The next shoe to drop

awgee_IHB

awgee_IHB

New member
Every now and then I rant about credit default swaps, and sometimes someone will ask a question, sometimes someone will add their two cents and it is obvious they know as little as I do, but mostly no one gives a hoot because the subject is too esoteric, confusing, and involves numbers that no one can relate to. Plus it is kind of boring.


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The other day I ranted a quick blurb about CDSes, credit default swaps, on the Calculated Risk blog and LawyerLiz asked a question. I don't remember what her question was, but she got some typical hack answers about how they would not be a problem and the Federal Reserve and America can take care of any problem. I could not answer her, because I was out for the day, but that evening a long time lurker decided to post.




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"Default" claimed to be a credit default swap trader, an insider, and began by answering LL's question and giving alot of extra info about CDSes. The following are his first few posts from that thread. The total of his posts are too long to paste all of them here, so I will continue to add more of that thread if I see interest. If you want to read both applicable threads in their entirety, here are the links:




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http://calculatedrisk.blogspot.com/2008/08/barronsroubini-interview.html




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and


http://calculatedrisk.blogspot.com/2008/08/open-thread.html




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Default writes:

Hey all, I just wanted to introduce myself and let you all know how much I appreciate your comments and knowledge. I work as a CDS (Credit Default Swaps) trader at a not-to-be named major Street firm. I've been lurking here for the past year and a half now - and the comments here have both colored my view of the markets and made me some pretty significant gains on the desk. A couple of the more "forward-looking" guys on the desk have started lurking here at my prodding as well - but for the most part, folks working on the Street are completely ignorant of the larger calamity we face in the fixed income markets/equity markets/world trade/the world in general. There is a degree of subtle intimidation that gets directed at those who question the sustainability of what we do on the Street, and so, for the most part, people trade their "product" and keep their heads down while praying for this year's bonus to be flat to last year's. The looks one gets when bringing up the existence of significant unaccounted for risks in my space (counterparty risk being the greatest) are not those that correspond with large EOY bonuses. And what are us traders if not profit-maximizing incentive-internalizing machines? But I digress... That being said, myself and a few other traders in CDS have really started to lose confidence in the validity/usefulness of our product. After all, if things really turn out the way that they look like they will, how many of our counterparties will have the money to pay up for their obligations? The fact that you are exposed to (what the street likes to call "residual", but what I consider MAJOR) counterparty risk in these transactions significantly impacts their value both as hedging and speculative instruments. For those of you more academically inclined, I would only point to the existence of the "basis trade" for proof of the contradictions within the CDS space. Anyways, I just wanted to say hello, and let you all know that I appreciate your continued proffering of information. Know that even at those institutions that many of you vilify daily (and for the most part, rightfully so), there are those of us who are on board with you, and would like to see the business change fundamentally to once again engage in its original purpose: the proper assessment of risk and the prudent allocation of capital. Cheers, Default | 08.02.08 - 10:10 pm | #




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Default writes: FIRST (1st) I'm going to deal with the question of the validity of the statistics proffered by our gentle and magnificent government from the perspective of the Street right now: We all know they're complete bullshit. But we trade on them anyway. Okay, hope that clears things up :) Cheers,


Default writes: Lawyerliz - Here comes the promised long-winded explanation on the mechanics of credit default swaps: Credit Default Swaps are an over-the-counter financial instrument used by participants in the fixed-income space to both hedge against & speculate on the risk of a company defaulting on its debt (hereafter referred to as the Reference Entity, or RE). Each CDS transaction involves two players - a "buyer" of protection on the RE, and the guy on the other side of the trade, the "seller" of protection on the RE. Essentially, the buyer of protection is "short" the creditworthiness of the RE - he is betting that the RE will default on its debt, and the seller of protection is "long" the creditworthiness of the RE - he is betting that for the duration of the CDS contract (typically 5 years), the RE will not default on its debt. Credit Default Swaps are typically purchased in blocks of 10 million dollars - that is, a buyer of protection is buying insurance against 10 million dollars' worth of an RE's debt defaulting. Per the terms of the contract between the buyer and seller of protection, the buyer will periodically (typically yearly) remit a payment for the protection to the seller of protection. This amount is typically notated in basis points, or "bps". Think of each basis point as representing 1/100th of a percent of 10 million dollars - so a CDS contract that costs the buyer of protection "100 bps" results in the buyer of protection remitting 100,000 dollars yearly to the seller of protection. The seller of protection receives these payments in exchange for his guarantee to remit, in the case of a default by the RE, the notional value of the CDS (10 million dollars) minus the eventual recovery rate on the defaulted debt (on the Street, it is generally assumed to be about a 40% recovery rate, meaning that contracts, when an RE actually defaults, pay out about 6 million dollars per 10 million notional to the buyer of protection). Now here is where things get tricky - what if I have bought protection from you, and when the RE defaults, you are unable to pay me? And what if shortly after I bought protection from you, the price of protection rose (lets say due to a negative earnings warning), and I sold protection to someone else, expecting my selling of protection to be fully hedged by my original purchase of protection? This is what Greenspan refers to as cascading-cross defaults - the fact that if one party in this chain of parties (and you can multiply the example I just gave by thousands of interconnected counterparties)defaults, the results can be catastrophic across the space. After all, I was relying on you paying me in order to pay the other guy, who was in turn depending on me to pay him to pay the OTHER guy...you get the picture. Something like this happening would be terribly destabilizing for the financial system, but its first-order effects are not what would hurt the average citizen - instead, it would be the complete seize-up in the financial markets (think the mortgage business in Florida today, but several orders of magnitude worse) resulting from such a situation that would hurt the average joe. So, in summary, CDS is more like the "pass the chips around" scenario you referred to before - but with profound implications for the many banks/insurance companies/other financial institutions that depend on them to hedge out credit risks. If you REALLY want an exciting Saturday night, ask me about monoline wrappers & synthetic CDOs...I'm ready to pop bottle number two. Cheers, Default | 08.02.08 - 11:15 pm | #




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Rob Dawg writes: Man, came here looking for wild game recipes and end up listening to a CDS inssider. Default, welcome they play hard here but they also play fair. Counterparty risk doesn't seem to be a working model. Seems everyone insured each other meaning no one can collect on a claim. Of course everyone has already collected their fees. Funny that. Anyway, I expect the next shoe to be insurance companies. Not only the payouts but the reduced business when new rates scare away a segment of clients. Then there's the fallout, insurance pools are backed by municipal and other large retirement investors who have been ramping benefits based on the broken returns model of recent years. Wadda ya think? Rob Dawg | Homepage | 08.02.08 - 11:16 pm | #




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Default writes: Misean - I'm assuming when you mentioned "cross-connects" in your previous post, you were referring to potential cascading cross-defaults & counterparty risk, no? If not, please explain.
 
I've been trying to figure out who loses at the end of this psycotic game of Duck Duck Goose, and what that cost is, since 2004.



I still don't have an answer.
 
[quote author="no_vaseline" date=1217931866]I've been trying to figure out who loses at the end of this psycotic game of Duck Duck Goose, and what that cost is, since 2004.



I still don't have an answer.</blockquote>
You know, those Ivy Leaguer who came up with all these "new and interesting" financial instruments never considered what would happen if their was a perfect storm. All in the quest to make bigger bonuses and hit the analysts' earnings expectations.
 
[quote author="no_vaseline" date=1217931866]I've been trying to figure out who loses at the end of this psycotic game of Duck Duck Goose, and what that cost is, since 2004.



I still don't have an answer.</blockquote>


To me, it's pretty simple, the loss is going to be 50% and it will be borne by the front end holder of the MBS. What is that? $7 TRILLION?



The whole line of CDS touchers is going to also suck up devastating parts of that 50% because they all played the hedge game of middle-man insurance premium collector. Unfortunately, nobody stopped to look that the guys collecting the last leg of premium for insurance was Johnny standing on the street corner and he's never paying, because frankly all Johnny ever had was $10 in his pocket and you and two hundred friends all paid him $1 each year for 'protection' which he is politely collecting from Latvia and will BK a soon as a claim comes in.
 
[quote author="no_vaseline" date=1217931866]I've been trying to figure out who loses at the end of this psycotic game of Duck Duck Goose, and what that cost is, since 2004.



I still don't have an answer.</blockquote>
I do. The first claims will get paid in an effort to reassure the markets, but somewhere along the line there will be one that can't be paid. The seller of the unpaid insurance claim will immediately file for bankruptcy protection; this begins the cascade of cross-defaults. From that point you have every bank, investment firm, pension fund, mutual fund, and sovereign fund filing claims as they rush to be "first" to get paid. When the actual money runs out, mass banruptcy filings occur across the country (maybe the world) and assets are frozen as injunctions are filed to by those same firms to prevent anyone getting paid before they do. Instant wealth destruction occurs as capital is vaporized or frozen solid in lawsuits. We skip the recession and fall headlong into a depression as no company can get credit (and can't afford to sell it's assets) to meet it's payroll, material, property, and debt service costs. Massive layoffs and closures begin as companies are forced to operate on actual cashflow alone. Unemployment skyrockets and claims for insurance benefits follow. Asset sales are so widespread that buildings and equipment are sold for pennies on the dollar because only a few have the cash to pay at time of sale; massive deflation begins. Congress and the President work together to "solve" this problem and the government begins spending money faster than the FRB & Treasury can create it. The dollar sinks to levels unimaginable in modern society as other countries refuse to buy any debt issued by the USA, or any company *in* the USA and we are cut off from any and all imports as dollars become worthless in international trade. Who loses? Go look in the mirror.



My bet for the company that starts the proverbial ball rolling? General Motors. They finance so much of their day-to-day operation and are bleeding cash so quickly that any default on their part will panic the world.
 
Cheery scenario, Nude!



I was reading "Default"s posts as he was writing and it was fascinating. did he ever explain sythetics, squared, etc?
 
<em>"My bet for the company that starts the proverbial ball rolling? General Motors".</em>



Funny your say that Nude. I just watched a story on CNBC a few hours ago about how GM cars (more specifically, Buicks) were considered status rides in China. I was like, Huh ?



Here comes the rah-rah propaganda to prop up GM !



<img src="http://www.analogstereo.com/images/om/buick_roadmaster.jpg" alt="" />
 
[quote author="freedomCM" date=1217988203]Cheery scenario, Nude!



I was reading "Default"s posts as he was writing and it was fascinating. did he ever explain sythetics, squared, etc?</blockquote>
Te next two post are for you, Freedom:




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Default writes: Misean - I'm assuming when you mentioned "cross-connects" in your previous post, you were referring to potential cascading cross-defaults & counterparty risk, no? If not, please explain.






Rob Dawg - You have more or less identified the weak link in the CDS space. For now, at least, folks on the Street believe that the Fed will ensure that counterparty risk never actually rears its ugly head - that major counterparties (a la Bear) will be continuously bailed out either by 1) a "strategic purchase" by another IB/CB, or 2) the Fed turning the notch on the firehose of "liquidity" it has directed at broker-dealers from "high" to "tear-apart-the-WTO-protesters" level. Misean (again) What exactly do I have to confess for? I'm doing my best to try and explain an esoteric product to people who have been nice enough over the year and a half I've been lurking here to provide reams of information within their body of knowledge/experience...sheesh. Synthetic CDOs, anyone? :) Cheers, Default | 08.02.08 - 11:29 pm | #


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Default writes: FRED - Your belief that the Fed bailout of Bear Stearns was really a bailout of JPM is the general belief across the Street. Like I wrote in my previous post, the Fed has a big firehose, and an even bigger lake to draw water from if the tank on the truck runs dry. They will do anything to keep this space from blowing up. The ramifications as far as future confidence in the U.S. financial markets, insurance companies who purchased expensive hedges for the riskier assets in their portfolios, hedge funds heavily involved in this space (who have state & local pension funds as major investors)...you get the picture. I don't really know a whole lot about the JPM derivatives book/gold manipulation rumor you mentioned - send me a link and I'll try and give color if I have any. Don't know anything about Chrysler either... Oh, and Lehman is alive because the Fed wants them alive. That's really all I can gather from the situation - after the Bear Stearns blowup,CDS traders across the Street were given a stern talking-to, with the message being that all firms will take all other firms as counterparties - full stop. What killed Bear was the Street essentially saying that it would no longer take Bear on as a counterparty - no CDS, no repos, no rate swaps, no complex hedges. Do I like Lehman as a counterparty? No. If I ran a hedge fund would I trade with them? No. But the Fed giveth and the Fed taketh away, and the Fed has spoken. As far as the transferability of CDS, what you are referring to is whats called "novation" of an existing contract. Essentially, if I have bought protection from you, and then decide that I really don't like you as a counterparty (or find that I need to rebalance my counterparty exposure away from you because you have been on the other side of too many trades of mine), I can ask a third party to step in and take your place on the other side of the trade (all parties must agree to this, and it can be pretty tough to get done). If the price of the CDS has increased, as a buyer of protection, I would have to make up the difference to the third party stepping into the space that you once occupied as my counterparty. Similarly, if the price of protection has decreased, I would have to make it up to you, the original seller of the protection (which is derived through a simple PV calculation of the future periodic payments I was to make to you, minus the lower payments I am to make to the new counterparty). Its only 11:43 out here, 2nd bottle popped and first glass poured. Cheers, Default | 08.02.08 - 11:49 pm | #




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Default writes: Whoa! Lots of stuff to reply to.

First things first: I am not an "astroturfer", whatever the hell that is. Merely a longtime lurker here & a participant in a corner of the market that I've begun losing confidence in. GM, Citi, LEH GM 5-years trade 2600 bps or so...of course, that means big points-up-front (due to the huge risk of default in the near-term), and probably 600-800 bps running yearly for the duration of the contract. I don't have my handy bloomberg & its CDSW function with me at home, so I'm stuck with the garbage that markit partners puts up. Citi, LEH Honestly, at this point, CDS on big financials like these are pretty much pointless. They have been getting bailed out. They will continue to be bailed out. If they fail, you probably wouldn't even get paid out on the CDS that you bought on them because they're probably a counterparty to your counterparty...and we're back to the problem I mentioned earlier, which the Fed will do everything in its power to keep from occurring.


Plantagenet - In the scenario you present, with the notional value of protection sold/bought on GM bonds far outweighing the value of the cash bonds outstanding, CDS buyers and sellers would do what's called a "cash settle." Essentially, (and this is probably a complete misrepresentation of the way it works, I can try and find the 200 page PDF on the process that I got from our research team), a very complicated auction is held in which the true recovery value of the GM bonds is discovered, and then applied across the board to all outstanding CDS contracts (remember, the buyer of protection only gets the notional value MINUS the recovery value in the case of a default). This has happened only once so far to my knowledge - the bankruptcy of Delphi (whoa, coincidence?)




Anonymous - LCDX is simply an index of leveraged loans that was put together by Markit. It works much the same way CMBX & CDX work, except its 100% 1st lien syndicated secured debt. Essentially, debt from LBOs. Hopefully that helps. Now for synthetic CDOs...coming right up ;) And the story ends horribly, just horribly. Cheers, Default | 08.03.08 - 12:15 am | #
 
Default writes: Konnoppolious - You have discovered Markit. Before Markit, the CDS market was, to use a very technical term, a complete shitshow. However, the pricing on single-name CDS (especially the more thinly traded REs) can be dodgy...(insert plug for your friendly local broker-dealer). Back to this synthetic CDO post...I'm debating between the "magic box" explanation or just telling you all that its much worse than you ever believed possible, but not as bad as CDO-squareds...talk about the epitome of ratings-agency arbitrage. Cheers, Default | 08.03.08 - 12:24 am | #




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Default writes: Dryfly - I trade CDS for a major Wall Street firm. I've been doing this for a couple of years now, after a much-detested stint as an investment banking analyst at another not-to-be-named Wall Street firm. I graduated from a not-to-be-named Ivy League school, and more or less "fell into finance" because its what was expected of a young man graduating from an Ivy. (We can get into a whole conversation regarding how bankrupt much of what goes on at the Ivies is at a later date). That's about as detailed an explanation as I feel comfortable giving right now...seeing as how the layoffs won't be stopping anytime soon across the Street, it might not be long before I'm posting as the Trader Formerly Known As Default. In my original post I laid out some of my reasons for finally jumping into the pool here - more or less, I've lost confidence in the efficacy & legitimacy of the product that I make a living trading. I've been lurking here (and a few other housing/finance/economics blogs) for a while now, and I've benefited both intellectually and financially from the comments posted here. I felt it was time to start sharing some of what I know, especially due to the fact that because CDS has no exchange, is completely OTC, and is often obscured (intentionally) by those who discuss it (mainly to protect their own arses when it comes to a risk committee meeting), people without exposure to the broker-dealer world may have no idea what's really going on in the space. No agenda here, just someone "Yearning to Learn", and possibly, if I can, yearning to teach just a little as well. Cheers, Default | 08.03.08 - 12:50 am | #




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Default writes: drone writes: No problem just wrap them with Ambac/MBIA insurance and they should be AAA, oops sorry I mean AA. Nothing can go wrong here. LMFAO That's what the guy who sat next to me said...I haven't seen him in a few months though ;) Cheers, Default | 08.03.08 - 12:53 am | #




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Default writes: Awgee - There are hedge funds that have written quite a bit of protection - many of them have actually been blown sky-high over the past year due to demands from their counterparties for a "cash settle" to their trades. However, as far as their dealings with Street firms, they get pretty rigorously checked out as far as ability to pay up. Such is the paradox of the Street - we might lose billions of dollars in a quarter due to positions moving against us, but we'll be damned if we let some rinky-dink 100 million dollar hedge fund that we've got a $500,000 position with walk away without paying up. Penny wise, pound foolish. Now here's a question you have to ask though: if you're a pension fund that decides to hedge some of its default risk through the use of CDS, wouldn't you purchase it from the strongest available counterparty? (Someone, say...with access to "the window") Why from a hedge fund? 25 people standing in a circle all with a gun pointed to their left...probably the best description I've heard of the CDS market so far... Cheers, Default | 08.03.08 - 1:08 am | #




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JP writes: Why from a hedge fund? Because the kickbacks are much more substantial. JP | Homepage | 08.03.08 - 1:12 am | #




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Mr. Beach writes: @Default: Glad to have you here sharing your insights. One question for you: do you have an overall counterparty CDS risk model for your firm that you can consult before considering a trade. Specifically, do you know exactly how much exposure you have with hedge fund X before you enter into a new CDS transaction with them? I guess what I'm trying to understand is whether your firm trades with systemic CDS risk in mind -- and attempts to keep it at a level considered 'safe'. In an ideal scenario, all market participants would do this and the whole market would not likely veer into systemic failure. Eagerly awaiting your post on synthetic CDOs. Mr. Beach | 08.03.08 - 1:14 am | #




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Default writes: Drone - I got turned on to Roubini about a year ago. He has been absolutely spot-on about everything that has happened thus far. Surprisingly, nobody on the Street wants to read him (or any of the blogs for that matter). What is it they say about a man believing in whatever he has to if his life depends upon its existence? If you're a typical trader/ibanker, Roubini doesn't exactly confirm your deep-seated belief that "models & bottles" are to forever be a major component of your lifestyle...

JP - To a certain extent, youth probably had something to do with it. But honestly, counterparty risk never even became part of the discussion in CDS World until the August meltdown. Before that, it was just another financial instrument traded OTC among "big boys." Much like interest rate swaps & other derivatives. As far as D.C. is concerned, I'm pretty confident that 1) Nobody up on the Hill even understands what the hell is going on, and 2) If somebody does, they are sufficiently frightened by the universe of possible outcomes that they will jump at the first "solution" offered by someone who appears to "be an expert" - so long as that person, and not that individual congressman, is the one doing the explaining in the public eye (Hank Paulson, anyone?) Cheers, Default | 08.03.08 - 1:20 am | #




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Default writes: Mr. Beach - If having a "risk guy" come by the desk and yell and scream that we have too much exposure to X or Y counterparty is considered a systematized method of reducing risk, then yes. I know that every firm on the street gauges CP risk across the firm, but as far as HF trades, its pretty much up to Mr. Screaming Risk Guy Whose Only Exposure To Anything Approaching Sunlight Is That Of His Liquid Crystal Display. Cheers, Default | 08.03.08 - 1:26 am | #




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crabsofsteel writes: Why let default have all the fun explaining what synthetic CDOs are? In "classic" securitizations, you would have to buy the collateral, whether it be subprime mortgages or corporate bonds, before putting a structure on top of it. The synthetic CDO did away with that bothersome detail, by just making up the collateral portfolio and paying the bonds according to its performance. crabsofsteel | Homepage | 08.03.08 - 1:52 am | #
 
Default writes: Synthetic CDOs. Imagine yourself a magic box. A box with infinite possibilities. A box in which one may place - say - credit risk. Imagine this thing - this "credit risk." What is credit risk? How does one "get" credit risk? From where? Why, there are two ways - either by purchasing actual bonds (cash bonds), or by writing credit default swaps (selling protection, see previous posts for more details). Now you are a lazy lazy magical box owner. How can your lazy self stuff your magical box with credit risk in the easiest way possible? Cash bonds are hard to find - sometimes quite illiquid - and you can never get the right size! You think to yourself...hmmm....why don't I just write a bunch of protection? Its credit risk, right? Yeah! Why don't I write a billion dollars of protection?! On 100 different companies, for 10 million dollars each! Brilliant! I can fill my magical box to the brim with the stroke of a pen! Now this magic box has 1 billion dollars in notional credit risk - and you're receiving several hundred basis points a year on 1 billion dollars in protection that you wrote! You're a genius! But wait...that's just too easy...you don't want ALL the credit risk, just the really, really, really risky stuff. Cause that's how you make money baby! Risk-reward! So what do you do? Well...you take the magic box, and next to it, you create a CAPITAL STRUCTURE. And what's in this capital structure? Well, there's a really good TRANCHE up top, and these guys at this place down the block called Moody's say its AAA. Triple-A! Like the U.S. Government! Oh boy, you say, but its just a bunch of credit risk! And Moody's tells you, no sir, you've SLICED and DICED, and if you SLICE some more, you can make ANYTHING YOU WANT! And you say to the Moody's guy: I WANT THE RISKIEST RISKIEST MOST RISKY PIECE! SLICE ME ONE! And the Moody's guy says to you: Well - take this slice off of the VERY BOTTOM - we call it the EQUITY TRANCHE - but don't forget, its RISKY! If somebody defaults, you lose a lot of money! And you say your thanks to the Moody's guy, because you?re a gung-ho RISK-TAKER, and you go on your way. Now everything has been humming along ? the magic box is stuffed to the brim, the capital structure has been made, and you, the genius who created it, sold off all of the pieces of the structure to various investors. Now, since you?re such a risk taker, you decide ? hey! Why don?t I take a bunch of everyone else?s riskiest pieces, and make ANOTHER capital structure, and slice it and dice it and get the Moody?s guy to tell me one piece is AAA and another is BBB and before you know it ? you?ve created a synthetic CDO of a synthetic CDO. Okay, maybe that was a terrible story to give you all an idea of what a synthetic CDO is. A synthetic CDO is just like a regular ol? normal CDO, except for instead of cash bonds being used as the collateral (CDO = Collateralized Debt Obligation), synthetics (CDS) are used to mirror the credit risk of cash bonds. The synthetic CDO will sell protection, and receive premium, on a variety of bonds ? and then a capital structure is created off of the CDO, with the cashflows from the sale of protection allocated pro-rata, and the losses from defaults allocated from the bottom up (i.e., the owner of the lowest tranche of the synthetic CDO has to pay in cash when the first defaults occur, and then the next lowest pays, and so on so forth all the way up the capital structure). Here is the problem with synthetic CDOs ? they are extremely hard to value. Not only must you factor in the cashflows that you are receiving from your original sales of protection (which were sold at levels far too cheap in my opinion given the current state of the credit markets and the state of the credit markets when most of these monsters were created), but you must also factor in recovery rates in the case of default, and the possibility that the highest tranche (the AAA tranche) may actually have to PAY OUT. This is absolutely NOT SUPPOSED TO HAPPEN ? the AAA tranche is supposed to be a AAA ? i.e. damn near zero risk of defaults ever touching it. I might do a better explanation when I am not nearly as intoxicated. Cheers, Default | 08.03.08 - 2:03 am | #
 
[quote author="no_vaseline" date=1217995771]You guys are scareing me.</blockquote>


Why? Cramer and all the talking heads on Bubblevision say the bottom is in for housing, the credit crunch, the financials, and the stock market, and the top is in for oil. Goldilocks is here again.
 
Konnaun von braun writes: What about this cat, does he have it right?http://boombustblog.com/content/...nt/view/361/34/Creation of colossal US$45 trillion CDS market may unfold into trouble larger than subprime crisis The creation of the massive US$45 trillion CDS market in the last few years, which faces some unique problems, can unfold into a massive bubble collapse that would easily dwarf that of the subprime crisis. The CDS are supposed to cover the losses of banks and bondholders in the event of default by companies. However, the CDS market has evolved from being primarily a means to hedge credit risk to a speculative and trading platform for a large number of banks and hedge funds. If the corporate defaults surge in the coming quarters (as Reggie Middleton, LLC expects them to) or there is default in payments of coupon and principal amounts, this could lead to a crisis far worse than what we have seen so far in the current ?asset securitization crisis? and quite possibly in the recent history of the financial system. The high yield default rate has increased significantly (125%) in the last few quarters from 0.4% in 1Q 07 to almost 0.9% in 1Q 08. In addition, the monolines which are under considerable stress and play the role of both counterparty as well as the reference entity in the CDS market could spell major trouble for the market participants. Konnaun von braun | Homepage | 08.03.08 - 2:04 am | #




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dk writes: Default - you rock. Thanks for that. I'm a Risk Manager (not credit :)) at a very large wall street bank. You've provided a better explanation of CDS etc than any cds trader/rm at my firm. Keep in mind they are not dumb - they just don't seem to be too forthcoming with the information at Risk Council Meetings :) I bet if the identities of the folks who post on this blog was ever made public we would all have one hell of a laugh... The postings on this blog from insiders have been some of the most honest, intelligent, and direct financial discussions I've heard outside of academia. Back to studying for the GRE - I'm off to pursue a PhD in underwater basket weaving once my firm implodes. Regards dk | 08.03.08 - 4:24 am | #




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syvanen writes: Jorge Sorros, I think default is legit. He is answering questions in a consistant fashion that I have been posing for months without anyone coming close to answering. More questions for default (once you sober up, I hope). What is the total value of all the CDS positions currently in play? I have heard numbers from a low of $45 trillion to as high as $500 trillion. These numbers seemed astoundingly large but see if I get this right. Let me use the simile of 25 people standing in a circle each with a gun pointed to the left. Let us say one of the participants has a $100 bond and buys insurance for it from someone on his left. This person then hedges his position by buying insurance from the person to his left. And down the line. The circle simile breaks down here since why would the person holding the bond want to also sell insurance, but whatever, let it be a line. Now we have 24 positions covering that bond which puts the total value of all positions at $2,400. If the bond defaults and each player is depending on the hedge than the last player in line will have to pay. If not, then we will then have total losses of $2,400. For accounting purposes these sound like real losses. Is that close? If so, it would explain why a total bond market of less say $20 trillion dollars could have produced a CDS market of $480 trillion. Or if Roubini is right and the defaults are "only" $2 trillion then we would have a losses in the CDS market of $48 trillion. What does it mean that the 'notational' losses are only in the 200 - 400 billion dollar range? (someone used that term early in this thread, I have no idea what it means). syvanen | 08.03.08 - 4:56 am | #




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MLM writes: Default - Thanks for posting, hope you continue to contribute. syvanen - I assume we're really talking about "notional value" see:http://financial-dictionary.thef.../notional+value A good way to think about this is that if you buy a CDS on $10 million of U.S. treasuries, the notional value is $10 million. But you didn't have to pay very much up front for the protection: "The cost to insure Treasury debt with credit default swaps jumped to 16.5 basis points, or $16,500 per year for five years to insure $10 million in debt, from 8 basis points on Thursday, an analyst said."http://www.reuters.com/article/m...SN1121920080711 The real question is what the "probable losses" are on all that notional value. That's a religious question. MLM | Homepage | 08.03.08 - 5:37 am | #




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MLM writes: As to the question of how much notional value of CDS are outstanding, looks like roughly 45 trillion is correct, with all derivates being about 500 trillion. MLM | Homepage | 08.03.08 - 5:53 am | #




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bond guy writes: "syvanen writes: What is the total value of all the CDS positions currently in play? I have heard numbers from a low of $45 trillion to as high as $500 trillion. Is that close? If so, it would explain why a total bond market of less say $20 trillion dollars could have produced a CDS market of $480 trillion."


As pointed out above, the CDS numbers are probably 45T, and the total derivatives is 200T. Interest rate and currency derivatives have huge exposures outstanding. The "don't worry, it's contained" story is that although the notional is huge, net positioning is small. For example, let's say a broker has a pair of clients who enter matched trades on GM for $100. (In real life, $100 million.) There will be two CDS contracts of $100 million each ($200 notional). But the broker is hedged, and there's really only $100 exposure between the two clients. Then those two clients again "close" their positions by entering trades with another broker. They will again enter $100 contracts that offset eachother. There's now $400 in CDS contracts, but $0 net exposure. That is of course, assuming that there's no problem settling the contracts that offset. This explosion in notionals not happen in markets where you deliver the underlying - futures, cash bonds. In those markets, offsetting positions are physically netted to zero, and are safer as a result. But they are not as profitable as the opaque Over The Counter markets for brokers. In addition to this netting effect, you have tons of arbitrage activity - client buys the index, the broker sells most of the constituents, etc. This is probably where most of the netting will occur. I'm am unsure whether the CDS market will blow sky high. But there is one impact that may in fact be stabilizing. There's such a high demand for defaulted corporate bonds to deliver into CDS contracts that bond holders may get surprisingly good recovery values, even though the CDS holders will ultimately get a lot less when the corporations are liquidated. (The delivery of bonds occurs a month after the default event; it typically takes at least a year to wind up a corporation.) bond guy | 08.03.08 - 8:36 am | #
 
[quote author="awgee" date=1217996139][quote author="no_vaseline" date=1217995771]You guys are scareing me.</blockquote>


Why? Cramer and all the talking heads on Bubblevision say the bottom is in for housing, the credit crunch, the financials, and the stock market, and the top is in for oil. Goldilocks is here again.</blockquote>


And Moody's says it's AAA!
 
Goldilocks may have overdosed on her kool-aid.

She is in the Emergency Room and on Life support.

Her Credit Cards are Maxed and her Health Insurance is

un paid. Things are looking poor for our young girl.



My analogy is its like a huge game of Musical Chairs.

But this game entails the music never stopping.

And now there are so many players and so few seats.

Suddenly the music is getting off key.

All its going to take is that first person running to sit down.

Thats not going to be a good day.
 
So to relate this story to housing.



Grandma's house is in Huntington Beach in need of little TLC. So grandma sold her place to a nice young man called Angelo. Angelo never wanted to live it in, he just wants a cut as a property manager so he decided to rent it out. So he slapped a coat of paint on it and got a renter. Being of quick wit, said, "hey, I bet I can do this a bunch", so he booted the renters, sold the property to an investor out of state that needed a proprty manager and wanted the cash flow. He steamcleaned the carpet and got a new renter, collecting his placement fee. Woohoo, he's rich, he can buy another. And does. Then he get's another idea. "Hey" he thinks, "I bet I sell my investors place to another investor and make a commission on the sale" so he does. And he sells both places managing both properties, getting new tenants. And so on. Around about time the eighth "landlord" shows up, the new renters aren't really pleased with their gourmet kitchen of painted cabinets and resurfaced procelain sink, but the final straw was when one of them came back from planting tomatoes in the garden covered in Texas Tea. So they call the EPA, who sends out the superfund and discovers somewhere along the line, someone chiseled out the concrete in the garage and used it as a drain for an underground used oil dumping operation. The superfund will clean it up, but first, they want the landlord to pay. Once the landlord is broke, they make the previous landlord pay, the previous landlord can get his money back after be proves he didn't dump the oil, but for now he's got to pay. And so on, all the way back to Angelo.



And then Grandma.





Do I have that about right?
 
[quote author="no_vaseline" date=1217995771]You guys are scareing me.</blockquote>
I spent that better part of last summer trying to get myself educated on what was really going on. I consumed enough information to give me chronic insomnia (even now), which leaves me more time to consume more information. After a year, I know enough to realize how little I know. It's like contemplating the size, scope, and age of the universe; every bit of information just leads to more questions and an eery feeling that you are never going to grasp it all. However, I am no longer scared by it because I realized that I can not change one damn thing about the situtation, no one knows when the real Black Swan Event will occur, and I have done all that I know how to do to prepare for what is possible without actually moving to a cabin in the woods with an entire Von's stuffed in my basement.
 
That thread was the greatest thread of all time, and it kept on going until

well into the next day hitting well over 400 posts.



Default hasn't shown up on subsequent threads that I've noticed.



It may be that he has to work.



And--didn't anybody check to see that there were assets set aside

to pay for defaults? Or, I guess it was that hedges were seen as a substition

for assets.



Didn't something like this happen, like 20-25 years ago with letters of

credit, where there was a big blow up?



GM is already whining to the gov-mint for money, and if it's gonna be as

bad as you say, nude, I'm sorta for giving it to them.
 
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