Credit Default Swaps

[Julia]

Thought this deserved a thread of its own - there are currently several comments on this in various other threads.

I've been looking for some background on this and came across an article from early this year by Alan Kohler which gives some indication of the extent of the problem.

http://www.businessspectator.com.au/bs.nsf/Article/Credit-default-swap-vertigo-C3S5W?OpenDocument

 

[Ageo]

Interesting article Julia, it seems like different legs in the financial system are slowly breaking down 1 by 1

 

[awg]

I have written in a couple of other threads about this, especially under the title of "highly leveraged derivatives" and asked a few questions, too which I got no answers.

I can easily understand why various companies would hedge their debts.

What I cant understand is how an unregulated market can be allowed to develop around leveraged third parties using these instruments for generation of fees and profit.

In my view it should be tightly regulated, or even prohibited, due to the exact risks that have developed...they have prohibited short selling for Chr!st sake!

If Warren Buffet, is so leary of them, that is good enough for me, and I note he does use them within his Berkshire Hathaway, for the exact reason they should be..hedging.

I dont care that there will be some winners out of this...we are all losers at the moment because financial and other companies everywhere are too scared to loan money, in case defaults blow up due to counterparty failure.

The failure of many hedge funds that use these third party derivatives is inevitable, causing further instability, due to their high leverage.

I think I came across as naive in my earlier posts, but I stand by them.

Sometimes simple commonsense tells you that taking a big risk is not wise.

the precedent is the LTCM blowup

There are numerous articles in the fin world stating that, at the present time, and for the forseable future, that the wherabouts of the risks of these instruments cannot be quantified.

I am amazed that not so much is written to say that they should be regulated, not include extensive of balance third parties and high leverage.

time will tell

 

[Buddy]

I woke up this morning feeling quite good. No hangover and not feeling sick.
Then I read this article.
Now I feel sick.

I think i said in another post that CDS trading should be made illegal, punishable by lengthy term of incarceration. Maybe I should change that to punishable by severe death.

I wonder if it is possible to unwind this mess by legislating to deem all CDSs valueless. Something positive has to be done to unwind this mess. Maybe the first step should be to shoot Blythe Masters.

 

[Julia]

AWG: Naive? Rather the opposite I would have thought.

"Business Spectator" are promising a further article on this in the next day or two.

 

[mayk]

Just to let you guys know, politicians are aware of this situation and will take care of it. Having said that I don't know how to absorb my last sentence.

Here is a reference:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aU18G__FI7zQ&refer=home

http://ap.google.com/article/ALeqM5iD1eTWjjS2Qw1YEjB6BflXPr6CagD93UBA783

A quick search on google news also show many interesting articles and it seems FED is in the final stages of regulating this CDS monster.
http://news.google.com/news?hl=en&tab=wn&ned=us&nolr=1&q=credit+default+swaps&btnG=Search

Hope they will be sorted and we will focus on developing the next weapon of mass financial destruction.

 

[Nick Radge]

I guess if we're going to know we will tomorrow when all the Lehman CDS holders need to pay up...

http://business.timesonline.co.uk/t...ectors/banking_and_finance/article4974438.ece

 

[cuttlefish]

Scary stuff isn't it.

I think that the institutions that bought CDS's to hedge didn't worry too much about counterparty risk on them because it was seen as a last resort sort of insurance - not really necessary except in an extreme event - so mainly taken on as a "dot the i's and cross the t's" sort of thing.

The black swan fund guy (can't remember his name) was all over this if my memory serves correctly.

Its a bit like the safety demo thing on the plane - nobody ever believes we'll need it and we all know that its a complete waste of time if the plane is going down. (no the brace position won't save you when you hurtle into the ground in a flaming fireball at hundreds of km per hour).

But we still get given the routine anyway - it makes everyone feel safe and comfortable - this to me is a bit analagous to the way CDS's were being used - to hedge against counterparty risk but never looking into the counterparty risk of the CDS writer because noone expected to actually have to call upon them.

 

[chops_a_must]

Taleb.

 

[awg]

In my opinion, it will be a nasty combination that will do the damage.

First: leverage..to my knowledge many hedge funds are leveraged up to 95%..
probably most are not that leveraged...but because they dont usually declare that info, no-one really knows...that money is borrowed off someone..who, banks?, private individuals, corporations and govt bodies...once again, no-one knows.

second: Redemptions..for sure I would be pulling lots of my bucks out of these funds...cause I dont know how liquid they are...dont want to be the last stupid basta#rd holding the sh!tcan.

third: Counterparty failure, due to the above and firesale prices, has already happened to numerous hedge funds.

I likened it to the commercial building industry, which also runs on leveraged credit..if the developer runs out of credit..no-one gets paid...there is a multi story building down the road from me, and work stopped 12 months ago.
I could detail 20 parties that are unpaid from this, and there would be dozens more

 

[Bushman]

ISDA has just issued a press release about the orderly settlement of the Lehman Bros CDS. Click on the web link below and go to Press Releases.

www.isda.org

Here is an excerpt from the release that should hopefully calm some of the hysteria surrounding Lehman collapse. All in all, Lehman's impact is now contrained. We await the next 'shock' with interest.

Also this thread should be in the 'Derivatives' section.


ISDA CEO NOTES SUCCESS OF LEHMAN SETTLEMENT,

ADDRESSES CDS MISPERCEPTIONS

NEW YORK, Tuesday, October 21, 2008 – Robert Pickel, Chief Executive Officer of the International Swaps and Derivatives Association, Inc. (ISDA) today commented on the cash settlement of CDS trades on Lehman Brothers and on certain misperceptions in relation to the CDS industry.

The cash settlement deadline for Lehman is today, October 21. Based on industry estimates, a total of $6bn to $8bn is expected to have changed hands by close of business. This is approximately 1% to 2% of the $400 billion in CDS trades referencing Lehman and does not account for the effects of collateral, which will further reduce the payment amounts.

“Today’s settlement demonstrates that the industry infrastructure for CDS clearly works,” said Mr. Pickel.

"This is not to say that market dislocation is not having an effect on the derivatives industry more generally,” Mr. Pickel said. “Clearly it is: many market participants have faced major losses that have their genesis in the subprime mortgage business. This is a concern to all of us. The events of this year must be examined thoroughly for a better understanding of how they can be avoided in the future."


Mr. Pickel emphasized that the Lehman default and settlement have not created the financial disruption that critics of the CDS business have claimed. First, because the number of CDS trades outstanding on Lehman includes a significant number of transactions that offset each other, settlement payments are only a fraction – about 1% to 2% – of the approximately $400bn notional of CDS trades referencing Lehman. IE IT IS A ZERO SUM GAME (B'man)

Second, because firms are required to mark their positions to market and to post collateral, any additional exposure arising from the cash settlement is incrementally minimal.

And third, despite the failure of this major dealer institution – as well as several other large counterparties – the CDS business continues to function effectively. CDS contracts have been consistently more liquid than their cash market equivalents.

Then again, maybe you would expect the CEO of the ISDA to defend the derivatives infrastructure.

 

[tcoates]

Another good explanation here...

http://vimeo.com/1915392

no reading required

 

[Julia]

The topic of the Thursday night ABC spot with John Clark and Brian Dawe is usually a realistic reflection of the most potent issue of the week. This evening it was a spoof interview with GWB including asking him about the CDS situation. Pretty funny, but pertinent to the problems still out there.
Figure suggested $500 trillion.