Comments on: Another potentially huge settlement day for CDS contracts ...

Another potentially huge settlement day for CDS contracts ...

Mutant — Fri, 10 Oct 2008 02:32:15 -0800

Credit Default Swaps (CDS) are derivative instruments providing the purchaser with protection against default on an underlying financial asset. When Fannie Mae and Freddie Mac technically defaulted on September 7th there was much speculation that the CDS market would collapse as a result of protection being invoked on $1.4 trillion dollars worth of debt. On October 6th these derivative contracts settled, and the CDS market didn't collapse with recovery rates of 92% being observed. Today CDS contracts protecting against the default of Lehman Brothers settle. The problem? Because industry lacks a central clearinghouse for these derivatives, nobody is really sure how many CDS contracts were written either by Lehman or by other banks providing protection against a Lehman default. Next on the list are CDS' covering Washington Mutual, which are due to settle October 23rd.

Meanwhile efforts to create a clearing house continue, as some folks speculate that the settlement of Credit Default Swaps is a major reason why banks are hoarding cash.

By: parki

parki — Fri, 10 Oct 2008 03:03:36 -0800

If nobody understands 'em, maybe we shouldn't, y'know, trade 'em.

By: Ritchie

Ritchie — Fri, 10 Oct 2008 03:04:47 -0800

Be honest: a small part of you is loving every minute of this, no?

By: slater

slater — Fri, 10 Oct 2008 03:12:06 -0800

Oh shi....

By: slater

slater — Fri, 10 Oct 2008 03:13:02 -0800

Ritchie: yes. :D

By: bystander

bystander — Fri, 10 Oct 2008 03:19:13 -0800

So most CDS were written to hedge an opposite bet. So at the end of each chain there is a big winner and at the other end a big loser, presumably, unless the whole thing ended in a loop. But most holders of the instruments will hold a relatively small arbitrage position. Assuming it is fear of the unhedged CDS not being honoured that is freezing the credit market, why can't we do like with short sales, and disallow uncovered CDS? This would cause a scramble to cover, but how about announcing they will be disallowed in 10 days time or a similar window to unwind positions?

By: adamvasco

adamvasco — Fri, 10 Oct 2008 03:33:15 -0800

Robert Peston For every winner in a claim, there is a loser, the underwriter who has to divvy up. And if the underwriter lacks the resources to pay - which may turn out to be the case in this under-regulated market - that creates two losers: viz the bust underwriter and the claimant which doesn't get the money on which it was counting. And if that claimant had been calculating its own financial strength on the basis that it had insurance against its Lehman debt, well then failure to receive payment could shatter the integrity of its balance sheet. Which in turn would create potential losers among its creditors.

By: generichuman

generichuman — Fri, 10 Oct 2008 03:37:53 -0800

Thanks, Mutant. I'd seen you mention Credit Default Swaps a few times before, but never really quite understood what they were. (Not that I do now, mind you. But I feel closer to groking this thing.)

By: nicolin

nicolin — Fri, 10 Oct 2008 03:53:26 -0800

Credit Default Swaps were explained in the program mentioned in that recent post. Thanks for more details.

By: JPD

JPD — Fri, 10 Oct 2008 03:55:35 -0800

The 92% recovery on FNM and FRE CDS is misleading. For the junior debt it was 99.9. The only reason why the senior settled at less then that was because they both had issued zero coupon senior securities that themselves were worth less then their par value. So it wasn't a stress on the system so much as a trial run on the operations of it all. Also it will be interesting to see how the prime brokerage side of all this works. It is my understanding (Tho I am not 100% certain) that prime brokers essentially took on the counterparty risk implicit in the CDS that their hedge fund clients were buying, so if the original writer of the protection is kaput, the hedge fund could compel their prime broker to payout.

By: bystander

bystander — Fri, 10 Oct 2008 03:58:06 -0800

JPD: but wasn't one of the big arguments for saving Lehman was their prime broker role?

By: Xurando

Xurando — Fri, 10 Oct 2008 03:58:08 -0800

Also it will be interesting to see how the prime brokerage side of all this works. It is my understanding (Tho I am not 100% certain) that prime brokers essentially took on the counterparty risk implicit in the CDS that their hedge fund clients were buying, so if the original writer of the protection is kaput, the hedge fund could compel their prime broker to payout. What in the hell are you talking about?

By: bardic

bardic — Fri, 10 Oct 2008 03:58:41 -0800

In a previous financial meltdown thread I was kind of surprised as how many people thought we HAD TO DO SOMETHING, i.e., give Wall Street billions, or otherwise we'd be post-apocalyptic cannibals by the end of the week. So I hate to say I told you so, but just like someone with a serious drug problem, giving Wall Street bail-outs is simply prolonging the pain. Instead of a rapid and shocking collapse, we're going to get three to five years of handouts amounting to trillions of dollars. Honestly, if someone was financially prudent over the past decade, beyond not being able to get a boost on their credit card limit what are they going to suffer? Obviously, if they work in the financial industry they might lose their job. But guess what? That happens to people every day. It's a part of life. I admit I want to see these fuckwits on Wall Street suffer, but it's not simply malice at work here. The responsible, pragmatic thing to do is let the banks with shitty books fail completely. Kind of like after 9/11 when all of the airlines wanted a hand-out. Simple fact was, we didn't need that many airlines any more.

By: bardic

bardic — Fri, 10 Oct 2008 03:59:20 -0800

Interesting post, btw.

By: JPD

JPD — Fri, 10 Oct 2008 04:05:45 -0800

Xurando - you saying I am factually incorrect? (Very plausible - it might be the other way around - HF wrote the protection, went bust, prime broker has to cover it) Or that my comment was too jargon-y?

By: nims

nims — Fri, 10 Oct 2008 04:09:03 -0800

Because industry lacks a central clearinghouse for these derivatives DTCC and CLS provide this service since october 2007.

By: bystander

bystander — Fri, 10 Oct 2008 04:12:20 -0800

Xurando: the idea is that a merchant bank (Lehman Brothers, Goldman Sachs etc.) organised the sale of CDS between end counterparties. I believe at least some of the sale contracts stipulated the brokers would stand behind the deal if one of the counter parties failed. The concern Mutant's post raises is that some of these counter parties may be hedge funds or others (AIG etc.) that did not cover the CDS, so they would need to pay the whole amount of the defaulted bond - possibly billions more than they have, sending them broke,. forcing the prime broker who organised the deal to step in. Because the prime brokers did many such deals, they could also be wiped out if they had to cough up the money. This is the cascading default fear that is making banks reluctant to loan money, because they fear the people they loan the money to may get caught up in this, and be unable to repay the principle of any new loans.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 04:15:52 -0800

As a first step, couldn't the govt mandate that every writer and purchaser of CDS istruments report their holdings/exposure? How do we even know the size of the market if all of these agreements are secret and undisclosed. BTW, the Oct 5th This American Life podcast has some excellent coverage of this problem by the NPR Money Planet crew.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 04:29:00 -0800

bystander: "5So most CDS were written to hedge an opposite bet. " You would think so, but it's counter-party risk that is causing the dominoes to fall. Think of it this way: 1..Say you write a fire insurance policy that a $300K house won't burn down and you collect $1000/year in premium. 2. Market conditions change. 3. Because of the market conditions changing now you buy a policy on that same house, but it only costs you $900/year. You would think that you are set up for life now. If the house doesn't burn down, you collect $100/year for the life of the policy(difference between the two premiums), If the house burns down the policy you bought pays off the owner. These arrangements are going sour for a couple reasons: 1. The houses are "burning", but perhaps the insurers won't/can't pay 2. There may be an nearly unlimited number(very large, anyway) of these policies on EVERY house. Think about #2, above. A $300K house burns down and it triggers $10 million dollars in losses for a lot of somebodies who though they were all locked up and hedged in "can't lose" "investments". It's crazy.

By: From Bklyn

From Bklyn — Fri, 10 Oct 2008 04:30:13 -0800

Sweet post, dude. No, seriously: concisely elucidates an aspect of all this excitement I had not previously grasped. Thanks.

By: bystander

bystander — Fri, 10 Oct 2008 04:47:28 -0800

Rafaelloello, yes, that is true, but as I understand it, most holders of CDS have them hedged off to someone else. Publicly traded companies *should* have risk management in place to stop them taking the whole risk, and it would have been good business to take the $100 a year, after all, Lehman's won't go broke ;-) So the actual number of counter parties that are fully exposed to a huge win or loss should be limited to a comparatively small number of unregulated hedge funds or similar - remember, there was no money to be made until default for an unhedged CDS, so there was an incentive to pass it on and make the $100 from arbitrage. So if we made a regulation forbidding the uncovered CDS it would only affect the end security holders, and both those on the winning and losing side would have to cover, effectively with each other. This would kill the winners, who at the moment are hoping for the huge windfall, but if the system breaks they won't ever see it, so the rational course will be for even them to deal and make an arbitrage profit.

By: DreamerFi

DreamerFi — Fri, 10 Oct 2008 05:01:43 -0800

were written [..] by Lehman [..] providing protection against a Lehman default. Wait, what? Are you telling me Lehman wrote something like "I will pay you X if I go bankrupt"? And people paid money for that?

By: Skeptic

Skeptic — Fri, 10 Oct 2008 05:02:04 -0800

You know, for a while I had been joking that, instead of a market economy, what we were increasingly having was a bazaar economy. What is supposed to distinguish a true market economy is price transparency, since only price transparency makes actual competition possible. As in a supermarket, all prices are clearly displayed and prospective buyers know what they are buying and for what price. In a bazaar, however, prices are not displayed: you have to express an interest to get a quote, and haggling is "de rigueur". The motivation behind this is blatant anticompetitive collusion between the stallowners, as you'll find out if you attempt to get some comparative pricing (price quotes keep rising and rising as word spreads -quite rapidly- across the bazaar that there's an interested buyer for a particular type of merchandise). Moreover, the haggling often involves bundling with other merchandise of dubious value and no real interest to the buyer. My "bazaar economy" quip used to refer to the price opaqueness of some services, such as telecoms, yield managed airlines, and...yes...retail banking and insurance, which apply very much the same techniques as the bazaar merchants to keep prices as opaque as possible. These days, reading about the CDS bazaar, I'm flabbergasted that the "bazaar economy" had permeated the higher spheres of finance to such a level.

By: claudius

claudius — Fri, 10 Oct 2008 05:09:07 -0800

DreamerFi: see here.

By: blue mustard

blue mustard — Fri, 10 Oct 2008 05:11:30 -0800

Here's the "Plain English" summary of the auction procedure for the Lehman settlement. I would hate to read the non-Plain-English version. Still, from the little I understand, it appears we'll find out at 2pm or so what the settlement prices will be, but the cash settlement doesn't take place until the 21st. I wonder if this means we have another two weeks of uncertainty until we find out who is newly bankrupt? Or will it play out faster than that?

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 05:19:01 -0800

bystander: "20Rafaelloello, yes, that is true, but as I understand it, most holders of CDS have them hedged off to someone else. ..." In (most?) lines of insurance you cannot take out a policy unless you have an insurable interest in the asset or life. In CDS's there was no requirement of this. Somebody buys Rafaelloello's mortgage, they want to hedge that risk with a CDS, fine. 5,000 other investors say, "Hey Rafaelloello hasn't missed a mortgage payment, I want to "insure" that he continues to pay." Then 5,000 more say, "I'll take that bet, because even though it looks like he's going to continue to pay, I can hedge my bet that he wont..." Enter the next 5,000 "investors". Before you know it, Rafaelloello is the equivalent of a top-ranked college athlete. Tens of millions of dollars are being bet on my ability to perform, with no direct ties to the underlying assets (My home and my ability to pay). You're only hedged as well the ability of all parties to pay their bets/bookies/vigs obligations. In this ring of hedges it only takes a player or two to skip town and the whole game implodes.

By: Pollomacho

Pollomacho — Fri, 10 Oct 2008 05:24:10 -0800

The problem? Because industry lacks a central clearinghouse for these derivatives, nobody is really sure how many CDS contracts were written either by Lehman or by other banks providing protection against a Lehman default. You know, how there is a problem with phantom riders whenever a public transport bus wrecks, the people that come out of the woodwork and claim they were on the bus and now deserve compensation for their "injuries." I think I just figured out a way to get rich. Not just phantom bus rider rich, I'm talking spouse of a Presidential candidate rich!

By: DreamerFi

DreamerFi — Fri, 10 Oct 2008 05:34:49 -0800

Claudius: Thank you. I think I can understand Lehman trying this, sort of, but I'm utterly flabbergasted that people fell for it and bought these CDS's...

By: garlic

garlic — Fri, 10 Oct 2008 05:38:00 -0800

pollomacho -- that's what everyone in the CDS market thought too. Instead, they discovered a way to gamble the economy into near collapse.

By: DreamerFi

DreamerFi — Fri, 10 Oct 2008 05:43:26 -0800

Claudius, I think it reminds me of this: "I'll bet you a dollar," says Ernie, "that if you give me two dollars I'll give you three dollars." Bert agrees and gives Ernie two dollars. Ernie says, "I lose," gives Bert one dollar and pockets the other.

By: sebas

sebas — Fri, 10 Oct 2008 05:44:29 -0800

I think I'll write a CDS contract providing protection against me losing my job in the next year. Should be worth several billion euros after I hedge them off to several unregulated hedge funds. It might take out several small countries but at least I'll be rich!

By: ryoshu

ryoshu — Fri, 10 Oct 2008 05:50:38 -0800

As a first step, couldn't the govt mandate that every writer and purchaser of CDS istruments report their holdings/exposure? Actually, this should be done for everything on the books, not just CDSs. People are nervous to loan money because no one is sure who has what on the books. The only way to unfreeze this market is to restore confidence and that is going to require transparency.

By: bonaldi

bonaldi — Fri, 10 Oct 2008 05:51:18 -0800

So the knock-on effects of today's CDS auction are likely to be felt when -- tonight or Monday? Because if it goes bad and people have two days to stew, that's a recipe for meltdown, no?

By: bystander

bystander — Fri, 10 Oct 2008 05:55:20 -0800

Again, yes, Rafaelello, it reminds me of blackjack where you can bet on a player's outcome, but in this case it appears the side bets have grown to a ridiculously huge amount. BUT, each bet is part of a chain, and each step of the chain only has a small exposure *IF* the next link comes through. And each chain of bets is discrete - a failure in one need not impact the other chains. My contention is there are a compratively small number of end links - the middle links can be smaller players because they only need to cover their arbitrage risk against the next link. At each end of the chain are the huge winner/losers. The winners were kind of left holding the bag by accident, they probably wouldn't have made their initial deal thinking they would just sit with an obligation to pay the "premium" on the CDS insurance unless they thought they could sell the obligation off. Otherwise they would be stuck paying the premium on insuring a bond from a company that could not fail (like Lehman ;-) They now view themselves as potentially massive winners *IF* all links back to the loser who took the opposite bet hold. I contend we can regulate to say - potential winners, you won't get paid, because the magnitude of your payout will break the financial system, so you should accept an arbitrage payment and sell the end link to someone who is a loser on the other end. Obviously, without a law to make this happen, by forcing CDS holders to hold a covering CDS the other way, the winners will hold out for the big pay off. If we made such a law, it would, I think, nip this in the bud, only exposing CDS holders of bonds that had already defaulted (like Lehman,n presumably). If we don't, it seems as though there will be cascading defaults to come. DISCLOSURE - I hold some mutual funds for retirement in superannuation and a few oil stocks, they all add up to less than 1 years income. I just want this to stop so I can keep my job.

By: sdodd

sdodd — Fri, 10 Oct 2008 05:56:05 -0800

Oh, wow. From claudius' link:

What this [writing a CDS on oneself situation] means is that it’s not possible to value a CDS (and therefore any kind of debt for the issuer) simply by looking at the risk of default for the insured firm, and then considering the risk of default for the issuer. You need to know the correlation between the two, and this requires detailed knowledge of the entire asset position of both parties, including their correlations with other parties.

Knowing the "correlation between the two" parties sounds suspiciously like what Computer Science guys call "reachability." It appears as though it may not be possible to perform reachability analysis (and therefore know the value of any given CDS) in the current regulatory environment. What's worrisome is the possibility that it may be mathematically impossible to perform reachability analysis even if all parties were to reveal their entire asset positions. I think there's an interesting Math paper in there.

By: bystander

bystander — Fri, 10 Oct 2008 06:10:58 -0800

The only way to unfreeze this market is to restore confidence and that is going to require transparency. I think this is entirely correct, and it frightens me that the people in charge haven't been smart enough to make this step one. Mutant talks about FASB 157 that makes companies report the value of a long term investment in today's value as the catalyst that pushed this all over the edge. I think he is right that it was the catalyst, but it exposed a bunch of things *today* that would have dribbled out as bad news over years to come, or turned out to be good investments after all. Warren Buffet bet $6b on GS and GE in the last fortnight. Are you going to tell him it was a bad move because he could have bought cheaper today, or will you think him a genius in 5 years when it makes a big profit? I think the reporting law should require a current market price and a projection of what the company expects the investment to be worth at maturity. After all, the day you invest $100 in a term deposit (COD), it is worth less than $100 because you no longer have that $100 to invest should a better *sure thing* emerge.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 06:29:33 -0800

"At each end of the chain are the huge winner/losers." But if it's ring and not a chain, who are the winners and losers? That's why no banks will lend to each other, because the only thing guaranteed is they've taken on more debt without knowing the quality of the increased debt they've just taken on because they don't know the counter-party's exposure.

By: ryoshu

ryoshu — Fri, 10 Oct 2008 06:39:23 -0800

And the market is in an absolute free fall. Wheee!

By: dances_with_sneetches

dances_with_sneetches — Fri, 10 Oct 2008 06:46:55 -0800

Could someone diagram all of the parts of this? I've been reading a lot about these in the past year, as many of us have and have come to a reasonable comprehension of what is going on. Really, it's not an infinite size and a Tufte-like graphic could bring needed clarity. The geek part of me believes one good graph can change the world.

By: Ironmouth

Ironmouth — Fri, 10 Oct 2008 06:48:34 -0800

The responsible, pragmatic thing to do is let the banks with shitty books fail completely. Kind of like after 9/11 when all of the airlines wanted a hand-out. Simple fact was, we didn't need that many airlines any more. Except for the fact that the airlines who wanted a bailout also didn't hold EVERYONE'S money, and insurance policies, and the money that businesses borrow to pay people while the profits come in, and the money that governments borrow to run services while they wait for tax revenue to come in. This isn't a bunch of fat cats going down, it is a bunch of fat cats with everybody's money going down.

By: inigo2

inigo2 — Fri, 10 Oct 2008 06:50:36 -0800

So most CDS were written to hedge an opposite bet. So at the end of each chain there is a big winner and at the other end a big loser ...and the best you can hope for is to die in your sleep.

By: felix

felix — Fri, 10 Oct 2008 06:50:58 -0800

By the by, asset management firms do have very complex systems for tracking and mitigating CDS risk. I know this because I've personally written and managed the implementation of several. And largely, these systems have properly held out against the strain of what's happening. In all of the situations with which I'm familiar -- including the 2nd biggest fixed income shop in the US, as well as anecdotally the 1st through 5th as well -- these systems have correctly handled the risk as the CDSes became illiquid and moved to a matrix-pricing rather than a market-pricing model. They're no longer used for coverage of levered positions except in the underlying, where possible. The problem at least for asset managers is that these securities are now illiquid, and the market for coverage replacements is very difficult/nonexistent right now. Managers are having to spend a great deal of (their clients') money trying to get the portfolios into balance. So I wouldn't say it's that nobody knows what the heck anything is worth or what to do, the problem is that everyone agrees that the CDS market is broken and that the repercussions of this are hideously complex and expensive to unwind. Doable, but given the tremendous lack of trust in the system right now, arduous at best.

By: Hubajube

Hubajube — Fri, 10 Oct 2008 06:55:21 -0800

It's like watching the end of Fight Club in slow motion.

By: bystander

bystander — Fri, 10 Oct 2008 07:07:50 -0800

But if it's ring and not a chain Then that is fine, the loss is contained, nobody is left with a big win/loss, just their arbitrage. That is really the best outcome. I sometimes wonder if the historical wrap up will be that it was an example of a market losing confidence because transparency was poor, and the fear of a huge loss that would never happen due to the ring, made the collapse. Which will be amusing to the historians...

By: vuron

vuron — Fri, 10 Oct 2008 07:13:23 -0800

So correct me if I'm wrong Investment Banks would buy mortgages bundle them together and sell them to investors. During the go go 2000s these mortgages (especially subprime ones) would give a decent return on investment and even if a certain percentage of mortgage borrowers defaulted there would always be the core asset (a home) that could be presumably sold for a higher price that mortgage was initially set for. Under such a system there is still some risk but as long as the default rate remains low and home prices don't decline precipitously there should be a decent return on investment. However people realize there is a potential downside to the subprime market and want to purchase a bit of insurance on their investment. So they say to the investment bank that they are interested in spending a certain percentage of their yearly return on investment on a policy that will pay them x amount of dollars in the case that homeowners quit paying. On the face of it this seems to be a good deal for both parties. Investor A is still getting a decent return on investment from their subprime mortgage payments and has some insurance that in the case of a housing market collapse they won't lose too much principal. The investment bank likes it because they are getting money from selling the security in the first place and they are also getting a bit of money every month for guaranteeing the security. For some groups that seems to have been enough (AIG) but some financial parties took it a step further and said to themselves this revenue stream is good but if the music finally stops I don't want to be the poor bastard holding the bag. So I'm going to spend a bit of the revenue stream that I'm getting to get another party to insure my risk. If the initial investment fails I'm out of money temporarily until the party I bought insurance from pays up. My investment is hedged. Some people started looking at this stream of income and began placing speculative side bets on various steps in the chain. Some might be betting that the mortgage borrowers might continue to pay, some might be betting that the initial link the CDS chain is secure, some might betting that the 10th link is secure. Some people might be using money from way downstream on the chain to speculate on the beginning part of the chain, etc. Fundamentally though each party only understands it's agreements with it's direct neighbor in the chain. So everything is going hunky-dory and people are making money hand over fist until suddenly the subprime borrowers realize a) they can't pay the new rate on their ARM because it was always beyond their income and b) they can't sell their home for what they paid for it because there are a ton of other fuckers doing the exact same thing. At this point in time investors who bought the mortgage backed securities are getting nervous because a) the revenue stream they expected isn't there anymore, b) even if people can refinance the expected return rate has gone down dramatically and c) the underlying assets are worth a fraction of the initial investment of capital. So this is when the insurance should kick in right? As an institutional investor I bought insurance from the investment banks and other financial companies so that my risk would be diminished. So I start telling those guys to pay up. They start to pay up but that requires that they get payments from the people downstream. And so on. If everyone has the wherewithal to cover their liability we are okay but each step in the chain takes time to resolve and each party is vulnerable in the short term. Initially they might be able to cover their insurance obligations but their debts keep piling. Insurance sellers that didn't get insurance themselves (AIG) begin to crater meaning that anyone that bought insurance from them is going to get fucked. Other parties might simply be overleveraged so that even though they in theory are hedged they don't have the resources to payout on any given liability. That there is no transparency makes this situation even more problematic because Bank A might have direct exposure to Bank B for a billion but there might be a ton of indirect exposure because Bank B also had relationships with Banks C,D,E,F and G. And guess what Bank A might have exposure to each and every one of those banks. Hell they probably have exposure to every other financial party even if it's through six degrees of seperation. So the failure of any single party can cause a catastrophic collapse of the chain or at least a massive period of unrest until all the crap begins to work it's way through the system. So even if the federal government steps in and honors someone's debts if the chain of collapses gets beyond a certain point there is no real effective way of stopping it right? The current actions are designed to stabilize the system so that the chains can be broken or at least made where each failure doesn't cause another one down the chain? Even if you remove the toxic assets from play each party is afraid about it's counterparty risk and isn't going to lend money unless it's reasonably secure that it can survive a short period of time if a bunch of requests for repayment come in all at once. However nobody can actually glean who will ultimately owe what to whom. So in the meantime we thrash about until the end of the chain is reached?

By: Fuzzy Monster

Fuzzy Monster — Fri, 10 Oct 2008 07:16:37 -0800

The $55 Trillion Question "The financial crisis has put a spotlight on the obscure world of credit default swaps - which trade in a vast, unregulated market that most people haven't heard of and even fewer understand. Will this be the next disaster?"

By: Hubajube

Hubajube — Fri, 10 Oct 2008 07:18:58 -0800

DreamerFi: see here. Huh. So this whole crisis is like a financial form of bovine spongiform encephalopathy.

By: saulgoodman

saulgoodman — Fri, 10 Oct 2008 07:19:11 -0800

Could someone diagram all of the parts of this? I'd go even further: Can someone do a cartoon explaining how Credit Default Swaps work? Or at a minimum, explain this: Do I understand correctly that CDSs are sort of just a speculative investment product, both of the parties to which have no real stake in the underlying debt being insured against default? Or is the insurer one of the parties? For some reason, I'm personally having a tough time wrapping my head around how these things work.

By: infini

infini — Fri, 10 Oct 2008 07:26:22 -0800

I don't have a clue, I scraped by in Finance in Valuation etc in MBA with the help of my friends. But I've favourited this anyway because I think its of value to know and try to understand what will affect us all in the near and medium term future. thanks for the post

By: bystander

bystander — Fri, 10 Oct 2008 07:30:19 -0800

vuron: pretty much yes, as I understand it* great summary! *not overlooking there may be secondary ramifications that will only become apparent next week :-) saulgoodman: sadly, some have no party - with the bad consequences you can imagine. For me, the CDS market is a bit like betting behind a blackjack player.

By: stbalbach

stbalbach — Fri, 10 Oct 2008 07:30:58 -0800

I'd go even further: animated by Pixar or Disney

By: Mutant

Mutant — Fri, 10 Oct 2008 07:34:10 -0800

Folks looking for an explanation of these instruments - Investopedia has a fairly decent two page explanation on Credit Default Swaps. Here is illustration of how a Credit Default Swap is structured. In this image, the Reference Asset is owned by the Investor, who is concerned about loss. The Investor purchases protection against default from the Protection Seller. The Protection Seller receives periodic payments from the Investor and if there is a default (this is a grey and potentially wide area) then the Protection Seller covers the losses experienced by the Investor. Janet Tavakoli has a very good explanation of Credit Default Swap's [ .pdf] on her website. This explanation is excerpted from her book, Credit Derivatives: A Guide to Instruments and Applications, which was one of the first books published on these instruments. Her book is a good read, very accessible and light on the math. However if you're seriously interested in these instruments, I've got a list of more advanced books in my profile; Das ("Credit Derivatives and Credit Linked Notes") is very highly regarded by practitioners. These instruments are fairly easy to understand, absolutely no reason to be intimidated by their arcane sounding name. In fact if you read the Investopedia article I've liked to you'll have a decent understanding of the instruments and how they're used. And if you read Tavakoli's pdf that I linked to above, you'll be an expert. Hope this helps! I'd like to participate in this thread more but can't at present due to all the market activity ... will try to check back later this evening London time

By: Pastabagel

Pastabagel — Fri, 10 Oct 2008 07:49:57 -0800

What I want to know is what is the next instrument people are going to trade and crash the market with 7 years from now. Water contracts? Hat futures?

By: garlic

garlic — Fri, 10 Oct 2008 07:51:08 -0800

Mutant's picture of a Credit Default swap is a reasonable use of a CDS. However, people not owning the asset being default swapped are the speculators that helped make the crazy network of CDS we have now. It's like how it's ok if I take out fire insurance on my house -- I'm invested in the house not actually burning down. But if you take out fire insurance on my house that's shady. And if the person we bought the insurance from can't actually pay off the insurance amount if a fire actually happens, then that's shady too.

By: infini

infini — Fri, 10 Oct 2008 07:51:47 -0800

I'd like to participate in this thread more but can't at present due to all the market activity ... will try to check back later this evening London time posted by Mutant Nooo... reallly? even on a Friday afternoon? what no beer runs? ;p

By: sfts2

sfts2 — Fri, 10 Oct 2008 07:53:38 -0800

Initial reports of Lehman CDS auction at about 9.75% versus expected 12-13% recovery. Worse than expected but not terrible, and provides some clarity for the market, which is a good thing. Mutant, please carry on keeping the financial world together!

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 08:06:39 -0800

"It's like how it's ok if I take out fire insurance on my house -- I'm invested in the house not actually burning down. But if you take out fire insurance on my house that's shady. And if the person we bought the insurance from can't actually pay off the insurance amount if a fire actually happens, then that's shady too." Exactly. Interestingly, you can trace some of the blame to both parties during the Bush/Gore/Supreme Court dealings. On 12/21/2000 Clinton signed the CFMA with some stuff that Phil Gramm slipped in: 1. CDS's will not be regulated, period. 2. The minimum size of a CDS reduced from $10 million to $5 million.

By: saulgoodman

saulgoodman — Fri, 10 Oct 2008 08:12:19 -0800

Now I see... From the Investopedia article Mutant referenced above: With the value of the CDS market, larger than the bonds and loans that the contracts reference, it is obvious that speculation has grown to be the most common function for a CDS contract. CDS provide a very efficient way to take a view on the credit of a reference entity. An investor with a positive view on the credit quality of a company can sell protection and collect the payments that go along with it rather than spend a lot of money to load up on the company's bonds. Let's say Company A owns some bonds and wants to hedge its risks in the event of a default. So Company B steps in and says, "Hey, I'll take that bet! I'm so sure that bond is good, I'll buy it from you if it goes bad." So Company A agrees to make regular small payments to Company B, in exchange for this assurance. An investor can exit a contract by selling his or her interest to another party, offsetting the contract by entering another contract on the other side with another party, or offsetting the terms with the original counterparty. Well, let's say Companies C thinks the bond is a pretty good bet, too. And Company B just figures it's good business to hedge its own bet. So Company A says to Company B, "Hey, let me in on the action. For a modest fee, I'll take on your risk if that bond goes bad." Company B mulls it over and finally agrees to let Company C assume ([some | all ]?) of the risk, in exchange for a slightly smaller regular payment. I think that about sums it up, right?

By: saulgoodman

saulgoodman — Fri, 10 Oct 2008 08:16:01 -0800

d'oh. that is: So Company A C says to Company B, "Hey, let me in on the action. For a modest fee, I'll take on your risk if that bond goes bad."

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 08:19:14 -0800

"I think that about sums it up, right?" Yep and everybody thought they were safe until the dominoes started to fall. It just takes a couple insolvent counter-parties (some wrote naked CDS's) and a couple defaulted bonds and the whole ring collapses. Again, remember the number of CDS's(bets) dwarves the number of actual assets (bonds, CDOs, etc.) being bet on.

By: infini

infini — Fri, 10 Oct 2008 08:20:04 -0800

what I haven't been able to understand (and fear and uncertainty don't seem good enough reasons) is why oil prices have been dropping so sharply ? you'd think they'd go up?

By: aramaic

aramaic — Fri, 10 Oct 2008 08:23:27 -0800

Oil prices are nosediving because everyone's expecting the global economy (and thus demand) to tank. OPEC is expected to cut supply soon, which may stabilize it.

By: The Bellman

The Bellman — Fri, 10 Oct 2008 08:25:46 -0800

(And no one except lawyers like me actually read the ISDA Master agreement that governs these things, so most people had no idea who actually owned the counterparty risk in the edge cases. But that's good, because it means I have a job.)

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 08:27:25 -0800

"what I haven't been able to understand (and fear and uncertainty don't seem good enough reasons) is why oil prices have been dropping so sharply ? you'd think they'd go up?" Perceived weaker demand going forward, along with reduced speculation. Now if the dollar crashes, that would influence oil prices in the opposite direction(up). Earlier in the year we had high speculation, high expectations of future demand, and a weaker dollar, hence the markedly higher oil prices.

By: exogenous

exogenous — Fri, 10 Oct 2008 08:47:32 -0800

Aristotle wrote on financial derivatives in Politics, Chapter One, Part XI ("Thales the Milesian and his financial device").

By: ryoshu

ryoshu — Fri, 10 Oct 2008 09:19:31 -0800

Picture of third party CDSs.

By: eriko

eriko — Fri, 10 Oct 2008 09:36:57 -0800

what I haven't been able to understand (and fear and uncertainty don't seem good enough reasons) is why oil prices have been dropping so sharply Because everyone is factoring in a major recession in Europe and the Americas. This will drive down demand. Demand drops, prices drops. Basically, the oil markets aren't betting on the chances of a recession, they're betting on how severe that recession will be.

By: lunit

lunit — Fri, 10 Oct 2008 09:41:37 -0800

Thanks very much for this post.

By: saulgoodman

saulgoodman — Fri, 10 Oct 2008 09:56:42 -0800

In more news that doesn't bode well: GM and Ford may be facing bankruptcy in the event of a global slowdown (in other words, they're probably going to go bankrupt). The ripple effects from those companies going down would be massive. Stop and think about this for a second: Ford and GM could completely cease to exist in the very near future. It's becoming increasingly urgent that investors stop fueling this negative market spiral we're in, I think. Dumping investments, as tempting as it may be, verges on unconsciously fulfilling a death-wish, at this point. The more the markets tank, the more insecurity there is; the more insecurity there is, the worse the credit crunch gets; the worse the credit crunch gets, the more jobs we'll lose and the more precipitous the economic decline. So if you're an investor, it's in your own best long-term interests not to sell, no matter how much you may think selling is a short-term necessity--even if you're a short seller making a mint off of shorting. If the entire economy collapses and the dollar becomes worthless, that great big pile of money you end up with won't be worth the paper and ink it's made of when the dust clears. And don't kid yourself that it couldn't happen.

By: Artful Codger

Artful Codger — Fri, 10 Oct 2008 10:10:06 -0800

Since you folk were helpful with the oil price question, here's another: If the US stands to be most hurt by the current crisis, why does it seem that many world currencies (including Canada's) are falling in comparison to the US dollar?

By: zippy

zippy — Fri, 10 Oct 2008 10:21:06 -0800

Bankruptcy for GM and Ford does not mean that they would cease to exist.

By: oaf

oaf — Fri, 10 Oct 2008 10:21:55 -0800

why does it seem that many world currencies (including Canada's) are falling in comparison to the US dollar If U.S. consumers can't buy very much, that means our largest trading partner will be selling fewer goods to us, and demand for their currency will drop with demand for their goods, since we need their currency to buy their goods.

By: dances_with_sneetches

dances_with_sneetches — Fri, 10 Oct 2008 10:23:30 -0800

So wouldn't an answer be to structure the default papers of such companies in a way that it wasn't defined as default? That way you can have the companies fail and not have to pay off the vultures.

By: gen

gen — Fri, 10 Oct 2008 10:27:41 -0800

If the US stands to be most hurt by the current crisis, why does it seem that many world currencies (including Canada's) are falling in comparison to the US dollar? Many non-US currencies are much, much weaker than even the weak US dollar, and have weakened farther or faster than the US dollar has in this global meltdown. Look at Iceland. There are places in Iceland that don't want to take Icelandic Króna because of the complete collapse of the Icelandic banking system.

By: PigAlien

PigAlien — Fri, 10 Oct 2008 10:28:00 -0800

That was a fantastic little side trip, exogenous! Thanks!

By: saulgoodman

saulgoodman — Fri, 10 Oct 2008 10:29:24 -0800

Bankruptcy for GM and Ford does not mean that they would cease to exist. Well, not right away, but depending on whether they filed under Chapter 11 or Chapter 7, it could mean they'd be gone as soon as all their accounts were settled. Even if they filed under Chapter 11, it would mean the end of GM and Ford as we know them.

By: newdaddy

newdaddy — Fri, 10 Oct 2008 10:35:05 -0800

OK, well, jumping ahead here, if all of these CDSes from Lehman settled on < 10 cents on the dollar, what does that imply for the value of the rest of CDSs outstanding? Presumably, somebody holding those thought they were assets, or potential assets? How are they valued? Does this now mean that another huge amount of somebody's wealth just evaporate?

By: Iosephus

Iosephus — Fri, 10 Oct 2008 10:35:17 -0800

*ponders vuron's post* So, the proper analogy is constipation?

By: SeizeTheDay

SeizeTheDay — Fri, 10 Oct 2008 10:35:38 -0800

By: Postroad

Postroad — Fri, 10 Oct 2008 10:37:40 -0800

pardon my ignorance but aren't the "swaps" a way to get around using the term 'insurance," which, if invoked would require sufficient money to cover losses but when called "swaps," no such requirement is on the books and now the losses can not be covered/ I don't know but I would like someone with background to help me on this, for which, thanks in advance.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 10:41:16 -0800

"Since you folk were helpful with the oil price question, here's another: If the US stands to be most hurt by the current crisis, why does it seem that many world currencies (including Canada's) are falling in comparison to the US dollar?" It's a flight to *temporary* safety, but in reality it is like the beaches going empty before a Tsunami hits. All the dollars are being pulled from the economy by foreign investors, unsure of what other assets to be in, so the value of these hoarded dollars goes up. As soon as the realization happens that this truly is a deflationary spiral, the dollars will come crashing back to our shores, grossly devalued compared to to a lot of other currencies.

By: felix

felix — Fri, 10 Oct 2008 10:43:21 -0800

Postroad: No. Although CDS are not regulated in the same way that other risk mitigation instruments are, they were not designed to fit through a loophole. Most of the participants in the CDS market are well aware of the need to cover obligations, and few wrote naked CDS contracts.

By: Pastabagel

Pastabagel — Fri, 10 Oct 2008 10:44:35 -0800

Well, not right away, but depending on whether they filed under Chapter 11 or Chapter 7, it could mean they'd be gone as soon as all their accounts were settled. Even if they filed under Chapter 11, it would mean the end of GM and Ford as we know them. posted by saulgoodman at 1:29 PM on October 10 No this isn't right, like SeizeTheDay says, the purpse of Chapter 11 is to allow the company to reorg, renegotiatie debts, and come out intact. Airlines have done this countless times (each). What might be confusing is that bankruptcy doesn't work for a company like Lehman Bros because of the investment banks' unique model that allowed them to use staggering leverage to do business. GM and Ford should absolutely go bankrupt. It would purge the top few tiers of management of ossified MBAs and hopefully inject some fresh thinking and strategy into the companies.

By: dirigibleman

dirigibleman — Fri, 10 Oct 2008 10:46:35 -0800

Well, let's say Companies C thinks the bond is a pretty good bet, too. And Company B just figures it's good business to hedge its own bet. So Company A says to Company B, "Hey, let me in on the action. For a modest fee, I'll take on your risk if that bond goes bad." Company B mulls it over and finally agrees to let Company C assume ([some | all ]?) of the risk, in exchange for a slightly smaller regular payment. Then someone from Company D shoots Company E's Archduke, and all hell breaks loose.

By: saulgoodman

saulgoodman — Fri, 10 Oct 2008 10:51:55 -0800

No saul, you're wrong. Bankruptcy means they'll shed some debt, renegotiate contract, engage in some serious layoffs, and re-emerge leaner, stronger, and with a capital structure that allows them to compete with Toyota and Honda on the same level. It might mean loss of pension benefits, which would suck, and loss of market share, but they'll look like the same company from the outside. Sure, that's by far the most likely outcome. It's absolutely not the case that it has to be the outcome, though; that depends on the extent of the damage. But my point is that GM and Ford going under, as unthinkable as it might once have seemed, actually is a possible outcome now. Look at Lehman Brothers. They filed for Chapter 11 protection, sold off all their viable assets to Barclay's, and now appear to be dead in the water no matter what form their Chapter 11 reorganization might eventually take. It is possible, under US bankruptcy law, for a company's creditor's to reject its proposed reorganization plans and trigger liquidation under Chapter 7. All I'm saying is that it could happen and that the possibility is a little too close for comfort.

By: saulgoodman

saulgoodman — Fri, 10 Oct 2008 10:56:24 -0800

What might be confusing is that bankruptcy doesn't work for a company like Lehman Bros because of the investment banks' unique model that allowed them to use staggering leverage to do business. PB: Sorry. Missed this part of your comment.

By: Artful Codger

Artful Codger — Fri, 10 Oct 2008 10:59:23 -0800

I have the same question as Postroad, with some naive expansion. bear with me please. I just finished this linked article about CDSs, and how they've caused the crisis. I believe these are points made by the article (and elsewhere): - CDSs started life as an "insurance" instrument, except that the issuers aren't in rany way regulated, including as insurers - the market for CDSs went huge when they began to be used as 3rd party bets. - current failures are amplified by CDSs - as one entity fails, and CDS-holders want payoff, other institutions get taken down. (felix could you expand on your answer to Postroad?) Here's the naive question: why can't CDSs be temporarily halted, and most if not all declared invalid, or at least frozen til there's more calm in the market? (for bonus points, "reverse" them and make brokers refund fees and premiums that they produced) Clearly they were abused and companies were wrong to issue them without some capability to pay them. To me, this action would most hurt the companies and funds who most profited from ruining the whole market. (told you I was naive ;) )

By: PigAlien

PigAlien — Fri, 10 Oct 2008 11:01:34 -0800

If the US stands to be most hurt by the current crisis, why does it seem that many world currencies (including Canada's) are falling in comparison to the US dollar? Well, despite everything, the dollar is still the world's reserve currency... When global markets are being rocked like they are, people still seek out stability and the dollar is still perceived as a safe haven because we are the world's largest sovereign economy. On that sovereign economy note, I was reading an article today about how the EU would not be able to bail out the Euro in a similar manner because the EU economy is larger than any of the independent member states, and the agreement also forbids bailouts.

By: saulgoodman

saulgoodman — Fri, 10 Oct 2008 11:02:17 -0800

Let me clarify again: Of course, it's really, really unlikely that Ford and GM wouldn't eventually emerge from a Chapter 11 filing even stronger than before (especially since any other outcome would be to the detriment of its creditors). But technically, there are no guarantees.

By: malocchio

malocchio — Fri, 10 Oct 2008 11:11:46 -0800

Honestly, if someone was financially prudent over the past decade, beyond not being able to get a boost on their credit card limit what are they going to suffer? Obviously, if they work in the financial industry they might lose their job. But guess what? That happens to people every day. It's a part of life. Yes, and wide-ranging economic collapses are a part of life as well. To think that the credit crisis is going to be confined to the financial industry is almost hopelessly optimistic; for just one example, grain shipments are already beginning to show the strain of frozen credit. Now maybe I'm a crazy financial industry type guy, but I expect that even the financially prudent enjoy having goods on the store shelves. Looking out the window, I notice that the cranes that were building skyscrapers a few weeks ago aren't moving anymore. But maybe those guys in hard hats were finance guys, too.

By: A Long and Troublesome Lameness

A Long and Troublesome Lameness — Fri, 10 Oct 2008 11:16:52 -0800

Final Lehman settlement = 8.625%. Double-plus ungood.

By: raysmj

raysmj — Fri, 10 Oct 2008 11:17:42 -0800

Bankruptcy means they'll shed some debt, renegotiate contract, engage in some serious layoffs You've obviously never sat through a federal bankruptcy hearing in which a company was not allowed to reorganize, but instead received an order to liquidate all assets and pay off debtors. It happens. I saw it as a small town southern daily paper reporter in the early 1990s, with a small aircraft manufacturer that was partially owned by a Fortune 500 company. The judge was brutal. Reorganization is not automatically allowed or rubber stamped.

By: SeizeTheDay

SeizeTheDay — Fri, 10 Oct 2008 11:45:47 -0800

By: felix

felix — Fri, 10 Oct 2008 11:46:44 -0800

Here's the naive question: why can't CDSs be temporarily halted, and most if not all declared invalid, or at least frozen til there's more calm in the market? (for bonus points, "reverse" them and make brokers refund fees and premiums that they produced) Clearly they were abused and companies were wrong to issue them without some capability to pay them. The trade in CDS is essentially halted right now organically -- not sure that saying 'no more CDS' would have an effect. The problem is that they are contractual agreements which cost sometimes significant money to get into, and now the danger that the contract will be called is very high. Declaring them all invalid is a pretty novel idea that actually in my opinion deserves some consideration, but it would create a pretty serious market disjunction. Not all CDS were used speculatively. How would people who used them to hedge against the risk of owning, say, Goldman Sachs, now defend themselves against a Goldman Sachs collapse?

By: tksh

tksh — Fri, 10 Oct 2008 11:50:34 -0800

why can't CDSs be temporarily halted, and most if not all declared invalid, or at least frozen til there's more calm in the market? I could be wrong on this but I recall Mutant as citing this to support the creation of a clearinghouse for derivatives. Because there is no clearing house right now, there is no way to stop derivatives (or as the Bloomberg article complains, no way to even know the size of the derivatives).

By: tkchrist

tkchrist — Fri, 10 Oct 2008 11:51:04 -0800

Yeah. Very, very, soon will be the time for the unscrupulous to go crazy on their credit cards. At least for a very brief window of time. Ironic.

By: infini

infini — Fri, 10 Oct 2008 11:54:41 -0800

hmm now, what would happen, just hypothesizing in the middle of hte night here, if the dollar wasn't the reserve currency for oil purchases? on another note, money. here in singapore the papers are full of explanations of what, why and how in order to keep the pretty finance savvy populace calm. I noted today that year to date, the euro against the singapore dollar has just gone down by 0.05 cents between october 2007 to 2008. It had its highs, I was tracking because I only bill in euros so its been a good year ;p However, the Aussie and NZ dollars otoh have gone to par or just below the SGD. Interesting. There's a part of me that wonders if this "chaos" will instead serve to rationalize the global economy along more sustainable lines and currencies will come to balance on their 'real' and not imagined values. i.e. the USD doesn't really have much to back it as of now, not even gold. just rambling here

By: bonaldi

bonaldi — Fri, 10 Oct 2008 11:54:53 -0800

Wait, wait, what's this? How did we get from complicated financial products to craziness with the plastic. I'm unscrupulous and have a very brief forward-planning window, I must know!

By: newdaddy

newdaddy — Fri, 10 Oct 2008 11:55:21 -0800

Just to reiterate my earlier question - how does the settlement of the Lehman CDSs, for such puny prices, alter the value of other outstanding CDSs held by everybody else? Is everybody going to conclude that the CDSs they have been paying for all these years are also likely to be proven (mostly) worthless? And how did these values come about, anyway? Did a lot of people who wrote these just put up their hands and say "We can't pay?" And what of the prime broker on these, as was discussed above?

By: infini

infini — Fri, 10 Oct 2008 11:56:54 -0800

Actually, I have watched a reorg in person. And I was speaking here about GM and Ford, not some tiny firm. You want a name of a firm that's too big to fail? Think GM. Or as any major airline. If you think that some judge would allow GM or Ford to get liquidated, you're the one with his hhead in the sand. posted by SeizeTheDay at 11:45 AM on October 10 [+] [!] What's ironic is that as far as China, Japan and other holders of a significant number of USD are concerned, the US is too big to fail...

By: lattiboy

lattiboy — Fri, 10 Oct 2008 11:57:34 -0800

"Yeah. Very, very, soon will be the time for the unscrupulous to go crazy on their credit cards. At least for a very brief window of time. Ironic. posted by tkchrist" I was thinking the EXACT same thing! I have a bunch of cash I was going to use to pay off my CC bills, but I'm going to put it off for a little bit just in case........

By: infini

infini — Fri, 10 Oct 2008 11:59:48 -0800

just in case what? I've just charged a whole trip to Helsinki on a card and if there's a loophole, well...

By: bonaldi

bonaldi — Fri, 10 Oct 2008 12:00:55 -0800

ok really now, I can run those bad boys up to the max in the blink of an eye, just give the word. And also please explain what the connection is.

By: felix

felix — Fri, 10 Oct 2008 12:05:20 -0800

The loophole that I believe the gentleman was referring to was the possibility that civilization collapses and, in that brief intermission before we all have to get mohawks and hockey masks and ride around on dune buggies cannibalizing the weak, we can exploit the system by buying goods with a monetary unit about to be rendered comedically useless.

By: vuron

vuron — Fri, 10 Oct 2008 12:11:25 -0800

GM and Ford have significant problems, which are abundant including but not limited to product lines predicated on cheap oil, high labor and health care costs, and an ultracompetitive cyclical market place. To assume they would go completely belly up seems a bit of doomsaying. Despite big losses in recent years they continue to have a high volume of sales. It just happens that they seem to be losing money on each of those sales. They can't really increase their prices significant because of foreign competition so they need to reduce their manufacturing costs. Some of that will be through renegotiating contracts with part suppliers, closing unprofitable product lines and investing in labor saving technologies but ultimately the majority of the cost structure will come from reducing labor costs. I'm sure a good percentage of the cuts can be made at the white collar level but a big amount of the cuts will be directed at blue collar factory workers. So it will either come down to wage and benefit concessions or mass layoffs until their cost structure resembles what it needs to in order to return to profitable. The problem seems to be that when GM and Ford's management (like that of most public companies) seems to be focused so much on the short-term profit rather than creating long-term profitable strategies. Thus there was the dependence on the hold onto a car a year and then trade it in during the 50s to the dependency on SUV sales (high profit margin items) of the 2000s. When the companies were profitable it didn't really seem like they were using those "good" times to reinvest in R&D and car designs that would allow them to surpass their Japanese, European and Korean counterparts. Yes both companies have fuel-flex and hybrid vehicles but they seem to always be playing catch-up rather than being first to market with a broadly available mass-market plug-in hybrid or diesel hybrid (or whatever you feel in the next big thing in the auto industry). They seem to be most focused on retaining market share and not planning for a post industrial combustion engine type of vehicle. If I were in charge of GM and Ford I would be doing all I could to support a single-payer health care system as it seems like being able to transfer the costs of employee health care off of your books would make a massive difference in terms of long-term liabilities. I think that would allow your cost structure to compete more readily with countries that subsidize health care. That would allow the much vaunted advantage in american productivity to shine vis a vis European and Asian car manufacturers. Yes it's not a free-market solution and might involve higher taxes I would think it would reduce their cost structure significantly (by externalizing internal costs). Otherwise I think that in the long-term massive layoffs simply reduce your potential consumer pool as your former workers can no longer afford to purchase your products (at least not as frequently) and the relatively high wages you pay them serve to produce an economic multiplier that fuels other car and truck sales.

By: exogenous

exogenous — Fri, 10 Oct 2008 12:16:46 -0800

I imagine the predicted massive devaluation of the dollar would do wonders for domestic producers by raising prices of imports.

By: vuron

vuron — Fri, 10 Oct 2008 12:27:42 -0800

I think the fundamental assumption concerning the credit cards is that we will be entering a period of deflationary pressures, ie the money that you borrowed now won't be worth as much "stuff" as it is in the future. Basically you might be borrowing a $1 today and be paying back the equivalent of $.80 or something like that. If you were using this money to finance a business expansion I might agree with you as in theory you could be buying a factory at today's prices and paying back the bank at a much smaller price. As long as the prices of your goods aren't vulnerable to the same deflationary pressures you get to finance an expansion for a cheaper rate than any other time. I guess you could also do something like buy a bunch of commodities on credit under the assumption that the commodities would not lose value in a deflationary period. Realistically though most people buy consumer goods with their credit cards which typically don't have a ton of resale value. Further consumers unlike people who own the means of production seem to be more vulnerable to layoffs. Sure the credit you borrowed might not be worth as much in the future but you also might not earn as much either. Besides most consumer credit cards have fairly usurious rates so you would need to be banking on a big nasty deflationary period.

By: Artful Codger

Artful Codger — Fri, 10 Oct 2008 12:36:50 -0800

hey felix, thanks for the response re cancelling CDSs. >Declaring [CDSs] all invalid is a pretty novel idea that actually in my opinion deserves some consideration, but it would create a pretty serious market disjunction. Not all CDS were used speculatively. How would people who used them to hedge against the risk of owning, say, Goldman Sachs, now defend themselves against a Goldman Sachs collapse? Well, one can rationalize that owning any stock is a speculation, and anything you do in relation to that ownership, including "insuring" it via a CDS, is also speculation. So... boo hoo. Also, if you're buying an unregulated product as a form of insurance, caveat emptor, right? And finally, do we not already have a pretty serious market disjunction? If we're paying the piper (a $trillion or so), one hopes we can call the tune. Anyway enough dreaming, back to reality...

By: XMLicious

XMLicious — Fri, 10 Oct 2008 12:43:25 -0800

I don't know finance at all but I've been reading about CDSs for a few days now and I want to test my knowledge. It seems like there are four especially salient points:

A CDS is kind of like insurance against a debt not being repaid / against a negative credit event on a reference asset.
Except it's really more like gambling because the purchaser doesn't have to be the creditor / owner of the reference asset.
Hence, an unlimited number of CDS contracts can be taken out against a single reference asset, such that the combined payoff of the CDS contracts is greatly in excess of the value of the reference asset.
The value of a CDS as an asset itself increases as default / a negative credit event on the reference asset becomes more likely.

It seems to me that, without all of the interrelatedness and lack of transparency that is also discussed, the above points alone are enough to be the source of the crisis. I would think that since a CDS on a riskier reference asset is more valuable, that would lead to CDS contracts being taken out against the riskiest assets. And more CDSs would be created against the same risky assets, which would have a lensing-like effect that would sort of magnify the volume of those risky assets.

By: tkchrist

tkchrist — Fri, 10 Oct 2008 12:46:21 -0800

Wait, wait, what's this? How did we get from complicated financial products to craziness with the plastic. I'm unscrupulous and have a very brief forward-planning window, I must know! Because it's likely the back that gives your credit card company the cash will go tits up or won't know who owes what to who. Sure your interest could inflate to 45% overnight, but they are gonna have bigger fish to fry as far as tracking down who owes them what. The window will be narrow because if all the banks go tits up nobody is gonna take plastic for very long. Also soon owning stuff, the right kind of stuff, might be much better than having paper. So using credit cards that you, and everybody else, will default on to acquire assets you can then later barter, trade, or sell might be a smart move. For the unscrupulous.

By: tkchrist

tkchrist — Fri, 10 Oct 2008 12:46:53 -0800

the back = "the bank"

By: Artful Codger

Artful Codger — Fri, 10 Oct 2008 12:58:44 -0800

Re "running up" one's credit debt: > ...it's likely the bank that gives your credit card company the cash will go tits up or won't know who owes what to who. Sure your interest could inflate to 45% overnight, but they are gonna have bigger fish to fry as far as tracking down who owes them what. The window will be narrow because if all the banks go tits up nobody is gonna take plastic for very long. Oh, I very much doubt that even a bankrupt bank will forget about you. Computers and whatnot... I would bet that even in the deepest, darkest scenario, a person's debt can be instantly matched with their assets and if there's a shred of hope of recovering, there will be no lack of hungry players willing to buy the debt and collect, by any means possible.

By: mrzarquon

mrzarquon — Fri, 10 Oct 2008 13:06:05 -0800

> Again, remember the number of CDS's(bets) dwarves the number of actual assets (bonds, CDOs, etc.) being bet on. No wonder why we are having such a banking crisis, they forgot step 2.

By: bonehead

bonehead — Fri, 10 Oct 2008 13:08:07 -0800

....acquire assets you can then later barter, trade, or sell might be a smart move Like bottlecaps! 'though drugs are a good choice too.

By: malocchio

malocchio — Fri, 10 Oct 2008 13:18:17 -0800

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 13:18:52 -0800

"Yeah. Very, very, soon will be the time for the unscrupulous to go crazy on their credit cards. At least for a very brief window of time. Ironic." Yeah, I've been predicting this privately for about 3 months. There won't be a run on banks. Poor people don't have money in banks. They will be running to get cash advances on their credit cards (probably the first thing to get cut off) and then they will try to max out their credit cards with goods. Cardholders will default and malls will turn into Ghost towns. If banks won't make securitized loansto each other, why would they lend to us in unsecuritized loans to us? In the end, they won't. In the present they will because people will stop paying anything on their balances if the banks cut them off.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 13:21:26 -0800

The value of a dollar goes up with price deflation. In a deflationary scenario, borrowing dollars today would mean paying back a greater debt in the future. This is exactly correct. Jobs are lost, prices go down. Jobs are lost, prices go down. In the end everything is bargain-priced, but few have any money to purchase goods. Just call me Mr. Sunshine

By: vuron

vuron — Fri, 10 Oct 2008 13:26:58 -0800

Ooops you are right I mixed up inflation and deflation in my post. Thanks for catching it.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 13:29:49 -0800

Also soon owning stuff, the right kind of stuff, might be much better than having paper. So using credit cards that you, and everybody else, will default on to acquire assets you can then later barter, trade, or sell might be a smart move. For the unscrupulous. Yep, also correct. I'm maxing out my credit cards to buy, fortify, and actively protect my hidden bunker chock full of tuna fish. Seriously, there will be a run on credit eventually. I'm guessing maybe not until the Spring, but everything else is moving faster than I thought. It's funny, back in the late Spring I bought some really nice bicycles for Bargain prices on CraigsList, which I check every day. It seemed like people were selling their unused high-end bikes to put gas in their SUVs. Now it seems like the market for used bikes is trending higher as people are starting to covet them as good, efficient transportation.

By: bonaldi

bonaldi — Fri, 10 Oct 2008 13:31:49 -0800

In the end, they won't. In the present they will because people will stop paying anything on their balances if the banks cut them off. How does that play out, then? If the banks do cut off the cards, then surely there will be epic defaults from cardholders.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 13:42:35 -0800

In the end, they won't. In the present they will because people will stop paying anything on their balances if the banks cut them off. How does that play out, then? If the banks do cut off the cards, then surely there will be epic defaults from cardholders. Yep. I bet there's bean counters already crunching the numbers, balancing what's going out and what will come back in. I have good credit and carry no credit card debt month-to-month, yet have many cards. I am myself debating the pros and cons of using that credit for something while it's still available. Interestingly, I have seen a notable increase in my credit card companies, urging me to do the same, which is mostly why I don't. Remember Visa/MC et al makes sizeable breakage on every purchase from the seller, even if the cardholder ends up paying no interest because he/she pays his full balance each month. That revenue would disappear for the card companies if they shut all consumer credit down.

By: ryoshu

ryoshu — Fri, 10 Oct 2008 13:50:45 -0800

I'm selling CDS protection on tkchrist's credit cards.

By: msalt

msalt — Fri, 10 Oct 2008 14:19:32 -0800

Final Lehman settlement = 8.625%. Double-plus ungood. Would someone please elaborate? Dow down only 168 at close, pretty good these days!

By: bonaldi

bonaldi — Fri, 10 Oct 2008 14:19:36 -0800

tkchrist: sell me some CDS protection on your cards, eh?

By: bonaldi

bonaldi — Fri, 10 Oct 2008 14:40:21 -0800

AMEX is already tightening up consumer credit it seems.

By: stbalbach

stbalbach — Fri, 10 Oct 2008 14:57:46 -0800

Final Lehman settlement = 8.625%. Double-plus ungood. Maybe not so bad?

Roughly $400 billion will be paid out on Lehman CDS, but, once all positive and negative positions are "netted" out, about 2% of that money will actually change hands, Pickel estimated

By: kaibutsu

kaibutsu — Fri, 10 Oct 2008 15:45:34 -0800

A diagram of the meltdown.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 16:50:08 -0800

bonaldi: "124AMEX is already tightening up consumer credit it seems." Exactly what I thought, just faster. Thanks for the link.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 17:03:45 -0800

I was just opening today's mail and I got those courtesy checks from one of my credit cards with Wamu. I haven't used either of my Wamu cards in about 18 months and have no balance with them. I only keep the cards because the accounts give me free access to my FICO credit score. Well they're offering me 0% interest on $6500 through August '09. Sounds pretty good, eh? The catch: 5% transaction charge. That works out to what, 6.5% up front interest for a "0%" loan. Funny.

By: yoyo_nyc

yoyo_nyc — Fri, 10 Oct 2008 17:16:09 -0800

The most important lesson on the market: The money is not gone. It is just owned now by somebody else...

By: Wood

Wood — Fri, 10 Oct 2008 17:41:39 -0800

Dumb question here. Why are such complicated hedges necessary? If I have a $ 1 million worth of Lehman bonds, why buy insurance when I could have instead just not bought so many bonds? In other words what's the difference between X million Lehman bonds plus insurance and X/2 Lehman bonds plus X/2 Treasury bonds?

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 17:59:32 -0800

yoyo_nyc: "129The most important lesson on the market: The money is not gone. It is just owned now by somebody else..." Unfortunately, not true. We are witnessing *true* wealth destruction. There is *literally* less money in the world every day. Welcome to your first course in fiat currency 101.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 18:05:52 -0800

Dumb question here. Why are such complicated hedges necessary? Why are multi-hundred-million dollar annual salaries necessary? If you can answer either question, you have the answer for the other.

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 18:08:50 -0800

Why are multi-hundred-million dollar annual salaries necessary? Did I really say that? Now I'm conflicted.

By: malocchio

malocchio — Fri, 10 Oct 2008 18:51:02 -0800

Why are multi-hundred-million dollar annual salaries necessary? Well, only yours and mine are. And mine is due to a rounding error, by several decimals. But shhhh! I won't tell if you won't!

By: radiobishop

radiobishop — Fri, 10 Oct 2008 18:58:31 -0800

From the CDS article on investopedia: "the value of the market had ballooned to an estimated $45 trillion, according to the International Swaps and Derivatives Association - over twice the size of the U.S. stock market". So if I understand this right, you have an unregulated and opaque market that has grown form nothing to twice the size of the stock market in just 13 years. And this may be the cause of the current crisis, but everybody is looking at the stock market because no one understands the CDS market nor has a way of knowing what the fuck is going on. Speculators have been using CDS for years to bet on diverse assets, including CDS themselves, and have created an enormous bubble in which the CDS can be worth a lot of times more than the asset they're supossed to insure. But where is all the money now? and where did the 45 trillion come from, in the first place? My head hurts.

By: saulgoodman

saulgoodman — Fri, 10 Oct 2008 19:34:07 -0800

So if I understand this right, you have an unregulated and opaque market that has grown form nothing to twice the size of the stock market in just 13 years. And this may be the cause of the current crisis, but everybody is looking at the stock market because no one understands the CDS market nor has a way of knowing what the fuck is going on. That seems to be a big part of what's feeding the panic now. The Republicans, though, are trying to lay all the blame at the feet of the GSEs, Fannie Mae and Freddie Mac (which they've been trying to take down almost since the days of FDR), on the grounds that Freddie and Fannie purchased a lot of the bad mortgage debt that was eventually bundled into the bonds that the CDSs were written as a hedge against (never mind that the loan originators and lenders who originally made the bad loans, the brokerage houses who bundled them into impossibly complex securities, the rating agencies that gave them AAA ratings, and plenty of other links in the chain should probably, by any reasonable standard, be held at least as culpable as the GSEs). ("...She swallowed the spider to catch the fly, but I don't know why she swallowed that fly... Perhaps she'll die...") Ach, what a mess.

By: Wood

Wood — Fri, 10 Oct 2008 19:47:27 -0800

Are ratings agencies evaluated? So that we can see what the historical meaning of AAA vs whatever has been with some numerical results?

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 20:24:15 -0800

The Republicans, though, are trying to lay all the blame at the feet of the GSEs, Fannie Mae and Freddie Mac (which they've been trying to take down almost since the days of FDR), on the grounds that Freddie and Fannie purchased a lot of the bad mortgage debt that was eventually bundled into the bonds that the CDSs were written as a hedge against (never mind that the loan originators and lenders who originally made the bad loans, the brokerage houses who bundled them into impossibly complex securities, the rating agencies that gave them AAA ratings, and plenty of other links in the chain should probably, by any reasonable standard, be held at least as culpable as the GSEs). Q. How old is the CDS Market A. 12 years Q. What President signed into law that CDS's would be absolutely unregulated. A. President Clinton, 12/21/2000, weeks before he left office. Disclaimer: I'm not saying this lands solely at the feet of the Democrats or the Republicans, just balancing the above statement with unrefutable facts. All politicians have one thing in common: they are connected to money and likely have it themselves. Everyone who has money has real estate and/or real estate interests, with rare exception. My belief is that all politicians attempted to prop the real estate market which would prop the CDS market which would prop the equities market. They've all failed. Despite government attempts to the contrary, free markets are, well, free. The market will find it's level and capitalism will survive.

By: homunculus

homunculus — Fri, 10 Oct 2008 22:18:41 -0800

Bill Moyers interviws George Soros

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 22:31:58 -0800

I liked the Soros SNL Parody better. Unfortunately, it's been pulled: http://michellemalkin.com/2008/10/06/the-missing-snl-bailout-skit-and-the-soros-connection/

By: Rafaelloello

Rafaelloello — Fri, 10 Oct 2008 22:33:04 -0800

I meant pulled.

By: infini

infini — Fri, 10 Oct 2008 23:20:28 -0800

If there is a Persian word for "schadenfreude", this is it.

By: msalt

msalt — Sat, 11 Oct 2008 00:02:16 -0800

Here's what I don't understand. Given everything spelled out very nicely here, how could Henry Paulson have let Lehman Brothers fail? He more than anyone on earth must have known that would cause the CDS house of cards to collapse.

By: Rafaelloello

Rafaelloello — Sat, 11 Oct 2008 03:09:48 -0800

msalt: "143Here's what I don't understand. Given everything spelled out very nicely here, how could Henry Paulson have let Lehman Brothers fail? He more than anyone on earth must have known that would cause the CDS house of cards to collapse." I think everybody on the street knew that Lehman would fall, they were just in too deep. Here is when I knew: This whole video from 7/30/08 is very, very good, especially in retrospect. If you want to just fast forward to the the signal that Lehman was going to fail go to 8:22 in this video ( via ) and listen to what Meredith Whitney has, or rather doesn't have, to say.

By: infini

infini — Sat, 11 Oct 2008 08:18:20 -0800

martial law or bailout?

By: sdodd

sdodd — Sat, 11 Oct 2008 08:47:43 -0800

infini, that has been posted or discussed here twice: A coup has taken place Active Army unit to be stationed within US I have been on the lookout for anything other than op-eds and blog posts about this; if anybody's run across something factual recently, I'd be much obliged to see it.

By: infini

infini — Sat, 11 Oct 2008 09:25:03 -0800

thanks, sdodd, must have missed it thru time zone differences btw, haven't found anything except stuff on MeFi btw

By: adamvasco

adamvasco — Sat, 11 Oct 2008 12:38:00 -0800

America's shadow government

By: homunculus

homunculus — Sat, 11 Oct 2008 13:43:33 -0800

Blaming the victims: After luring low-income home buyers with sub-prime mortgages, conservatives are now blaming the mess on the poor

By: progosk

progosk — Sat, 11 Oct 2008 15:44:03 -0800

so, what'll it be: systemic meltdown or death by hyperinflation?

By: progosk

progosk — Sat, 11 Oct 2008 15:46:18 -0800

(oops: systemic meltdown, page 1)

By: finite

finite — Sat, 11 Oct 2008 20:07:49 -0800

sdodd, re: there's an interesting Math paper in there Why the banks collapsed, and how a paper on Haskell programming can help stop it happening next time:

The solution has to be for big financial companies to reveal their positions to the regulators as formal models of the contracts they have written. At the moment they don't even have to reveal all their contracts, but merely knowing the legal terms of a contract is only the first step. Those terms have to be converted into a mathematical model. That model probably already exists, but only as an internal artefact of the parties to the contract. What ought to be happening is that the contract is specified in a well-defined mathematical language that can be converted into a model automatically.

From my [extremely] limited understanding of this stuff, that sounds like a pretty good idea!

By: sdodd

sdodd — Sun, 12 Oct 2008 03:33:26 -0800

finite, get out of my head! I was just talking to a lawyer friend of mine today about this sort of thing. I was using Creative Commons' machine-readable licenses as an example. But this link of yours is much better. OTC derivative contracts like CDSes are English-language documents, but I was speculating that since there are so many of them, they must be automatically generated by software. (My friend agreed.) If so, and given an industry-vertical standard (e.g. OASIS), that same software could also spit out a machine-readable summary of the contract. I expect that'd help provide market-wide transparency (think: securities search engine) and/or aid in analysis of value and risk of individual deals.

By: saulgoodman

saulgoodman — Sun, 12 Oct 2008 18:12:48 -0800

Q. What President signed into law that CDS's would be absolutely unregulated. A. President Clinton, 12/21/2000, weeks before he left office. Disclaimer: I'm not saying this lands solely at the feet of the Democrats or the Republicans, just balancing the above statement with unrefutable facts. Rafaelloello: No doubt about it. I just take issue with all the emphasis on Fannie and Freddie's roles in particular. That aspect of the mess seems over-hyped to me. This crisis represents a convergence of many, many factors, and implicates parties and entities all across the spectrum. (Particularly, the aspects of the mess involving rampant speculation and systematic relaxation of long-established regulatory mechanisms.)

By: homunculus

homunculus — Wed, 15 Oct 2008 15:40:48 -0800

Rolling Stone's Matt Taibbi and National Review's Byron York argue over the headwinds facing McCain, what Phil Gramm had to do with the financial crisis, and the importance of credit default swaps.