Why CDSs are not a big problem

[e1618978]

I'm not an expert, of course, but here is my understanding:

A CDS has three involved parties -

reference entity - the company that has to default in order to trigger an insurance payout
buying counterparty - the company that gets the payout
selling counterparty - the company providing the insurance, has to pay the premium when the reference entity defaults.

Lehmann brothers had $600 billion in debt - suppose the people that bought that debt insured it via credit default swaps. That doesn't mean that the total amount of damage is doubled to $1200 billion, it just shifts the liability from the buying counterparty to the selling counterparty (moves that $600 billion in losses around from one company to another company).

There are winners and losers in the CDS game, but in the end all it does is shift liabilities around, it does not add or subtract any net wealth. The only added risk is bankrupsies of selling counterparties, which would mean that the buying counterparties get ripped off a bit (not being able to collect insurance that they paid for), but in the end the amount of bad debt is the same.

All the government has to do to fix this is to force selling counterparties to keep reserves - and if they can't afford to do that they would have to buy back their CDS notes. The CDS market isn't the $62 trillion black hole that people are making it out to be, IMHO, since it is just a shell game with no real extra debt added to the system.

[franksargent]

I'm not an expert, of course, but here is my understanding:

A CDS has three involved parties -

reference entity - the company that has to default in order to trigger an insurance payout
buying counterparty - the company that gets the payout
selling counterparty - the company providing the insurance, has to pay the premium when the reference entity defaults.

Lehmann brothers had $600 billion in debt - suppose the people that bought that debt insured it via credit default swaps. That doesn't mean that the total amount of damage is doubled to $1200 billion, it just shifts the liability from the buying counterparty to the selling counterparty (moves that $600 billion in losses around from one company to another company).

There are winners and losers in the CDS game, but in the end all it does is shift liabilities around, it does not add or subtract any net wealth. The only added risk is bankrupsies of selling counterparties, which would mean that the buying counterparties get ripped off a bit (not being able to collect insurance that they paid for), but in the end the amount of bad debt is the same.

All the government has to do to fix this is to force selling counterparties to keep reserves - and if they can't afford to do that they would have to buy back their CDS notes. The CDS market isn't the $62 trillion black hole that people are making it out to be, IMHO, since it is just a shell game with no real extra debt added to the system.

What is a CDS?

Also a $62 trillion black hole is a $62 trillion black hole, per your shell game analogy.

Bad debt is bad debt.

Unsecured bad debt is unsecured bad debt.

In the end who gets stuck with all this bad debt? The public? I don't know, or won't know for some time yet.

Everyone in the financial markets seems to be panicking at the moment. Everyone seem to want to cutoff their own losses. The run on the stock market is unprecedented, you just have to look at the volume of daily trades to see what is going on, a major sell off.

[e1618978]

CDS = credit default swap

The market for credit default swaps is supposedly $62 trillion, but only a small part of that is in default. My point is that people are often making the mistake of thinking that credit default swaps represent *extra* bad debt - they don't, they just represent insurance on regular debt (so the $62 trillion of CDSes have a corresponding $62 trillion in real debt, unless more than one policy was issued for the same debt).

The person or company that gets "stuck" with the bad debt is either the one who sold the CDS associated with the debt, or (if the seller of the CDS goes bankrupt) the person who owns the debt. The government is not involved unless it chooses to be.

[FloorJack]

What if the buyer and the seller are both losers. What if they are swapping the same type of risk?

[e1618978]

What if the buyer and the seller are both losers. What if they are swapping the same type of risk?

Does not matter - they are not "swapping risks", they are "transferring risks" - the buyer gets less risk and the seller gets more, in exchange for periodic payments. $5 billion of bad debt is exactly the same as ($5 billion in bad debt + $5 billion CDS), it just changes the person who gets screwed, it does not increase the screwing.

The seller of the CDS ends up paying the borrower money due to the default, so it increases the pain of the seller and decreases the pain of the buyer - net pain is equal to the situation with no CDS in the picture.

[FloorJack]

Explaining CDS And CDOs With Doodles
(http://vimeo.com/1915392)http://bc1.vimeo.com/vimeo/thumbs/156597927_100.jpg (http://vimeo.com/1915392)

Gosh I feel so much smarter now.

[tonton]

What if the buyer and the seller are both losers?

Then they will vote McCain/Palin in a few weeks.

[trumptman]

I'll gladly admit I haven't read up on this in a while but from what I recall he real issues were that one, these had been rated by bond agencies and were treated like bonds. Thus they were the "conservative and safe" part of the portfolios when they were actually pretty much junk. Second, since they were the safe part, they were reserves. The fact that the exploded was basically a way of people being radically overleveraged and not knowing it due to the misleading nature of their ratings.

[e1618978]

Explaining CDS And CDOs With Doodles


The thing that I was not taking into account that he did was the effect of ratings downgrades, and the thing he was not taking into account was the positive effects of payouts in the insurance (so the web of companies is both pulled down and propped up). I don't think that the ratings downgrades make that big of a difference, because that posted collateral would have to be paid out anyway as part of the insurance payout.

For example, Lehmann bonds are selling for 8 cents on the dollar, but it won't supposedly be a big hit because the issuers of Lehmann CDSs have already posted 92 cents of collateral.

I'll gladly admit I haven't read up on this in a while but from what I recall he real issues were that one, these had been rated by bond agencies and were treated like bonds. Thus they were the "conservative and safe" part of the portfolios when they were actually pretty much junk. Second, since they were the safe part, they were reserves. The fact that the exploded was basically a way of people being radically overleveraged and not knowing it due to the misleading nature of their ratings.

That is mostly a different issue - mortgage backed securities, CDOs, etc. The only effect this has on CDSes is when a company goes out of business due to mortgage backed securities all of a sudden, and then the CDSes on the company come due unexpectedly.

[midwinter]

these had been rated by bond agencies and were treated like bonds. Thus they were the "conservative and safe" part of the portfolios when they were actually pretty much junk

The rating agencies are not really overseen, though, right? And aren't there a bunch of them, so that if you don't like the rating from one you can go to another one to rate your trash?

[FloorJack]

It's interesting that CDS can be used to short a security or a bond in a way that does not cause its price to fall directly. Its like there's no feed back to the value of security or a bond. Contrast that with stocks where when you short a stock (with the exception of naked shtorting) you have to sell the stock right off. Which let's the market know that a stock is not worth holding on to.

[SDW2001]

I'm not an expert, of course, but here is my understanding:

No, they ARE a huge problem:


A CDS has three involved parties -

reference entity - the company that has to default in order to trigger an insurance payout
buying counterparty - the company that gets the payout
selling counterparty - the company providing the insurance, has to pay the premium when the reference entity defaults.

Good...but see below...



Lehmann brothers had $600 billion in debt - suppose the people that bought that debt insured it via credit default swaps. That doesn't mean that the total amount of damage is doubled to $1200 billion, it just shifts the liability from the buying counterparty to the selling counterparty (moves that $600 billion in losses around from one company to another company).

Why would it double it? I haven't heard anyone claim it did. I see what you're saying..you're insuring one "set" of $600B, not two. But I didn't think anyone believed otherwise.



There are winners and losers in the CDS game, but in the end all it does is shift liabilities around, it does not add or subtract any net wealth. The only added risk is bankrupsies of selling counterparties, which would mean that the buying counterparties get ripped off a bit (not being able to collect insurance that they paid for), but in the end the amount of bad debt is the same.

That "only risk" is THE risk. Many CDSs were not worth the paper they were printed on. The rules governing CDSs, from my understanding, were basically equivalent to Wild West justice--as in, there were almost none. A neighbor of mine who know a bit about this explained it all. Apparently many of the selling counterparties (the providers of the insurance) simply said "sorry cousin, can't pay you."

Therefore, we had this 10 step process happen on a huge scale:

1. Borrower takes loan.
2. Bank provides loan and insures loan with CDS.
3. Bank thinks its ass is covered.
4. Bank sells loan, loan gets packaged in funds, etc. (Real estate market collapses)
5. Borrower defaults.
6. Bank calls CDS.
7. CPS (counter party seller) says "sorry, we're bankrupt").
8. Repeat about 1,000,000 times.
9. Bank is left holding the bag. Bank realizes it doesn't have enough capital to cover losses. Bank shares collapse, making situation worse.
10. Government bails out bank.



All the government has to do to fix this is to force selling counterparties to keep reserves - and if they can't afford to do that they would have to buy back their CDS notes. The CDS market isn't the $62 trillion black hole that people are making it out to be, IMHO, since it is just a shell game with no real extra debt added to the system.

That would help, yes. But the real root of it is the real estate collapse, subprime loans and the byzantine MBS system.

[e1618978]

1. Borrower takes loan.
2. Bank provides loan and insures loan with CDS.
3. Bank thinks its ass is covered.
4. Bank sells loan, loan gets packaged in funds, etc. (Real estate market collapses)
5. Borrower defaults.
6. Bank calls CDS.
7. CPS (counter party seller) says "sorry, we're bankrupt").
8. Repeat about 1,000,000 times.
9. Bank is left holding the bag. Bank realizes it doesn't have enough capital to cover losses. Bank shares collapse, making situation worse.
10. Government bails out bank.

I don't think that CDSes were used to insure mortgages - they were used to insure bonds issued by companies. Mortgage backed securities and CDOs are a different issue, seperate. Default on corporate bonds is an issue, but CDS insurance on those defaults adds no extra trauma.

I don't know of anyone who has gone bankrupt due to CDS calls except for AIG. FRE/FNM were not due to CDSes, and neither was Lehmann - they failed due to mortgage problems.

midwinter - the two rating agencies are Moodies and S&P, which will both be taken out back and beaten as soon as somebody has time.

[trumptman]

I think the issue can accurately be summed up, having now done some reading on this in a few areas, by saying that derivitive products, be they CDS's, CDO's being rated like and acting similarly to bonds, etc. were all mispriced and it was their derivitive nature that allowed this mispricing.

I would consider the rating change activating collateral payouts to be important in a two-fold manner. One the relationships were not only one way. Those insured might have also been insuring so it could set up a domino effect. Secondly by manipulating the price of the asset, possibly via collusion, you could effectly legally engage in a run on insuring agency like you would the bank.

The final point would be that even when something is not called bond, if it is a debt instrument structured like a bond then it is a bond even if they don't want to call it that.

[FloorJack]

Here's a very good article on how CDS took down AIG.

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test (http://online.wsj.com/article/SB122538449722784635.html?)

[screener]

Here's a very good article on how CDS took down AIG.

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test (http://online.wsj.com/article/SB122538449722784635.html?)
Try linking to the article, not the tease.

[FloorJack]

Try linking to the article, not the tease.

I did. You need to subscribe.

[screener]

I did. You need to subscribe.
Pay?
Not gonna happen.

[@_@ Artman]

I did. You need to subscribe.

You're selling the wrong newspaper.

[franksargent]

I did. You need to subscribe.

Subscribe?

When Hell freezes over again, and over again, and over again, and over again, ... , ad infinitum, ad nauseam.

Peddle the WSJ lies and distortions elsewhere, say over there at FRee Pee Nation (http://www.freerepublic.com/home.htm).

In fact, that's one website I'll be watching tonight as McCain loses, because for the life of me, I have no doubt that that will be the largest group of whiners ever seen at one time on the internets.

TYVM

[FloorJack]

It's actually a very good article. Should I post it here? It's about the modeling used to estimate the risk that bucked the old system. Also about how no one put all the dominoes together to answer the "what if" question.

I guess if it doesn't peddle "corporate greed" as the problem you guys aren't interested. Heads down guys!


http://msfriendly.files.wordpress.com/2008/04/ostrich_head_in_ground_full.jpg

[franksargent]

It's actually a very good article. Should I post it here? It's about the modeling used to estimate the risk that bucked the old system. Also about how no one put all the dominoes together to answer the "what if" question.

I guess if it doesn't peddle "corporate greed" as the problem you guys aren't interested. Heads down guys!


http://www.hoax-slayer.com/images/skywalk-grand-canyon.jpg

You betcha.

I know just enough about risk based modeling and the myriad number of gross oversimplified assumptions that are required, or ill defined, or unknown, too know that's it's a piece of heaping stinking shit wrt economics.

You have to have a firm and certain knowledge of the PDF's and CDF's before you leap of the edge off an economic Grand Canyon.

Economics isn't a hard science, it's just a social science, and in my book it isn't even worthy of being called a science in any way, shape, or form.

It's just about bookkeeping and accounting of things that humans place an arbitrary value on.

[FloorJack]

I thought this was an interesting perspective too.

Why Paulson's Plan Won't Work
(http://online.wsj.com/video/why-paulson-plan-wont-work/52373D05-8BF6-464F-945D-F6BDF7FFA689.html)