Here's How Messed Up Our Financial System Is

[VeryMeanReversion]

"$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?

para 1 says banks made loans they knew would default

para 2 says those premiums were ridiculously expensive if just one party took out the insurance

=> the only way to resolve this is if the bonds were insured by say 100x different parties, doesnt sound realistic.

Another way of looking at it:

The banks expected insurance to pay out multiple times for one car crash. Instead, the insurers paid out just enough so the car crash never actually happened.

The driver was an idiot who was certain to have a crash but the insurance company took hefty premiums from lots of interested parties to insure them.

VMR.

[Joey Buttafueco Jr]

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.

"They are in management but below VP level."

Are they close to the business? Doesn't make sense as people tend to attain VP by mid 20s in those areas (and management tend to be MD or above)

"Which bit sounded suspicious"

The whole lot to be honest, but I will type it later and see what your contact thinks.

[Joey Buttafueco Jr]

para 1 says banks made loans they knew would default

para 2 says those premiums were ridiculously expensive if just one party took out the insurance

=> the only way to resolve this is if the bonds were insured by say 100x different parties, doesnt sound realistic.

Another way of looking at it:

The banks expected insurance to pay out multiple times for one car crash. Instead, the insurers paid out just enough so the car crash never actually happened.

The driver was an idiot who was certain to have a crash but the insurance company took hefty premiums from lots of interested parties to insure them.

VMR.

I was wondering how the protection seller managed to pocket the full notional upfront. I've not seen that often.

[Dave Spart]

Do you think this made the news because it is commonplace or because it was unusual?

Judging by the $38Tr involved there have evidently been highly commonplace occurences of highly fraudulent acts, of which the public had practically no knowledge and against which the regulators failed to act - the banks exploited the apparent complexity of the instruments to throw the hounds off the scent, turbo charging their way to ill-gotten fortunes and penury for everyone else.

I have previously argued that - as in pharmaceuticals, aerospace, construction, engineering and other arenas the private sector operate - no new financial products should be allowed to be traded until its likely ramifications have been fully tested and its behaviour fully understood. Banks have been exempted from this process and the consequences are clear for all to see. Its time that changed.

If pharmaceutical companies, aerospace companies, construction & engineering companies didn't bother testing their products before releasing them millions would be made sick or killed by lethal drugs, crashing aircraft, collapsed buildings and broken bridges. Those companies would then be sued out of existence and the directors jailed but its because they test their products before selling them those events rarely happen.

Drugs, planes, buildings and bridges - and other engineered products - all have to be certified for worthiness one way or the other. Banks however seem exempt from such inconvenience and instead the result is the near bankruptcy of the West.

Edited July 8, 2009 by Dave Spart

[Joey Buttafueco Jr]

Judging by the $38Tr involved there have evidently been highly commonplace occurences of highly fraudulent acts, of which the public had practically no knowledge and against which the regulators failed to act - the banks exploited the apparent complexity of the instruments to throw the hounds off the scent, turbo charging their way to ill-gotten fortunes and penury for everyone else.

I have previously argued that - as in pharmaceuticals, aerospace, construction, engineering and other arenas the private sector operate - no new financial products should be allowed to be traded until its likely ramifications have been fully tested and its behaviour fully understood. Banks have been exempted from this process and the consequences are clear for all to see. Its time that changed.

If pharmaceutical companies, aerospace companies, construction & engineering companies didn't bother testing their products before releasing them millions would be made sick or killed by lethal drugs, crashing aircraft, collapsed buildings and broken bridges. Those companies would then be sued out of existence and the directors jailed but its because they test their products before selling them those events rarely happen.

Drugs, planes, buildings and bridges - and other engineered products - all have to be certified for worthiness one way or the other. Banks however seem exempt from such inconvenience and instead the result is the near bankruptcy of the West.

"Judging by the $38Tr "

Where did this number come from?

"there have evidently been highly commonplace occurences of highly fraudulent acts"

Don't understand the link????

"the banks exploited the apparent complexity of the instruments"

I thought we were talking about CDS - or are we discussing something else?

[Dave Spart]

"Judging by the $38Tr "

Where did this number come from?

From the article:

"Thanks to the ability to insure debt for multiple times its value, the notional size of the CDS market is more than $38 trillion, or nearly three times U.S. GDP."

and

"As Goldman Sachs' (NYSE: GS) annual report states, "The market for credit default swaps is relatively new, although very large, and it has proven to be extremely volatile and currently lacks a high degree of structure or transparency." Whoo-hoo!"

"there have evidently been highly commonplace occurences of highly fraudulent acts"

Don't understand the link????

See above.

"the banks exploited the apparent complexity of the instruments"

I thought we were talking about CDS - or are we discussing something else?

Oh! You and your stochastic calculus, you!

Edited July 8, 2009 by Dave Spart

[Tiger Woods?]

"$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?

I don't see your problem with this. It was reported in the papers a few months ago and the big boys were spitting chips that they had been beaten at their own game.

[Charterhouse]

This story was reported over a month ago originally. It is quite funny though.

I'm not saying that CDS don't need some extra regulation but the problem is that half the reason that so many of them were done is because there weren't enough corporate bonds in the world to satisfy the people who want to buy them, so people started selling CDS on corporates instead.

[Dave Spart]

This story was reported over a month ago originally. It is quite funny though.

I'm not saying that CDS don't need some extra regulation but the problem is that half the reason that so many of them were done is because there weren't enough corporate bonds in the world to satisfy the people who want to buy them, so people started selling CDS on corporates instead.

In this scene from Jurassic Park Dr Ian Malcolm (Jeff GoldBlum) expresses his concerns to the park owner John Hammond (Richard Attenborough).

MALCOLM

Don't you see the danger, John, inherent in what you're

doing here? Genetic power is the most awesome force

ever seen on this planet. But you wield it like a kid

who's found his dad's gun. . . . .

MALCOLM (cont'd)

The problem with scientific power you've used is it

didn't require any discipline to attain it. You read

what others had done and you took the next step. You

didn't earn the knowledge yourselves, so you don't take

the responsibility for it. You stood on the shoulders

of geniuses to accomplish something as fast as you

could, and before you knew what you had, you patented

it, packaged it, slapped in on a plastic lunch box, and

now you want to sell it.

HAMMOND

You don't give us our due credit. Our scientists have

done things no one could ever do before.

MALCOLM

Your scientists were so preoccupied with whether or not

they could that they didn't stop to think if they

should. Science can create pesticides, but it can't

tell us not to use them. Science can make a nuclear

reactor, but it can't tell us not to build it!

Edited July 8, 2009 by Dave Spart

[Dave Spart]

Also:

MALCOLM

God creates dinosaurs. God destroys dinosaurs. God

creates man. Man destroys God. Man creates dinosaurs.

ELLIE

(finishing it for him)

Dinosaur eats man.

[Joey Buttafueco Jr]

This story was reported over a month ago originally. It is quite funny though.

I'm not saying that CDS don't need some extra regulation but the problem is that half the reason that so many of them were done is because there weren't enough corporate bonds in the world to satisfy the people who want to buy them, so people started selling CDS on corporates instead.

Thought this deal was MBS?

[Joey Buttafueco Jr]

I don't see your problem with this. It was reported in the papers a few months ago and the big boys were spitting chips that they had been beaten at their own game.

I don't understand how selling a certain amount of protection means that you pocket the same amount instantaneously. Unless the underlying was trading at 10000bps upfront. Either that or the author made a mistake.

[Joey Buttafueco Jr]

From the article:

"Thanks to the ability to insure debt for multiple times its value, the notional size of the CDS market is more than $38 trillion, or nearly three times U.S. GDP."

and

"As Goldman Sachs' (NYSE: GS) annual report states, "The market for credit default swaps is relatively new, although very large, and it has proven to be extremely volatile and currently lacks a high degree of structure or transparency." Whoo-hoo!"

See above.

Oh! You and your stochastic calculus, you!

""Thanks to the ability to insure debt for multiple times its value, the notional size of the CDS market is more than $38 trillion, or nearly three times U.S. GDP.""

But the large part of this is where the underlying is corporates???

I don't see what Amherst did is fraudulent.

[Tiger Woods?]

I don't understand how selling a certain amount of protection means that you pocket the same amount instantaneously. Unless the underlying was trading at 10000bps upfront. Either that or the author made a mistake.

Here is the WSJ's report on the Amherst case from June:

http://online.wsj.com/article/SB124468148614104619.html

If you aren't a subscriber, type the name of the article (A Daring Trade Has Wall Street Seething) into Google and go to it from the search results rather than the direct link above - you will get the entire article instead of the first paragraphs.

It was widely reported at the time and the banks involved were quite angry, i.e. they lost money on the deal one way or the other.

Edited July 8, 2009 by D'oh

[Joey Buttafueco Jr]

Here is the WSJ's report on the Amherst case from June:

http://online.wsj.com/article/SB124468148614104619.html

If you aren't a subscriber, type the name of the article (A Daring Trade Has Wall Street Seething) into Google and go to it from the search results rather than the direct link above - you will get the entire article instead of the first paragraphs.

It was widely reported at the time and the banks involved were quite angry, i.e. they lost money on the deal one way or the other.

Thanks

"The banks had to pay up for the protection, similar to a person buying insurance on a beach house just before a hurricane. They paid as much as 80 to 90 cents for every dollar of insurance, the going rate last fall according to dealer quotes, expecting to receive a dollar back when the securities became worthless over the coming months."

So not quite 10000bps, but not far off. TBH I don't know much about CDS on MBS as he desks I know have been wound up due to lack of volume - maybe someone else on here can comment.

[Joey Buttafueco Jr]

Thanks

"The banks had to pay up for the protection, similar to a person buying insurance on a beach house just before a hurricane. They paid as much as 80 to 90 cents for every dollar of insurance, the going rate last fall according to dealer quotes, expecting to receive a dollar back when the securities became worthless over the coming months."

So not quite 10000bps, but not far off. TBH I don't know much about CDS on MBS as he desks I know have been wound up due to lack of volume - maybe someone else on here can comment.

But then....

"When the bonds got paid off, the swaps became worthless, meaning the banks effectively forfeited what they had paid for the insurance. J.P. Morgan lost millions, while RBS and BofA suffered minimal losses, said people familiar with the matter"

so not sure why RBS and BoA didn't suffer if they had paid 80-90% of notional???

[Dave Spart]

""Thanks to the ability to insure debt for multiple times its value, the notional size of the CDS market is more than $38 trillion, or nearly three times U.S. GDP.""

But the large part of this is where the underlying is corporates???

[Joey Buttafueco Jr]

?

[Charterhouse]

I presume either RBS bought the swaps at a lower level, or just transacted a smaller volume.

[Dave Spart]

I don't see what Amherst did is fraudulent.

OK. For Noel's sake - as he obviously isn't getting it - here a Wild West analogy of what Amherst did.

A stranger comes from outta town.

He strolls into the bar and lets the towns people know everyone can buy insurance on his house – from him. He tells them it’s a spaciously deceptively-spacious pwoperty, with room to bring up children, land for raising crops and a barn for keeping animals.

The townspeople scramble to buy his insurance, paying him a fortune in the process. Some people raid their life savings. Others borrow from family, friends and banks.

He then secretly pays the local injins to burn the house down.

Everyone then thinks “Great! The house burnt down! I’m gonna get my payout! I’m rich!”

He then tells everyone “Oh sorry, I had the house valued before it burnt down. Here’s the valuer’s report. It was derelict before the fire and wasn’t worth anything.”

“You all paid me a handsome price to insure something that was worth nothing.”

“From all of you, I got something for nothing. Have a good day now y’all.”

I am quite sure Noel you possess some excellent academic qualifications but you don't possess the guile needed to exploit them like Amherst did. Take a visit to Vegas and you'll see a perfect analogy of what the world's financial system has really descended into.

The world's financial system ony functions when there is trust. Take that trust away and what you get is a global crisis.

Edited July 10, 2009 by Dave Spart

[Joey Buttafueco Jr]

OK. For Noel's sake - as he obviously isn't getting it - here a Wild West analogy of what Amherst did.

A stranger comes from outta town.

He strolls into the bar and lets the towns people know everyone can buy insurance on his house – from him. He tells them it’s a spaciously deceptively-spacious pwoperty, with room to bring up children, land for raising crops and a barn for keeping animals.

The townspeople scramble to buy his insurance, paying him a fortune in the process. Some people raid their life savings. Others borrow from family, friends and banks.

He then secretly pays the local injins to burn the house down.

Everyone then thinks “Great! The house burnt down! I’m gonna get my payout! I’m rich!â€

He then tells everyone “Oh sorry, I had the house valued before it burnt down. Here’s the valuer’s report. It was derelict before the fire and wasn’t worth anything.â€

“You all paid me a handsome price to insure something that was worth nothing.â€

“From all of you, I got something for nothing. Have a good day now y’all.â€

I am quite sure Noel you possess some excellent academic qualifications but you don't possess the guile needed to exploit them like Amherst did. Take a visit to Vegas and you'll see a perfect analogy of what the world's financial system has really descended into.

The world's financial system ony functions when there is trust. Take that trust away and what you get is a global crisis.

"but you don't possess the guile needed to exploit them like Amherst did"

What are you on about you cretin? Please understand some of the subject matter, how banks operate, and stop reading Bloomberg articles and becoming a subject expert overnight.

[Dave Spart]

Following on from my post above (#45), a publicly accessible central register of CDS contracts would go a long way to helping stopping this happening.

Everyone would then know if a given asset was insured, who had insured it and what premiums had been paid. It would also shine a light on the murky world of corporate finance, offering transparency the general public could use to spot criminal behaviour and take action.

What I find truly amazing is that the banks involved in the Amherst fraud had no idea of each other's interest in the assets and no idea that the assets had been insured for many times their value.

In the absence of a central register they couldn't know - there was no way to check - and that is what Amherst and doubtless others exploited. Had a publicly accessible public register been available Amherst would have found it very difficult to pull off their fraud.

Edited July 10, 2009 by Dave Spart

[Charterhouse]

Just so you know, that idiotic analogy is the stupidest thing I've ever read. I feel dumber having actually read it.

[Dave Spart]

Essentially folks what you need to know is with regard the the emergence of derivatives and simialr instrument s over the last decade, that a bunch of Wild West crooks recruited a bunch of brilliant but naive mathmos and paid them a pretty penny to create financial instruments that were really insurance policies dressed up in new terminology.

The regulators unaware of the crook's wicked intentions were hamstrung, plied with drink (keeping the Wild West analogy) or blinded by the new science and rendered incapable of spotting the fraud.

Regulations governing the behaviour of insurance companies are well established and have been in place since the industry first developed.

Banksters however are constantly on the look out for hustles they can exploit before the regulators catch up on them. Essentially they are exploiting regulatory arbitrage.

There's an easy way to put an end to this.

Regulate financial innovation like innovation in other industries: pharmaceutical, aeropace, construction and engineering.

If we are ever going to stop the casinofication of the world economy all financial instruments must be thoroughly tested and certified before sale. Its that simple.

But its because our corrupt politicians, especially in the UK and US, would never impose such inconvenices on their bankster paymasters that's never gonna happen.

Edited July 10, 2009 by Dave Spart

[Charterhouse]

Seriously, what's your qualification to talk about this?

You are talking as if you are an expert, but your content makes it evident to anyone who actually knows anything about financial markets that you are completely clueless in this area.