Wednesday, April 22, 2009

CDS: which do you want to hear first the good news or the bad news?

Credit Swaps Market Cut to $38 Trillion, ISDA Says

CDS market was behind a lot of the risk taking that fueled the hp bubble. When it came to the risks to the CDS market itself there was the arguement that "most contracts balanced each other out". Since the crunch it seems players have been tearing up balancing contracts. The good news is that 38% have been torn up. The bad news is that it was only 38%, which means that most presumably most don't balance each other out. So this still leaves $38 Trillion financial weapons of mass destruction targeting the world's economy, I mean the world's tax payers.

Posted by mountain goat @ 12:58 PM (1139 views)
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19 thoughts on “CDS: which do you want to hear first the good news or the bad news?

  • general congreve says:

    So that’s $38,000 billion then? Only $6333 for every man, woman and child in the world. Glad I’m not a kid, OAP, or someone in the third-world who earns a dollar a day. I can afford my share thankfully. Oh, hang on a minute, what’s that? I’ve got to pay for them too, now wait a minute!!!

    We’re all doomed!!!

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  • “CDS market was behind a lot of the risk taking that fueled the hp bubble”

    You are talking rubbish

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  • Yes, it is like every person on this planet should assume a part of the risk for the economic activities and limited liability for lenders. That was probably Clinton thinking when he approved the CDSs.

    Great idea or genius idea thought at the time that proved almost to have destroy capitalism in only 10 years.

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  • Mountain Goat, the reference is a lack of understanding at best and scaremongering at worst.

    The headline figure of $38bn is notional outstanding, not exposure (i.e. not a reflection of credit risks).

    The risk cutting was driven primarily by counterparty risk, rather than that of the credit risk of the reference obligation (i.e. the exposure to the other side of the bet defaulting rather than the exposure to the entity bet on) – kind of like less hose race bets being laid because the punters don’t trust that Ladbrokes, William Hill, etc are good for their word.

    Well yes of course the contracts ‘balance out’ (net out) every trade has a buyer and a seller, hence by definition they ‘balance out’. Of course the unwanted risk is that of a counterparty failure (as per the bookie example), but if we look at the test case of the Lehman’s bankruptcy we see whilst the directional bets laid by Lehman may well have led to their demise we also see that this netting out does hold and whilst the disruption would certainly be less with the implementation of a clearing system, we saw it was relatively mild in the end (impressively so for a first test to be honest) the credit markets seized up with fear because the market had not been tested to such an extent in this respect before, but the fact remains that liquidity returned and the instruments are still used, just probably less directional bets are made with them for now, which is a Good Thing.

    ** If every contract were cancelled right now, there would be very little outstanding settlements compared to this scary number, probably nearer $1bn, so the reference to taxpayer risk is utter nonsense.

    CDS are an extremely simple, very useful instrument which trade in a very liquid market (at least for major names) which quickly reprice due to basis arbitrage between this, the synthetic market, and bonds, the cash market, hence increasing market efficiency.

    For a thorough understanding of CDS read the articles at YieldCurve.com I recommend Moorad Choudry’s – he has been involved in the market from the early days at JP Morgan (although not quite from day 1 I gather).

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  • Oh, and…

    “CDS market was behind a lot of the risk taking that fueled the hp bubble. ” – I believe you are confusing cause and effect. The HP bubble was fuelled by cheap finance, which in turn was fuelled by government and central banking policy. The CDS market grew in notional due to the excess capital that accumulated in the system due to this and other asset bubbles induced by cheap finance and due to the cheap finance itself (hedge funds).

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  • general congreve says:

    You seem to be better informed on this than many of us 666, so you think this is effectively a non-story then and there’s little need to panic?

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  • 51ck-6-51x said… if we look at the test case of the Lehman’s bankruptcy we see whilst the directional bets laid by Lehman may well have led to their demise we also see that this netting out does hold and whilst the disruption would certainly be less with the implementation of a clearing system, we saw it was relatively mild in the end

    In the end??? That makes it sound like the Lehman story is over.

    Naughty 666!

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  • Is this your definition of ‘relatively mild’, 51ck?

    Accountants and lawyers who are trying to sort out the European collapse of Lehman Brothers, the American investment bank, have charged more than £100 million in fees in six months.

    The bonanza shows no sign of abating. PricewaterhouseCoopers (PwC), the administrator, says that costs will accrue at a similar rate over the coming months as a team of nearly 1,500 people unwinds the complex financial web behind the world’s biggest bankruptcy.

    When Lehman Brothers collapsed last year, $582 billion of assets owned by institutions that traded with the bank were frozen, pushing hundreds of hedge funds to the brink of financial collapse. PwC said yesterday that more than a hundred investment funds — predominantly hedge funds — had applied for “hardship status” to get their money released early.

    The majority of the requests were granted. To qualify for hardship consideration, funds must convince the administrator and the courts that they face bankruptcy.

    PwC is close to completing a scheme to distribute frozen assets to their owners. The accountancy firm is consulting with creditors and expects to finalise the scheme by the end of next month, then start to implement it by around September.

    Mr Pearson said: “This is without doubt the most complex and challenging insolvency the UK, and arguably the world, has ever seen.

    The Times, April 15, 2009

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  • GC (I see you’re becoming a regular :D) – this is not a non-story at all. It’s, as I said, either misunderstanding or scaremongering (or a combination. The reason I have an understanding is because I have studied quantitative finance. CDS, although relatively new instruments, are very simple, and given a little reading time most should be able to understand them – they are a bet between two parties on an event, default (or technical default), that may or may not occur the bet is made on a notional amount and settlements are made periodically (the buyer of protection pays a premium, usually every quarter). CDS are quoted in basis points – one basis point is 1/100th of 1% – which, by convention, refers to the annual premium (which is simply divided by 4 for the conventional quarterly settlements). A safe company may trade at only a few basis points, whereas a high credit risk entity may trade at over 800bps. Most outstanding notional is in big, relatively safe names. (as an example, a 50bps CDS with a notional of $1bn would mean premia of $1.25m a quarter. Upon default the protection seller would provide the difference between par and recovery values (i.e. the shortfall caused by default) of the notional – the recovery value is ‘guessed’ an auction process called the credit fixing (valuing the bonds) – which varies from case to case, but is always less than the notional).

    What would be interesting, and could be scary (I don’t know these numbers), is the notional outstanding on financial companies, especially those contracts with financial companies as counterparties too – the most foolish trades IMO, bar buying a CDS on U.S. government debt where the payout is to be made in U.S. dollars (!!) – yes these contracts do exist and are priced.at a few bps… I guess I should sell them, eh?!

    devo said “In the end??? That makes it sound like the Lehman story is over.” – No I anm talking about the CDS market.

    devo – quoted the Times. This shows the need for a clearing house more than anything else. Since CDS are OTC, each and every contract must be examined for deviations from the standard, and chains of netting must be followed, both are laborious processes which would be largely avoided (or at least could be performed automatically) when on-exchange.

    It is, indeed, without a doubt the most complex and challenging insolvency the UK has ever seen. No questioning that!

    The point is there has not been a massive wave of bankruptcies, which was the fear… and with the implementation of a clearing system and application of the standard the market would be even less of a systemic risk (any market has a systemic risk associated, all we can do is minimise).

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  • “The point is there has not been a massive wave of bankruptcies”…yet. Hence the complexity of unwinding described in the Times article.

    The powers-that-be seem to think they can get through this economic storm without major casualities.

    They can’t, and they won’t.

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  • devo – I agree that they can’t and won’t (and will, I think, most likely manage to push problems into the future by a fairly considerable time)
    However, I do not think there will be much as a result of the lehman collapse.
    I concede that I could be wrong (of course).

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  • mountain goat says:

    51ck-6-51x – thanks for sharing your knowledge. Still not sure how I am guilty of scare mongering though? Is it because I suggest 62% of CDS can’t be torn up and so are dangerous? I still think this instrument is more complex and less benign than you suggest. If AIG had been allowed to fall we may have found out. I also stick by my assertion that the CDS market stimulated risk taking in the housing bubble because investors in mortgage back securities were able to insure against credit risk by buying CDS. It was arguably the insatiable investor appetite for these securities that fueled the bubble rather than government financial policies as you suggest.

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  • general congreve says:

    5ick-6-6 @ 9 – Thanks for additional info – if a little difficult to digest.

    The simple way I understood CDS’s is that it’s effectively an insurance policy, as you describe, but it differs from a traditional insurance policy, like you’d have on your car, in that any one can buy a CDS to cover the default of any other party. So, it’s like everyone in my street buying insurance on my car. All well and good if I don’t crash, the insurance company cleans up, but if one day I write my motor off, then the insurance company suddenly has to cough up on all the policies at once, so their losses are severely leveraged.

    This is the situation with CDS’s in the financial markets, so I am led to believe. With AIG at the centre selling CDS’s, and what not, like they were going out of fashion to anyone who’d buy one, but without sufficient capital to cover the payouts because of the leverage. They were simply gambling on the fact that nothing would go wrong with the financial system.

    When Lehman went down that almost sunk AIG because of they couldn’t cover the CDS’s they had sold covering it’s collapse, hence the mutliple multi-billion US Govt. bailouts to AIG to make sure they could make their CDS payments and stay afloat, either that or see the financial system implode.

    Only problem is now the world economy has been brought down, especially the west, by the crippling tax bill to stop this collapse, so we’re in for a long tortuous death, rather than a swift explosive one. Although I guess there is still a decent risk that there will never be enough money to cover all CDS positions if something else goes wrong and we could still see a systemic collapse instead.

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  • MG – scaremongering at worst …maybe just miscomprehension. All CDS could be torn up, after all they are just bets, and bets may be cancelled if both parties agree. After study I feel CDS are very simple contracts and their price depends on very few things. Removing the counterparty risk would vastly reduce the systemic risk the market poses, that much is correct. If AIG had been allowed to fall we would, indeed, be in a whole heap of pain, but that is because of their decisions and the lack of transparency with respect to organisational positions (some people would suggest it were the lack of regulation, but regulation is just one way of enforcing transparency – but I could go on for days…)

    I agree that there was feedback within the CDS market in terms of the housing bubble once securitisation of banking assets took off. However I only think this is due to the nature of credit and the way the regulatory requirements (Basel accords) were written [i.e. capital requirements]. But this is more the fault of the market participants not understanding CDO’s and similar structured products (or more precisely thinking they understood them!). There is (& was) no way to hedge the risk of holding an MBS using CDS, the credit risk of an MBS is that of the default of the mortgage holders and there are no CDS on me & you, only on companies and soveriegns (although I guess there is nothing really stopping us making such bets) – there are, however, MBS that are collective default protection products (issued by Fannie, Freddy, etc..) however these notionals are a tiny drop in the ocean – most of it will be GM, Exxon, etc…

    I firmly believe investors will always fuel any bubble, that it is unavoidable human nature (herding behaviour), but also that it is policies that lie at the root and the self-interest, non-belief in freedom, or flawed logic of politicians and the greed or complete misunderstanding of the associated lobbyists and other parties that influence the political sphere in pursuit of profit that seeds them. Economic agents are meant to pursue profit, so we should not blame them unless they have broken rules (sure we can mock those who got a 125% mortgage that they could only afford the interest on the eve of the bubble popping, but they are not to blame for example). Politicians are meant to act in the interest of their voters and therein lies the rub.

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  • GC – yes, a naïve insurance company would sell insurance to multiple parties on the same event, but it would go directly against the very principles of insurance. AIG Financial Products seems to have been a big fool. There is no doubt in my mind that there was misuse of the instrument, however that is not in my mind an argument against the market, only in bringing the instrument on-exchange (probably will happen) or removing all ties between democracy and capitalism and moving to a truly free market (not going to happen any time soon, but I believe this is the way we should be looking, at least intellectually with an eye to the future.)

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  • mountain goat says:

    51ck-6-51x – As an investor I want the government to protect me from corruption and theft, not risk. Risk taking is what investment is about. In my view the crisis we face is mainly about a failure to understand risks, not failure of regulation. CDS played a big role in this.

    “Collateralized Debt Obligations or CDO’s. These are tough to understand and I won’t bore you with the internals, but think of this as a Mortgage Backed Security on steroids….CDO’s were purchased by investors who were told by “creditable” ratings agencies that these securities were “investment grade”. Some of these investors obviously didn’t believe the credit agencies and decided to seek insurance in the case that their CDO defaulted. They went out and bought………Credit Default Swaps or CDS….There is nothing wrong with a Credit Default Swap – it is basically an insurance policy against the failure of a specific asset. The reason these have been in the news is because some companies – like AIG, Lehman and Fortis (and many others) found these insurance policies to be very lucrative business. AIG in particular issued Credit Default Swaps on CDO’s so that institutions that held CDO’s would be made whole if the CDO defaulted. The problem is that AIG didn’t foresee that ANY of these would default – they thought this was a risk free operation. AIG took in a ton of money to insure the CDO’s through Credit Default Swaps – but never reserved for losses. As we all know now, AIG made a huge mistake as there were and is risk with CDO’s. Credit Default Swaps are basically just insurance policies for securities.” source

    and

    “As mentioned above, under a mortgage, the lender expects to benefit from the interest paid on the mortgage, while the borrower expects to benefit from the use and eventual ownership or sale of the home. Both parties assume that the mortgage will be repaid…
    An economist would say that the lender is long on the mortgage, which is to say, the lender gains if the mortgage is fully repaid… If we consider only lenders and borrowers, then, there are no participants with a true short position in the market….This is not the case with credit default swaps (CDSs) referencing MBSs. In such a CDS, the protection seller is long on the MBS and therefore long on the underlying mortgages, and the protection buyer is short. That is, if the MBS pays out, the protection seller gains on the swap; and if the MBS defaults, the protection buyer gains on the swap. The two parties are expressing, through the CDS, their opposing expectations of the performance of the underlying security. Thus, the CDS market provides an opportunity to express a negative view of mortgage default risk….” source

    In other words CDS allows someone to benefit if mortgages in the MBS go bust. This effectively allows MBS insurance. CDS market was central to risk protection of mortgages securities. It is not the CDS that is inherently wrong but it is the mistakes in this market that contributed to the debt housing bubble getting out of hand.

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  • mountain goat. It seems that we agree. It is the market, not the instrument.

    I would add, however, that CDO are not particularly tough to understand. That is a big part of the problem:
    – CDO are relatively easy to understand when one visualises their workings using the cash flow waterfall idea used across the securitisation space.
    – The problem here is that to model how these things actually work in the real world, with all the co-variances between every pair of assets in the basket, is slow. Painfully slow when the number of assets is typical (200). So the people who design the models cut corners for efficiency (e.g. by using a copula to reduce the problems dimensionality) but there are hidden effects of this corner cutting that are not so obvious, and without a thorough understanding of the tool (e.g. here, copulas) certain risks are hidden from the investors view.
    – So it comes down to the old adage “Do not trade what you do not understand” with the added caveat that one must look out for any way that one may have fooled oneself into believing one understands (which is hard, especially since those who are more incompetent are more likely to overrate themselves (<< a favourite of mine).

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  • ^^ 200 should read 200+.

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  • ^^ and problems should read problem’s (but that is pretty obvious!)

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