way rates skyrocket, no frikken way. It is a bet on fedres and fedgub manipulation.

Sat, 11/07/2009 - 20:57 | 123672 Ned Zeppelin
Ned Zeppelin's picture

Kudos, TD - this should be published elsewhere, to a broader audience. Fascinating dissection of an opaque subject.  Merits several readings.

Sat, 11/07/2009 - 22:26 | 123694 Anonymous
Anonymous's picture

Honestly, I get real tired of the deitization of CDSs, sorry TD. The flat facts are that they are basically OK, they serve their purpose, but like Sgt Doom (123553)alludes, they aren't benign. Indeed, as Lizzy36 asked (123586), "who's the new AIG?

The issue is purely one of no price discovery -its all off exchange transactions. Yeah, yeah, yeah, its between two consenting , fully informed and sophisticated parties.

Its funny the change in behavior that occurs when you suggest CDS get traded on an exchange. Apart from the difficulty and capital risk an exchange would have, the bright sunlight of open visibility seems to bring on a Draculean response, or at least on that implies the suggestor is somehow not adult or smart enough to handle the trade.

Did I mention no requirement for reserves against what is an insurance contract? Once again, the behavoir changes. Do the sidestep, baby

Agreed that Einhorn may be talking his book, but that's about all. Put some sunlight on price discovery, and reserve for potential losses, and CDS are on its way to legitimacy. Absent that, its the underlying cause of the next collapse, just like the last

DH- yeah, exactly: who's on the other side of RF? or WFC...and by what multiple...

Sat, 11/07/2009 - 22:34 | 123700 Anonymous
Anonymous's picture

david einhorn is in on it...he is one of the bad guys.

http://www.deepcapture.com/well-its-nice-she-landed-on-her-feet-sec-enfo...

Sun, 11/08/2009 - 00:08 | 123730 tom a taxpayer
tom a taxpayer's picture

Brilliant, eye-opening analysis, TD! 

That Liquidity Pyramid looks like a Titanic-financial-system-busting iceberg.

Sun, 11/08/2009 - 00:24 | 123734 laughing_swordfish
laughing_swordfish's picture

Tyler:

EXCELLENT DISCUSSION.

I have printed out both your piece and Einhorn's piece as a fairly complete and BALANCED exposition of both sides of the CDS controversy, and am circulating both to my wardroom for further discussion.

Everybody had best study, as there will be a "pop quiz" Monday.

I don't have a problem with CDS's in particular or derivatives in general, but I am concerned that there are "no rules" governing this huge percentage of total liquidity and that if and when such rules and regulations are written that they will be strictly for the benefit of the TBTF players - and certain cephalopodic marine predators.

 

KptLt. laughing swordfish

9er Unterseeboote Flotille

Sun, 11/08/2009 - 14:39 | 123973 sgt_doom
sgt_doom's picture

"I don't have a problem with CDS's in particular or derivatives in general,.."

I suspect that is due to a lack of understanding (no criticism implied here, it has taken me some years to fully comprehend the credit derivatives market, the credit default swaps subcategory, and the history of securitized instruments and its previous appearance leading up to the Great Depression - the first one in the '30s, that is).

Credit derivatives in general (and there are now over 3,000 categories and growing) and credit default swaps in particular, work as a reverse insurance pool.  Instead of thousands of of people funding one pool, from which the injured party will receive a proper payout, the credit default swap is generally structured the opposite:  one individual or corporate entity purchases thousands of credit default swaps against one borrower (an unlimited number of CDSes can be purchased against one entity, you realize?), and then the purchaser burns down their house, so to speak, thus receiving payouts on thousands of policies, all unknown to the original borrower --- thus providing for the perfect insurance swindle!

Instead of the oft-repeated "transferring risk" or "removing risk" what in reality occurs is the compounding of risk to infinity.

This entire scheme is designed to allow for ultraleveraging, with the principal result - by design - of debt-financed multi-millionaires and billionaires.

Sun, 11/08/2009 - 15:55 | 124010 Anonymous
Anonymous's picture

Great analogy! This comment alone would scare the crap out of any reasonable person. But of course, those reasonable people are not the billionaires, who -- of course -- control the media.

Sun, 11/08/2009 - 05:54 | 123792 Anonymous
Anonymous's picture

Thank you for this article.

I LOVE CDS!!

Sun, 11/08/2009 - 06:32 | 123795 Anonymous
Anonymous's picture

"At that point, watch for $1.2 quadrillion in interest rate bets to politely (or not) line up in front of the single file exit door of the burning theater. This begs the question: who has "sold" this incomprehensible amount of IR protection, and has bet the ranch, city, country, and basically all of capitalism, that a black swan in the IR arena will never happen?"

Hmmm...who believes in "unconventional" monetary policy solutions? Who keeps trying to tell Congress that the world as we know it would come to an end if his organisation was audited?

Sun, 11/08/2009 - 07:53 | 123801 Stevm30
Stevm30's picture

not even printing another $23 trillion in actual dollars (printing, not mere guarantees) won't save the financial system.

don't you mean "will save"?

 

Also - what does the "fresh start" look like?

Sun, 11/08/2009 - 10:00 | 123831 Anonymous
Anonymous's picture

Retail can trade cds at this website:

http://www.traccr.com/index.php

Sun, 11/08/2009 - 10:42 | 123844 chumbawamba
chumbawamba's picture

Wow.  After reading this I've come to realize that the finance industry is a waste of humanity.  We should close down Wall Street entirely and put all those good people to work in the fields to provide some actual value to humanity growing food.

I am Chumbawamba.

Sun, 11/08/2009 - 11:20 | 123863 Anonymous
Anonymous's picture

Go home, you pathetic daytrader, go home

Oh wait, give you're a DAYTRADER you're probably already AT HOME....sponging off other hard working americans.

Sun, 11/08/2009 - 15:26 | 123999 phaesed
phaesed's picture

That was one of the best articles I've read, thank you very much. Also, thank you for pointing out printing versus guarantees/credit.

Sun, 11/08/2009 - 19:06 | 124089 jippie
jippie's picture

It's just as sgt_doom pointed out.

The problem is the same with all derivatives:
In THEORY derviatives serve a purpose as they make a market more complete, thus allowing people to hedge risks (by creating replication strategies). In theory derivatives help price discovery, as specific risk profiles can be priced by the market.
A complete market is desirable as it implies no arbitrage opportunities, or put differently every contingent claim can be perfectly replicated by using the available instruments.
This is all basic Mathematical Finance theory, or at least in Germany where I learnt it.

HOWEVER, in practice derivatives lead to the exact opposite. Our human nature loves gambling, thus it is perfectly clear that there will always be more speculators than hedgers, especially the more speculating opportunities there are available.
This means that derivatives START off being used for hedging purposes (the way it is meant to be). This is quickly perverted into increased risk taking. In addition, given that the actual risks cannot be calculated accurately (only by 'models' that all turn out to be horribly wrong at some stage) the enhanced 'price discovery' only exists in flashy WS brochures.
The result is that market participants take more and more leverage and risk through derivatives which they would not be able to do otherwise. Derivatives are the building block of the Global Casino that all financial markets have become.

To think that CDS are the only way to express negative vies may be right. But if an investor buys an unlimited amount of CDS of a single firm, and eventually brings the company down to its knees, this has nothing to do with expressing a view. As the 'view' is self materializing by the reflexive impact of the purchase of CDS itself. t.

Sun, 11/08/2009 - 20:39 | 124146 panda6
panda6's picture

Please provide evidence of a company ever being brought down by having too much cds bouht on it......

 

As this article points out...you can't buy cds without someone being willing to sell it to you....

Mon, 11/09/2009 - 00:28 | 124303 bruiserND
bruiserND's picture

whoever wrote this is a very bright person.

 

I love ZH

Mon, 11/09/2009 - 04:16 | 124420 Anonymous
Anonymous's picture

I was with the author right up until the end - when he said that abolition of all derivatives would result in a 10x devaluation in fiat currency. It seems that such a contraction in money supply/deleveraging would result in revaluation at a HIGHER rate. Also, it was convenient segue to conclude the entire segment with "BUY GOLD". Sorry kids, I think everybody is unloading that gold they bought in the 80s for $800/oz. So you'll be holding your $1100 gold ounces until... about 2030? Bash away, goldbugs.

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