Credit Default Swaps

Credit Default Swaps

Postby fclim » Fri Sep 26, 2008 9:57 am

ermm.... anybody have intimate knowledge of this black box thingy?

from what i read, it seems like:
- the market seems to be about $60 trillion
- it does not seem to be regulated, i.e. not under SEC, nor any other regulators
- it appears that it *was* used as a hedge tool (something like buying some warranty) against financial insititutions defaulting payment from loans
- now, rumours is that it *has become* sort of money making tool for insurance companies, incl AIG
- the "warranty" agreements can be bought and resold amongst the market players, something like re-insurance?
- there seems to be no standard / strict requirement in terms of, having how much capital an organization need, before providing how much of "warranty"...
- it is rumoured to be the next big thingy to 'shock' the economy & policy makers....

anybody can clarify whether the above is correct / accurate?

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Re: CDS Market?

Postby LenaHuat » Fri Sep 26, 2008 10:11 am

Do a little google on how after the Enron case, some banks packaged their debts into sophisticated sounding financial derivatives and moved them off and then back into their balance sheets as assets. Very clever financial engineering but pretty unscrupulous.

Besides the insurance companies, the large banks also made pools of $$ from CDS. CDS is a derivative upon a derivative. Both instruments are OTC trades. Both the CDOs and CDSs are 'notes'.............the bankers made them sound so attractive and risk-free like our notebooks. And some got into miniBonds etc. It's like calling a simple orange : "SUN-KISSED". That's how emotive things work.

On one hand I feel sorry for investors who lost $$ in these NOTES. On the other hand, they only have themselves to be blamed if they have not taken the effort to get an education on the US capital markets.
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Re: CDS Market

Postby kennynah » Fri Sep 26, 2008 11:09 am

thanks lena, as usual for simplifying a complex issue into bite size pieces for all to digest... 2 thumbs up.... 8-)
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Re: CDS Market

Postby financecaptain » Fri Sep 26, 2008 2:17 pm

If you want to know in detail what a CDS is and how it works, you can go to http://en.wikipedia.org/wiki/Credit_default_swap. It is essentially financial insurance that is tradeable among the different players.

On how this has created a time bomb, I have included a good article below. Of course in the web there are many more good articles. Essentially, CDS is a derivative instrument and hence its nominal value has gone way way higher than the cash value of the debt it seeks to protect. I think easily 100X now. Since it is not traded on a regulated exchange and not regulated as an insurance product, there is substantial counter-party risks and may not have shown up in many banks' books. Most banks assume that they are well-protected with CDS; but if all hell break lose, they will find that they are in fact naked.

Between 2000 and 2007, the nominal value of CDS transacted has increased many fold to now about US$60 trillion. And a large chunk is in mortgages and banks. Now we are seeing real estate crashing and bank bankrupcies in the doves. Is it not a potential time bomb for holders of CDS, whether your position is long or short ?

Other than counterparty risk in a CDS, I have never believed in the concept of financial insurance. It does not make sense to me that credit risk can be arbitraged. For example, if you are DBS and you lent to SIA at 50 basis points above S$ SWAP. Say immediately, you are able to buy a CDS on SIA from UOB at say 30 basis points. This means you effectively yield 20 basis points on UOB risk when in the interbank market you yield zero spread from lending to UOB.

Historically, in the US, given its sophistication in the corporate debt market, CDS makes sense as they are priced to fill up the gap between the spot and swap pricing of a debt. As competition increases, CDS pricing did not make sense any more. But insurance companies, investment banks and hedge funds underwrire them because of the attractive premiums (basically greed) received upfront believing that the underwritten assets will not fail :- "It was like writing fire insurance, assuming no one is ever going to have a fire, only now they're turning around and watching as the whole town burns down."

Several years ago already, many insurance companies in the US were severely burnt by financial insurance products that they launched to bank customers. They think that like any other insurance products, they could manage credit risk based on "law of big numbers or large portfolio". In reality, the risks were not able to be modeled conventionally and they were severely burnt (in statistics, it means that outlier risks occur more often than you think). But there was no sysmetic risk on the financial system due to the fact that they were still regulated as insurance products (you need to provide reserves for them). With CDS, it is still financial insurance, but because of the way that they are structured they have missed regulation. So that is how we have ended up with all these shit. Again, basically greed.

Buffett's "time bomb" goes off on Wall Street
Thu Sep 18, 2008 1:42pm EDT Email | Print | Share| Reprints | Single Page | Recommend (251) [-] Text [+]

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¥ € $ - Learn. Practice. Trade.By James B. Kelleher - Analysis

CHICAGO (Reuters) - On Main Street, insurance protects people from the effects of catastrophes.

But on Wall Street, specialized insurance known as a credit default swaps are turning a bad situation into a catastrophe.

When historians write about the current crisis, much of the blame will go to the slump in the housing and mortgage markets, which triggered the losses, layoffs and liquidations sweeping the financial industry.

But credit default swaps -- complex derivatives originally designed to protect banks from deadbeat borrowers -- are adding to the turmoil.

"This was supposedly a way to hedge risk," says Ellen Brown, the author of the book "Web of Debt."

"I'm sure their predictive models were right as far as the risk of the things they were insuring against. But what they didn't factor in was the risk that the sellers of this protection wouldn't pay ... That's what we're seeing now."

Brown is hardly alone in her criticism of the derivatives. Five years ago, billionaire investor Warren Buffett called them a "time bomb" and "financial weapons of mass destruction" and directed the insurance arm of his Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research, Stock Buzz) to exit the business.

LINKED TO MORTGAGES

Recent events suggest Buffett was right. The collapse of Bear Stearns. The fire sale of Merrill Lynch & Co Inc (MER.N: Quote, Profile, Research, Stock Buzz). The meltdown at American International Group Inc (AIG.N: Quote, Profile, Research, Stock Buzz). In each case, credit default swaps played a role in the fall of these financial giants.

The latest victim is insurer AIG, which received an emergency $85 billion loan from the U.S. Federal Reserve late on Tuesday to stave off a bankruptcy.

Over the last three quarters, AIG suffered $18 billion of losses tied to guarantees it wrote on mortgage-linked derivatives.

Its struggles intensified in recent weeks as losses in its own investments led to cuts in its credit ratings. Those cuts triggered clauses in the policies AIG had written that forced it to put up billions of dollars in extra collateral -- billions it did not have and could not raise.

EASY MONEY

When the credit default market began back in the mid-1990s, the transactions were simpler, more transparent affairs. Not all the sellers were insurance companies like AIG -- most were not. But the protection buyer usually knew the protection seller.

As it grew -- according to the industry's trade group, the credit default market grew to $46 trillion by the first half of 2007 from $631 billion in 2000 -- all that changed.

An over-the-counter market grew up and some of the most active players became asset managers, including hedge fund managers, who bought and sold the policies like any other investment.

And in those deals, they sold protection as often as they bought it -- although they rarely set aside the reserves they would need if the obligation ever had to be paid.

In one notorious case, a small hedge fund agreed to insure UBS AG (UBSN.VX: Quote, Profile, Research, Stock Buzz), the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million.

The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee -- and capitalized it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44 percent.

But in the summer of 2007, as home owners began to default, things got ugly. UBS demanded the hedge fund put up additional collateral. The fund balked. UBS sued.

The dispute is hardly unique. Both Wachovia Corp (WB.N: Quote, Profile, Research, Stock Buzz) and Citigroup Inc (C.N: Quote, Profile, Research, Stock Buzz) are involved in similar litigation with firms that promised to step up and act like insurers -- but were not actually insurers.

"Insurance companies have armies of actuaries and deep pools of policyholders and the financial wherewithal to pay claims," says Mike Barry, a spokesman at the Insurance Information Institute.

"SLOPPY"

Another problem: As hedge funds and others bought and sold these protection policies, they did not always get prior written consent from the people they were supposed to be insuring. Patrick Parkinson, the deputy director of the Fed's research and statistic arm, calls the practice "sloppy."

As a result, some protection buyers had trouble figuring out who was standing behind the insurance they bought. And it put investors into webs of relationships they did not understand.

"This is the derivative nightmare that everyone has been warning about," says Peter Schiff, the president of Euro Pacific Capital at the author of "Crash Proof: How to Profit From the Coming Economic Collapse."

"They booked all these derivatives assuming bad things would never happen. It was like writing fire insurance, assuming no one is ever going to have a fire, only now they're turning around and watching as the whole town burns down."

(Editing by Andre Grenon)
Last edited by financecaptain on Fri Sep 26, 2008 3:12 pm, edited 5 times in total.
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Re: CDS Market

Postby kennynah » Fri Sep 26, 2008 2:41 pm

financecaptain : thanks for the writeup on cds.... pls continue with educating all of us here at huatopedia...
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Re: CDS Market

Postby LenaHuat » Fri Sep 26, 2008 3:19 pm

Hi K - Sometimes I write juz to jazz up this forum. :lol:

Hi financecaptain - Thumbs up :!:

Actually a forumer, d.o.g (disciple of Graham) at wallstraits has written an excellent piece on CDS. Juz search for 'pinnacle' (for Pinnacle notes) at that forum.
Furthermore, the BizTimes on 19 Sep also published an excellent piece on the minibonds too.
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Re: CDS Market

Postby caseyc » Fri Sep 26, 2008 4:56 pm

LenaHuat wrote:Actually a forumer, d.o.g (disciple of Grahan) at wallstraits has written an excellent piece on CDS. Juz search for 'pinnacle' (for Pinnacle notes) at that forum.


Lena, thx for the tip! I didn't know D.O.G. is back on Wallstraits forum until u mentioned... Really happy to see him back. He mentioned that he's here too, under the nick "newdog". Newdog, if you're reading this, a very warm welcome :)
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Re: CDS Market

Postby LenaHuat » Fri Sep 26, 2008 8:04 pm

Hi caseyc
Not at all. It's a pleasure to read great posts and to share them with forumers here. :D

Hi newdog
A very warm welcome from me too :D .
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Re: CDS Market

Postby financecaptain » Fri Oct 03, 2008 9:17 am

Credit Default Swaps Get Messier
Asian Wall Street Journal
3 October 2008


The credit-default swap market, rocked by multiple corporate defaults and large price moves, is causing confusion and hand-wringing among investors.

Over the past few weeks, takeovers or failures of financial institutions have forced participants to take steps to unwind or settle derivative contracts tied to hundreds of billions of dollars in bonds. Worries are mounting that some firms that sold swaps on defaulted Lehman Brothers Holdings Inc. and Washington Mutual Inc. bonds may not have enough cash to make the big payouts they promised. At the same time, differing opinions over the value of certain contracts is leading to disputes.

"There's a belief among many big participants in the CDS market that they don't have much of a say in how the contracts are interpreted," said Brian Yelvington, a strategist at research firm CreditSights.

Even though short selling was banned on financial stocks, traders still are using credit-default swaps to bet against many banks and lenders, making investors concerned about the impact swap prices could have on companies. The cost of insuring the debt of General Electric Capital Corp. was sharply higher Wednesday morning, hours before parent General Electric Co. announced it would raise $15 billion.

Credit-default swaps are insurance-like contracts in which buyers make regular payments to sellers, who agree to make payouts if a company defaults or files for bankruptcy.

The government's takeover of mortgage companies Fannie Mae and Freddie Mac on Sept. 7 triggered payouts on swaps tied to as much as $1 trillion in debt, because the conservatorship was treated as tantamount to a bankruptcy filing.

More than three weeks after that event, some hedge funds that bought credit-default swaps on Fannie and Freddie are complaining the industry wants to force them to accept small payouts on their swaps, when they believe they should be paid much more.

On Sept. 15, Lehman Brothers filed for bankruptcy protection, leaving many hedge funds that faced the investment bank in swaps in limbo and unsure of how much they owed or are owed by Lehman. Some funds are having difficulty figuring out the value of their positions because they can't get market prices on some instruments.

For Fannie and Freddie swaps, an auction to determine a settlement price will be held Monday, and about 350 firms have signed up. But some holders of swaps tied to the two mortgage companies disagree with elements of the settlement process. These investors, which include Pershing Square Capital Management LP, a hedge fund run by activist investor William Ackman, believe a certain type of Freddie and Fannie debt, called "agency principal-only" bonds, should be exchanged for large payouts under the contracts.

These types of bonds, whose interest payments have been stripped out, trade at a discount to their par value, because they make only a single payout at maturity, often 20 or more years into the future. If such bonds can be used to settle the contracts, swap holders can reap as much as 50 cents on the dollar versus two or three cents if regular Fannie and Freddie bonds, which trade close to their full values, are used.

An industry trade group, the International Swaps and Derivatives Association, last month said that principal-only bonds aren't "whole obligations" of Fannie and Freddie, and thus they shouldn't be used to settle the contracts. It made that decision after consulting with large dealers, lawyers and officials from the Federal Reserve Bank of New York, according to people familiar with the matter. Many market participants expect "that the CDS settlements for Fannie and Freddie debt would not result in windfall gains for anyone," said Robert Pickel, chief of the International Swaps and Derivatives Association.

Roy Katzovicz, chief legal officer at Pershing Square, said in a letter to the association's board this week that the group's approach "risks undermining buy-side confidence in the credit default swap market."
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Re: CDS Market

Postby winston » Sun Oct 05, 2008 4:23 pm

This is the best explaination that I have read of the Credit Crunch... ENJOY !

==================================================

How AIG's Collapse Began a Global Run on the Banks By Porter Stansberry


Something very strange is happening in the financial markets. And I can show you what it is and what it means...

If September didn't give you enough to worry about, consider what will happen to real estate prices as unemployment grows steadily over the next several months. As bad as things are now, they'll get much worse.

They'll get worse for the obvious reason: because more people will default on their mortgages. But they'll also remain depressed for far longer than anyone expects, for a reason most people will never understand.

What follows is one of the real secrets to September's stock market collapse. Once you understand what really happened last month, the events to come will be much clearer to you...

Every great bull market has similar characteristics. The speculation must – at the beginning – start with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats.

Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals.

As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into fraud.

And this is where AIG comes into the story.

Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.

Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.

So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.

"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.

Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for say, 2% of face value.

Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.

Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year – long before the actual profit on the contract was made.

With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.

It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.

Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.

On September 15, all of the major credit-rating agencies downgraded AIG – the world's largest insurance company. At issue were the soaring losses in its credit default swaps. The first big writeoff came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt.

The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity.

Most people never understood how AIG was the linchpin to the entire system. And there's one more secret yet to come out...

AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.

I'd wondered for years how Goldman avoided the kind of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.

The collapse of the credit default swap market also meant the investment banks – all of them – had no way to borrow money, because no one would insure their obligations.

To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG's failure. Things are so bad at the investment banks, the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman the ability to use equities as collateral for these loans, an unprecedented step.

The mainstream press hasn't reported this either: A provision in the $700 billion bailout bill permits the Fed to pay interest on the collateral it's holding, which is simply a way to funnel taxpayer dollars directly into the investment banks.

Why do you need to know all of these details? First, you must understand that without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.

Second, without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore.

And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.

There's no way to replace this massive credit-building machine, which makes me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can't actually replace the trust and credit that existed... because it was a fraud.

And that leads me to believe the coming economic contraction will be longer and deeper than most people understand.

You might find this strange... but this is great news for those who understand what's going on. Knowing why the economy is shrinking and knowing it's not going to rebound quickly gives you a huge advantage over most investors, who don't understand what's happening and can't plan to take advantage of it.

How can you take advantage?

First, make sure you have at least 10% of your net worth in precious metals. I prefer gold bullion. World governments' gigantic liabilities will vastly decrease the value of paper currencies.

Second, I can tell you we're either at or approaching a moment of maximum pessimism in the markets. These kinds of panics give you the chance to buy world-class businesses incredibly cheaply. A few worth mentioning are ExxonMobil, Intel, and Microsoft. I have several stocks like these in the portfolio of my Investment Advisory.

Third, if you're comfortable short selling stocks (betting they'll fall in price), now is the time to be doing it... simply as a hedge against further declines.

Keep the fraud of AIG in mind when you form your investment plan for the coming years. By following these three strategies, you'll survive and prosper while most investors sit back and wonder what the hell is going on.
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