Why ? Because that are unnatural instruments whose sole purpose is leveraged speculation, and the counterparty obligations entangle and propagate one financial institution's troubles to other.
What is a Credit Default Swap ("CDS") ?
In simple terms, it's a contract on possible future default by X providing for small ongoing and/or a upfront payment by the Buyer to the Seller. Then if X defaults (as defined in the contract) during the term of the CD swap (say, 5 years), then Seller must pay Buyer a large amount. For example, a credit default swap for $100 million on company X might require annual payments of 0.5% of that amount by Buyer to Seller, or $500,000 per year. If company X defaults within the specified time, Seller must pay Buyer for losses on $100 million of company X debt. That loss amount is settled at an auction, where the value of company X debt after defaults compared to its face amount determined the loss. If company X debt is worth 20% of face amount, then the loss is 80% making the CDS payment on default $80 million.
That's quite a payment for that crummy $500,000 per year. This asymmetry causes enormous problems.
What is the commercial purpose for such a contract ?
Are there natural buyers and sellers ?
Natural Buyers
These could be bondholders of debt of company X and any other entity that company X owes money to, such as lessors, commercial vendors, etc. There are plenty of these.
Natural Sellers
Hmmm ... who would effectively insure risk of default of company X ? Hmmmm ... ta da dum ta da di dum ... buzzzzzzzz. Time's up ! No one.
That's a big problem. These contracts have no natural commercial existence. Gosh, no wonder they did not exist for over two centuries of modern commerce and finance. Perhaps more, since Lloyd's of London has existed for over 300 years.
Why is this risk not like a simple insurance risk ?
Because each individual risk is hugely correlated with each other. A CDS is more like flood insurance, or volcano insurance, or nuclear contamination insurance. One default of a company impacts the whole network of its customers & vendors. And in a financial panic, a huge swath of companies can default. Gosh .. what just happened in 2008 ? Without government support, a large number of companies would have technically defaulted on debt as the commercial paper market collapsed.
All CDS risk is too highly correlated to be insurable, just like floods. Who provides flood insurance ? The government.
What Moral Hazards Arise from CDS ?
Normally in insurance, one cannot buy insurance unless one has an insurable risk. I can't buy fire insurance on my neighbor's house, since I lose nothing if his house burns. But a hedge fund can buy a CDS now to speculate on and profit from financial troubles of company X. And that same hedge fund could buy up its debt at pennies on the dollar (before default), then refuse to negotiate better terms and cause a default. That's bad.
Also, as company X experiences problems, the hedge funds can "gang-buy" that company's CDS. Without any natural sellers, the CDS market will be quickly flooded, making its debt seem far riskier than the cash market for its debt might otherwise be. So if the hedge fund is short a millions of shares of company X stock, the increased appearance of financial distress caused by overloading the CDS market with buy orders would likely cause the stock to drop precipitously. The beefers profit by creating credit problems via CDS.
This actually happened in many examples in 2008.
What to Do ?
Ban credit default swaps. Make credit insurance a true insurance contract with rules on having insurable interest (such as actually owning the bonds to collect), and tight rules on capital and diversification to make payoff prospects very strong. Regulate the contract like insurance and regulate writers of such insurance as insurance. That's what it is.
Word of the Day
"Asseverate" - verb, transitive [$10] and "asseveration" - noun [$10]
Asseverate means to declare solemnly or emphatically.
Asseveration is an instance of such.
Sentence: Bunkerman hereby asseverates with impeccable logic that all credit default swaps should be banned as unnatural and harmful products for undue speculation.
Showing posts with label credit default swaps. Show all posts
Showing posts with label credit default swaps. Show all posts
Thursday, April 22, 2010
Monday, March 9, 2009
Some Analysis
AIG and the credit default swap.
Those seem to be at the core of the credit bubble that occurred in the past four years. I've been wondering: whence came all that credit? After all, it did not come from the Fed or the ECB or any other monetary authority. Money was rather tight.
I think the banks, hedge funds and AIG exploited a loophole in the banking regulations created after the 1990 recession and collapse of the savings and loans, commercial mortgage and junk bond markets. At that time capital requirements were increased for banks and insurance companies and re-written to be adjusted depending on presumed risk characteristics of the assets of those financial institutions.
Some assets had zero or near nil capital requirements, namely AAA/Aaa, AA/Aa and similar highly rated securities. I'd guess some regulator decided that having an insurance wrapper made even those bonds riskless. So what do the financial engineers do?
Find a way to "insure" financial assets. Enter AIG and the credit default swap..
AIG proceeds to write a huge unhedged book of credit default swaps for other financial institutions. Those institutions no longer need to hold capital against those assets, so can buy more assets. Where do they get the credit? From overnight repurchase agreements with other financial institutions. In other words, a daisy chain of overnight debt to fund supposedly riskless assets.
Which of course eventually collapsed. Who can insure a default on a AAA asset? No one except a government that can print the money. Any other institution is likely to be in trouble and unable to pay in a severe downturn. So AIG was a house of cards. As was and EVEN NOW IS the entire credit default swap market.
Why is the credit default swap allowed to exist? It is a fraud and a scam. Even a clearing house cannot provide the ability to pay off its insurance in a severe downturn, unless Treasury collateral is required. But we know that is not what Wall Street wants. That would eliminate the profits in that market.
Get rid of credit default swaps. NOW.
Other Frauds
From this morning's WSJ story, Madoff was apparently a fraud for over 20 years. Hmmm. And he helped loosen short sale rules. Which brings another matter to mind: Why isn't a strong short sale uptick rule in place?
Markets
The public and hedge funds are likely to continue selling until the near the end of March. I am being cautious, but plan to buy stocks in April with new money. Krypto Fund is severely underweight in stocks.
Futures are weak early, a poor sign.
Word of the Day
"Catholicon" - noun [$100]; a Mrs. B word.
Catholicon means a universal remedy, panacea.
Sentence: If there is a cathicon for the current severe downturn, it's not "investing" in green technologies. Almost all those are heavily subsidized pits for long term losses. However, a catholicon for avoiding another or even more financial market turmoil does exist: get rid of credit default swaps and regulate hedge funds.
Le Mot du Jour
"Haltère" - noun, masculine.
Haltère means weight, dumbell, barbell in context.
La Phrase: L'homme du bunker a font des haltères hier matin.
Sentence: Bunkerman lifted weights yesterday morning.
Those seem to be at the core of the credit bubble that occurred in the past four years. I've been wondering: whence came all that credit? After all, it did not come from the Fed or the ECB or any other monetary authority. Money was rather tight.
I think the banks, hedge funds and AIG exploited a loophole in the banking regulations created after the 1990 recession and collapse of the savings and loans, commercial mortgage and junk bond markets. At that time capital requirements were increased for banks and insurance companies and re-written to be adjusted depending on presumed risk characteristics of the assets of those financial institutions.
Some assets had zero or near nil capital requirements, namely AAA/Aaa, AA/Aa and similar highly rated securities. I'd guess some regulator decided that having an insurance wrapper made even those bonds riskless. So what do the financial engineers do?
Find a way to "insure" financial assets. Enter AIG and the credit default swap..
AIG proceeds to write a huge unhedged book of credit default swaps for other financial institutions. Those institutions no longer need to hold capital against those assets, so can buy more assets. Where do they get the credit? From overnight repurchase agreements with other financial institutions. In other words, a daisy chain of overnight debt to fund supposedly riskless assets.
Which of course eventually collapsed. Who can insure a default on a AAA asset? No one except a government that can print the money. Any other institution is likely to be in trouble and unable to pay in a severe downturn. So AIG was a house of cards. As was and EVEN NOW IS the entire credit default swap market.
Why is the credit default swap allowed to exist? It is a fraud and a scam. Even a clearing house cannot provide the ability to pay off its insurance in a severe downturn, unless Treasury collateral is required. But we know that is not what Wall Street wants. That would eliminate the profits in that market.
Get rid of credit default swaps. NOW.
Other Frauds
From this morning's WSJ story, Madoff was apparently a fraud for over 20 years. Hmmm. And he helped loosen short sale rules. Which brings another matter to mind: Why isn't a strong short sale uptick rule in place?
Markets
The public and hedge funds are likely to continue selling until the near the end of March. I am being cautious, but plan to buy stocks in April with new money. Krypto Fund is severely underweight in stocks.
Futures are weak early, a poor sign.
Word of the Day
"Catholicon" - noun [$100]; a Mrs. B word.
Catholicon means a universal remedy, panacea.
Sentence: If there is a cathicon for the current severe downturn, it's not "investing" in green technologies. Almost all those are heavily subsidized pits for long term losses. However, a catholicon for avoiding another or even more financial market turmoil does exist: get rid of credit default swaps and regulate hedge funds.
Le Mot du Jour
"Haltère" - noun, masculine.
Haltère means weight, dumbell, barbell in context.
La Phrase: L'homme du bunker a font des haltères hier matin.
Sentence: Bunkerman lifted weights yesterday morning.
Friday, December 12, 2008
Kill the Credit Default Swaps Market
As usual, the Financial Times leads the way in both news and good analysis. Here is the link to an article that I read this morning at around 3AM ET in Tuesday's paper edition:
http://www.ft.com/cms/s/0/8979777c-c591-11dd-b516-000077b07658.html
The title and author are "Put the credit default swaps market out of its misery" by John Dizard. Read it.
The ludicrous commentary on Babblevision and in some financial press about the price of insuring US government debt show how phony that credit default swap market is. Hundreds of billions of $$$ in real cash are being invested in US government bills, notes and bonds at all time record low rates, yet the pundits point to that phony credit defaults swap spread. How stupid !
Who is going to pay that CDS off if the US defaults ? One of the banks who trade it ? How is the counterparty risk distinguished from the credit risk on the named credit ? Those contracts are really betting parlor slips for Wall Street bucket shops. It's time to put those shops out of business.
Events
The US Senate killed the auto industry bridge loan. News reports says the reason was the UAW's refusal for accept immediate wage cuts to the level of its US Japanese competitors. Tough to argue with that demand as a starter. So the last hope to avoid major disruption is a large, $100 billion or more debtor-in-possession financing. Whether DC ruling classes can find the wisdom in doing that is debatable. The battle in DC seems mostly posturing now.
Concern about this is why I have deferred implementing the new "fund" for which I am researching stocks. I was burned in September by thinking the Congress would do the right thing, but it didn't ans the ensuing panic has been quite bad. So we might see a repeat of that mess in the real economy now.
The big problem with a GM bankruptcy is that it will not pay its suppliers, and likely thousands of those businesses in the supply chain will in turn have to file bankruptcy. After that, we'll have a food fight from one bankruptcy court to another. Ugh ....
Markets
Futures are down substantially early morning. Alpha Fund has a lot of cash.
I HATE WINDOWS !!!!!!!!!!!!!!!!!!
VISTA ABSOLUTELY SUCKS !!!!!!!!!!!!!!!!!!!!!!
I JUST LOST 10 MINUTES OF WRITING WHEN THIS PIECE OF SH*T OPERATING SYSTEM "RESTARTED" AUTOMATICALLY TO "UPDATE"
YES, I TOLD IT TO "POSTPONE" BUT IT DID NOT.
I WILL NEVER, EVER BUY ANOTHER COMPUTER USING WINDOWS !!!!!!!
My list of stocks to consider that "could" return 5 or 10x over two years numbers about 70. I'll trim it some today. Many good names appear - it seems one can get some quality in this risky venture.
PS: I never heard of Madoff, but this is just another bit of evidence that one should not trust a hedge fund. Ever. They are just bombs awaiting detonation in one manner or another.
PPS: The Madoff fraud suports my suggestion that all hedge funds over $100 million be subject to the Investment Company Act.
Word of the Day
"Rallentando" - adverb, adjective & noun [$10] musical
Rallentando means (adv. & adj.) with a gradual decrease in speed; (noun) a passage to be performed in this way.
Sentence: The US Senate, misnamed as the "World's Greatest Deliberative Body", has through its inaction sentenced the US economy to endure long rallentando movement in economic activity.
http://www.ft.com/cms/s/0/8979777c-c591-11dd-b516-000077b07658.html
The title and author are "Put the credit default swaps market out of its misery" by John Dizard. Read it.
The ludicrous commentary on Babblevision and in some financial press about the price of insuring US government debt show how phony that credit default swap market is. Hundreds of billions of $$$ in real cash are being invested in US government bills, notes and bonds at all time record low rates, yet the pundits point to that phony credit defaults swap spread. How stupid !
Who is going to pay that CDS off if the US defaults ? One of the banks who trade it ? How is the counterparty risk distinguished from the credit risk on the named credit ? Those contracts are really betting parlor slips for Wall Street bucket shops. It's time to put those shops out of business.
Events
The US Senate killed the auto industry bridge loan. News reports says the reason was the UAW's refusal for accept immediate wage cuts to the level of its US Japanese competitors. Tough to argue with that demand as a starter. So the last hope to avoid major disruption is a large, $100 billion or more debtor-in-possession financing. Whether DC ruling classes can find the wisdom in doing that is debatable. The battle in DC seems mostly posturing now.
Concern about this is why I have deferred implementing the new "fund" for which I am researching stocks. I was burned in September by thinking the Congress would do the right thing, but it didn't ans the ensuing panic has been quite bad. So we might see a repeat of that mess in the real economy now.
The big problem with a GM bankruptcy is that it will not pay its suppliers, and likely thousands of those businesses in the supply chain will in turn have to file bankruptcy. After that, we'll have a food fight from one bankruptcy court to another. Ugh ....
Markets
Futures are down substantially early morning. Alpha Fund has a lot of cash.
I HATE WINDOWS !!!!!!!!!!!!!!!!!!
VISTA ABSOLUTELY SUCKS !!!!!!!!!!!!!!!!!!!!!!
I JUST LOST 10 MINUTES OF WRITING WHEN THIS PIECE OF SH*T OPERATING SYSTEM "RESTARTED" AUTOMATICALLY TO "UPDATE"
YES, I TOLD IT TO "POSTPONE" BUT IT DID NOT.
I WILL NEVER, EVER BUY ANOTHER COMPUTER USING WINDOWS !!!!!!!
My list of stocks to consider that "could" return 5 or 10x over two years numbers about 70. I'll trim it some today. Many good names appear - it seems one can get some quality in this risky venture.
PS: I never heard of Madoff, but this is just another bit of evidence that one should not trust a hedge fund. Ever. They are just bombs awaiting detonation in one manner or another.
PPS: The Madoff fraud suports my suggestion that all hedge funds over $100 million be subject to the Investment Company Act.
Word of the Day
"Rallentando" - adverb, adjective & noun [$10] musical
Rallentando means (adv. & adj.) with a gradual decrease in speed; (noun) a passage to be performed in this way.
Sentence: The US Senate, misnamed as the "World's Greatest Deliberative Body", has through its inaction sentenced the US economy to endure long rallentando movement in economic activity.
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