Credit Default Swaps

ianmr65

purch wrote: »

The way this $50 trillion is bandied about,

Wether it's $50trillion or $25trillion, and it's somewhere between the two. If the default level is even as low as 1% we are still talking a huge number. That's the issue. I think.

Meltdown_2

purch wrote: »

That is all very true, and even more so by the 'bloggers' who are the main peddlars of guesswork, misinformation and rumours of impending doom.

What ... all of them?

purch

[FONT=Arial, Helvetica, sans-serif]This is from an article by Anatole Kaletsky (not that I agree with much of what he says)[/FONT]
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[FONT=Arial, Helvetica, sans-serif]The probability of the American GSEs defaulting remains essentially zero, as it has always been. If anything, the willingness of the US Government to stand behind these enterprises is even higher today than it was before the financial crisis. The market value of these bonds has fallen simply because they have turned out to be less liquid assets than previously believed - and liquidity has been recognised as a much more important and valuable characteristic than investors suspected until a few weeks ago.

Until last month, it was still widely assumed that the danger of illiquidity affected only inherently risky assets, such as sub-prime mortgages, complex derivatives and leveraged loans. But this assumption completely changed when the US bond insurers started to be downgraded in January. Suddenly, ultra-safe municipal bond prices plunged to levels normally associated with the riskiest junk bonds. This was not because the Port Authority of New York or the California Water Board suddenly looked like defaulting. It was simply because municipal bonds became illiquid as investors were forced by regulations to dump them into a market with no bids.

After the municipal meltdown, forced sellers of top-quality mortgages, and even of government-backed GSE bonds, suddenly could find no buyers. It was this disappearance of liquidity - not a growing risk of default by borrowers in the non-financial economy - that caused the collapse of Bear Stearns.

By last week, the liquidity crisis had spread even to assets whose default risk was literally zero. A widely quoted story on Bloomberg read: "The risk of losses on US Treasury notes exceeded German bunds for the first time ever, amid investor concern the sub-prime mortgage crisis is sapping govern- ment reserves." The evidence cited was a sale of credit-default swap (CDS) insurance on US Treasuries, which implied a default probability of 0.16 percentage points, as against 0.15 points on German bonds. But what did these "probabilities" actually show? After all, Washington can always print the money with which it pays for its bonds - and, like all governments, invariably does so. Moreover, in the vanishingly improbable event that the US Treasury really did decide to stop printing dollars, would the underwriters of CDS insurance still be in business and pay up? What court would enforce a private CDS deal if contracts with the US Treasury were no longer in force? And what currency would such a judgement be paid in, since US dollars would no longer exist?[/FONT]
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[FONT=Arial, Helvetica, sans-serif]This bit is the view of David Fuller, the very well respected commentator[/FONT]
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[FONT=Arial, Helvetica, sans-serif]I believe that Credit Default Swaps (CDS) are a useful invention which can be used to hedge default risk but that's about all. The ongoing situation in the credit markets which I have described as 'Model Myopia', where the price of insurance against default is being used to evaluate the integrity of companies, can not persist, but it is creating value. Buying opportunities for investors capable of placing competitive bids in that market are available now and I have little doubt we will hear of a number of funds who benefitted enormously from this crisis over the coming months. [/FONT]


At least a counter point to some of the extreme comments made on these instruments.
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ianmr65

Thanks Purch.

"The evidence cited was a sale of credit-default swap (CDS) insurance on US Treasuries, which implied a default probability of 0.16 percentage points, as against 0.15 points on German bonds"

This say's it all really.

jamesd

ianmr65 wrote: »

Wether it's $50trillion or $25trillion, and it's somewhere between the two. If the default level is even as low as 1% we are still talking a huge number. That's the issue. I think.

That's the scaremongering issue. The exposure is not between 25 and 50 trillion. That's merely the total of the values of all of the contracts. Once you offset the ones betting one way with those betting the other way the actual exposure is a small percentage of those numbers. Then a small percentage of that small percentage will default.

It's similar to an offset mortgage of 100,000 with 95,000 in the mortgage offset savings account. The scaremongering value is 195,000 to be lost (by lender and borrower combined, even though both won't happen at the same time) but the real risk exposure is only 5,000 and much of that won't be lost if there's a mortgage default and the house has to be sold. And in CDS trading this stuff gets bought and sold many times so the multiplier effect is larger.

There's a liquidity risk also, if a big middleman couldn't continue to help settle the contracts so the winners and losers end up up or down by the right amounts. The winners may be out a lot of money that they were relying on to cover losses that they used the CDS to protect against. And that's where Bear Stearns comes into the picture, as a middleman that might hurt the liquidity of others if it froze up for a while.

purch

This say's it all really

Yes............a default risk created by these mad professors from 'higher realms of pure mathematics' when a default risk doesn't actually exist !!!

I wouldn't ever understate the huge damage that Derivative products potentially could do to the Banking industry and the wider Economy

I decided it was time to 'retire' from the market, when two of my ex-trainees, both Oxford Grads, one with a higher first in Statistics and the other with one in Applied Mathematics began arbitraging two derivative products against each other and creating a 'book' profit, even though no money was actually changing hands..........and that was 12 years ago, so I dread to think what these wizards from 'the higher realms of pure mathematics' are up to now !!!!:eek: .......( blah blah blah.........who cares anyway ????)


However these 'bloggers', (who are as far detached from the Banking industry as all of us), are doing much damage by continually overstating the potential for damage.

ianmr65

"so I dread to think what these wizards from 'the higher realms of pure mathematics' are up to now"

What's worse is that their current bosses probably don't know either. :eek: :eek:

ianmr65

jamesd wrote: »

.

It's similar to an offset mortgage of 100,000 with 95,000 in the mortgage offset savings account. The scaremongering value is 195,000 to be lost (by lender and borrower combined, even though both won't happen at the same time) but the real risk exposure is only 5,000 and much of that won't be lost if there's a mortgage default and the house has to be sold. And in CDS trading this stuff gets bought and sold many times so the multiplier effect is larger.

.

Good analogy. Ok $64,000 question, and putting you on the spot a bit. What is your estimate of the level of default expsoure in the CDS market?

jamesd

ianmr65, I've been looking for some Bear Stearns numbers that I saw but haven't found them. It's very low as a percentage; my imperfect recollection is in the tenth of a percent range but don't trust that unless I come up with the citation for it - my memory of just how low it is might be wrong.

That's still many tens of billions. But it's not the big problem. That's the loss of liquidity if banks start defaulting and the swaps act as a default multiplier. Small problems and they reduce risk, big ones of bank size and they can do the opposite.

So far the UK and US governments have both acquired ownership of the credit risk of one medium sized bank, after the shareholders already lost almost all of their money. Not good, but not so bad yet. And the Federal Reserve does have a chairman who's an expert on the Great Depression and who has already used a measure last used in 1930, lending to banks that don't directly take consumer deposits. So I expect very prompt action, to include things like ordering markets to shut while bailouts are arranged, if that sort of thing becomes appropriate. So lots of nasty potential but I think it'll be handled before meltdown.

On the UK side, note how HBOS went to both the FSA and BoE and got very prompt reactions from both when it was under attack. It looks as though regulators on both sides of the Atlantic are on a hair trigger and ready to respond very quickly. Not sure that the UK side is yet in a mindset that's sufficiently willing to act as strongly as might be necessary, though.

ianmr65

jamesd wrote: »

Not sure that the UK side is yet in a mindset that's sufficiently willing to act as strongly as might be necessary, though.

Thanks jamesd. Very insightful piece. Tho I think Merv has read your mind, according to this, in todays FT.

He may just be coming round to your way of thinking.

http://www.ft.com/cms/s/0/d0071df4-fb28-11dc-8c3e-000077b07658.html

He'll be taking the reins off inflation and helicopter dropping money next, sat at the feet of Obi Wan Bernake. Or just plain old Ben:

"Beware The Dark Side Mervyn, Darth Brown is your enemy. He is more machine now, than man...twisted and evil."