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# CDS Implied Probability of Default – Be Careful

Submitted by Peter Tchir of TF Market Advisors

CDS Implied Probability Of Default – Be Careful

Unless something changes in the next 24 hours, I expect we will hear more and more talk about default, not only of Greece but of other countries and of banks.  Just in case that happens, here is some information that may help you make good decisions.  There will be lots of chatter about the “likelihood of default” the CDS market is implying, but although it can be a useful statistic, it can also be very misleading.  Before jumping into trades based on erroneous assumptions, it is worth spending a few minutes reading this.  If all it does is confuse you, maybe that is a good thing in itself, because you won’t take a headline about default probability as fact.

Recovery is Key and is often assumed away making default probability calculations less useful

Let’s start with a simple example.  You have bonds of 2 different companies, each maturing in the near term, both trading at 70.  What is the probability of default of each of these companies?  You don’t know because that isn’t enough information.  You know the bonds are trading at 70, and without a default they would pay par, providing a 30 point return.  What you need to know to figure out the probability of default, is what the recovery value will be.  Let’s assume that the recovery value for one company is going to be 60 and for the other will be 10.  Then in the first case, the default probability is 75%.  There is a 75% chance an investor would lose 10 points, and a 25% chance that they would lose 30 points, giving an “expected” value of 0 (today’s risk free rate).   In the second case the default probability is only 33% (66% chance of 30 point gain plus a 33% chance of a 60 point loss).

So recovery is a key element of determining what default probability the market is pricing in.  Yet, although it is key, it is often assumed to be 40% or some other number based on historical averages.  That is a reason to be very concerned when you see a default probability mentioned.  It is useless without looking at the recovery value, and recovery value isn’t easy to figure out.  Recovery value is figuring out the enterprise value of a company after it has defaulted.  It is not any easier than figuring out enterprise value of a company that is not in default, so treat estimated recovery values with the respect they deserve.

In the CDS pricing model, there are 3 key variables:  the spread, the recovery value, and the up-front premium.  If you know any 2 of those 3, then you can solve for the other.  The market trades with the assumption of 40% recovery.  That let’s traders quote a spread, and then the up-front premium is just a calculation.  This is done more out of convenience than anything else.  Agreeing to a recovery rate on each trade would be time consuming, and 40% seems reasonable enough for the purposes of calculating the up-front.

For high quality (tight spread names) the up-front premium is not very sensitive to recovery.

For names that trade at 400 over (BAC for example), the probability to default over 5 years is 21% with a 10% recovery, and 51% with a 70% recovery.  So you need to take any probability of default derived from CDS prices with a grain of salt.  Without a rational assumption for recovery, the probability of default is somewhat meaningless.   Since changing recovery would change the “up front” premium, you could try and argue that the recovery must be valid.  I would argue that the smartest credit investors figure out what premium they need to earn to take the risk, based on their assumptions, and then figure out what spread in a 40% recovery model world gives that up-front premium.

At the other extreme, names will eventually trade in “points”.  With a 40% recovery in the model, there is no spread that can give an up-front premium of more than 60.  If a dealer was willing to buy protection and pay 55 points up front, or sell that protection at 57 points up front, most investors wouldn’t complain about the liquidity.  It would be as good as in the bond market.  On the other hand, if the same dealer quoted that market as 3470/4430 some client might argue that 1000 bps seems egregious.  Also, if a company has a bond trading at 35, dealers will not want to floor recovery at 40 since a bond trading at 35 shouldn’t exist if recovery is 40.  So as default becomes more likely, the model becomes less useful.

The Curve is also important

For simplicity and market convention, the 5 year cumulative default probability is based on a flat curve.  As a situation deteriorates it becomes more important to look at each point on the curve.  Two names trading at 1000 in 5 year CDS would have the same implied probability of default from the standard model.  But if one is trading “inverted” at the short end, and the other is steep, then at the very least the timing of default that is being priced is very different.  An inverted curve means the risk of default in the near term is much higher.  If you, as an investor are going to make decisions based on default probability headlines, you need to look at the curve.  The 5 year default probability is a nice headline, but the devil is in the details.

Sovereigns are even more problematic when divining default probabilities

Sovereign CDS for Eurozone countries trades in USD.  CDS on US government debt trades in Euros.  This helps explain why CDS trades so wide for many sovereign names.  If you bought €10 million of a European sovereign at par, and it defaulted, recovering 40%, you would have lost €6 million.  If you had bought CDS in Euro that trade would basically offset it.  If you bought protection in \$’s and the exchange rate was unchanged, you would break even on the trade.  But many investors believe that a default of a European sovereign would cause the Euro to get a lot weaker.  So let’s say at the time of the trade the FX rate was 1.40.   You would need to purchase \$14 million of CDS to cover the €10 million bond position.  If the default occurs and the FX rate went to 1.20, then you would have made \$8.4 million on the CDS trade, which when converted back to Euros at 1.2 is now €7 million.

If investors believe an FX move is highly correlated with default, they will pay more for CDS.  They make more on their negative view than they would if the FX trade wasn’t embedded.  Similarly they lose less if the market rebounds.  Their position in the bonds will go up, while their losing position in CDS gets converted back into more expensive Euros, thus mitigating their losses.

So on sovereign CDS, particularly at times of stress where the market clearly believes that  a default is bad for the currency, the CDS spread is not just pricing in default, it is pricing in default with a currency move, making implied default probability less useful.

On top of that, recovery for sovereigns is purely guesswork.  Creditors have NO rights.  There is nothing they can do to try and collect on their bad debts.  It is purely a negotiation.  That is why the distressed investors don’t do much in sovereigns, because they are used to playing by rules, and in a sovereign default there are no rules.  In some sovereign defaults, shorter dated bonds have received better treatment than longer dated bonds.  That is uncommon in corporate defaults, but not uncommon in sovereign defaults, making picking a recovery value even more difficult.

Cheapest to Deliver Bonds

For banks, financials, and sovereigns the cheapest to deliver option embedded in CDS has less impact on daily CDS prices because they are such frequent issuers.  For companies with fewer bonds, the cheapest to deliver option can impact CDS prices, without really impacting probability of default in the real world.  If two very similar companies existed, but one had only issued bonds at times of high coupons, and the other had issued when rates were very low, the CDS on the low coupon bond company should trade a bit wider.  Investors who like the “basis package” where they buy bonds and buy CDS generally prefer to buy lower priced bonds because they can benefit from a “jump to default” and lock in their basis trade profits sooner than later.

## Comment viewing options

Sun, 09/25/2011 - 11:28 | fdisk

Silver back to \$20?

http://www.clivemaund.com/article.php?art_id=67

wow.. Unless QE3 hit the Markets first, possibility still there.

Sun, 09/25/2011 - 11:36 | oogs66

no way, they have to print there way out of this....inflation is the only strategy they have left

Sun, 09/25/2011 - 11:46 | kito

Wrong oog. No more printing. Your view of how this will play out is simplistic. It is not possible to print enough to make up for the staggering amount of debt/credit destruction that will occur. Cbs know this. They will save the euro and dollar, not debase it. Get out of pms while you can.

Sun, 09/25/2011 - 11:59 | BandGap

And kito, that is far too simplistic on your part.  Don't assume the only players are the US and ECB. There are more than a few X factors.

The funny thing about how this will play out is human nature.  Think along the lines of a poker game, some players do not follow rational guidelines. And a losing night always has its share of irrational fire works.

Best to hold steady until the smoke clears.

Sun, 09/25/2011 - 13:19 | ZeroPower

Agree oogs, they will print. BoE is setup to do so before 1Q12, will see what the Fed decides into the holiday season.

Sun, 09/25/2011 - 19:55 | AldousHuxley

Default is the best antidote to banksters

Sun, 09/25/2011 - 12:12 | Snakeeyes

Kito, what are "pms?"

Sun, 09/25/2011 - 12:39 | boiltherich

Snake, PMs is Precious Metals, and for all you newbies we should post a list of commonly used acronyms to help you out, not everyone with a stake in this economy actually have a degree in finance, and we can't bitch about the economic ignorance of Americans if we are unwilling to help people understand.

So I will post a few and if I get some wrong please correct me, if you have more to add (intelligently) please do that as well.

TBTF= too big to fail

TPTB= the powers that be

cbs= central banks

And then there are the financial instruments like:

CDOs= collateralized debt obligations

MBS= mortgage backed securities

It is early and I know we use a lot more than those, please do add if you can think of a few.

Sun, 09/25/2011 - 13:39 | SamuelMaverick

cds = credit default swap

Sun, 09/25/2011 - 14:36 | Hobbleknee

OMGWTFBBQ

Sun, 09/25/2011 - 14:02 | NuckingFuts

Bitchez = Everyone but yourself

Sun, 09/25/2011 - 14:18 | sasebo

Urban Dictionary is pretty good.

Sun, 09/25/2011 - 14:30 | polak potrafi

Holy fuck!

Thanks for straightening this up.

I've tought that "pms" stands for the premenstrual syndrome...

now everythings starts to make sense

Sun, 09/25/2011 - 22:04 | bid the soldier...

I thought it was sell the fucking dips.

I thought BTFD meant burn the Fed down.

Mon, 09/26/2011 - 00:25 | udecker

Same intended outcome.  Predictable confusion :-)

Mon, 09/26/2011 - 01:06 | boiltherich

Like I said, how can we whine about financial illiteracy if we are unwilling to help those that ask?  We do not even agree about what is going on on among ourselves, if someone comes to you and asks what you mean then if you are a decent person you will answer, like a gentleman.  Did your mother teach you nothiing?

Mon, 09/26/2011 - 01:14 | bid the soldier...

No, it wasn't the "same intended outcome." It was more like the "same" (pick one) accidental, inadvertent, causeless, fortuitous, uncaused unintentional, unplanned, unwitting "outcome."

Hint: I like fortuitous. :o)

Mon, 09/26/2011 - 01:38 | boiltherich

Help those that ask for it, no matter the possible cost to you and your family.  Help them in any way you can.  Give your life and your wealth to help those that ask, it is only right.  Otherwise you are the enemy.  You are one of them, the Timmy.  The Bernanke.  The squid.  The worst thing you can do is to hoard at this point, with the intent to save yourself.

It was a great strategy during the massive upheavals.  But now we are faced with the big fall.  Punish those that brought us the mess, but when people ask for help you give.  If you do not I will hunt you down myself and make sure you do not pollute the gene pool again.  Promise.

Never make fun of those that want to understand, by doing so you show yourself as the worst of posters, and the enemy of those that might survive what is now just days away.

Mon, 09/26/2011 - 03:01 | bid the soldier...

The world you describe is a world without any humor. Is that what you want us all to want? :o(

Sun, 09/25/2011 - 12:27 | BigJim

It is not possible to print enough to make up for the staggering amount of debt/credit destruction that will occur. Cbs know this. They will save the euro and dollar, not debase it. Get out of pms while you can.

What choice do they have? To allow true deflation they'd have to allow house prices to tank. Their puppets would get voted out - or hung from lampposts - and their banks would collapse left, right, and center.

Inflation is the easiest way out. It fools the sheep... in 5 years time, you'll hear sheep all over the West bleating "look, my house has gained 10%! Thank you TPTB" while complaining that energy and food 'costs' have quintupled.

I agree PMs might go lower from here - anything is possible in a world where naked shorting of physical metal is legal - but it seems highly unlikely in the medium/long term. Unless TPTB have got secret tonnes of PMs salted away, ready to deploy to prop up their paper games, their time is running out. And Ag is already 40% down from its high in May.

Like any 'investment', though, never buy more than you can afford to lose.

Sun, 09/25/2011 - 12:24 | Sequitur

Kito I absolutely agree with you. Sold nearly all PMs at a profit, some decent, some small. I've looked at the recent M numbers, and the simple fact is credit/debt issuance >>>> supply of money or "money printing." By many orders of magnitude.

Central banks cannot stop the deflation. They cannot stop implosion of these bad credits and debts. Currencies are going to become more valuable relative to other assets/commodities, esp. when earnings resets are announced over the next few quarters.

And yes, precious metals are going to get killed.

Sun, 09/25/2011 - 12:42 | Hearst

'Deflation' and implosion of debts and credit will take down the fractional reserve based monetary system that currently propagates the planet.  Precious metals stand alone from that system.  'Deflation' in todays situation will bring about the end of fiat currencies faster than steady inflation.  They know this.  They are trying to trick everyone into clutching on to their debt ridden currencies.  Smart investors know the game and know that selling real physical Gold and Silver is the worst possible move right now.

Sun, 09/25/2011 - 15:56 | sqz

The difference between you and Kito/Sequitur is that in option speak, you're long gamma, they are not. You think this will happen a lot faster, either deflationary or inflationary, than the fundamentals or economic history has shown. That isn't to say you are simply wrong, but the facts suggest you are pricing in a likelihood that cannot happen as fast as you think.

In today's modern economies and even trade financing, you cannot do the majority of your transactions backed by PMs, even gold. We're talking many orders of magnitude difference here. If it wasn't happening/spiking exponentially during the once in a century 2008 debacle, which did see a collapse in non-trade backed financing, the likelihood that such massive restructuring of financial terms or fast growth of PM-financing markets is going to happen now is incredibly low. If it happens, it will be slow, seem glacial (and quite possibly painful) to someone who is long PMs on or around these levels, until all the weak hands in these markets are flushed out at likely lower prices.

In the meantime, debt writedowns and business profit reductions combined with slowing emerging markets *leveraged* growth, will collapse the money supply. In short, central bank monetary policy (most importantly at the Fed) becomes ineffective at creating inflation without accompanying strong structural changes, especially fiscal. All types of businesses will be chasing any kind of funding and, on the other side, looking for the safest yields. This largely means you can expect government debt markets to keep screaming skyward and yield curves to both continue to collapse and flatten. This is bullish for their associated currencies.

At the macro level, you can think of it as every state in the world containing many powerful "Japanese" people with savings (the bank intermediaries, other financial institutions and large private wealth), they will be investing in their "Japanese gov. bonds", which in this case since the liquidity haven of the US Treasury market is so much larger than any other gov. debt market, means UST and therefore USD will get bid up. There will also be large investments into German Bunds as the Euro mess plays out, though its much less likely to be Euro supportive in this case but just due to cross-EU flows. Yes, we're all turning "Japanese"!

So, as an individual, sure, hold PMs, but hold them for the right reason and as part of a diversified long-term portfolio. Do not try to trade them based on short term monetary policy reasons in this case because oddly enough, this is one of those rare situations it's precisely because it has failed that we're in the situation we are in today, as evidenced by successive QE attempts without underlying restructuring of past, present or future debt. The world cannot move on without this change and preferably ensuring it cannot happen again at the expense of the overall economic system.

Sun, 09/25/2011 - 16:07 | dpr10

so you say ust rates will be zero forever ha...with all this deleveraging, deflationary environment around you, usd will still be a reserve currency...how will us finance its 1.2-1.5 trillion budget deficit...japan had the same experience but with high savings rates and more reasonable debt levels, not trillions and trillions.....people will flock to pms as they are flocking to dollar now...

Sun, 09/25/2011 - 12:46 | Debugas

deflation can be prevented very easily - Congress borrows money from the Fed at zero interest and gives it away to the main street in the form of food stams, pay-check for digging useles holes  and other welfare benefits.

They will do it right before the elections

Sun, 09/25/2011 - 13:16 | CapitalistRock

You haven't read any of the things Bernanke wrote before becoming fed chairman. The economic depression and high unemloyment that would come from restricting the money supply is clearly not on his agenda.

Sun, 09/25/2011 - 16:54 | WonderDawg

I've read them, and I don't think it makes a bit of difference. Like the other gentleman said, the magnitude of the debt collapse will overwhelm the CBs efforts to stop deflation. So many people assume Bernanke can create inflation or hyperinflation at his whim. I think the markets will determine a different outcome. Maybe the Fed can do it after the debt is defaulted, but not before or during. IMO.

Sun, 09/25/2011 - 17:31 | Vampyroteuthis ...

The credit collapse will overwhelm the market. Achieving inflation with one of the biggest bubbles bursting in history is impossible without going Zimbabwe style in printing which ends up ruining the CBs reputation. They are immoral, but not dumb. The CBs are going to partially implode the debt bubble resulting in collapsing markets with deflation. When the wreckage is near over, the printing presses will fire up, then, you will have your double digit inflation.

Sun, 09/25/2011 - 12:30 | boiltherich

For those who really believe that the folly has to end somewhere... GOTCHA!  Look at this in today's London Telegraph...

£1.75 trillion deal to save the euro

http://www.telegraph.co.uk/news/worldnews/europe/eu/8786945/1.75-trillion-deal-to-save-the-euro.html

Greece, and eventually presumably Ireland and Portugal will be allowed to default on some of their debt but remain in the EZ, while this new \$2.7 trillion EFSF will buy Spanish and Italian bonds with some of the money coming from the IMF/you, and who knows how much more directly from the G20 central banks.  Since this we assume add foreign sovereign debt to the Fed balance sheet it will not affect our own budget deficit directly, it will however impact the dollar and thus our living standards.  No word from China in response so far.

So to those that say they cannot possibly get away with more printing than they already have done I say you just have to use your imagination a little more, don't let it rust in place, get creative.  Timmy might not be the sharpest tool in the shed but by god he has balls and creativity when it comes to destroying the USA.

Sun, 09/25/2011 - 13:36 | boiltherich

Timmy went to the EZ and demanded something mind blowingly large and he got it, almost three trillion in bailouts, call all bailouts before this their QE1, and this is their QE2, what will their QE3 be?  So, while the banksters have just elevated finance into new realms of the stratosphere by adding more zeroes to all numbers in elite money center institutions while we still grub for our daily bread making \$7.50 an hour without benefits at the lower end of the spectrum, even less if you are on a fixed income.  Little mention of where this money will come from, how it will affect core EZ nations, and all to keep SocGen and BNP, Credit Ly, Banque PG, BN de Paris, Agricole, and the rest, not to mention German zombies, out of the shitter.  LET THEM FAIL, along with BAC, WF, Citi, Chase, and the rest, others run by real bankers instead of criminal conmen will rise to replace them and rebuild our collective economies without all the fraud and theft.  PLEASE, we are dying out here, please quit with the stealing.  Wealth is so distorted because of this criminality that nations are now all on the verge of death and depression, it has to end now!

Sun, 09/25/2011 - 15:37 | joshua10

kito, never underestimate the central banks' ability to be simplistic and to take the path of least resistance. It appears that despite tens of trillions of dollars in newly created liquidity flooding the global monetary system since 2008 the net effect has been negative across all the economic metrics that count, unemployment, home sales, price inflation, CPI, etc. Elected and unelected officials feel an overwhelming urge to do "something" when the SHTF even if they know that "something" will be a worthless effort because the greater public at large is not educated enough to know what works and what doesn't work within the economy, and since the public has an attention span of less than a 30 second commercial, they will not remember what worked or didn't work in the past. IMO politicians and central bankers throw liquidity at this solvency crisis knowing full well it will not work this time because it's all the ammunition they have left to use. As global paper currencies are not linked to a gold standard, bankers can print an infinite amount of paper to throw at this crisis to appease an uneducated population thereby opening a fresh can of worms.

Sun, 09/25/2011 - 18:10 | LongBalls

And if deflation takes hold and tax reciepts decline even further how in the hell will they fund the wars and government? Let alone pay for deficit spending? I would agree that the swings are going to force a man to gut check his PM holdings. But in the end we will understand that deflation was never on the table! Central Banks around the world say so. They are buying gold......you hear that....they are buying gold!!!!!

There is no way they will let it deflate and carry this sack of crap debt. And if they tried the American people will scream default or revalue our gold against our dollar debt. The American allies will allow it too. For they are in the same problem and they need our military might despite our financial woes. Libya anyone?

Sun, 09/25/2011 - 11:48 | DeadFred

We're riding this wave without any printing for a least a month. We go where it goes. It's a big wave with a life of it's own.

Sun, 09/25/2011 - 11:37 | Kina

That will depend on the CFTC/JPM. Painted tapes and heavily corrupted/manipulated markets kinda makes TA a joke.

Sun, 09/25/2011 - 11:41 | reader2010

\$Silver's P&F Chart says its next stop is \$16.

Sun, 09/25/2011 - 11:45 | Kina

Well I guess it is possible if JPM decide to sell a gazillion ozs of its invisible silver.

Sun, 09/25/2011 - 11:47 | X.inf.capt

silver at \$16, man, im glad im having a garage sale this weekend, and took my stuff to the surplus store.

at 16, ill give blood and get a paper route,plus work O.T. to buy that dip!

Sun, 09/25/2011 - 12:00 | reader2010

I don't know about you guys. I will be starting to buy when it hits \$20 and on the way down. Because when they outlaw personal owership of gold, silver will go through the roof.

Sun, 09/25/2011 - 21:22 | X.inf.capt

i dont think you understand, reader,

i wasnt being sarcasic, i did have a garage sale today, and i did take all my old S-R stuff to the surplus store. i dont need it, im not going to fight in this coming problem. i will lighten my load.

dont worry about all this troll b.s. people are throwing.

i wrote a comment about people dumping phyiscal silver at 39 on weds. in the story called 'disapointment with the fed'. and was promptly nailed to a cross...

yeah, whatbhappened then, 2days later we were down 25%, and after talking it over with the boys, we figured a lot of well connect money had more than just an educated guess.

Sun, 09/25/2011 - 12:43 | Hearst

\$16 Silver???  I've got a 50k credit line just waiting to be tapped for that kind of sale!

Sun, 09/25/2011 - 13:34 | IEVI

The anti PM trolls are crapping everywhere today.... be careful don't step in anything.

Sun, 09/25/2011 - 17:03 | WonderDawg

Just because someone understands that PMs aren't magical, and are subject to market influences, doesn't make them a troll. I'm definitely not a troll, and I see a scenario that has silver trading at \$16 and gold trading at \$1000 again. I'm not anti-PM, either. Got a nice stack of silver and a stack of gold I hope to add to pretty soon. I'm not emotionally attached to PMs, like some folks are, and when looked at objectively, it's easy to see a large correction coming. When it happens, the PM fanboys will cry manipulation, but the objective observer will shrug and back up the truck.

Sun, 09/25/2011 - 15:43 | joshua10

I can only dream of \$16/oz silver. I will back my truck up to the loading dock of my PM dealer and tell him to bring over the fork lift.

Sun, 09/25/2011 - 13:09 | Thought criminal

Look at Clive Maund's record a little bit more thoroughly - he's been calling tops in gold and silver since gold raised to 1000\$ and silver to 20\$ and was previously (from what I've seen) never right except for this time. 30\$ silver and 1630\$ gold were imo floors, because that was where the very steep raises involving many leveraged speculators started. I really don't see any more downside possibilty especially for gold...

Sun, 09/25/2011 - 11:32 | Victorio

that is confusing...

heres a tip-  just don't fuck with paper

phyzz baby

Sun, 09/25/2011 - 11:36 | PaperBugsBurn

OT but just too good to pass up:

Sat, 09/24/2011 - 19:44 | new bob_dabolina

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I wanted to touch on this comment you made:

(which was just a combination of options expiration coming up, and gold positions being sold to cover losses in other asset classes).
Options expiration are "gamed" because the banks are the largest non-sovereign owners of gold so they can play that on the speculators.

More importantly I wanted to touch on the second part of that sentance. There were a lot of people whom were using housing as collateral during the housing boom because the overall belief was that housing could never go down. Once housing went down everything went with it. The belief with gold is that...well gold has never been worth \$0 so it can only go up...I saw someone lastnight on ZH say that said gold could go to \$40,000 dollars and he had over 60 up votes)

Tulip bulbs have never been worth \$0 and housing (to my knowledge unless the home was destroyed without insurance) has never been worth \$0 either, even the property the home was on would have value.

The point being is that there are far too many people thinking that gold is "the place to be, because it never goes down" but it does, and it has. I also think there are a lot of institutions pledging gold as collateral and if gold goes down....we could be in a world of hurt.

IMHO

Sat, 09/24/2011 - 19:54 | new Dick Fitz

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I was wondering why you were getting junked so hard (I'm new to ZH) but this post explains it- you have no clue as to why gold is going up.

Nothing- land, food, oil- has "intrinsic" value. All value is imputed by the buyer. A vegan has no use for a cow.

Gold has "value" because people all over the world -99% of them, anyway- realize that virtually anyone will trade their gold for the fish they caught, or the coal they excavated, or the house they build, and that allows for a productive division of labor.

I understand now why you get junked- you're a fucking moron retard motherfucker who should get his head out of his ass and look at the REAL world.

(Editor's comments:  roflmao  dabobo is the same guy who said all black people were worthless -with some Canadian redneck named zero_power backing him up)

Sat, 09/24/2011 - 20:11 | new bob_dabolina

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Wait a minute....

You're saying that people are trading gold for

-fish

-homes

-coal

Is that what you're saying?

Yourself is selling gold for fish?

(Boy, I shoulda known he was "special")

Sat, 09/24/2011 - 20:28 | new sitenine

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Try to make enough room in your brain to imagine that your fiat paper money suddenly, for whatever reason, became worthless.  You have 10,000 units of currency, but Joe doesn't want to sell you a loaf of bread for it.  You have an ounce of Gold, and Joe will sell you his entire bakery.  It's not rocket science.

(Psst...Dabobo is a lost cause)

Sat, 09/24/2011 - 20:26 | new BigDuke6 (bigduke???)

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May i come in on this one?  i think bob is balancing some of the (moronic - dick fitz included) arguments here on zh.

my parents spent all my goddam pocket money on an ounce of 9ct (poor persons ) gold when i was age 8.  it would be about the time of the oil crises....

i sold that ounce of gold 25 years later for less than what i paid for it  - and that gold made me no interest in that time...

i'm a gold bull and have been buying seriously for almost 10 years but all the dumb 'gold bitchez' screamers are turning this site away from real thinking.

if china is beginning to unravel then that is my worry on the gold price, we read articles about how all those chinks and indians were going to support the price forever.

i may be keen on gold but i'm not a fool.... not after that first ounce,

if i'm backing up the truck i will pick the time with care

bob, thoughts?

(Dabobo II)
Sat, 09/24/2011 - 20:47 | new BigDuke6

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i was thinking of seriously going all in.... as many on this site perhaps are/were.

but there's a few reasons to b careful.

as an aussie we keep a close eye on china, its demise has been predicted for years.

i hope i have helped readers here when telling them to relax about chinas problems ... that time is over.

(Dabobos in da house!!)
Sat, 09/24/2011 - 21:01 | new Withdrawn Sanction

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A story in the weekend Journal too about slowing luxury car sales after a very strong first half.

Sat, 09/24/2011 - 21:08 | new BigDuke6

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i give up.

time for a holiday.

(Thank God!)
Sat, 09/24/2011 - 20:07 | new Debugas

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Bob, the difference between tulips and gold is that you can grow alot of tulips pretty fast but you can not do the same with gold. As to the housing - the bubble in housing was so huge because houses were used as collateral to keep the credit ponzi going so it is worth investigating how much gold is used as collateral - from 2007 crisis i can say it is just about the amount to drop the gold down by 20-30% not more

Sat, 09/24/2011 - 20:21 | new bob_dabolina

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because houses were used as collateral to keep the credit ponzi going so it is worth investigating how much gold is used as collateral

"J.P. Morgan Will Accept Gold as Type of Collateral"

http://online.wsj.com/article/SB1000142405274870442220457613019245725259...

Gold has been used as collateral to make other investments. That's what I've been trying to say, and NO ONE thinks gold will go down.

(Dabobo say,"Im stupiiiid!")
Sat, 09/24/2011 - 20:44 | new Hulk

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NO ONE thinks gold will go down? I have been riding this bull for 5 years,as have many here, and I'm fairly certain we know it can go down...

Sat, 09/24/2011 - 20:45 | new Bendromeda Strain

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So many strident proclamations lately. Why should paper gold continue to go up once it is proven that it isn't backed by bullion? For the first time in my memory, people are now pointing out the dark side of ETFs, and what if GLD ends up being the granddaddy of all fraudulent indexes? Should it go up? You don't think the custodians of the PM indexes (JPM and HSBC) won't push the game to the supernova flameout end? JPM accepts gold as collateral because they are stacking bullion while selling paper.

Sat, 09/24/2011 - 20:58 | new bob_dabolina

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I think the banks are the largest holders of PM's

If you would like to dispute me than do it.

You're retail. You buy the top and sell the bottom.

(Wasnt that just freaking priceless? These Dabobo characters are drooling and staring cross-eyed while "answering"  comments.)

ZH, not just another dry economics blog...

Comedy gold, by Dabobo!

Sun, 09/25/2011 - 11:41 | Kina

Huh??

Sun, 09/25/2011 - 11:48 | BigJim

Sun, 09/25/2011 - 11:55 | Clint Liquor

Yes, just post a link and quit smoking that shit.

Sun, 09/25/2011 - 12:59 | Motley Fool
Sun, 09/25/2011 - 13:22 | CapitalistRock

Those tulips are worth trillions today. Trillions in the currency people were buying them in, that is. Why? Because the currency is worthless.

Don't get confused by thinking the dollar is the center of the universe and has a fixed value. If Ben doubles M2 and the price of gold in dollars doubles, it isn't because gold "went up" or "doubled".

Oh never mind. Buy your dollars. Someone has to hold them or else we can't get rid of ours.

Sun, 09/25/2011 - 21:02 | IrritableBowels

Fuck off.

Sun, 09/25/2011 - 11:39 | GeneMarchbanks

Is the tension gnawing away at you Peter? Be Careful. K. Great advice thanks for dispensing wisdom.

Sun, 09/25/2011 - 11:39 | Fips_OnTheSpot

That article is complicated -- how will this play in bi-netting and all the domino-"theory"?

Sun, 09/25/2011 - 11:39 | old naughty

Excellent bit of info...So they have 'default' priced in, but not soverign recovery.. Hummmmmmmmmmm.

Sun, 09/25/2011 - 11:42 | BigJim

I love articles like this. They remind me how little I know.

Sun, 09/25/2011 - 11:44 | Mutatto

OT- I have been itching to go long a ZH t-shirt for months.

If/when the Euro goes to parity, I think I might enter a buy order.

Might even go all in with a hoodie, too.

Sun, 09/25/2011 - 12:20 | famousamos

The ZH baseball caps are AWESOME. They have a low profile cut and  lots of structure up front (not flimsy held up by cardboard). I have two. My favorite hats of all time.

Sun, 09/25/2011 - 11:45 | SparkySC

Will ZH get on the Bull Bandwagon really late after this market Gaps up huge Monday?

Or will they point to Mayan/Nostradamous 12/21/2012 to concentrate their efforts if they get their faithful to miss out on a 10%+ up move over the next 2 weeks?

They'll call it a algo hiccup, and don't worry.

Sun, 09/25/2011 - 11:48 | Kina

Huh??? Getting a number of garbled posts this morning. Monkey with a typwriter???

Sun, 09/25/2011 - 11:54 | Cynical Sidney

title should read: CDS Inevitable Probability of Default

Sun, 09/25/2011 - 12:17 | famousamos

I hate asking this question, but heck... I have a TrowePrice 401k that I can't touch unless I get fired or quit. I treid pulling it out a couple of months ago beofre the downturn, but was unable to do so. Not many good 401k options to choose from. Stable value fund has historically been stable, but who knows what they are invested in... looks like a bunch of synthetic BS investments and insurance contracts (CDS?) and I just think when the CDS blow up, these stable value funds are going to blow up. I went with Bill Gross and El-Erian with Pimco's total return fund - mostly because they seem to know what the big picture is. Is Pimco my best 401k option? or am I overly worried on the 'stable value fund' with all it's unknown insurance contract investments?

Sun, 09/25/2011 - 12:29 | TradingJoe

Wifey has same problem put her in pimpco's TR because at the end of the day the guys are connected and might get a "hint" so I figured it's as safe as one can expect it from this crippled joke of a market!

Sun, 09/25/2011 - 13:02 | totem

Same situation, same line of thinking.. similar solution.  I did a split between short term treasuries and Pimco's TR.  Figure USD will be okay short term, and if not, trust Pimco to buy stable bonds of other government, etc.

Sun, 09/25/2011 - 13:11 | snowball777

a) you can 'touch' whatever you want if you're willing to take the tax hit

b) you can buy gold in an IRA or self-direct and buy a whole mess of SKF and SDS should you be so inclined

Sun, 09/25/2011 - 14:35 | DosZap

famousamos

Check with your company, depending on tenure, you should be able to pull out a percentage of YOUR PERSONAL monies invested.

Not the companies share,but it's YOUR money, and most 401k's provide you a way to remove YOUR part, or a percentage(depending on the tenure, and the % ).

I cashed out my wifes portion on a Fidelity 2yrs ago, and got nearly 100% of her PERSONAL contribs out.

Put it into a 401k rollover, and can cash it out whenever  we choose to pay the taxes.

Sun, 09/25/2011 - 18:07 | famousamos

Policy used to be 5 year mark - could pull out all company contributions and gains and pay 10% penalty. Can't touch any of it unless it's post-tax. I've got tenure, and they recommended I take out a loan if I needed the money. (lol).

Sun, 09/25/2011 - 12:27 | TradingJoe

Am sad to read posts from otherwise serious and knowledgeable ZHers! Just few weeks ago they all went nuts where PMs might wind up and now silver will hit 16 and gold will go to 300, don't know if I should laugh or be sad?!
Truth, as always is somewhere in the middle so my question is:

WHAT WOULD A POLITICIAN, HIS BACK PINNED TO THE WALL, DO TO SAVE HIS CAREER, HIS JOB AND HIS VOTES?!

We will see printing, for sure, one last time, one last attempt at "starting things out" one more rip your face rally, PMs going parabolic, but, it will be THE LAST TIME before THE GREAT RESET!

You will see PMs decoupling from currencies and markers(stocks etc) and rest go down and stay there until debt is somehow resolved(I tip some debt forgiveness will do with some of the rich but not gov connected taking the biggest hit) and we can all start fresh as in we can now go about making new debt :)))!

Lots a noise for nothing, I say, live as well and die as hard as you possibly can, rest will be history!!!

Sun, 09/25/2011 - 13:26 | CapitalistRock

No. The truth is nt always in the middle. What a stupid statement. The truth is the truth and lies and misconceptions orbit around it. Some are closer than others.

By your logic I can assume that everything you say is half wrong at all times.

Sun, 09/25/2011 - 14:14 | ping

It's just a phrase.

Sun, 09/25/2011 - 17:11 | WonderDawg

That's classic, CR. Talk about a bitch slap. Well done!

Sun, 09/25/2011 - 19:08 | DCFusor

Indeed it was.  My favorite version of that one is "Some think the sun rises in the east, some think the west, but the truth is probably in the middle somewhere".

Sun, 09/25/2011 - 17:13 | WonderDawg

Well, it's all about the projected time frame of your expectations. I see a lot of predicitons here, but not many actually put a time horizon on it, which is the only way it has any value or meaning.

Sun, 09/25/2011 - 12:29 | buzlightening

Acute silver shortage will be apparent very soon.  All the physical went on sale and China, India, and all the BRICS; along with sovereigns, seeing the writting on the wall, already know fiat paper money always dies a horrible death.  Keep stacking the physical real money gold & silver, as western bankstering has no way out.  Anyone who has accumulated physical for years knows the end game is near and bankstering is convulsing in horror to relieve people of that physical real money.  Let'em take the paper price to zero.  In the street, paper money will not be exchanged for any amount of silver or gold.  What other way could a corrupted system end but in complete destruction; paper money always reaching its intrinsic value zero.

Sun, 09/25/2011 - 12:50 | Hearst

And that's exactly it.  Let them take the price of Silver to \$0 or \$4 per oz.  That will illustrate in real life better than anyone could ever describe how broken the system has become.  Prices and money must come from real life, the real market, real supply and demand.  Since the end of any sort of Gold or Silver standard prices are all artificial!  I like that quote Chris Powell over at Gata says:

"In fact, of course, gold remains the secret knowledge of the financial universe, and its price is actually the determinant of every other price and value in the world."

Sun, 09/25/2011 - 12:45 | Clycntct

How to lose a idiot “Then in the first case, the default probability is 75%."

Can someone elaborate on how a 60 valuation brings about a 75% probability of failure?

Sun, 09/25/2011 - 13:19 | ZeroPower

CDSs matter the most when paying out due to recovery value.

Any CDS that gets triggered because the bond is going to zero doesn't actually go to 0, theres a recovery value associated with that bond, much much lower than par.

In this case, it was just an example as well, there are 2 recovery's, 60 & 10. Weighted average, so 75% is your Pd.

On most CDS threads there are lots of questions on valuation, it would be worthwhile for people in this to google for 'credit default swaps' and valuations, plethora of stuff out there, especially if from MarkIt or the ISDA. Lots of whitepapers too.

Sun, 09/25/2011 - 13:48 | Clycntct

Thainks much.

Sun, 09/25/2011 - 15:09 | Mister Ponzi

It is also important to note that the recovery value of a CDS can be considerably different from the recovery value of a bond of the same company. As the bond's recovery value may only be known years later in some instances (we still do not know recovery values of Lehman or the Icelandic banks), the recovery value of the CDS will be determined in an auction usually some weeks after ISDA has declared a credit event. Participants in the auction are a couple of CDS dealers who - of course - determine the estimate of the recovery rate using fair value assessment without taking into account the position in their books (/sarc off). This led to bizarre auction results in the past. E.g., the CDS recovery rate for Fannie Mae (Senior) was 91.5%, although there was no loss on senior bonds. Simultaneously, the recovery rate for Fannie Mae subordinated CDS was determined as 99.9%.

Sun, 09/25/2011 - 12:37 | RobotTrader

Unfortunately, if we get a global credit event...

Resource stocks will go down 2x faster than anything else

And PM's and PM stocks will go down 3x faster.

Unless they turn this around ASAP, I'd say we are in a 1970's market and we are headed back to the March 2009 lows again.

The key will be to watch the high flyers like GMCR, SBUX, AAPL, etc., it they crack then its game on.

Sun, 09/25/2011 - 13:04 | Corn1945

So after you told everyone to buy GMCR, SBUX, APPLE, etc; you are now telling everyone we are going back to the March 2009 lows?

Sun, 09/25/2011 - 13:54 | Withdrawn Sanction

"Resource stocks will go down 2x faster than anything else

And PM's and PM stocks will go down 3x faster."

That's a very nice summary of Beta, RT.

If there is a global credit event triggering a flight from risk assets, the risk assets' prices fall (deflate). In such an asset deflation, money gains in purchasing power relative to the deflating assets.

Now recall JP Morgan's (the man not the bank) dictum (and no, not "dicked 'em"), that "...gold is money, nothing else." In other words, is it possible that as a result of credit contraction, gold actually gains purchasing power relative to alternative assets. For it to do so, it need only fall LESS slowly than competing assets (which would contradict traditional measures of Beta for PM stocks, but since we aren't in the 1960s anymore...). And given the gold market's tiny size, any selling that does occur should rapidly allow gold to migrate into stronger hands. Lastly, I recognize that gold is not currently (officially) money; but I also recognize that gold HAS been money for thousands of years, while the current fiat money experiment has only been ongoing since <1933, 1945, 1971...take your pick>.

Bottom line, PMs seem as likely as not to behave differently than in past downturns given the scale of the credit and derivative problems involved.

Sun, 09/25/2011 - 12:47 | PulauHantu29

Jeffrey Tucker interviews Thorsten Polleit, Honorary Professor at the Frankfurt School of Finance and Management, and discusses fractional reserve banking:

Sun, 09/25/2011 - 12:48 | mkkby

This whole post needed a total rewrite with the help of an editor.  It did nothing to make this subject clearer.

Sun, 09/25/2011 - 17:22 | WonderDawg

At least he warned us that it would be confusing, but pepped us up by telling us that would be a good thing. He's a master lol.

Sun, 09/25/2011 - 12:50 | Hannibal

DEFAULT is not the end of the world, in fact it's rather very liberating, I know this 'cause I simply walked away from all of my "debt". Freedom at last. Cheers.

Sun, 09/25/2011 - 13:27 | CapitalistRock

Loser.

Sun, 09/25/2011 - 13:12 | bugs_

if they allow default it does mean the peak of this printmania is in.

ending the printmania is far more beneficial to the people of the world than the negative impact of the defaults.

Sun, 09/25/2011 - 13:15 | dwdollar

You deflationist nut-jobs need to read more history.  Nine times out of ten the fiat authority chooses to print when faced with it's own destruction.

Sun, 09/25/2011 - 17:24 | WonderDawg

Sure, they can choose to print. And they probably will. But it will be like taking a piss in the ocean and expecting it to raise the sea level.

Sun, 09/25/2011 - 21:27 | BigJim

Faced with choosing between widespread riots, or printing money to feed the populace... which do you think they'll choose?

Sun, 09/25/2011 - 22:05 | WonderDawg

Read my previous post carefully, BigJim. I said they'll probably print, so we agree on that. The more important point, though, is I don't believe the CB's are all powerful. They'll be overwhelmed by the magnitude of the credit collapse. Deflation will prevail, IMO.

Sun, 09/25/2011 - 22:26 | bid the soldier...

MOVE OVER, JEHOVER, THE CENTRAL BANKS GOT THE WHOLE WORLD IN THEIR HANDS.

"Oh the weather outside is frightful
But the fire is so delightful
And since Bernanke can't take a hint
Let em print! Let em print! Let em print!

Sun, 09/25/2011 - 13:23 | Obvious Paradox

Hannibal, there is a World of difference between a person going BK supported by a healthy (sarc) economy and a Nation going BK supported by nothing. Ask Argentina. I am not looking forward to the inevitable.

Sun, 09/25/2011 - 13:27 | TrustWho

Please send this analytical paper to the simple-minded business TV news media. The beauty models and talking heads need help!

Sun, 09/25/2011 - 13:53 | love

TPTB I thought that was sarcasm implying we were = To Poor To Bail.

Sun, 09/25/2011 - 14:45 | polak potrafi

jeez

with all those CDS-es flying around, I really hope that when something defaults,

everybody else will be safe and deep-hedged

zero problemo

Sun, 09/25/2011 - 14:47 | Snakeeyes

Excellent points!

But I think that QE3 and Euroeasing (sounds like a Volkswagen product) are inevitable.

http://confoundedinterest.wordpress.com

Pandora's Box renamed Bernanke's Box

Sun, 09/25/2011 - 15:01 | Mister Ponzi

Great article! When I started using CDS in fixed income portfolios it took me some time to sort out all the technical aspects. Good summary, although I would like to add that the majority of buyside investors using CDS use cash settlement in the case of a default. This is obviously a necessity as there are a couple of corporate issuers with a higher volume of CDS on the company outstanding than the issued bond volume.

Sun, 09/25/2011 - 22:49 | oogs66

I think the SNAC protocol forces cash settlment, making deliverability and short squeezes a thing of the past...

and awesome avatar!

Mon, 09/26/2011 - 02:16 | Mister Ponzi

Thanks.

I don't know about the US conventions as we are Europe-based. However, how I understood the conventions, there is at least a theoretical possibility of a physical settlement. At least this was the reason for hours of discussions with investment companies.

Sun, 09/25/2011 - 15:14 | polak potrafi

Really guys,

it's just great

that in these difficult times

there is somebody out there

providing a top-notch protection

good that you've thought about it just in time

Sun, 09/25/2011 - 15:58 | Lester

What you need to understand is if you ain't deep inside the inner cadre you're an outsider and you're there to provide liquidity and to make markets.  The insiders can look at all the positions and control all the parameters to move against you.

Anyone who believes in TA (technical analysis) validity likely checks under their pillow for toothfairy money every morning.

The only things in this world that you own or have right to are those you have posession of or can oversee with your physical presence.  New Rules which operate always against your interest are continually introduced.  Legislation is more likely than not retroactively applied.

If you don't understand you are playing THEIR Game and they always win, you are just steak on their table.

Every cost that can go against you is implemented immediately. There are no cost reductions occuring when commodity moves go the other way.  It is LIFO pricing with an expectation of price moves against you always added in for good measure.

All that you have been conditioned to see as routine and acceptable in these markets is manipulation to fleece you.   America has been slaughtered on the killing floor and all that remains is some gristle, blood splatter in the sawdust and tufts of hair; all else stolen from you and sold.  But you think you're not about to suffer the same fate?

These markets are more like Russian Roulette played nonstop than investing.

Sun, 09/25/2011 - 21:46 | bid the soldier...

I like your thumbnail. As a major Peak Oil Theory conspiracist, I would have mentioned that were the global dipstick not at such dangerously low mark, the markets would still be where you so eloquently described them.

Now the fig leaf is gone. They spin the cylinder of the revolver in public in front of children.

Sun, 09/25/2011 - 16:35 | boiltherich

"...recovery for sovereigns is purely guesswork.  Creditors have NO rights.  There is nothing they can do to try and collect on their bad debts.  It is purely a negotiation.  That is why the distressed investors don’t do much in sovereigns, because they are used to playing by rules, and in a sovereign default there are no rules."

No wonder the Finnish (and others) demands for collateral for any new bailouts was doomed to fail.  I mean so what if they got a promise of hard assets in return for further help, if the Greeks are going to stiff the bond market they can just as easily stiff the Finns.  The only way to collect would be by the generosity of the Greeks or go to war to carve away their pounds of flesh.

This also is a good reason for those that believe the end of the EZ would have to be accompanied by the end of the EU, bravo!

Sun, 09/25/2011 - 17:29 | disabledvet

What all of you are missing is the dynamic aspect of a reging bull market in treasuries. Call it our White Swan the impact of the world's largest market sucking in all global capital cannot be over stated. This includes CDS's btw. What value for the insurance of a CDS when all I need is the ultimate insurance with principle appreciation to boot? I say those contracts are WAY over valued and are going to collapse. That would be your trigger for a failure of Greece and a generalized banking crisis in Europe and the collapse of BofA. I think this is the trigger and I also think it will happen as soon as this week.

Sun, 09/25/2011 - 17:45 | s2man

I understand completely, and I am going to make a killing in the CDS and sov-bond markets, tomorrow morning.

Sun, 09/25/2011 - 22:38 | juno9604

Outstanding notional CDS value worldwide absolutely swamps other risk...sluggish and sheepish Central Banks will bail but hole in pail will result in soveriegn debt crisis that has potential to make U.S. true 3rd world.  I banks..and their trading desks must be reigned in...otherwise we'll all end up w/ ring in our noses...which i suppose is the point.