Credit Default Swaps

Why are credit default swaps potentially (well, we will soon find out their real life impact) so devastating and pose a huge risk to the financial system?

Here I will think not about the actual amounts floating around the world. They are mind bogling, incomprehensible.
And they do not appear in the balance sheets directly, except as fair value, which might be close to zero at the moment, as long as all goes well (well, now that we have the first real casualty, we will soon learn a bit more). Instead I want to think why CDSs are inherently dangerous, just as a mind experiment.

It is not only, that they allow to distribute the risk to other parties who might have much less knowledge about the risk of depth. It is that CDSs can magnify the impact of a credit default.

Credit default swaps insure bonds. BTW, a bond is nothing else than a loan.
Let's see how the world is different if a CDS gets utilised or not.

Let's say company A issues a bond B. Party C buys some of the bond B.

Company A -> issues -> Bond B

Party C -> buys Bond B

If party C changes its mind about the quality of the bond B or the company C, and thinks there might be an increased chance that company A will default on the bond B, what can it do?

A world without CDSs:

Party C -> sells bond B -> to party D.

Maybe with a loss, if the market also thinks the same. But that is not important at this point, because company A has not defaulted on the bond B at this time, and no one knows the true probability of this event yet.

A world with CDSs:

Now company C can also buy a credit default swap.

Party C -> buys from party D -> a credit default swap E.

Now party C has to pay regular interest to party D. In exchange party D holds the risk if company A defaults on bond B.

Now party D holds the risk of bond B. Just as in the first case, when party C sold the bond B to party D.

So far all is nice and beautiful.

But, what, if party D buys the bond B, there is no other party being able to buy the same bond. Only if party D wants to sell it as well. Party C can only sell the bond once!

With CDSs, now party C could kind of sell it twice, three times, as many times as it could effort to pay the interest payments. In fact, many different parties where able to kind of "sell" the bond B many times over to many different parties (all in the form of "buying" a CDS).

Party C -> buys from Party D -> credit default swap E
Party C -> buys from Party F -> credit default swap G
Party C -> buys from Party H -> credit default swap I
Party C -> buys from Party J -> credit default swap K
Party C -> buys from Party L -> credit default swap M
Party C -> buys from Party N -> credit default swap M
etc.

All of them covering for the default of Company A on Bond B.

Now if company A really defaults on bond B, now there is not only one single party that has to pay the difference of what company C can pay back and the original value of the bond, but potentially a big number of other parties will have to do the same payments! This is pure gambling in a big scale without any grounding in any productive activity!

Now the economic impact of company A has a huge impact on many different parties, not just a one to one as with the sale of a bond.

(BTW, ironically, now Party C might actually have an incredible interest of seeing Company A to fail! They are super super short now on company A.)


Getting a loan with the promise to do something productive has the risk that this party than just goes on an extended spending fee for personal gain with the corresponding impact for its creditor.

But CDSs can magnify the impact of any loan gone sour and create a massive chain reaction of insolvencies.

What is wrong with just selling Bond B if anyone doesn't like it and in the end, well, someone will have to pay up for their mistake.

The total amount insured with CDSs goes in the trillions of USD. It seems more in value than the bonds that our outstanding.

This all reminds my of an impressive experience I had years ago in the early days of internet chatting, then the common network was called internet relay chat, short IRC.

There anyone can login, take a free pseudonym, open a chat room with a chat room name that was not yet taken, and invite other people.

The person opening the room had all the power to kick people out and ban them from the room, so they could not enter again.

He was the administrator of this room. Of course, with lot's of people hanging out in a particular room, it became a sign of prestige to hold this admin right, which BTW is transferable. So normally 80 to 100% of the people in a chat room have this admin status after a while (which was visible buy adding a "@" in front of the pseudonym name, or nick name, to be precise).

With normal chat client software, mirc the standard one, there were sophisticated macro languages and other features available. E.g. you could create a list of your friends. If a friend joined your room where you had admin rights, immediately and automatically you would give them admin rights too. And there were standard macros that would help and protect your friends. E.g. someone would kick one of your friends out of the chat room, your client would automatically kick out and ban that person out of the room as well.

Now think for a moment, what this will result in, if almost everyone in this room has admin rights?

And then... one person kicks out, for fun, only one other person?!

Of course, the person kicked out will have friends, kicking out the person who just kicked someone. Now that person has friends as well, kicking out the person helping the first person being kicked out. WHAMMMMMMMMMMMMMMBOOOM!

Almost everyone get's kicked out in a chain reaction.

That is, what you call on a chat server, a Kick Fest. A festival indeed.

It is fun the first two time. Then it get's old real fast!

An example of a negative feedback loop, that happens if all do the same, fully automated, without thinking, and than one person lights a match.

Selling a CDS without having the money to be good for is like selling a naked call when you have neither the underlying stock nor money to cover it. It is not that it makes our system more stable, it makes it much more prone to a huge shake out. IMHO:).

And like a Kick Fest, it might be a good show to tell your grand children about, but it might just as quickly get pretty old restoring your "normal" life once your bank account and job has just evaporated, because a few trillion of funny/fiat money have just vanished in a man made financial mini black hole.

Gigantic Bank Run?

A comment from the comments page at The Big Picture post regarding the Funny and Freaky bailout:
Here Comes the Half Trillion Dollar Fannie/Freddie Bailout!

Cold Facts re US Banks & FDIC

A. There is roughly $6.84 Trillion in bank deposits. $2.60 Trillion of that is uninsured. There is only $53 billion in FDIC insurance to cover $6.84 Trillion in bank deposits. Indymac will eat up roughly $8 billion of that.

B. Of the $6.84 Trillion in bank deposits, the total cash on hand at banks is a mere $273.7 Billion. Where is the rest of the loot? The answer is in off balance sheet SIVs, imploding commercial real estate deals, Alt-A liar loans, Fannie Mae and Freddie Mac bonds, toggle bonds where debt is amazingly paid back with more debt, and all sorts of other silly (and arguably fraudulent) financial wizardry schemes that have bank and brokerage firms leveraged at 30-1 or more. Those loans cannot be paid back.

Now this GSEs bailout?! Printing the American pesos is the last desperate measure. Next - CRISIS OF CONFIDENCE

Posted by: Sunny 129 | Sep 6, 2008 11:55:47 AM

How To Steal A Company (In Russia)

... and if that doesn't work, manufacture a USD 230 million tax refund. RUSSIAN ROULETTE

Via Trader Daily.

Market Bottoms

A very common sense article about what differenciates market bottoms from market tops:

The Aleph Blog: The Fundamentals of Market Bottoms

The Investor Base Becomes Fundamentally-Driven

1) Now, by fundamentally-driven, I don’t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.

2) Fundamental investors are quiet, and valuation-oriented. They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.

3) But at the bottom, even long-term fundamental investors are questioning their sanity. Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling. In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.

4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.

5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.

6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then. M&A volumes are small.

7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven’t morphed into permabears.

8 ) Value managers tend to outperform growth managers at bottoms, though in today’s context, where financials are doing so badly, I would expect growth managers to do better than value managers.

9) On CNBC, and other media outlets, you tend to hear from the “adults” more often. By adults, I mean those who say “You should have seen this coming. Our nation has been irresponsible, yada, yada, yada.” When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom. The “chrome dome count” shows more older investors on the tube is another sign of a bottom.

10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.

11) Value investors find no lack of promising ideas, only a lack of capital.

12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains. They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.

13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot — e.g. money market funds, collectibles, gold, real estate — they chase the next trend in search of easy money.

14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.

...

No Bottom Yet

There are some reasons for optimism in the present environment. Shorts are feared. Value investors are seeing more and more ideas that are intriguing. Credit-sensitive names have been hurt. The yield curve has a positive slope. Short interest is pretty high. But a bottom is not with us yet, for the following reasons:

* Implied volatility is low.
* Corporate defaults are not at crisis levels yet.
* Housing prices still have further to fall.
* Bear markets have duration, and this one has been pretty short so far.
* Leverage hasn’t decreased much. In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
* The Fed is not adding liquidity to the system.
* I don’t sense true panic among investors yet. Not enough neophytes have left the game.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me in the game in 2001-2002. I hope that I — and you — can achieve the same with them as we near the next bottom.

Via The Big Picture.

Risk Manager

Very good article how a risk manager sees the current debacle:

The Economist: Confessions of a risk manager
An insider explains why it is so hard to stop traders behaving recklessly

But we did not believe that prices on AAA assets could fall by more than about 1% in price. A 20% drop on assets with virtually no default risk seemed inconceivable—though this did eventually occur.
...
The focus of our risk management was on the loan portfolio and classic market risk. Loans were illiquid and accounted for on an accrual basis in the “banking book” rather than on a mark-to-market basis in the “trading book”. Rigorous credit analysis to ensure minimum loan-loss provisions was important. Loan risks and classic market risks were generally well understood and regularly reviewed.
...
The gap in our risk management only opened up gradually over the years with the growth of traded credit products such as CDO tranches and other asset-backed securities. These sat uncomfortably between market and credit risk. The market-risk department never really took ownership of them, believing them to be primarily credit-risk instruments, and the credit-risk department thought of them as market risk as they sat in the trading book.

The explosive growth and profitability of the structured-credit market made this an ever greater problem. Our risk-management response was half-hearted.
...
Gradually the structures became more complicated. Since they were held in the trading book, many avoided the rigorous credit process applied to the banking-book assets which might have identified some of the weaknesses.
...
Collective common sense suffered as a result. Often in meetings, our gut reactions as risk managers were negative. But it was difficult to come up with hard-and-fast arguments for why you should decline a transaction, especially when you were sitting opposite a team that had worked for weeks on a proposal, which you had received an hour before the meeting started. In the end, with pressure for earnings and a calm market environment, we reluctantly agreed to marginal transactions.

Over time we accumulated a balance-sheet of traded assets which allowed for very little margin of error. We owned a large portfolio of “very low-risk” assets which turned out to be high-risk. A small price movement on billions of dollars’ worth of securities would translate into large mark-to-market losses.
...
We had not fully appreciated that 20% of a very large number can inflict far greater losses than 80% of a small number.

John Paulson

Wow, this is ironic.

Die Zeit: Die Global Zocker

Hinter ihm liegt ein langes Wochenende – eines, an dem das amerikanische Finanzsystem bedrohlich wackelte, weil die Investmentbank Bear Stearns Bankrott angemeldet hat. Auch Paulson hat seine Gelder dort, über Bear Stearns wickelte er die Käufe und Verkäufe für seinen Fonds ab. Das ganze Wochenende hat er in Meetings verbracht, Besprechungen am Telefon geführt. Bis klar war, sein Geld ist sicher: JP Morgan übernimmt Bear Stearns, und die amerikanische Notenbank hilft beim Kauf.

Dass Paulson den ehemaligen amerikanischen Notenbankchef Alan Greenspan vor Kurzem als Berater eingestellt hat, hat an jenem Wochenende wahrscheinlich nicht geschadet.

As you may recall, John Paulson made USD 15 billion in 2007 betting on a melting sub prime market. So if you ask, where did the money go that UBS etc. lost, well, he has a chunk of it now. Nice play money. But maybe he has a better idea what to do with it, so I thought.

Just funny that he kept it at Bear Stearns. Imagine it would have all vanished again in a Bear Stearns meltdown, haha, easy come, easy go. But apparently Greenspan not only helped him to make the money... I wonder how much help Phil Gramm is for UBS today?!

Via WEISSGARNIX.

Fortis

Fortis bows to pressure and ousts CFO

the ambitious ABN Amro deal, which saw Fortis take over its Dutch rival’s retail banking, private banking and asset management arms for €24bn last autumn.

The move, undertaken in concert with Royal Bank of Scotland and Santander of Spain, landed Fortis in a precarious position even after it undertook Europe’s second-largest rights issue ever, worth €13.4bn, to finance it.

The bank then startled investors in June when it scrapped its interim dividend and raised a further €1.5bn of equity as part of a plan to boost its capital reserves by €8.3bn in spite of assurances that no such move was necessary.

Shares in Fortis, which yesterday rose 8 cents to €9.16, are worth a third of their €29 peak before the crunch, leaving the bank with a market capitalisation worth less than what it paid to enter the ABN Amro deal.

Not long ago Fortis used to pay a dividend of EUR 1.40 per share annually. Obviously the market didn't believe this was sustainable and was right (would be a dividend yield of over 15 % otherwise).

Merrill Lynch

Bloomberg: Merrill to Sell $8.5 Billion of Stock, Unload CDOs

In yesterday's statement, Merrill said it agreed to sell $30.6 billion of collateralized debt obligations -- the mortgage- related bonds that have caused most of the firm's losses -- for $6.7 billion. The buyer is an affiliate of Lone Star Funds, a Dallas-based investment manager.

``Our consistent focus has been to opportunistically reduce risk, and in order to take advantage of this sizeable sale on an accelerated basis, we have decided to further enhance our capital position,'' Thain, 53, said in the statement.

`Little Disheartening'

Merrill will provide financing for about 75 percent of the purchase price, according to the statement. The financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion.

In other words: ML gets a USD 1.68 billion cash infusion (hopefully), but otherwise keeps the remaining risk on the USD 5 billion CDO crap without having any upside potential. If it wasn't so obvious anyway (selling Bloomberg stake and on and on), this looks pretty desperate.

WEISSGARNIX has more comments (in German) on the shareholder dilution etc.

WEISSGARNIX

Good analysises, funny comments. I could say unfortunately in German, but actually it is this blog's strength.

WEISSGARNIX
Wirtschaft & Politik aus allerletzter Hand …

Here two example posts, a good look at the recent Credit Suisse quarterly result...

Credit Suisse, Version für Erwachsene

... and here some Barrack-Berlin impressions (hehe:):

Aus Obamas JFK-Karaoke

Housing Crisis

Brett Steenbarger took a first hand look at the housing market around his area. Very well worth the read!

Beneath the Housing Crisis: Variation in Housing Inventory

It was clear from our drive that there is no single housing crisis. Much of Naperville real estate is in slow-down mode: prices are holding reasonably well, but taking longer, on average, to sell. In the formerly hot areas of development, however, the overexpansion is mind-boggling. Not even free cars and large rebates can move the inventory--particularly with the tightening of mortgage loan criteria for would-be buyers.

This is not an intensification of the slowdown in the general market; it is many standard deviations from the mean. I have significant doubts that many of these subdivisions are viable at any price. From the pricing of the regional bank stocks that have loaned to these developers, I don't seem to be alone in this opinion. C'mon: are you going to jump in and buy a home in a half-filled, half-built development, when it's not clear that the builder will ever be able to finish the work? Are you going to buy a condo in a partially filled building and hope that the remainder of the units will sell, so that you won't have to cover the shortfall in maintenance assessments?
...
this is like tech stocks in early 2000. While many sectors back then were overpriced and experienced a significant but normal bear market, a host of internet-related companies were brought to market with no underlying demand or value whatsoever. The bust wasn't over until many of these roundtripped to zero.

The difference, of course, with housing is that, when developments fail, contractors don't get paid; their suppliers aren't paid; bank loans go into default; mortgage-backed securities are threatened; homeowners lose value in their homes; municipalities lose property tax income; and on and on. Just as surviving the 2000-2003 period meant staying out of the formerly hot areas, I suspect that those who get through the current crisis will insulate their funds from the many areas touched by the collapse of developments that are forced to resort to increasingly desperate discounts and come-ons.
...
When I looked at the homes that were selling for $1 million and over, however, there was six years or more of inventory on the market. Is anyone likely to pony up that kind of money for what looks to be a depreciating asset? With tightening loan conditions, where are these buyers going to come from?

Short Selling

Bloomberg: Never Have So Many Short Sellers Made So Much Money

More than $1.4 trillion of equities worldwide are now on loan, about a third higher than at the start of 2007, data compiled by Spitalfields Advisors, the London-based firm specializing in securities lending, show. Almost all of that is being used to speculate that shares will fall, according to James Angel, a finance professor at Georgetown University who studies short selling. The global economic slowdown, $447 billion in bank losses and an explosion of funds that can profit from stock declines spurred the increase in short selling, helping send 22 of 23 countries in the MSCI World Index into bear markets.
...
Assets at so-called 130/30 and 120/20 funds, or those that are allowed to both hold stocks and short them, may climb to $2 trillion by 2010 from $140 billion in 2007, according to a study last year by Westborough, Massachusetts-based Tabb Group. Spitalfields estimates these funds may borrow an additional $600 billion by 2010.

Via Trader Daily.

Funny & Fried

The basic accounting equation goes like:

Assets = Liabilities + Shareholder's Equity

Now for Fanny and Freddie the news paper have it that Liabilities equals USD 5000 billion. So how much will be the assets worth? 10% less than liabilities would result in a loss of USD 500 billion etc.

The NY Times has a detailed list of foreign countries that hold USD 1200 billion of these liabilities. F&F do not only threaten the US financial system, but directly the international ones as well.

Trouble at Fannie Mae and Freddie Mac Stirs Concern Abroad

Asian institutions and investors hold some $800 billion in securities issued by Fannie and Freddie, the bulk of that in China and Japan. China held $376 billion and Japan $228 billion as of June 2007, the most recent country-specific Treasury figures.

In Europe, roughly $39 billion in Fannie and Freddie debt is held in Luxembourg and $33 billion more in Belgium, countries that are home to large investment management firms. Investors in Britain hold $28 billion, and Russian buyers hold $75 billion. Sovereign wealth funds in the Middle East are also believed to be big investors in Fannie and Freddie debt.

So this is also very much about bailing out the US's international creditors.

E.g. Swiss Re has 10 billion in their books. There could be a beautiful chain reaction all over the planet if the US goverment doesn't cover any fallout.

Buffett Buffet

Lessons from Lunch with Warren Buffett

Do the Right Thing Even if it’s Hard
Buffet has become one of the richest men in the world while never sacrificing the highest ethical standards. “People will always try to stop you doing the right thing if it is unconventional,” said Buffet.

Listen to Yourself, Not the Crowd
Buffet learned at an early age from his father that it is important to listen to yourself rather than seek the affirmation of others. Although he was heavily criticized for not investing with the crowd in technology and Internet stocks in the late '90s, he stuck to what he believed and turned out to be right. During the lunch he asked his guests, “Would you rather be considered the best lover in the world and know privately that you're the worst — or would you prefer to know privately that you're the best lover in the world, but be considered the worst?"

The Numbers Don’t Lie
Buffet said that he limits contact with the managers of businesses that he invests in, choosing rather to examine the company’s financial records. By relying on the numbers he is able to focus on neutral information and prevent outside noise from affecting his decisions.