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Here's How Messed Up Our Financial System Is


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Excellent discussion on Motley Fool.

Charlie Munger explains precisely why CDSes are dangeeous in their present form and why reform in needed.

Many of the comments beneath are enlightened.

It is out and out fraud on all sorts of levels. Spiv companies have been actively taking down companies to claim on these bets. What has been suspected for a long time is coming out into the open, the scale of it is astounding, The market has been turned into a fraudsters cartel. It has nothing to do with investment, or anything to do with growing businesses or growing wealth in the eyes of these major players.

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It is out and out fraud on all sorts of levels. Spiv companies have been actively taking down companies to claim on these bets. What has been suspected for a long time is coming out into the open, the scale of it is astounding, The market has been turned into a fraudsters cartel. It has nothing to do with investment, or anything to do with growing businesses or growing wealth in the eyes of these major players.

Yep.

As some of the comments note the big problems we have is that ordinary people don't understand what CDSes are and how dangerously they've been abused.

The article spells it out nicely with the simple building insurance analogy:

So why does Munger, Berkshire Hathaway's co-chairman, want them banned?

See, in everyday life, you can't insure things you don't own. Thankfully, your neighbor can't take out homeowners insurance on your house. If the entire town could buy insurance on one house, they'd have a huge incentive to make sure it was destroyed. They'd burn it down, blow it up, bulldoze it, what have you, pocket gobs of insurance claims for their trouble, and happily move onto the next town. For good reason, laws prohibit this.

With credit default swaps, there are no such laws. Investors can take out infinite amounts of insurance on debt products they don't own. This seriously distorts the motives and incentives between buyers and sellers. CDSes often don't act as insurance, but a tool to manipulate stupidly large amounts of money and rip gaping holes in the financial system, a la AIG (NYSE: AIG).

One of the comments cements this view and provides a sensible sounding solution:

On July 07, 2009, at 5:45 PM, Palmair wrote: The problem isn't necessarily with the credit default swaps. Rather, it's with the policy that allows for multiple CDSes on the same risk. If the system was changed, such that the maximum credit default swap(s) that could be placed on a potential loss was the total of the loss (not multiples of it), and no more, the gaming aspect would be substantially reduced and the swaps could then be used properly for their intended purpose.
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Yep.

As some of the comments note the big problems we have is that ordinary people don't understand what CDSes are and how dangerously they've been abused.

The article spells it out nicely with the simple building insurance analogy:

One of the comments cements this view and provides a sensible sounding solution:

With the likes of Goldman Sachs making the market free from interference from regulators its easy to see how the crooks got away with it.

Essentially the banks came up with something that looked like insurance, walked like insurance and quacked like insurance but got away with having it regulated like insurance by using terminology and fancy maths that baffled the regulators.

Edited by Dave Spart
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It is out and out fraud on all sorts of levels. Spiv companies have been actively taking down companies to claim on these bets. What has been suspected for a long time is coming out into the open, the scale of it is astounding, The market has been turned into a fraudsters cartel. It has nothing to do with investment, or anything to do with growing businesses or growing wealth in the eyes of these major players.

And to think that some people on this site are STILL trying to defend them in their current form...FFS

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Yep.

As some of the comments note the big problems we have is that ordinary people don't understand what CDSes are and how dangerously they've been abused.

The article spells it out nicely with the simple building insurance analogy:

See, in everyday life, you can't insure things you don't own. Thankfully, your neighbor can't take out homeowners insurance on your house. If the entire town could buy insurance on one house, they'd have a huge incentive to make sure it was destroyed. They'd burn it down, blow it up, bulldoze it, what have you, pocket gobs of insurance claims for their trouble, and happily move onto the next town. For good reason, laws prohibit this.

One of the comments cements this view and provides a sensible sounding solution:

Yes, that is the perfect example.

Same as the shenanigans with trading fake shares and naked shorting. Just sell enough until the company is ground into bankruptcy (assuming at some stage it needed to issue shares to fund existence).

The US stockmarket has become the premier location for the destruction of capital and fraud, led by a gang of puppetmasters.

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Excellent discussion on Motley Fool.

Charlie Munger explains precisely why CDSes are dangerous in their present form and why reform in needed.

Many of the comments beneath are enlightened.

"Charlie Munger explains precisely why CDSes are dangerous in their present form and why reform in needed."

Does Charlie Munger explains precisely why selling out of the money put options are dangerous in their present form and why reform in needed?

"Many of the comments beneath are enlightened."

Which ones in particular?

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"Charlie Munger explains precisely why CDSes are dangerous in their present form and why reform in needed."

Does Charlie Munger explains precisely why selling out of the money put options are dangerous in their present form and why reform in needed?

Yes

"Many of the comments beneath are enlightened."

Which ones in particular?

Read my post above and click the link to the article, if that's not too much trouble.

Edited by Dave Spart
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Please provide evidence.

I did, you just have chosen to ignore it so for your sake I'll copy and paste it here:

The Wall Street Journal recently reported an almost comical example of this. It tells the story of a tiny Texas brokerage firm called Amherst Holdings which, likely along with other CDS underwriters, took a $27 million debt security and sold $130 million of credit default protection on it. Big banks like RBS (NYSE: RBS) JPMorgan Chase (NYSE: JPM) and Bank of America (NYSE: BAC) bought these CDSes. The debt, when reviewed, was total garbage and almost certain to default, so the banks had no problem paying up for the insurance.

Now, think about this for a moment: Amherst, and likely other CDS counterparties, pocketed $130 million to insure $27 million worth of bonds. So what do you think Amherst did? Exploiting a small loophole, it used the proceeds to have the underlying bonds bought back at par, which instantly rendered the credit default swaps worthless.

It was incentivized to do this because the amount it took in from CDS proceeds substantially exceeded the bond's par value, so it could burn millions of dollars buying out the bonds and still make a tidy profit. By making the bonds whole, there was zero chance of default, so Amherst's insurance obligation disappeared.

Of course, there really was no insurance involved. There wasn't even an investment. As Munger notes in the opening quote, it's simply a vast, unregulated game of poker. Spun the other way, CDS buyers have an incentive to make sure underlying debt defaults. They can achieve this by buying CDSes for multiple times a company's debt load and causing a run on its assets. Indeed, this is exactly what many believe ultimately pushed Lehman Brothers into bankruptcy.

Edited by Dave Spart
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I brought these issues up with someone that works in the CDS group at JP Morgan. They realise it's a bit silly but they are now allowed to mark to myth again so it really helps with the profit reporting. :o

i.e. both side of a CDS contract can report a profit based on what they think it's worth.

My opinion was that they are just using them as profit generators without anything to actually back it up. They don't seem to realise the consequences of what they are doing.

A little factoid is that 75% of JPM's CDS's are internal, not involving counterparty risk.

Currently, CDS are a manual process but this is being standardised and automated so its easier to find contracts that cancel out.

My understanding is that its a tool for offsetting risk so you can arrange trades so that whatever happens, you end up with a positive margin so it looks like money for nothing. (As long as the rates for borrow+CDS < sell).

The problem is that "money for nothing" soon turns into "lots of money for nothing" and the counterparty risk is overlooked. That's when you end up with something like AIG not able to pay out. Then it all goes bang.

VMR.

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I brought these issues up with someone that works in the CDS group at JP Morgan. They realise it's a bit silly but they are now allowed to mark to myth again so it really helps with the profit reporting. :o

i.e. both side of a CDS contract can report a profit based on what they think it's worth.

My opinion was that they are just using them as profit generators without anything to actually back it up. They don't seem to realise the consequences of what they are doing.

A little factoid is that 75% of JPM's CDS's are internal, not involving counterparty risk.

Currently, CDS are a manual process but this is being standardised and automated so its easier to find contracts that cancel out.

My understanding is that its a tool for offsetting risk so you can arrange trades so that whatever happens, you end up with a positive margin so it looks like money for nothing. (As long as the rates for borrow+CDS < sell).

The problem is that "money for nothing" soon turns into "lots of money for nothing" and the counterparty risk is overlooked. That's when you end up with something like AIG not able to pay out. Then it all goes bang.

VMR.

"I brought these issues up with someone that works in the CDS group at JP Morgan"

What role is this person in? I will do some digging, as it sounds very suspicious.

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"I brought these issues up with someone that works in the CDS group at JP Morgan"

What role is this person in? I will do some digging, as it sounds very suspicious.

indeed. Im going to do a CDS with my rent to myself and claim the 20bps as extra income.

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"$130 million of credit default protection on it. Big banks like RBS (NYSE: RBS) JPMorgan Chase (NYSE: JPM) and Bank of America (NYSE: BAC) bought these CDSes. The debt, when reviewed, was total garbage and almost certain to default, so the banks had no problem paying up for the insurance."

"Now, think about this for a moment: Amherst, and likely other CDS counterparties, pocketed $130 million to insure $27 million worth of bonds."

Seeing as everyone is now an expert, what doesn't make sense in the above two sentences?

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What role is this person in? I will do some digging, as it sounds very suspicious.

It's not possible to give much more detail without them being identified. They are in management but below VP level. Which bit sounded suspicious? I can always ask them more questions.

They did know about the example where an event can be insured multiple times so it's in the interest of the CDS holder to cause a default.

VMR.

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It's not possible to give much more detail without them being identified. They are in management but below VP level. Which bit sounded suspicious? I can always ask them more questions.

They did know about the example where an event can be insured multiple times so it's in the interest of the CDS holder to cause a default.

VMR.

ah, but CDS is NOT insurance.

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