Tuesday, Oct 21, 2008
The CDS market is enormous, one reason for its enormous implications or the health of global finance
Credit Writedowns: Lehman Brothers: a primer on Credit Default Swaps
Somethings happening later today (I think) but it's not in the news yet, so here's a recent primer.
The bankruptcy of Lehman Brothers was a credit event which triggered a massive liability to participants in the large and potentially dangerous Credit Default Swaps (CDS) market. This is a market that represents the "weapons of financial mass destruction" label which Warren Buffett gave to the derivatives.
Below, I will attempt to explain, with much help from Wikipedia, what Credit Default Swaps are, how the market functions and why it is THE derivatives market that needs to be regulated before systemic risk threatens the global financial system.
Posted by malct @ 08:43 AM (1034 views) Add Comment
25 Comments
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1. malct said...
http://climateerinvest.blogspot.com/2008/10/lehman-cds-payout-on-october-21-360bn.html
Lehman CDS Payout On October 21: $360bn or $6bn?
From RGE Monitor:
The publicly reported facts so far are the following:
1) the gross notional volume of CDS contracts written on Lehman is around $400bn.
2) At the October 10 auction organized by the ISDA defaulted Lehman bonds secured a recovery value of 8.7 cents on the dollar. CDS protection sellers are thus called to pay out 91.3 cents of the insured face value to the protection buyers on October 21.
3) In dollar terms, protection buyers are called to pay out a gross amount of around $270-360bn as widely reported by observers.
4) The The Depository Trust and Clearing Corporation (DTCC) argues that the gross amount ignores bilateral trades among counterparties that cancel out. The net payout will only be in the range of $6bn instead of the average $300bn reported in the press (i.e. divided by a factor of 50)
5) ISDA CEO Robert Pickel in January 2008 notes in a response to Bill Gross’ (PIMCO) “Pyramids Crumbling” that, based on a recent Fitch study for the year 2006, the difference between gross and net CDS exposure is a factor of 50 and that the total CDS market exposure is not the notional $50 trillion but just $1 trillion.
2. Gardeniadotnet said...
From Reuters:
"...of the companies that have so far announced exposures to Lehman's default swaps, none have indicated any threat to the viability of the firm.
Genworth Financial (GNW.N: Quote, Profile, Research, Stock Buzz), for example, said it had only $5.4 million in credit default swap exposure to Lehman credit default swaps, and Hartford Financial Service Group (HIG.N: Quote, Profile, Research, Stock Buzz) said it had $30 million in exposure to Lehman's swaps."
I ain't got exposure, you ain't got no exposure, who's got all the flippin' exposure then?
Just a thought.
3. sold 2 rent 1 said...
Today marks the end of the physical fighting in The Korean War (Calleman's fifth night transformation) that I identified as 2-21 October.
Things look pretty quiet for the next 6 months until the Berlin Wall goes up and the Vietnam War escalates (next May).
The next major destruction phase won't start until the sixth night in November 2009.
4. shipbuilder said...
That's interesting malct, thanks. So not as big a disaster as predicted, then? Or is this wrong and the doom mongers correct about derivatives?
One lesson is that we all need to get back to displaying the same level of scrutiny to all news stories, mainstream or alternative, that brought us to this site in the first place.
Understanding this sort of thing properly is crucial to spotting a potential bottom in the market.
5. shipbuilder said...
S2R1 - you specifically said that the destruction would continue into November.
6. malct said...
NEW YORK (Reuters) - Tuesday's deadline to settle an estimated $400 billion in credit default swaps on debt in failed investment bank Lehman Brothers is unlikely to trigger new havoc in the market, derivatives analysts said.
Tuesday is the final day credit default swaps on Lehman's LEH.N(LEHMQ.PK: Quote, Profile, Research, Stock Buzz) debt can be paid out.
Speculation has mounted that banks and other sellers have been hoarding cash to pay out a massive 91 percent loss on the contracts.
http://www.reuters.com/article/businessNews/idUSTRE49K0W120081021?pageNumber=1&virtualBrandChannel=0
7. malct said...
Markets hold breath as $360bn Lehman swaps unwind
The $54trillion credit derivatives market faces a delicate test as $360bn worth of contracts on now-defaulted derivatives on Lehman Brothers are due to be settled on Tuesday.
By Louise Armitstead and Peter Koenig
Last Updated: 8:02AM BST 21 Oct 2008
Lehman Brothers' complex network of derivatives will be settled on Tuesday October 22 Due to the opacity of the market, which is one of the most complex, least regulated and least understood in the global financial system, it is still not clear how many contracts have to be settled or which institutions will take the ultimate hits once the billions of dollars worth of contracts have been unravelled.
The collapse of Lehman Brothers, is expected to trigger credit default swap (CDS) protection pay-outs of about $400bn but because the contracts were sold many times through different counterparties it is not yet known who will be liable.
One commentator said: “This will be the greatest illustration of the follies of Wall Street and how unnecessarily complicated the wild off-track betting became in the past few years.”
8. sold 2 rent 1 said...
shipbuilder,
"S2R1 - you specifically said that the destruction would continue into November."
The fifth night finishes on 12 November - 3 weeks away.
It peaked in May so I can't see much happening as The Korean War went into a stalemate phase for 2 years after today.
Suez crisis in 1956 maps to Jan/Feb 2009 - but this was a relatively small piece of history.
The late 1950s and early 1960s is generally known as a golden era.
9. James said...
oh, shipbuilder, don't bother trying to hold s2r1to account. He's rather slippery and you'll only get called an NWO schill/ common purpose stooge. Besides, we have enough examples of him being wrong just to ignore him.
malct - suggesting that this hasn't been talked about is also plain wrong. Perhaps on the loony sites you read, but plenty in the FT / WSJ.
10. sold 2 rent 1 said...
One more thought
"Suez crisis in 1956 maps to Jan/Feb 2009 - but this was a relatively small piece of history."
Any trouble for the western economies in Jan/Feb 2009 could well see IRs slashed to their all time lows.
This would give the markets the boost they need make the Armstrong high in April 2009
The financial crisis will be declared over by April 2009
Banks will start lending again.....but to hedge funds to buy oil..... on margin....oh dear.
11. inbreda said...
4. shipbuilder said...
S2R1 - you specifically said that the destruction would continue into November.
Don't worry shipbuilder. He also said that gold would be $1,500 by now. Clearly the Mayans took Calleman out on the p1ss on the fourth night, and it is affecting their ability for a proper 5th night destruction.
Seriously s2r1 - quoting rubbish about calleman - rather than explaining the premise behind their predictions in a sensible and adult way (perhaps without actually mentioning calleman at all?) - is getting a bit more than boring. If there is any sense behind these models, then let's talk about that rather than just blindly quoting "calleman said this, calleman said that". It makes us look like a bunch of tin foil hatters, and has no intellectual interest whatsoever. I don't know if you are trying to discredit this site, but please keep the naff references to Mayans etc down to a minimum eh.
12. Eternal Sceptic said...
The world is taking a long time to realise that sophisticated financial instruments( far too complex for joe average to understand) were just a smoke and mirrors exercise to make the few very rich and the rest very poor. Theft, deceit, dishonesty would be a much better description of the mechanics of shuffling all this used bogpaper around the world.
13. sold 2 rent 1 said...
inbreda,
Far from trying to discredit this site, I am actually trying to give people an alternative view of why the chaos that will grip this planet has to take place.
Have you actually read his books or watched Ian Lungold's videos?
There is no point having a poper discussion until you have done this. There are no short cuts to discovering the truth.
Even if you have done some research then that is no guarantee for believing. P4AC is not convinced after his research.
IMHO you have to stare into the abyss before understanding.
I have managed to stare into the abyss with my research.
Most will have to undergo personal trauma.
Maybe I haven't dodged a bullet after all and I still have my personal trauma ahead of me. That would make sense.
14. icarus said...
shipbuilder & inbreda - the problem with responding to calleman/Mayan calendar blogs is that it will generate more of them.
s2r1 - everybody is already convinced of the merits or otherwise of these prophecies. You're unlikely to gain new converts to them so, given that only about three people hold the beliefs, wouldn't it make sense to conduct these blogs among yourselves elsewhere? Why choose hpc.co.uk?
15. James said...
"There are no short cuts to discovering the truth"
Indeed. But that's precisely what you're trying to do. You have no grounding in 'proper' economic theory, so can't see that Calleman and Lungold for all their fancy verbiage, are nothing but snake-oil salesmen.
When you knuckle down and do the hard work required to properly understand economic theory, you'll see why all your stuff is bobbins.
16. holding out said...
S2R1 says "I have managed to stare into the abyss with my research."
No you haven't you've stared into the dark, heard a funny noise and seen a monster.
17. still renting said...
A few points to note about CDSs:
- The CDS market is large and liquid, therefore CDSs are easy to price, buy and sell. (Unlike some credit derivatives such as the MBSs and other CDOs.
- Many players in the CDS market, such as hedge funds, are margined daily on their exposure at market prices.
The above points mean that most of the money changes hands through margin accounts long before the instruments are actually due to pay out. That helps to avoid any "payment shock" type crisis.
On the whole, the CDS market effectively and transparently transfers risk within the credit markets, as is their purpose. Unlike some other types of credit derivative, they do actually contribute to the stability of the markets. They would do this even more effectively in future if CDS trades can be moved onto exchanges, but there is not a clear argument for additional regulation in one of the few markets which seems to have worked well so far in the crunch.
18. icarus said...
still renting - according to the article CDS contracts are OTC and not standardised as they would be if they were traded on an exchange. This lack of standardisation (the contracts are two-party negotiations with very specific terms and therefore connot be exchanged on a like-for-like basis) means they're not very liquid and not interchangeable with other contracts "even with the same company and debt issuance". The $40-50 trillion figure for outstanding CDSs is the OTC figure.
19. still renting said...
@icarus
You're right that they are currently only traded OTC. However, they are similar enough and sold in such quantities that they are in fact highly liquid and easy to trade.
They have now reached the point where it would be viable to set up an exchange for standardised CDSs. (Obviously existing OTC CDSs couldn't be traded on the exchange, it would only apply to newly issued OTCs with standard terms, though counterparties might agree some kind of switch into an equivalent exchange-traded contract, if it was mutually beneficial.) This is no different to what has already happened with many other forms of derivatives, such as equity options.
20. sold 2 rent 1 said...
icarus,
"s2r1 - everybody is already convinced of the merits or otherwise of these prophecies. You're unlikely to gain new converts to them so, given that only about three people hold the beliefs, wouldn't it make sense to conduct these blogs among yourselves elsewhere? Why choose hpc.co.uk?"
Actually malct and p4ac don't have much time for calleman's model.
As for new converts, lets wait and see how things pan out.
Why HPC.co.uk?
Well if it wasn't for this site and you bloggers I may not have been able to get this far in my thinking... so thanks for all your input.
I don't think there are many blogs that can match hpc.co.uk
21. shipbuilder said...
My point was that we are seeing a flood of armageddon-is-nigh articles recently from 'experts' quoting this $50 trillion figure and how it will collapse the world economy.
The majority of bearish scenarios are spun around this figure - indeed it's the number 1 weapon in the nwo's arsenal.
Now, as malct quoted in his first post, this figure isn't so clear and may be $1 trillion.
Does anyone know the truth here?
This is what I meant by my post a while ago that I just don't buy the armageddon scenarios posted by many here - I don't believe tham because I don't believe that the people making them are in full understanding of the facts. This seems like another example of that. Or maybe i'm completely wrong?
22. still renting said...
Not sure if it's been posted here before, but here's what Felix Salmon has to say about it:
Why the CDS market didn't fail
23. icarus said...
still renting - thanks for the clarification - but what do you make of the argument that CDSs have been unstandardised/illiquid for the reasons given in the article?
24. still renting said...
@icarus
Well, it's true to say that contracts aren't standardised, can't be exchanged, etc. That is an arguments about OTC derivatives in general. But CDSs are relatively standardised, simply because trading them is now so commonplace that counterparties don't want to re-invent the wheel every time the write a new contract. So CDSs are among the most liquid OTC derivatives, though still substantially less liquid than an equity traded on the LSE, for example. (However, big name CDSs are probably more liquid than some of the less traded on names on AIM, so having an exchange is not a guarantee of liquidity.)
The point that we don't know various party's exposure because they don't have to disclose it is true, but it's equally true of many other tradeable instruments. Individual trades are disclosed, not positions, so you don't know a given party's exposure to bonds or options either, for example.
So:
- The market seems to be working well, but could be improved in future by creating an exchange for CDSs
- We don't know the risks that market players are taking, but that's true of most forms of trading - disclosure of positions is the exception rather than the norm.
- The fact that they are marked to market and paid on margin by most market participants reduces the likelihood of counterparties failing to meet their obligations
- If I'm going to be proved completely wrong about all this, we'll probably find out today. :o)
25. icarus said...
@ still renting - thanks again for the succinct clarification
@ shipbuilder - dire predictions don't depend so heavily on the size of the CDS market. It's the debt mountain, defaults, HPC, bank insolvencies (unless they mark their assets to anything but the market) etc. that are of more concern. That's before we get into problems with oil supply and land, sea and air environments.