Credit Default Swaps

Re: CDS Market

Postby mojo_ » Sat Oct 11, 2008 11:25 am

thanks to financecaptain:
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.
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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.
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Important test case of the CDS implications of 1st big firm that went bankrupt:
After the (10 Oct) anxiously awaited Lehman CDS auction - cnbc video

Nobody died (causing further counter party risk turmoil)... :? :)

(WaMu was taken over and also smaller, so it's debt auction 23 Oct should be much less fearful.)
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Re: Credit Default Swaps

Postby blid2def » Mon Oct 13, 2008 10:40 am

fclim wrote: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?

have fun,
fc


Just read this article, and it might answer some of the questions above:
- http://optionarmageddon.ml-implode.com/ ... insurance/

Notice the part about "buying insurance on something that doesn't belong to you". :D
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Re: Credit Default Swaps

Postby mojo_ » Mon Oct 13, 2008 11:15 am

grandrake wrote:Notice the part about "buying insurance on something that doesn't belong to you". :D

Similar to "buying insurance on someone who isn't related to you". ;)
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Re: Credit Default Swaps

Postby blid2def » Mon Oct 13, 2008 12:16 pm

mojo_ wrote:
grandrake wrote:Notice the part about "buying insurance on something that doesn't belong to you". :D

Similar to "buying insurance on someone who isn't related to you". ;)


Should've bought insurance on Britney Spears' virginity. :D
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Re: Credit Default Swaps

Postby mojo_ » Mon Oct 13, 2008 12:39 pm

the premium on her virginity will be more than 100% :lol:

Has the media over-sensationalised the CDS issue?
DTCC Addresses Misconceptions About the Credit Default Swap Market

New York, October 11, 2008 – The idea that the industry lacks a central registry for over-the-counter (OTC) credit default swaps (CDS) is grossly misleading and has resulted in inaccurate speculation on a number of matters, including the overall size of the market, its role in the mortgage crisis, and the size of potential payment obligations under credit default swaps relating to Lehman Brothers. The extent to which such speculation has fueled last week’s market turmoil is difficult to determine. The facts are these:

Central Trade Registry

* In November 2006, The Depository Trust and Clearing Corporation (DTCC) established its automated Trade Information Warehouse as the electronic central registry for credit default swaps. Since that time, the vast majority of credit default swaps traded have been registered in the Warehouse. In addition, all of the major global credit default swap dealers have registered in the Warehouse the vast majority all contracts executed among each other before that date.

Size of the Market

* Reported estimates of the size of the credit default swap market have so far been based on surveys. These surveys tend to overstate the size of the market due to each party to a trade separately reporting its own side. Thus, when two parties to a single $10 million dollar trade each report their “side” of the trade, the amount reported is $20 million, which overstates the actual size by a factor of two since both reports relate to a single $10 million contract. When examining the outstanding amount of actual contracts registered in the Warehouse (not separately reported “sides”) as of October 9, 2008, credit default swap contracts registered in the Warehouse totaled approximately $34.8 trillion (in US Dollar equivalents). This is down significantly from the approximately $44 trillion that were registered in the Warehouse at the end of April this year.

Percentage of the Market Related to Mortgages

* Less than 1% of credit default swap contracts currently registered in the Warehouse relate to particular residential mortgage-backed securities. Mortgage-related index products also have some components relating to residential mortgages and, as a whole, also constitute a relatively small fraction of total credit default swaps registered in the Warehouse.

Payment Obligations Related to the Lehman Bankruptcy

* One of the many central servicing functions of the Trade Information Warehouse is to caculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written. Calculated amounts are netted on a bilateral basis, and then, for firms electing to use the service, transmitted to CLS Bank (the world’s central settlement bank for foreign exchange) where they are combined with foreign exchange settlement obligations and settled on a multi-lateral net basis. Currently, all major global credit default swap dealers use CLS Bank to settle obligations under credit default swaps. It is expected that all major institutional players in the credit default swap market will use the same process for settlement by the end of 2009.

* The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents).
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Re: Credit Default Swaps

Postby financecaptain » Mon Oct 13, 2008 12:53 pm

mojo_ wrote:the premium on her virginity will be more than 100% :lol:


Technically, should still be less than 100%; discounted by the risk free rate over the insured period. Payout is 100% certain. :D :D :D
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Re: Credit Default Swaps

Postby millionairemind » Fri Nov 07, 2008 9:03 am

Credit Swap Disclosure Obscures True Financial Risk (Update3)

By Shannon D. Harrington and Abigail Moses

Nov. 6 (Bloomberg) -- The most comprehensive report on unregulated credit-default swaps didn't disclose bets in the section of the more than $47 trillion market that helped destroy American International Group Inc., once the world's biggest insurer.

A report by the Depository Trust and Clearing Corp. doesn't include privately negotiated credit-default swaps that insurers such as AIG, MBIA Inc. and Ambac Financial Group Inc. sold to guarantee securities known as collateralized debt obligations. It includes only a ``small fraction'' of contracts linked to mortgage securities, according to Andrea Cicione at BNP Paribas SA in London.

New York-based DTCC's data, released on its Web site Nov. 4, showed a total $33.6 trillion of transactions on governments, companies and asset-backed securities worldwide, based on gross numbers. While designed to ease concerns about the amount of risk banks and investors amassed on borrowers from companies to homeowners, the report may have missed as much as 40 percent of the trades outstanding in the market, Cicione said.

The data are ``likely to underestimate the amount of net CDS exposure,'' Cicione, who correctly forecast in January that the cost of protecting European companies from default would rise, said in an interview. ``A broadening of the coverage to the entire market is what investors really need.''

`Increased Transparency'

DTCC released the data as dealers and investors in the market seek to counter criticism that the market has amplified the financial crisis. The Nov. 4 report showed, for example, that $15.4 trillion of contracts linked to individual companies, governments and other borrowers were created. After canceling out contracts that offset one another, though, sellers of that protection would have to pay $1.76 trillion if all underlying borrowers defaulted and debt holders recovered nothing.

The data is ``definitely a welcome development,'' Cicione said.

Trading of credit derivatives soared 100-fold the past decade as banks, hedge funds, insurance companies and other investors used the contracts to protect against losses or speculate on debt they didn't own. The growth was driven partly by CDOs, securities that parcel bonds, loans and credit-default swaps, slicing them into varying layers of risk.

Banks worldwide have taken $693 billion in writedowns and losses on loans, CDOs and other investments since the start of 2007, according to data compiled by Bloomberg.

CDX Indexes


Investors hedging against losses on CDOs helped push the cost of default protection to a record last week. The benchmark Markit CDX North America Investment Grade Index, linked to the bonds of 125 companies in the U.S. and Canada, reached 240 basis points on Oct. 27. The index rose 11.75 basis points today to 195.5 basis points, according to CMA Datavision.

The Markit iTraxx Europe rose to as high as 195 basis points from as low as 20 in June 2007. It closed at 141.5 basis points today, according to JPMorgan Chase & Co. A basis point on a credit-default swap protecting $10 million of debt from default for five years costs $1,000 a year.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. An increase indicates deterioration in the perception of credit quality; a decline signals the opposite.

$440 Billion
AIG first disclosed to investors in August 2007 that it held more than $440 billion of credit-swap trades linked to CDOs. The New York-based company was brought to the edge of bankruptcy in September after the value of the transactions plunged. The insurer was forced to come up with more than $10 billion in collateral to back the contracts after its debt rankings were cut. It accepted an $85 billion government loan in exchange for ceding control to the U.S.

MBIA and Ambac, previously the world's two biggest bond insurers, lost their top AAA ratings earlier this year because of potential losses on credit swaps sold to guarantee CDOs backed by home loans. Moody's Investors Service cut New York-based Ambac's bond insurance rating four levels yesterday to Baa1, three steps above junk, because of potential losses on the derivatives.

A market survey this year by the New York-based International Swaps and Derivatives Association, which includes credit swaps on CDOs and other contracts that may not be captured by DTCC's Trade Information Warehouse, estimates more than $47 trillion in gross contracts are outstanding.

`Gaps'
The Federal Reserve Bank of New York, which urged dealers to curb risks and improve transparency in the credit swaps market over the past three years, said regulators will continue to push for more disclosure. Among the information the Fed wants to see are prices at which the derivatives trade, according to a New York Fed spokesman.

``There appear to be gaps,'' said Henry Hu, a law professor at the University of Texas in Austin who has pressed for the creation of a data warehouse encompassing all privately negotiated derivative trades to offer a better understanding of their risks.

``Hopefully, regulators are getting more information,'' he said.

Because the DTCC registry captures only commonly traded contracts that can be confirmed over electronic systems, not every swap trade is in the company's report, spokeswoman Judy Inosanto said. Among those not included are credit-default swaps on CDOs, she said.

MBIA, the Armonk, New York-based insurer crippled by ratings downgrades earlier this year following losses from such contracts, has said it sold $126.3 billion in guarantees on slices of CDOs backed by corporate bonds, mortgages and other debt. Ambac sold $60.7 billion in guarantees on these so-called tranches, mostly through credit swaps, the company said.

CDO Losses

Insurers including AIG, MBIA and Ambac typically sold protection on the highest ranking slices of such deals, meaning they'd be required to make good on payments only after a substantial part of the underlying debt defaults.


The failures of Lehman Brothers Holdings Inc., Washington Mutual Inc. and three Icelandic banks that were widely held in CDOs linked to corporate debt caused no losses on tranches MBIA guaranteed, Mitchell Sonkin, the company's head of insured portfolio management, said in a conference call yesterday.

New York-based Lehman and WaMu, based in Seattle, filed for bankruptcy. Iceland's government took over its three biggest lenders last month after they were unable to raise short-term funding, triggering pay-outs on credit-default swaps.

Some investors holding the riskier slices of CDOs that weren't guaranteed lost more than 90 percent because of the bank failures.

``The worry is that these bespoke tranches are being eaten away, and who knows if and when these losses will get realized,'' Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California, wrote in a note to clients yesterday.
"If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong" - Bernard Baruch

Disclaimer - The author may at times own some of the stocks mentioned in this forum. All discussions are NOT to be construed as buy/sell recommendations. Readers are advised to do their own research and analysis.
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Re: Credit Default Swaps

Postby millionairemind » Mon Nov 10, 2008 8:05 pm

An interesting article in this week's Economist.

Derivatives
Giving credit where it is due

Nov 6th 2008
From The Economist print edition

The credit-default swap needs reform, not abolition

FINANCIAL innovations tend to go through four phases. At first, they are hailed as proof of the brilliance of the bankers who devised them. Then they succumb to rampant speculation, as investors try to exploit them. And that leads to revulsion, as a crisis causes widespread losses. The question is: should the fourth phase be rejection or rehabilitation?

The latest innovation to pass through the cycle is the credit-default swap or CDS. Despite its forbidding name, the CDS is a simple idea: it allows an investor to buy insurance against a company defaulting on its debt payments. When it was invented, the CDS was a useful concept because more people felt comfortable owning corporate debt if they could eliminate the risk of the issuer failing. The extra appetite for debt helped lower the cost of capital.

But any insurance contract requires someone to take the other side of the bargain, and that person will often be a speculator. Even a dull-sounding insurance company that sells you fire cover is in effect speculating that your house will not burn down. Insurers have lots of historical data to fall back on when setting their premiums—and even then many have gone bust in the past. Sellers of CDSs had no such record to consult. Indeed the past has been no guide to the future of CDSs, because the corporate-debt market has been transformed over the past 20 years as investors have chased yield by lending to less creditworthy borrowers.

As with previous innovations, speculation on the health of companies soon swamped the need for insurance that was the market’s original purpose. CDS contracts were worth $62 trillion at the peak, far more than the bonds the CDSs were insuring. Companies like AIG, a giant American insurer, wrote far too many contracts. Wild swings in the cost of bond insurance may have helped hasten the demise of investment banks like Bear Stearns and Lehman Brothers because they found it harder to raise new capital in the teeth of the crisis. When Lehman failed it looked as if the market was unsafe: Lehman not only issued its own debt (the basis for lots of Lehman CDSs), but it was also an important dealer in those of other companies—party to perhaps 7-10% of all the trades in the market.

Plenty of people (including the New York insurance commissioner) have concluded that the fourth phase for CDSs is now obvious: rejection. They want the market to meet tight new regulations, such as requiring that any buyer of a CDS should have an interest in the underlying bond.

In fact, rehabilitation makes more sense. With a bit of nudging, the market is reforming itself. At the moment, trades are settled directly, leaving participants exposed to the failure of the other party. A central clearing house would have reduced the damage of Lehman’s collapse by around two-thirds, according to a report by Moody’s, the ratings agency.

Even without a clearing house, the market survived both the demise of Lehman and the earlier (largely technical) default of Fannie Mae and Freddie Mac, the two housing giants. The potentially complex procedure for settling the trades worked, without wrecking other firms; Moody’s reckons the Lehman-related losses were widely spread. If banks and investors learn anything from the crisis, it is that they will make sure the firms they deal with can meet their side of the bargain.

A Betty Ford clinic for derivatives
Doubtless, the CDS market has caused immense problems, largely because no one was sure of the extent of investors’ exposure. Had AIG as well as Lehman gone bust, the market might have collapsed. The failure of another big bank would still put the system under strain, but the CDS market would not be alone. And remember that the default of big bond issuers disrupted the system long before anybody had thought of inventing the CDS.

Every bubble sees excesses; it seems odd to single out the CDS. Think back to the crash of 1987 when fingers pointed at the equity-futures market, which institutions were using to protect against falls in their share portfolios. It was argued that this exacerbated the crash. A commission was established; restrictions were imposed. Twenty years later, the Chicago equity futures and options market is vast: some $45 trillion of contracts traded on the S&P 500 index alone last year compared with the total American stockmarket value of just $10 trillion. But equity futures are unnoticed and unblamed in the crisis.

In 20 years the CDS may well be as little remarked as the equity future is now. But only with reform. As well as a clearing house, the market must be more transparent. Banks and other quoted firms should reveal how exposed they are to the market. CDSs have their uses. There is no reason why investors should not speculate in corporate debt if they can speculate on equities, currencies, commodities and the rest.
"If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong" - Bernard Baruch

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Re: Credit Default Swaps

Postby millionairemind » Thu Jan 29, 2009 7:15 pm

U.S. Draft Law Would Ban Most Trading in Credit Swaps (Update1)
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By Matthew Leising

Jan. 29 (Bloomberg) -- Draft legislation that would change how over-the-counter derivatives are regulated might prohibit most trading in the $29 trillion credit-default swap market.

House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota circulated an updated draft bill yesterday that would ban credit-default swap trading unless investors owned the underlying bonds. The document, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the $684 trillion over-the-counter derivatives market to be processed by a clearinghouse.

“This would basically kill the single-name CDS market,” said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California. “Given the small size of many issuers’ bonds outstanding, this would make it practically impossible for the CDS market to exist.”

U.S. regulators and politicians are stepping up pressure on banks to use clearinghouses and agree to increased oversight of the OTC markets to improve transparency amid the credit crisis. Bad bets on credit-default swaps led to the U.S. takeover of American International Group Inc. in September.

80 Percent

As much as 80 percent of the credit-default swap market is traded by investors who don’t own the underlying bonds, according to Eric Dinallo, superintendent of the New York Department of Insurance. Dinallo last year proposed outlawing so-called “naked” credit-default swap trading. He shelved the proposal in November because of progress by federal regulators on broader oversight of the market.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.


Proposals that would impair the credit-default swaps market “are likely to prove counterproductive to efforts to promote lending and return the credit markets to a healthy, functioning state,
” said Greg Zerzan, the counsel and head of global regulatory policy at the International Swaps and Derivatives Association, which represents participants in the privately negotiated derivatives industry.

“This is a bad idea,” said Robert Webb, a finance professor at the University of Virginia and a former CME trader. “It is reminiscent of the opposition in the 19th Century to futures trading in the belief that speculators were controlling the market and driving agricultural prices down.”

European Reaction

European Union Financial Services Commissioner Charlie McCreevy said today he wouldn’t support a ban on trading credit- default swaps without owning the underlying bonds. Speaking in an interview at the World Economic Forum in Davos, Switzerland, McCreevy also said he favored creating a clearinghouse for OTC derivatives.

Forcing interest-rate swaps and credit-default swaps through a clearinghouse, which would establish prices for the privately traded contracts, may reduce how much banks are able to make from them.


As much as 40 percent of profit at Goldman Sachs Group Inc. and Morgan Stanley comes from OTC derivatives trading, according to CreditSights Inc. Estimating the new income that exchanges such as CME Group Inc. could earn from processing the OTC trades is difficult because clearing fees and volumes aren’t known yet, said Bruce Weber, a finance professor at the London Business School.

JPMorgan’s Holdings

JPMorgan Chase & Co. held $87.7 trillion of derivatives as of Sept. 30, more than twice as much as the next largest holder, Bank of America Corp., which had $38.7 trillion
, according to data from the Office of the Comptroller of the Currency. Of the holdings at New York-based JPMorgan, 96 percent were in the OTC market, compared with 94 percent for Bank of America.

The largest positions at JPMorgan and Bank of America, based in Charlotte, North Carolina, were in interest-rate swaps. Banks enter into interest-rate swaps with clients such as cities or hospitals that sold bonds and seek protection against adverse moves in interest rates. They also hedge their exposure to rates in the inter-dealer market.

The OCC data only included U.S. commercial banks, so Morgan Stanley and Goldman Sachs Group Inc. weren’t listed at the time. Both New York-based investment banks converted to banks regulated by the Federal Reserve on Sept. 21.

Provision for Exemption

A provision in Peterson’s bill, which will be discussed in hearings next week, allows for the U.S. Commodity Futures Trading Commission to exempt certain OTC contracts that are too customized or don’t trade frequently enough to be cleared.

Funded by its members, a clearinghouse adds stability to markets by becoming the buyer to every seller and the seller to every buyer.

The standardization necessary to process a contract in a clearinghouse may harm the market and drive the trading overseas, Weber said.

“It’s a big deal because the OTC market has developed almost as an alternative to the exchange market with its clearinghouses,” he said. “It would be advantageous for places like London, Hong Kong or Singapore where OTC trading wouldn’t have that kind of restriction.”

Weber said that if price transparency is what Chairman Peterson wants, it can be achieved in other ways, such as putting OTC derivative prices on a system such as Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Peterson’s draft bill would also authorize a study by the CFTC to determine if OTC trading influences prices on exchange- traded contracts such as oil. If the commission found such an influence it would be authorized to set limits on the size of positions held by OTC traders.
"If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong" - Bernard Baruch

Disclaimer - The author may at times own some of the stocks mentioned in this forum. All discussions are NOT to be construed as buy/sell recommendations. Readers are advised to do their own research and analysis.
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Re: Credit Default Swaps

Postby fclim » Fri Jan 30, 2009 8:07 am

hi mm,

thanks for the update! :)

if naked CDS trading is banned as proposed in the drafted bill, i think there will be more chaos as the unwinding process takes place... i.e. those who are swimming naked suddenly find that the tide has subsided... and again the scene will be ugly....

more bailout by ah-gong? i wonder when will the rest of the world start shouting bluff on the $USD... i.e. the dollar is really not worth a dollar anymore... ;)

have fun,
fc
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