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Guest Post: Has Derivatives Deleveraging Fueled The Stock Rally?
Submitted by Charles Hugh Smith from Of Two Minds
Has Derivatives Deleveraging Fueled The Stock Rally?
A mad scramble to avoid insolvency as Greek default becomes likely may be driving the rally in equities.
Deleveraging typically means selling assets to raise cash to meet margin calls or pay debts coming due. But there may be another twist to deleveraging that has fueled the manic market rally since late December. I am indebted to Peter C. of M3 Financial Sense for explaining this dynamic.
To understand this non-intuitive dynamic, let's start with a simple example of how options work. If this is new to you, please stay with me, your head will not explode.... at least for awhile.
An option is a financial instrument which grants you the right to buy X number of shares of a company at Y price (the strike price). One option controls 100 shares. An option is either a put (a bet the price will decline in the future) or a call (a bet the price will rise in the future).
An option is "in the money" when the stock price is above the call strike price or below the put strike price. For example, if you own one call option on Netflix (NFLX) at a strike price of $100, then your option is worth $2,900 ($29 per share) as of today because Netflix is trading for $129 per share. (There is also a time value in options, but let's leave that aside in this example.)
So if you bought 10,000 options on Netflix (NFLX), whomever sold you the options is obligated to deliver 1,000,000 shares of Netflix to you (at the strike price of the option) upon expiration of the option.
If your option is "in the money" as in the above example, the specialist who sold you the options will hedge his position so he can meet the obligation. If your options are just barely in the money, he might buy 250,000 shares of Netflix to cover his future obligation.
As your option becomes ever more valuable, i.e. becomes deeper in the money, the specialist has to increase his hedge up to the full 1,000,000 shares that he is obligated to deliver to you upon expiration.
That purchase of 750,000 shares to cover his bet will drive the price of Netflix up.
Here is an important point about options and derivatives. In theory, the number of options should equal the number of outstanding shares. If there are 1,000,000 shares of a stock outstanding, then there shouldn't be more than 10,000 options contracts written and sold.
In the parlance of options, these puts and calls are "covered," meaning there are enough shares available to "cover" the options, i.e. when the option expires, there are enough shares to meet the delivery obligations of actual shares.
If a specialist sells options without holding the requisite number of actual shares to cover the options, then he will have to buy those shares as the delivery date looms. If the number of option contracts exceeds the number of available shares, then the rush to acquire those shares for delivery will spark a massive rally.
This is somewhat akin to the infamous "short-covering rallies" triggered when those who sold shares short have to buy shares to close their short positions.
Options and futures contracts are all marked to market at the close of every trading day. The price is thus transparent for all to see.
Derivatives are not marked to market. That sort of requirement is evil, evil, evil and anti-capitalist--or so we are told by the financial cartels who profit from selling derivatives.
Derivatives can be sold in whatever quantity can be fobbed off to credulous buyers. This is how the world ends up with 700 gazillion dollars in notional derivatives.
Consider the debt of a sovereign state--for example, Greece. Just to keep things simple, let's say there are $100 billion of outstanding Greek bonds. Back in the good old days around 2009, the risk of Geece defaulting on that debt was considered low. Nonetheless, prudent owners of the debt bought insurance against default. The insurance is a derivative called a credit default swap (CDS).
The contract works somewhat like an option, in the sense that if a default occurs, the seller of the CDS must cover their contract by delivering the value promised in the CDS to its owner. If no default ever occurs, the financial institution that originated and sold the CDS gets to keep the hefty premium.
Nice. Since there are no limits on how many CDs I can write on Greek debt, why not sell more CDS? In fact, why not sell more CDS than there are Greek bonds?
As in our options example, in the normal course of things the number of CDS equals the outstanding bonds. In other words, the owners of the $100 billion in bonds would buy $100 billion in notional CDS insurance against default.
If Greece defaulted and the value of the bonds fell in half to $50 billion, the sellers of the CDS would owe the owners of the CDS $50 billion. (This is simplified, but you get the picture.) That was, after all, the bet: in exchange for this hefty premium, if Greece defaults then we will make good your horrendous losses.
But a funny thing happened on the way to the derivatives market: wise guys realized they weren't limited to selling CDS to the owners of Greek bonds--anyone could buy a CDS on Greek debt. So why not sell $1 trillion in CDS against Greek bonds? That's ten times the premium.
Some issuers hedged their bet by buying CDS issued by other institutions. These other institutions are the "counterparty", that is, the party who pays off the CDS I bought from them so I can pay off the owner of my CDS. Thus the derivatives market for Greek debt is a daisy-chain of counterparties, all planning to use the proceeds from the CDS they own to pay off the CDS they sold.
It was a license to print money--until Greece defaults. Yikes, now what? Just as in the classic film The Producers, where 100% of the proceeds of the Broadway play were promised to ten different investors, the CDS schemers reckoned the odds of a Greek default were effectively zero--"the E.U. will never let a member state default."
Ahem. Until they do. In The Producers, the schemers devised a play so odious, so bad and so repellent that they felt extremely confident it would close after one night for a tremendous loss--and they would get to keep the 10X oversubscribed investors' money.
This was the same bet made by sellers of CDS on Greek debt--and on Italian, Portuguese, Spanish, Irish et al. debt as well.
Now that leaves the canny financiers in a pickle, as they owe various parties $1 trillion when $100 billion in Greek debt goes up in smoke.
Now we get to the deleveraging part. As I understand it, some of these CDS are written against various swaps or stock indices, meaning that the asset to be delivered upon default is ultimately a claim against stock indices, currencies, etc.
That means that those holding the CDS obligations have to acquire these assets so they can pay off their obligation when Greece defaults.
There is one more wrinkle. Many sellers of CDS protected themselves against any potential loss by buying a CDS originated by someone else. As noted in When Greece Defaults, the Credit Default Swap Dominoes Fall (February 4, 2012), this "can be likened to a pool of $100 bets leveraged off $5 in cash. If every bet is covered perfectly, then it's somewhat like $95 in bets being paid by passing $5 around--much like the famous email that depicts all debts in a small town being paid by the same $5."
But some players have issued more CDS than they bought as insurance, meaning that they will be unable to meet all their obligations. Everyone is depending on a host of counterparties to deliver, and now there is a growing fear that some counterparties will be unable to make good on their obligations.
That's how the dominoes topple. Prudent institutions aren't waiting around until the dominoes fall--they're buying the underlying assets so they can meet their CDS obligations. That's the only way not to topple into insolvency when the default causes CDS to be recognized as due and payable.
In this light, it's no wonder stocks have been rising. If even a modest percentage of CDS are tied to stock indices, then those deleveraging their derivatives positions must acquire the underlying assets. They can no longer count on all counterparties paying off as promised, and so they are raising cash and buying the underlying assets needed to make good their obligations.
The whole thing is a farce, just like The Producers. The moment the default is recognized, then all the CDS become due and payable, and it will only take handful of failed counterparties to bring the entire system down.
No wonder the Eurocrats and central bankers are twisting everyone's arms to accept a 70% loss--the alternative is a Greek default and the collapse of the banking cartel's profitable scheme. It is beyond absurd--what is a 70% loss but default? When banana republics default, their bondholders don't necessarily absorb a 70% loss. yet now, to "save" the despicably parastic shadow banking system and the "too big to fail" financial institutions, a default cannot be called a default: it is a "voluntary haircut."
Greece, please do the world a favor and openly default--right now, today. Declare a default and pay nothing. Force the shadow banking system to recognize a default and bring down the entire rotten heap of worm-eaten corruption.
At that point, there will be no reason to buy equities.
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HERE-HERE!!!
Plan on this shit show to continue....till after the US elections
Then watch out below...
Who's left holding the empty bag at the end of the day. I bet it will be baby boomer retirement/pension acounts.
2008 was an election year.
BTW....the numbers don't add up for the above theory to make sense:
http://www.telegraph.co.uk/finance/financialcrisis/9029612/What-happens-if-Greece-defaults.html
Outstanding Greek CDS contracts are in the $100 billion range. The liquidity lifting markets is far larger in scope.
But, I like his conspiracy theory Ben. Damn YOU!
They may pay nothing, they will have nothing left either. They are as corrupt as others. So, don't count on it.
This makes no sense to me. The only way a cds writer has to pay up ios if something really bad happens (ie. a greek default (and it has to be a technical default). In that event, prices will be a lot lower. Perhaps there are additional rwrinkles here, but this article as written doesn't make any sense. If soemone can make sense of it, I look forward to reading your comment.
Yeah, I agree. why would they buy the underlying asset or index if ithe security falls in price with a crash?
He lost me at "prudent institutions"
Not a very good article. The Greek CDS volume was €3.8 billion and has apparently been unwinding since July of 2011 when ISDA seemed to suggest that they won't likely trigger Default on even that puny level.
http://www.euromoney.com/Article/2913259/Greek-solution-unlikely-to-trigger-CDS.html
It is wrong and irriatating to hear talk about Greece CDS being some sort of Lehman II type bugbear.
Just default already.
>>The only way a cds writer has to pay up ios if something really bad happens (ie. a greek default (and it has to be a technical default).
CDSs can be triggered by any number of "credit events": a credit rating downgrade, a default, a debt restructuring. I'm not sure if a 70%+ haircut would count as a "restructuring" in legal terms, but it definitely doesn't have to be a "technical default." So the Greek CDS market has been deleveraging for a while I believe, but a straight-up default would definitely still pack a major kick.
>>why would they buy the underlying asset or index if ithe security falls in price with a crash?
I think you're confused. I don't think securities or equities indices are an "underlying asset" with a CDS. The underlying asset is the loan/debt, which in most cases is handed over to the CDS seller in a credit event. If I understood Tyler correctly, some CDSs are structured so that the payout in a credit event is in the form of an equity index or a bundle of securities. CDS sellers who foresee a coming default will begin to buy these assets en masse so that they can meet their obligations when the time comes, and that may be a major reason for the on-going upward swing in U.S. stock prices.
Prices of what will be a lot lower?
Simple
They don't know what the fuck to do or how this will impact CDS triggers
A default IS a default @ 100%
But what about a 50% -70% 73-1/2% default?
All this is is creative bullshit to avoid the un-avoidable. akin to the same creative bullshit that got us here in the first place
I am not so sophisticated in my understanding of the many factors at play but I think paying back less than 100% could be construed by some as default.
Has the affect of Credit Default Swaps morphed from their original intent, maybe in an unintended way? I can see how when they first started getting used, how they might have been looked upon as a hedge and a type of insurance, such that in a particular circumstance, a large payout might be expected as the result of a business affecting event. As long as the writer of a CDS wasn't exposed to too many of them, and the amounts were smaller than the net worth of the writing institution, then it might have just seemed like normal business risk. But once the amount of CDS written could start to bankrupt the writers, then a kind of perversion and moral hazaard might have set in. Since the whole shebang was on the table, it started to make sense to churn the market and generate as many as possible to get the fees and commisions involved, since in the event of a payout being needed was going to crash the writers institution anyway, and possibly be crashing much of the market too. So the IBG YBG mindset might have taken over, where people were doing the getting while the getting was good. The amount of CDS written that were essentially naked bets on things for which the institutions may not have collateral on, or even or a controlling interest on, and maybe even unrelated to their business interests, got so large that if a credit event did occur, the consequences of that were going to tie up the legal system with lawsuits and counterlawsuits over huge sums, and expose the moral shortcomings of that business model to the media and to the public. And the result of that might have been a general observation that the emporer had no clothes, or at least that the CDS business model was flawed in ways.
Yep. They started as a type of quasi-insurance for bondholders and became nothing more than a way of creating multiple revenue streams (for the seller) or a new market to speculate in (for some of the buyers).
The author clearly has no idea how credit derivatives work, so I wouldn't take any of the detail seriously.
There are potential problems if the ultimate sellers of protection become insolvent. Oftentimes the ultimate sellers are indeed banks, and the effect of a default on the creditworthiness of these institutions is potentially a serious worry.
This is where "kicking the can" pays off, actually, since everyone has known pretty much all along to prepare for this eventuality. There are ways you can hedge corporate credit exposure approximately (and expensively) in the equity options market, but with sovereign exposure it's harder.
Last I saw, the outstanding notional on sovereign Greek CDS is very small in relation to the size of the cash market. So it's really banks' holdings of actual Greek paper that you should worry about more than the derivatives.
+1. seriously ZH should be able to spot a journo hack like this from a mile away.
Here's how it works, in a true story form (and the reason to first explain options). Like the CDS market, primary dealers are market makers in the options market. Like CDS, options are essentially a crude form of insurance. Being that PDs make the rules, they sell the insurance "naked" and then hedge their risk by off-loading most of a position to a counterparty. By doing this, the PD will make a spread between the higher, original contract premium and the reduced, secondary premium. In the options market, the levels don't run as deep as CDS; however, the same fundamentals are present, which is described by the following example.
In July of last year, Wirehouse (actual name redacted) touted a Structured Product (SP) that seemed like a no brainer (like Greece not defaulting). The SP was based on the ETF GDX with a duration from late July to late December (12/28, if I recall correctly). The structure was that if GDX closed at or above $58/share on the day of maturity, the retail investor would receive a 12% payout on their invested principal. If it closed below $58/share, the retail investor would participate 1:1 on the downside. I'm not sure of when Wirehouse placed the derivative trade or trades; however, it was likely placed in late June, when GDX was trading in the $54 range.
The SP derivative trade was selling the GDX $58 December Put. After collecting a good premium for the "out-of-the-money" contract, they graciously shared their spoils with their retail arm's investors (their hedge). The story made sense. Gold was flying high and going through $2,000 by year-end, yet the gold miners had been lagging through 2011. Everything was going well for the next couple of months, with GDX making it as high as $66/share. Then, MF Global errupted and sent gold on a downward trend, which also affected GDX.
If I had to guess, the counterparty probably knew the trouble that was brewing with MF and bought the put in "naked" form (think about which firm had a profitable trading quarter, also called for gold to surpass $2k and also profited from VAPORIZED MF Global funds). On 10/04, the counterparty could have bought GDX for as little as $50.42/share, as well as in the sub-$52.50 range in the days leading up to Saturday, December 17, 2011 Expiry (accumulation discussed in the above guest post). Counterparty was able to pocket the spread between their breakeven (strike price minus premium) and where they purchased the shares to put onto Wirehouse. Upon expiration, Wirehouse had to purchase GDX at $58/share from the counterparty, when the shares closed at $52.68 on Friday, 12/16 and $51.17 on Monday, 12/19. On 12/28, GDX closed at $50.06 and the retail investor's principal was used to offset the exposure that Wirehouse had between the put's $58/share strike price and the $50.06 market price, when the shares were put to them.
In summary, Wirehouse sold the puts as insurance. Then, they turned around and sold a structured product to retail investors that hedged all their risk, while still making a profit upon the trade going the other way. If Wirehouse had sold more puts than outstanding shares, not all of the speculating counterparties would be able to buy enough shares to cover the trade, despite the trade being a gain to all counterparties. The result would be 1) Counterparties without collateral (Treasuries) or ability to buy shares at a lower price would be in default to Wirehouse, as Wirehouse's obligation was to buy the collaterall or shares; 2) Wirehouse does not receive the collateral and the loss spread becomes a loss that cannot be quantified (a total loss); and 3) Without collateral that could be sold to quantify a loss, Wirehouse would be able to tell the structured product investor that their funds VAPORIZED, despite the cash sitting in their coffers. Does this sound familiar (MF Global)? Although there will be a wave of defaults, the originating PD holds all the cards and would reap the benefits of a default. Now put this into context with CDS.
If any of the above assumptions are in error, please correct me. I arrived at much of the above through reading the prospectus and watching the trade unfold.
Like I said.
The bigger the OTC Derivatives "Ball of Twine" gets, the better it is for stock and PM bulls.
Why is that?
Because millions of hedge fund managers who keep reading all these "gloom and doom" articles and those who keep clutching to the "Endgame" paradigms continue to buy exotic hedges to protect themselves against a crash that never happens.
Shill.
If you and Robo ever kiss and make up, I want to watch. ;)
And tell us, Robo, how long after an artificial spike in stock prices due to scarcity buying will it be before some semblance of valuation is re-established, and those CDS payees are holding the bag?
By the time you post your troll-gloat on the "surge," the wave will have crested and the Mortimer Dukes will be carried out on stretchers.
Thank You!
Clear and worth the effort to understand.
For the love of Anthony Quinn and his 49 children, just default already.
He should have played Genghis and not John Wayne. As a kid that really riled me to see John W as slit eyed Temujin.
TO: falak pema
"He should have played Genghis and not John Wayne. As a kid that really riled me to see John W as slit eyed Temujin. "
that movie was called 'the conqueror'; part of it was shot downwind from the nevada atomic bomb test site near a place called st. george utah. that is where jw got the cancer that killed him...................
http://www.ickypeople.com/2009/12/unknown-john-wayne-movie-duke-as.html
thanks for the link Hange!
What a tragedy, I didn't know the story behind the story!
Place was called Yucca Flats. A lot of guys from the 95th Combat Engineer Battalion lost their lives also. They built the "city" that was blown up. They were a 1 1/2 miles down wind in slit trenches covered with their rain ponchos. I was drafted into the outfit a few years later and talked to a lot of the Sgts etc. who were there. Milestones
Here, Here! Thanks for the fantastic article - very very logical, easy to understand and makes a lot of sense!
I'm right with you in saying "Greece should just default and get on with it!" instead of the politicians mugging us all off with this stupid "Voluntary soft re-profiling" or whatever bullsh*t they call it.
If it looks like a default, smells like a default and walks like a default then sure as heck......IT IS A DEFAULT!
Give that NxCore animated graph from yesterday, this makes PERFECT sense!
The house is beyond stacking the deck. It's building a custom deck of cards to save it from itself.
Great article that really pulls it all together. Very well written.
And Robo you are full of shit.
This is really interesting because there is the real potential here that we get a collision of event risk and parametric risk. If the event risk (Greece default) is insured by the promise of delivered securities, and the whole structure is untenable because of the number of shares underlying (plus...or rather multiplied by...the multiples of coverage on the default risk in the first place), the whole thing could really blow up rather spectacularly.
If I were holding an in-the-money CDS, and the default trips a short-covering run on stocks by my (highly-imprudent and greedy) CDS underwriter, I would be anxious to SELL the proceeds (stocks) almost as soon as I got them. It would be like a fast-motion ponzi scheme rise and collapse.
In the end, the paid-out stocks will quickly revert to real valuations (to the extent such a notion still exist), and the transfer of losses will be complete to the final bag-holders.
My two oz.
With a "partial" default, err haircut the damage could be lessoned to a degree, or so Euro thinking goes
That depends on how many multiples of the actual underlying bonds are "insured" by CDSs. If the speculators and mortgage-backed CDS idiots have gone all in again, that multiplier could be ugly-high.
Leverage works both ways, no?
A partial default is like a football game with a 24 point spread. Team A is ahead by 30 with 2 minutes left. The bookies send down the goons to convince everyone playing and watching the game that team A is really only ahead by 20 so they don't have to pay.
This is how the best and the brightest play the game? When they are losing, they change the rules, scoring format and players.
Leverage works both ways, no?
Absolutely it does...when ALL parties involved are solvent ^-^
Portentous if true and not so much if not true, or more likely, neither.
This is all pretty much in line with what I was reading last week about the ISDA ran by the US big 5 banks that they won't allow Greece to be called a default even at a 70% loss because it would trigger this event. The question arose what would they call it at a 100% loss? It remains to be seen if these crooks can escape alive------which wouldn't surprise me one bit and then they'll be off to the next totally ridiculous theft enterprise.
"Probable greek default"...and Merkozy say "no way"...and the Marx Bros continue their closet pantomime.
I love a long prolonged love affair and breathless moments, hiatus, and then back to the salt mine resurgence. With all the Hitchcockian --will he get away-- suspense, we don't know how this thrilla from Athina will end.
The rest is tepid water in comparison to Greek blood n guts drama. Oh, the final blow, but here final is not a word you say like "au revoir". The greeks never say au revoir, its victory or its return of dead body on shield. Adieu Athina.
Let the Euro Boa go to strangulation. That's what the markets anticipate. RIse Empire, in purple nights and ephemeral delights, until it all crumbles.
I'll have my dolmados now.
Time to sell your pms before it all comes crasing down?
http://finance.yahoo.com/blogs/breakout/last-chance-sell-gold-suttmeier-...
I agree mayhem yet my brother has decided to 'invest' with his hometown broker who has started his own thing of selling derivatives!!!(strangely enough we spoke several yrs ago [the broker...not my brother] and he seemed to understand gold and why it was going up). I guess there is no shortage of 'informed decision makers' still out there.........huh?
"As I understand it, some of these CDS are written against various swaps or stock indices, meaning that the asset to be delivered upon default is ultimately a claim against stock indices, currencies, etc.
That means that those holding the CDS obligations have to acquire these assets so they can pay off their obligation when Greece defaults."
This is innacurate I believe.
The CDS that are written for indices and other products concern only those products, and have nothing to do with Greece.
There are no CDS written on Greek debt that are supposed to pay out various assets upon default.
The CDS written with Greek debt being the underlying are cash settled contracts so far as I can find. Would certainly be interested if someone could show otherwise but I don't think that can be shown.
CDS written with a stock index as the underlying can sometimes be settled in the underlying equites (though usually cash settled as well).
And the CDS on other products operate in a similar fashion for the most part.
yes. counterfieting plain and simple.
Hedge Funds Bet on Profits from Greek Debt Talks
and are betting that the voluntary debt rescheduling will fail
Der Spiegel 01/25/2012 Haircut Negotiations
Hedge Funds Bet on Profits from Greek Debt Talks
The negotiations over the Greek debt haircut are becoming increasingly suspenseful,
with euro-zone finance ministers and the IMF pushing investors to accept greater losses.
Hedge funds, more than any others, stand to profit, and are betting that the voluntary debt rescheduling will fail.
Who will bleed for Greece?
For weeks, private creditors like banks and insurers have been trying to negotiate a debt rescheduling with the country without success. Even when they seem close to agreement, it remains unclear if all creditors are on board. In particular, hedge funds that own Greek bonds could have a significant interest in ignoring the results of the negotiations, instead preferring to focus on an official national default.
Bank representatives assume in the meantime that many hedge funds are not really interested in an agreement. With a controversial investment strategy they have assured themselves of profiting with either a low level of Greek bad debts, or a complete Greek bankruptcy.
At issue are Greek bonds with a total volume of about €200 billion.
How many are owned by hedge funds is unclear, but the amount is estimated to be about €70 billion (including other funds).
The bondholders are expected to voluntarily give up 50 percent of their claims. Another 15 percent is to be compensated with either cash or secure bonds of the European rescue fund EFSF. The remaining 35 percent should come in the form of new Greek bonds, that will likely reach maturity in 30 years.
The amount of money the creditors will actually have to give up depends on the interest rates on the new bonds. The Institute of International Finance (IIF), which is leading the negotiations with Greece, is insisting on an average of at least four percent. The euro-zone finance ministers and the International Monetary Fund (IMF) have instead insisted on rates lower than four percent, in order to make the burden on Greece more bearable. The banks calculate that this means they would actually lose closer to between 70 and 80 percent of their claims, and they are balking.
'Not Worried About Their Public Image'
For some hedge funds, the fight over interest rates has given them more incentive to push for a breakdown of the proposed plan. Officially, they are in the same boat as the banks and insurance companies. But in reality their interests are vastly opposed. "Hedge funds don't need to worry about their public image," one banker says. Their reputation has already been destroyed. Therefore, they can be relatively cavalier in gambling with the possibility of a Greek bankruptcy.
In an internal analysis of the German Savings Banks Association (DSGV), which represents the public banks, the hedge funds come off fairly badly. With the financial investors "only the performance" is most important. There is "hardly a political or economic corrective factor," such as long-term customer or contractual relations, the analysis says. Therefore, "one can conclude that they are not really interested in an actual Greek rescue."
Unlike the creditors who have long held Greek state bonds and definitely stand to lose in the case of a Greek debt haircut, some investors have only jumped in over the past few weeks. They have stocked up not just on Greek bonds, but also on the related Credit Default Swaps (CDS). These Credit Default Swaps guarantee the buyer protection in the event that the underlying bonds default. "This week alone there will be scores of new CDS transactions," one insider says. "And some of them at exorbitant prices."
Those who in the past few days have bought Greek state bonds worth €1 million euros and wanted to protect them against loss with CDS, would have had to pay more than €400,000 or even €500,000. And they fluctuated wildly -- depending on the news, the price of CDS rose and fell sharply. That indicates that the CDS are being used mainly for gambling.
This example shows how the calculations made by short-term investors work:
a) One hedge fund stocks up on Greek state bonds. Since the market participants have long expected a haircut of 50 percent, the prices of the bonds are extremely low. They are, for example, at 30 percent of the nominal value at which the bonds were issued. The funds, for example, have bought Greek state loans with a nominal value of €100 million, but paid €30 million for them.
b) At the same time, the hedge funds are protecting themselves with so-called Credit Default Swaps (CDS) against a Greek payment default. Such Credit Default Swaps are deals between two market participants. The seller agrees to compensate the buyer for losses, should the underlying obligation default, in this case the Greek state bonds.
c) As long as a debt haircut for Greece has not officially been finalized, the CDS secure the full nominal value of the bond, or 100 percent. Therefore they are also very expensive and cost, for example, 30 percent of the nominal value. In addition to the €30 million for the bonds, the funds have also paid €30 million for the CDS, or a total of €60 million euros.
But there are other ways in which the poker game can play itself out, and the funds can make large profits.
1) If it comes to a haircut of 50 percent, then two things would happen: The Greek state bonds would gain in value and instead of costing €30 million, run at maybe €45 million. At the same time, the CDS safeguard for the hedge funds would fall significantly in value. Therefore, the funds would only reap a small profit. This variation, therefore, is not attractive for them.
2) Things look different for the hedge funds if an agreement breaks down. In this case, the threat of insolvency exists. The chance that the bondholders would get their money back would dramatically decrease. The bonds would have less value than before, and would no longer be worth €30 million, but say just €10 million. And the CDS guarantees would be due. The hedge funds would, depending on the arrangement of the CDS, receive up to 100 percent of the bonds' nominal value, or €100 million. Under this scenario, the hedge fund that invested €60 million would get €110 in return - a profit of almost 100 percent.
If the Institute of International Finance (IIF) and Greece agree on a voluntary haircut, it is attractive for the hedge funds holding the CDS to simply not to take part. In this case, there are three possibilities:
1) Too few of the bondholders take part in the haircut. Should more than 20 percent of the bondholders refuse to accept the negotiated conditions, the debt rescheduling could break down, and with it also likely the second rescue package for Greece. The country would be bankrupt, the CDS would be due, and the hedge funds could cash in.
2) A lot of bondholders partake. Should, for example, 90 percent of the investors promise to take part, the few holdouts could emerge unscathed, and bet on Greece paying off the bonds as they mature. Hedge funds that hold Greek bonds could in this case become the classic definition of a freeloader.
3) The Greek government, though, has threatened not to tolerate such freeloaders. If an agreement is reached with 80 percent of the bond holders, they want to force the remaining 20 percent to take part in the haircut. In that case, the existing bonds would later be so-called "Collective Action Clauses." The hedge funds could still cash in because in this case the debt repayment would not be voluntary, and it would be considered a payment default, making the CDS also come due, and the gamblers would profit.
The strategy does have one snag. The hedge funds assume that in the event of a payment default all CDS providers can pay. That is by no means certain, though. The CDS papers are distributed opaquely throughout the financial system.
No one knows for sure who holds them at a given time, and who, in the end, will be responsible for them.
The majority of large banks have both issued and bought CDS. The net risks are therefore officially quite small.
But should only one of the larger CDS issuers turn out to have difficulty paying, a chain reaction could be possible with unknown consequences. Under that scenario, it would also likely affect the hedge funds.
http://www.spiegel.de/international/europe/0,1518,811295,00.html
Article...
perfectly explained, snake eating its tail and wanting to have its cake. These HFs should be burnt along with the banks. The CDS market closed. As all naked derivatives, and OTC trades. Clean the shit house now and impose Tobin tax world wide. Fukk the City shills and their cheapster HFT, derivative and rehypothecated thrills.
Not buying it. from what I've heard, the number of CDS on greek debt does not exceed the total amount of greek debt. however, there is some plausibilty to the short option theory, but if this is an issue, it's a small one and doesn't fully account for the magnitude of this melt up.
POMO
SOMO
ST OMO
or whatever Open market Operations have Pumped Up Wall Street!
Gold and Silver are bought down and the Stock Market is Pumped Up..
This is what the Debt Ceiling Hike was for!
where in the fuck does all this other bullshit come into play?
smoke screen?
mirrors?
Eat the Rich!
The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.
http://www.federalreserve.gov/faqs/about_14986.htm
They have been eating You! and Yours!! for GENERATIONS!!!
Article I, Section 8, Clause 5, of the United States Constitution says
"Congress shall have the power to coin money and regulate the value thereof and of any foreign coins".
But that is not the case.
The United States government has no power to issue money, control the flow of money, or to even distribute it - that belongs to a private corporation registered in the State of Delaware - the Federal Reserve Bank.
http://www.youtube.com/watch?v=V74DERg_aCI
Keiser Report: It's All Legal, Folks! (E246)
Uploaded by RussiaToday on Feb 7, 2012
In this episode, Max Keiser and co-host, Stacy Herbert, discuss the supercommittee that runs America, the perils of Draghi's "blitz" and the IMF turnaround on austerity for Greece. In the second half of the show, Max talks to Gonzalo Lira about austerity, printing and running.
KR on FB: http://www.facebook.com/KeiserReport
Loved the post, but I can't go along with the conclusion. ( ie.:At that point, there will be no reason to buy equities.)
Maybe that would be true, if we were just talking about Greece in trouble. What about the whole slew of sovereigns up to their necks in debt with no way to pay them off except through currency devaluation??
As currencies devalue real 'stuff' has to become worth more. That includes stocks, but certainly does not include sovereign bonds, notes or of course the currency itself.
my roomate's step-sister makes $73/hr on the laptop. She has been out of work for 6 months but last month her income was $7334 just working on the laptop for a few hours. Read more on this site.... http://LazyCash9.com
http://www.killyourselfyouassholespammer.com
I don't buy this- even if the author is correct about the volume of Greek CDS outsanding (I'm skeptical), surely the contracts call for cash or the equivalent value in securities. Why would banks, worried about imminent liabilties on the Greek CDS they sold, convert cash to securities in anticipation of this event? Are we really to believe that the CDS purchaser will say: "no, don't give me that cash payout- just give me the QQQ in the equivalent amount?" Perhaps you are not explaining it well (or I am not understanding) but I don't buy it...
Banksters want it all. They can't let Greece default, or risk a Lehman type melt down or worse, nor take a haircut no matter what it may be called, so they will get their pound of flesh by inflating currency. They will have their way. However big the derivatives monster with all it's alphabet soup acronyms, wherever the banksters may be holding the other side of anyones trade, they will end up winners. Place your bets accordingly, or get wiped out.
Exactly. Too Big To Fail has become a laughable misnomer. Too Big To Go Bankrupt? Maybe. But, they have already failed many times over.
Personally I think they should just let Greece default, and then let the CDS writers default as well. Or maybe not a total CDS default, but when you go to demand payment you should need to show true exposure to the underlying thing that is being insured - not this remotely derived investment. Do something like that once and I'll bet you would see some sort of reform enacted in a hurry.
I wonder what the world would be like today if they had defaulted on all those MBS CDSs which made some people so famous. "For the sake of the world - we decided to not pay off" - or maybe annuitize the payments.
At least I haven't heard of Synthetic Greek CDOs :-)
You present an interesting narrative. Do you have any evidence that you are correct?
Watching Jamie Dimon eat his own leg off would be possibly the most enjoyable scene ever.
Although watching Blythe and Jamie eat each others legs off would top it.
Shit Jamie, you gotta get through those massive feet first. Fuck you gotta a job to do there mate :)
Gambling in the stock market is outlawed after the 1907 financial panic. Bucket shops (where betting ten-to-one or $1 trillion dollars on an underlying $100 billion dollars in securities) are declared illegal.
The Commodity Futures Modernization Act of 2000—championed by Robert Rubin, Larry Summers, Alan Greenspan, Arthur Levitt and signed into law by President Clinton—deregulates the over the counter (OTC) derivatives market, despite the objection of CFTC Chair Brooksley Born. Bucket shops, more sophisticated than before but bucket shops nonetheless, are now back in operation.
The Gramm-Leach-Bliley Financial Services Modernization Act (1999) repeals the Glass–Steagall Act (used to separate investment banks, commercial banks and insurance companies), creating our now systemically fragile financial system. Banks use depositors’ money to gamble with, keeping all the profits and expecting the taxpayers to bail them out when their bets go bad or banksters threaten to bring down the financial system. This bankster extortion is uncivilized.
President Obama has added about +$5 trillion dollars to the national debt in the past three years trying to cover up the credit crisis caused by the financial elite. Obama’s inaction is sure to bring on a double catastrophe of a combined 1907 and 1929 economic debacle. America needs the government to start unwinding the +$707 trillion dollar OTC derivatives market and reinstate the Glass–Steagall Act, NOW!
Sorry folks, I don't believe any of this - there is no evidence to back the whole article and it's all based or hearsay. Not only that - it just doesn't make sense at all. Greece CDS is what? 70B in notional total? I call it B/S people. Why did you guys post it? I mean the whole thing sounds like a conspiracy rant by a crazy person. The argument doesn't hold ground.
The article is entirely meritless.
Complicating issues: The OTC derivatives market is opaque. We have no way of knowing its size. If the underlying securities are leveraged 30-to-1 and off balance sheet structured investment vehicles are used, this could get very messy quickly, during a bankruptcy.
which is why you have to be extra careful and back it up with at least some evidence.
I mean anything. He didn't provide ANY evidence.
Don't get me wrong - I would like to be able to justify this - because it's a VERY IMPORTANT claim.
If he is right - then all that buying will disappear after the bankruptcy and will reverse as the benefiting parties start to liquidate.
If he is right - then we can go out there and buy OTM puts and make a fortune once Greece fails.
So it is a very good trading idea.
Problem is I do not believe it. Absolutely not. Any of it.
I don't believe such contracts even exist.
Convince me.
The Bank of International Settlements (BIS), the central bankers’ central bank, estimates that there are $707 trillion dollars of OTC derivatives outstanding, of which the notional amount of credit default swaps (CDS) is $26.3 trillion at mid-year 2010. CDS have probably increased to $38 trillion dollars today, or over twice America’s 2012 GDP.
With all due respect HOW DO YOU KNOW anyone is buying or planning to buy stocks just because some European country has a debt problem?
Where did you get that knowledge from?
Can you provide a source or any other backup for that claim?
If you can't then please stop distributing assumptions.
one more thing - I would actually reconsider the whole thing if someone provided a copy of a contract showing ANY CDS for ANY govt debt with a defined reimbursement provisions detailing payout in stocks.
It doesn't need to be anything specific - it could be an edited copy - I don't care.
It's just that the whole idea of a CDS for Greece debt payable with stocks sounds so absurd that I can't accept it until someone shows me otherwise.
Pssst...Charles.
Ever hear of the PPT and the ESF...???
I kinda think they are in the market....
Would ZH stop quoting this guy? Once again Charles Hughes Smith proves he
is nothing a cheap hack and plagiarist who actually knows little about markets.
here are some gems:
Options and futures contracts are all marked to market at the close of every trading day. The price is thus transparent for all to see.
Derivatives are not marked to market. That sort of requirement is evil, evil, evil and anti-capitalist...
Fact is Options and Futures *are* derivatives. Maybe he means to say OTC derivatives
are not marked to market, but that's not even true, depends on whatever system the
seller wishes to use. And there's listed Options and unlisted Options (dealer options).
sure mark to market is desired. but this guy rehashes what others say and misses the mark.
it's good to vulgarize ongoing events, but you better make sure you are an authoritative source.
Charles Hugh Smith is clearly not. He belongs in bloggoland, not ZH.