The next shoe to drop

thanks for reposting the part after i stopped reading.



I'm not really sure what real world effect the higher-order bonding is going to have (the 200T or 480T biz), but i think that the lower order (20T) biz is more grounded in recoverables.



I guess the higher order stuff could blow up, and further freeze up the financial markets.



My impression is that the 20T is vulnerable, but only 10-25%.



Anyone else hazard a guess?
 
[quote author="lawyerliz" date=1217999644]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.</blockquote>


My fear is the Gov-Mint gets involved, in which case, it will be as bad as Nude says and my peso comment will come true.



I'm cynical and my gut tells me, when wall street finds out the Gov-Mint isn't going to pay it, they'll actually hunt down the money just like they hunted down the UK broker that lost billions on derivatives years back trying to disappear in Bali, or Indonesia or Australia somewhere.



That's the amazing thing about WallStreet, when they are OWED money, they're about as tenacious as the Tony Soprano and Paulie and coming to get it.
 
[quote author="lawyerliz" date=1217999644]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.</blockquote>
Hell no. Giving taxes to corporations as a reward for bad performance? What the hell is good about that? That's the true definition of corporate welfare. As far as I am concerned, the entire system needs to fail because patches, fixes, and bailouts will not change the underlying issues that caused this mess. Screw the banks, screw the hedge funds, screw the pensions funds, screw the mega-corporations; they brought this on themselves directly, and even though this country (and others) will suffer for it mightily, this is what *we* deserve. We handed our money over to some asshats in exchange for some vague promise of a high rate of return. We bid up the price of land so we could have bigger houses with 15' ceilings and 4 car garages. We took out massive debt and revolving credit lines and spent it all on "wants" so we could keep up our vain and selfish appearances. We put each other at risk with zero worry about what lay down the road, passing off any consequences to grandchildren we don't even have yet.



It's time that this country paid the price for living on tomorrow's income. We all have to suck it up and take the pain, pay off the debts, cut back on every want and focus instead on getting through the lean times with what we need. We have to force companies to act as if their behavior actually comes with the consequences of failure. Executives need to be accountable for failure, politicians need to be fiscally responsible with our collective tax dollars, and we the people need to demand that we get a better education in matters of finance so that we can't be bamboozled by shady salesmen with a "Big Idea".



Sorry for the screed, it's not directed specifically at you but at any idea that another bailout is gonna fix things. The party is over and it's time for everyone to settle their tabs.
 
[quote author="freedomCM" date=1218000704]thanks for reposting the part after i stopped reading.



I'm not really sure what real world effect the higher-order bonding is going to have (the 200T or 480T biz), but i think that the lower order (20T) biz is more grounded in recoverables.



I guess the higher order stuff could blow up, and further freeze up the financial markets.



My impression is that the 20T is vulnerable, but only 10-25%.



Anyone else hazard a guess?</blockquote>


Actually, it is no big deal as long as the counterparties make good and settlements are paid. The problem is if a few counterparties do not pay and it sets off cascading defaults. Then notional value becomes real value which will be zero. No, that doesn't mean no one owes anybody. It means everybody owes everybody and no one has any money to pay. Yeah, I know that sounds nuts, but that is reality. Like Nude said, there is not a darn thing he can do about it, and I will add, there is nothing anybody can do about it.
 
[quote author="No_Such_Reality" date=1218000895][quote author="lawyerliz" date=1217999644]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.</blockquote>


My fear is the Gov-Mint gets involved, in which case, it will be as bad as Nude says and my peso comment will come true.



I'm cynical and my gut tells me, when wall street finds out the Gov-Mint isn't going to pay it, they'll actually hunt down the money just like they hunted down the UK broker that lost billions on derivatives years back trying to disappear in Bali, or Indonesia or Australia somewhere.



That's the amazing thing about WallStreet, when they are OWED money, they're about as tenacious as the Tony Soprano and Paulie and coming to get it.</blockquote>


The Fed will try to pay.
 
[quote author="Nude" date=1218001192][quote author="lawyerliz" date=1217999644]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.</blockquote>
Hell no. Giving taxes to corporations as a reward for bad performance? What the hell is good about that? That's the true definition of corporate welfare. As far as I am concerned, the entire system needs to fail because patches, fixes, and bailouts will not change the underlying issues that caused this mess. Screw the banks, screw the hedge funds, screw the pensions funds, screw the mega-corporations; they brought this on themselves directly, and even though this country (and others) will suffer for it mightily, this is what *we* deserve. We handed our money over to some asshats in exchange for some vague promise of a high rate of return. We bid up the price of land so we could have bigger houses with 15' ceilings and 4 car garages. We took out massive debt and revolving credit lines and spent it all on "wants" so we could keep up our vain and selfish appearances. We put each other at risk with zero worry about what lay down the road, passing off any consequences to grandchildren we don't even have yet.



It's time that this country paid the price for living on tomorrow's income. We all have to suck it up and take the pain, pay off the debts, cut back on every want and focus instead on getting through the lean times with what we need. We have to force companies to act as if their behavior actually comes with the consequences of failure. Executives need to be accountable for failure, politicians need to be fiscally responsible with our collective tax dollars, and we the people need to demand that we get a better education in matters of finance so that we can't be bamboozled by shady salesmen with a "Big Idea".



Sorry for the screed, it's not directed specifically at you but at any idea that another bailout is gonna fix things. The party is over and it's time for everyone to settle their tabs.</blockquote>


LL - Nude is right. Trying to bail out bankruptcies just prolongs the problem and makes it worse. It is analogous to giving heroin to a addict.
 
Default writes: Hey all,




I just had a chance to catch up on all of the comments posted re: CDS after I

hit the sack.




MLM - The auction mechanism bond guy gave some color on (and the concomitant inflated

recovery values that can occur due to the notional amount of CDS far

outnumbering actual cash bonds in case of default) is described - very well on

www.creditfixings.com These are the guys that run the auction process.




Bond guy's assertion that cash bonds are 1) tough to short, and 2) even tougher

to cover is 100% accurate. This is probably the major reason for the CDS space

expanding so rapidly in the past couple of years. Instead of getting stuck with

whatever size a broker-dealer/insurance company/hedge fund has in terms of cash

bonds, its much easier to just buy protection from a willing seller. The

implicit leverage of CDS is an additional bonus to the buyer of protection -

unless you're paying points up front (like protection on GM, for example), a CDS

transaction is far cheaper in terms of cash going out the door than financing

the purchase of a cash bond. Additionally, you can tweak duration however much

you'd like to when buying/selling CDS - 1,2,3,4,5,7,10 year protection is all

available, whereas with a cash bond, you are stuck with the original maturity

stipulated at the time of issuance.




If CDS were traded on an exchange, much like eurodollars, S&P;futures, etc, all

of the problems myself and other posters have pointed to would be moot - your

only counterparty risk would be that of the exchange (instead of buyers and

sellers of protection meeting each other, each side would meet the exchange, and

it would be the exchange's responsibility to ensure that the market reaches

equillibrium). Greater transparency, better information, lower transaction

costs, etc would result.




When I say that I have lost confidence in the efficacy of the product I trade, I

mean that in its current form. CDS, if rethought and reworked, actually makes

perfect sense, both as a hedging and speculative tool. However, in its current

form, the market is just too opaque & convoluted for it to be able to withstand

any significant stress event. Just my two cents.



Cheers,

Default | 08.03.08 - 12:08 pm | #




/




Default writes: Energyecon - I think TPTB would eventually like for much of CDS world to move onto an

exchange - and I'm in complete support. I think they've just been distracted *a

bit* with all of the other shoes that have been dropping around the Street.

Getting the major banks to get on board with an exchange is like herding cats -

one of the largest areas of profit growth over the past few years at most banks

has been CDS & other OTC derivatives (we can get into bespokes if you want) due

to the fact that when I give a price for protection, I'm really only competing

with 20-30 other entities liquid/creditworthy enough for folks to actually buy

protection from. This lack of competition means...drumroll...fat profits.




So yeah, longer-term, its moving to an exchange-based model, but for now, we'll

be limping along & collecting outrageous (when compared to liquid, competitive,

efficient exchanges) bid/offer spreads.



Cheers,

Default | 08.03.08 - 12:17 pm | #




/








Default writes: Bond Guy - I'd take that one step further - once clients & customers realize that they can

isolate themselves from risk of their counterparty paying up on their

obligations, and that it makes absolutely no sense for them to be paying fairly

high transaction fees for standard transactions (i.e. 5 year protection, the

most liquid), they will clamor for an exchange-traded, standardized product.

Imagine how much easier that would be for mr. insurance company risk manager guy

to deal with...




But that's still a few years off. For now, the "customized clearinghouse" you

mention is probably where we go.



Cheers,

Default | 08.03.08 - 12:31 pm | #
 
[quote author="awgee" date=1218017391] It is analogous to giving heroin to a addict.</blockquote>


You say that like enabling is a bad thing.
 
awgee,



I simple click of the thanks button would not do justice for the time you have taken to copy and post those comments. I love CR, but I stopped reading the comments about a year ago because I want to read them all, but I just don't have the time. I never would have known about some of the most informative breakdown of CDSs were posted there. So thanks awgee, you rock and so does default.
 
[quote author="lawyerliz" date=1217999644]

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.



</blockquote>


Well now, that is the $45 trillion question. First, let us figure out who "they" are in this circumstance. "They" are insurance companies, oil companies, investment banks, sovereign wealth funds, monoline insurers, pension funds, and anybody who cares to invest in credit risk or hedge credit risk. So there is not one "they" with one method of evaluation or any standard for checking on the assets. Each party will check however they deem necesary.


And what does recent history tell us on how well these entities have calculated risk assessment on mortgage backed securities and other asset backed securities? I kinda doubt "they" did any better due diligence on something as complex and opaque as credit default swaps.


Ya think maybe they used the ratings agencies to evaluate the credit worthiness of the issuing parties?


Since there is no central clearing house, there is no way to know if the counterparty you are using to hedge risk, has not already hedged the same risk with 10 other entiites. And when you check their balance sheet, you will see credit default swaps listed as assets and liabilites, but at what valuation? Uh-oh! Did it just occur to you that they may be, (are), using the infamous mark to model method of valuation? There is no market for CDSes, so they can value them at any valuation they please and who will question?


And the big question, just what the heck are CDSes worth if cascading defaults occur? How the heck do you value something which pays you nothing? And you have been carrying on your books as an asset with a valuation?


The good news is that there is nothing you or anybody else can do about it, so you may as well not worry. But, you may consider being prepared.
 
Prepared for what?



Turn into Ted Kazinski?



It it explodes the way you describe (and I'm not saying it won't) we're all fish food anyway.
 
[quote author="no_vaseline" date=1218061686]Prepared for what?



Turn into Ted Kazinski?



It it explodes the way you describe (and I'm not saying it won't) we're all fish food anyway.</blockquote>


Prepared for credit deflation and Federal Reserve implemented monetary inflation.


/




David Pearson writes: Default,



A simple question that has been dogging me: why haven't the CDS cross-defaults

already occurred?

<br.

Its tempting to think of CDS-writing as the ultimate 2006/2007 hedge fund tool:

rake in the premium, show no volatility in returns (clients gotta love that!),

then go mansion-hunting in the Hamptons. Oh, and if it (housing) blows up, no

worries! Its OPM, and you can probably shut down and open a new fund anyway.




So, I imagine a lot of CDS on ABS was written by hedge funds with very little

supporting capital. If that's the case, CDS is similar to a severely

undercapitalized Lloyds of London. Following the analogy of Lloyds, we just got

hit with multiple, simultaneous CAT-5 hurricanes (in the form of six-sigma ABS

losses).




So why is the under-reserved, undercapitalized "Lloyds of London" still

standing?

David Pearson | 08.03.08 - 12:47 pm | #




/






Default writes: mock turtle -



Its not as though anybody who trades CDS for a major broker-dealer actually owns

any or has sold any protection, so a meltdown in CDS world would instead affect

their lives by its second-order effects (layoffs, etc).




Beyond a certain point, most people on the Street receive their bonus

compensation in company stock that vests on a 3-5 year schedule. The CDS/other

derivatives traders that I know (who are probably a somewhat more skeptical

bunch than most) have been hedging this "permalong financials" position that

they have due to a large concentration of their net worth being tied up in

company stock by 1) going long oil/other commodities in the past year, and 2)

buying options on SKF, SRS, etc.



Hopefully that helps.



Cheers,

Default | 08.03.08 - 12:49 pm | #




/






Default writes: David Pearson -



The cross-defaults have not yet occurred due to the existence of a mysterious

character who I referred to on last night's thread: Mr. Screaming Risk Guy Whose

Only Exposure To Anything Approaching Sunlight Is That Of His Liquid Crystal

Display.




His job is to investigate the ability of hedge fund/other non-broker-dealers'

ability to pay. Additionally, there really haven't been very many defaults yet.

However, I suspect that this party is only just getting started...



Cheers,

Default | 08.03.08 - 12:57 pm | #




/






MLM writes: Default -



Does Screaming Risk Guy (that would make a nice handle, BTW) keep up with what

the counterparty does after the fact? i.e. anything to keep those zit-faced

hedgies from writing more protection to someone else a month later and Risk Guy

is none the wiser?

MLM | Homepage | 08.03.08 - 1:04 pm | #




/




Default writes: Trapped Inside Kona -



You'd probably have to talk with a middle-office/risk management/legal person to

get answers to the questions your asking. Most traders of CDS (at least at the

broker-dealer level) aren't even remotely concerned with their counterparty risk

- Mr. Screaming Risk Guy comes by, yells at them to DK the trade they just did

with XYZ hedge fund for whatever reason, and the trader gets on the phone and

has an awkward conversation. That's really it.




As far as the mechanics of CDS trades, there are pre-existing, standard

contracts used (concerning the definition of the reference entity, what

qualifies as a credit event, whether the contract is "modified restructuring" or

"no restructuring", etc) and really all you can do as a line trader is:




1) Indicate your bid/offer

2) Indicate the size at which you are willing to execute

3) Indicate the duration of protection




Hopefully this helps.



Cheers,

Default | 08.03.08 - 1:04 pm | #
 
So now that my head hurts, it basically boils down to inefficient markets allowing someone to make a fat profit by leveraging a perceived small risk multiples of times and charging excessive premiums. Wow, can we say "Liar's Poker"



IOW:



Mr. Hedge fund uses their billion dollar bank roll to 'insure' a hundred billion dollars worth of stuff. Mr Hedge fund does this by doing a thousand or more different transactions in which he is selling a hundred million dollars worth of protection for 50 basis points/yr for five years on a AAA 'rated' investment. Mr. Screaming Risk Manager thinks it's okay because Mr. Hedge Fund has the assets to cover their protection. The underlying 'rated' collateral has an expected default of 1%, so with 1000 transactions, he's expecting 10 to go bad over the five years. In an orderly world, that's losing two hundred million a year, but Mr. Hedge Fund is collecting five hundred million dollars in premiums and collecting another forty million or so on the back end on liquidation of assets. The annual transactions allow him to post like clockwork profits in the 38% range or more if the defaults aren't occuring. But if defaults spike and that AAA rated debt really isn't AAA and defaults ramp to 10 a year, Mr Hedge Fund gets wiped out, shutdowns, and looks back in fondness to the former profits from which he raked 10% off the top with his annual $38,000,000.00 bonus.







Does that sound about right? (I'm not being factitious, just trying to find the money]
 
NSR - I think you got it about 97%. My main thought is that when your hedge fund can not pay, it is not just the hedge fund which goes under, but it may set off cascading defaults.
 
I did very little of any of that, and I resent having to

pay for these idiot's idocy.



On the credit Default swap thing:



It takes a while for this stuff to penetrate my teeny weeny

brain, but was default saying that when somebody hedges

with somebody and hands them money, instead of buying an
 
[quote author="awgee" date=1218083613]NSR - I think you got it about 97%. My main thought is that when your hedge fund can not pay, it is not just the hedge fund which goes under, but it may set off cascading defaults.</blockquote>




That is the scenario where the discussion moves from the 40T number to the 500T number, no?



this would BK/freeze up all of the credit markets/street/hedge work, and we would be back to 1950s finance, i take it?
 
I get that cascading part too then. (although my numbers are way too generous)



That scenario is were Mr. Hedge Fund realizes he can have something for nothing.



Mr Hedge Fund takes that hundred billion of 'protection' aka "risk" that he sold and bundles it up together as a synthetic CDS (sCDS). It has a bunch of tranches at a billion a piece:



<pre class="code"><table>

Seniority Quantity Basis Pts Paid Amt. Per Total Payment

1st 60 5 $500,000.00 $30,000,000.00

2nd 20 10 $1,000,000.00 $20,000,000.00

3rd 10 25 $2,500,000.00 $25,000,000.00

4th 4 35 $3,500,000.00 $14,000,000.00

5ht 3 40 $4,000,000.00 $12,000,000.00

6th 2 50 $5,000,000.00 $10,000,000.00

Last Eqt 1 2500 $250,000,000.00 $250,000,000.00

Total 100 $361,000,000.00

Profit $139,000,000.00

</table></pre>



Now Mr. Fund goes looking for a little protection of his own, for this sCDS. It's all an amalgam of that original AAA 'protection' he sold that has a 1% perceived default rate over five years. So Mr. Fund can make some money. Mr. Fund realizes that by bundling his risk up and creating seniority levels, just like 1st and 2nd mortgages, he can nearly eliminate the risk to the top tranches and thus, buy protection for them for nearly nothing.



For the 1st seniority tranche, he only needs to pay five basis points, a mere half a million dollars for a billion dollars of protection! He know it sounds nuts, but his old friend Mr. Bear Stearns says sure, I'd love to provide you that protection. It's five free basis points on a billion for me. The other six tranches have to fail before I don't get paid and that's a 40X expected default rate. I'll take all sixty!



Likewise down the line serious discounts to the orignal premium because we have to have way in excess the default before we pay out. Even down in the 3rd most senior tranche, we're paying 1/2 the premium rate for protection because they expect the default to be 1% and that means we need 10X the default rate before we even start to pay. And so on, to the 2nd to the last (6th most senior) and last seniority, the equity tranche.



For the 6th most senior, he can pay par on the premium because we need to exceed the default rate by about 100% before the provider has to pay, they are protected by the equity tranche, which expects to get wiped out but between the recovery rate and the fat 2500 basis point premium, expects to crank out fifty million dollars profit from their premiums over their expected pay outs of two hundred million a year and then suck up eighty million more in recovery. He sells that 6th tranche free money maker to his friend Buddy Hedge another billion dollar hedge fund.



Everybody is protected by the equity tranche, not only do the losses need to wipe out the tranche, but the losses have to exceed both the premiums and the recovery rate before the equity tranche has to pony up money. Roughly four hundred million in defaults per year before Mr. Equity Tranche feels a pinch becuase he's getting two hundred and fifty million in premiums, pulling in (40%) a 160 million in recoveries for $410MM. A touch over double the expected losses before the annual cash flow won't cover it.



Naturally, Mr. Hedge Fund will keep the equity tranche for himself, pocketing $389MM/yr, but he appears to only be exposed for two hundred million a year and he's got a billion, so he does it five times. Making 1.9 Billion in premiums and losing a Billion in protection payouts, but gaining an additional 400 Million in recoveries for a net 139% yearly profit. He takes his hundred and thirty nine million dollar bonus and feels like a god.



Until...



the defaults roll in at 3X and he doesn't have the money. He's short a billion... Then the ____ hits the fan. You see, Mr. Buddy Hedge, thought his risk was super small, and so did Moody's and everybody else, so he's holding a two hundred billion dollars of those 6th equity traches from a bunch of different people, two hundred in fact, and frankly, isn't expecting to pay out a bloody thing. Let alone one hundred million per tranche he's holding. He's short $18 billion dollars...



And the snowball is away...
 
[quote author="No_Such_Reality" date=1218090238]

(summarizes) </blockquote>
Well done! Now extrapolate that to include every pool of wealth looking for a high rate of return (SWF, PF, HF, IB, etc.) and the true scope of the possible problem begins to show itself. Lock up all that supposed wealth in lawsuits, counter-claims, withdrawals, and deductions and the entire economic machine seizes like a piston in a dry engine as people scramble to meet cash demands. That means liquidating any equity positions, sell-offs of any treasuries, and a buyer's market in commodities.



Wheee!
 
Nude, except... if any of those tranches actually has the $100 million the ball stops.



Mr. Buddy is in a crux, he's liquid as long as less than 20 of the 200 positions go bad. Keep in mind, he's sucking up a billion in year of premiums too. So much depends on the actual default rates, premiums and and qauntity of the tranches. Do you have a sample pool?



The bad news, I suspect they've missed their default projections by at least 300%. I suspect 3X the construct rate is the real rate if not higher and in the crunch coming will actually be even higher.



Great, now I can't get this out of my head. Actually my defaults are wrong, technically Hedge wouldn't be short a billion until 4X which merely burns his capital. At 3X he's break even in+recovery=out. But at 2X default he is going out of business, because he is ROI=0% and his investors will flee forcing the raising of capital or liquidation of the positions.
 
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