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Bearshort Posts: 1765 Incept: 2007-09-13 
NYC 
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Arcane Market Is Next to Face Big Credit Test By GRETCHEN MORGENSON Published: February 17, 2008 Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term. In the Shadow of an Unregulated Market A Primer on Credit Default Insurance Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts. The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market. No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity. It is entirely possible that this market can withstand a big jump in corporate defaults, if it comes. But an inkling of trouble emerged in a recent report from the Office of the Comptroller of the Currency, a federal banking regulator. It warned that a significant increase in trading in swaps during the third quarter of last year “put a strain on processing systems” used by banks to handle these trades and make sure they match up. And last week, the American International Group said that it had incorrectly valued some of the swaps it had written and that sharp declines in some of these instruments had translated to $3.6 billion more in losses than the company had previously estimated. Its stock dropped 12 percent on the news but edged up in the days after. A.I.G. says it expects to file its year-end financial statements on time by the end of this month with appropriate valuations. Placing accurate values on these contracts is just one of the uncertainties facing the big banks, insurance companies and hedge funds that create and trade these instruments. In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured. But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold. As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims. “This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.” Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim. In late 2005, at the urging of the Federal Reserve Bank of New York, market participants agreed to advise their trading partners in a swap when they assigned contracts to others. But it is unclear how closely participants adhere to this practice. It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim. Credit default swaps were invented by major banks in the mid-1990s as a way to offset risk in their lending or bond portfolios. At the outset, each contract was different, volume in the market was small and participants knew whom they were dealing with. Years of a healthy economy and few corporate defaults led many banks to write more credit insurance, finding it a low-risk way to earn income because failures were few. Speculators have also flooded into the credit insurance market recently because these securities make it easier to bet on the health of a company than using corporate bonds. Both factors have resulted in a market of credit swaps that now far exceeds the face value of corporate bonds underlying it. Commercial banks are among the biggest participants — at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter. JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively. But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer. The market’s popularity raises the possibility that undercapitalized participants could have trouble paying their obligations. “The theme had been that derivatives are an instrument that helps diversify risk and stabilize risk-taking,” said Henry Kaufman, the economist at Henry Kaufman & Company in New York and an authority on the ways of Wall Street. “My own view of that has always been highly questionable — those instruments also encourage significant risk-taking and looking at risk modestly rather than incisively.” Officials at the International Swaps and Derivatives Association, a trade group, say they are confident that the market will stand up, even under stress. “During the volatility we have seen in the last eight months, credit default swaps continue to trade, unlike other parts of the credit market that have shut down,” said Robert G. Pickel, chief executive of the association. “Even if we have a series of credit events at the same time, we have the processes in place to enable the market to deliver.” Such credit problems have been rare recently. The default rate among high-yield junk bonds fell to 0.9 percent in December, a record low. But financial history is rife with examples of market breakdowns that followed the creation of complex securities. Financial innovation often gets ahead of the mechanics necessary to track trades or regulators’ ability to monitor the market for safety and soundness. The market for default insurance, like the subprime mortgage securities market, is a product of good economic times and has boomed in recent years. In 2000, $900 billion of credit insurance contracts changed hands. Since then, the face value of the contracts outstanding has doubled every year as new contracts have been written. In the first six months of 2007, the figure rose 75 percent; the market now dwarfs the value of United States Treasuries outstanding. Roughly one-third of the credit default swaps provided insurance against a default by a specific corporate debt issuer in 2006, according to the British Bankers’ Association. Around 30 percent of the contracts were written against indexes representing baskets of debt from numerous issuers. But 16 percent were created to protect holders of collateralized debt obligations, complex pools of bonds that have recently experienced problems because of mortgage holdings. There is no exchange where these insurance contracts trade, and their prices are not reported to the public. Because of this, institutions typically value them based on computer models rather than prices set by the market. Neither are the participants overseen by regulators verifying that the parties to the transactions can meet their obligations. The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks’ books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books. Investors are already reeling from the recognition that major banks inaccurately estimated losses from the mortgage debacle. If further write-downs emerge as a result of hedges that did not work, investor confidence could take another dive. To be sure, the $45 trillion in credit default swaps is not an exact reflection of what would be lost or won if all the underlying securities defaulted. That figure is impossible to pinpoint since the amounts that are recovered in default situations vary. But one of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against. To the uninitiated trying to understand this complex market, its size might initially seem a comfort, as if there were far more insurance covering the bonds than could ever be needed. But because each contract must be settled between buyer and seller if a default occurs, this imbalance can present a problem. Typically, settling the agreements has required the delivery of defaulted bonds if the insurance buyer wants to be fully covered. If the insurance contracts exceed the bonds that are available for delivery, problems arise. For example, when Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company’s debt exceeded the value of underlying bonds tenfold. Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt. Market participants worked out an auction system where settlements of Delphi contracts could be made even if the bonds could not be physically delivered. This arrangement was done at just over 36 cents on the dollar; so buyers of protection on Delphi who did not have the bonds received $366.25 for every $1,000 in coverage they had bought. Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond. That is why the valuation of these contracts is of such concern to some participants. As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in. “The insurance business is very difficult to quantify risk in,” said Mr. Farrell of Annaly Capital Management. “You have to really read the contract to make sure you are covered. That is going to be the test of the market this year. As defaults kick in and as these events unfold, you are going to find out who has managed this well.” And who hasn’t. ---------- The Fed has a vault full of Vomit! 2008-02-16 19:57:14
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Pcap Posts: 12225 Incept: 2007-08-16
Canada
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Quote:Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond. I don't think anyone was marking their Delphi CDS at par here because they knew that the recover would be > 0% Delphi has some hard assets. ---------- ``We know in a crisis the Federal Reserve tap would be open'' Former St. Louis Federal Reserve President William Poole Maximize the pain 2008-02-16 20:00:51
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Financeguy Posts: 4720 Incept: 2007-08-10
Charlotte
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Welcome to the party mainstream media! For more info http://www.tickerforum.org/cgi-ticker/ak.... ---------- "Granted, if you are not into Barbara Streisand and creme brulee, South Beach could be a tad lonely." Eleua 2008-02-16 20:03:33
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Bearshort Posts: 1765 Incept: 2007-09-13
NYC
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"But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold." Trillions sold/bought, then traded. Now buyers don't even know the ability to pay of the counter party. ****ing scary. Imagine how many hedge funds took in a premium to provide insurance thinking they will never have to make good, and no one was regulating the transaction, or even recording it apparently.......we're ****ed when Corporates start failing. ---------- The Fed has a vault full of Vomit! Last modified:
2008-02-16 20:47:27 by bearshort
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Financeguy Posts: 4720 Incept: 2007-08-10
Charlotte
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I spoke in NY back in October (on a panel with Wall Street risk types) and the folks I talked with were really worried about this issue. Some of the blogs have talked about it, but not much in the MSM until recently. This regulatory oversight could bite us in the ass more than all of the other blunders combined. Nobody knows how bad this may get- I can assure you counterparties are going to default and the question is how will the system deal with it. My guess is that this is a big part of the complexity in trying to understand how to fix the monoline insurers. Hedge funds are also counterparty to a ton of these transactions and who knows how they are going to do in this market. ---------- "Granted, if you are not into Barbara Streisand and creme brulee, South Beach could be a tad lonely." Eleua 2008-02-16 20:23:21
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Nothing Posts: 4382 Incept: 2007-09-13 
Russian River Appellation Banned
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Finance Defaults have already occured and are being hidden. Folks I talk to are already accepting that all counterparties are in defacto default...there never was the kind of money there to cover those bets. There was never the kind of money there, because they took the bet based on the sales pitch that defaults on the debt were near impossible and that the same debt was insured by so many folks, they would never have to pay. Well, the truth is obvious about defaults and as it turns out, not only is there no money there...there are no contractual agreements that they have to honor. ---------- One creates from nothing. If you try to create from something, you're just changing something. So in order to create something, you first have to be able to create nothing. Last modified:
2008-02-16 20:47:57 by nothing
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Bearshort Posts: 1765 Incept: 2007-09-13
NYC
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I'm sorry Sir, that insurance you paid for is broken. With companies being fored into BK 'cause they can't access credit lines that are being pulled. This will start imploding pretty soon IMO. ---------- The Fed has a vault full of Vomit! Last modified:
2008-02-16 20:49:31 by bearshort
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Financeguy Posts: 4720 Incept: 2007-08-10
Charlotte
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This confirms my fear Nothing- then I agree with you that we are screwed.... No wonder the regulators seem to be just jawboning. They powerless to do anything. ---------- "Granted, if you are not into Barbara Streisand and creme brulee, South Beach could be a tad lonely." Eleua Last modified:
2008-02-16 20:49:50 by financeguy
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Eternalblue Posts: 3883 Incept: 2007-08-09
sokali
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do the ultrashort funds use these mechanisms in them?
---------- all pullbacks are bear traps 2008-02-16 21:20:10
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Oxfordrick Posts: 2550 Incept: 2007-07-09
san diego
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Equity swaps.......I give SRS 140 or 60 days, whichever is sooner. ****ing shame because it's a beautiful security, saves having to do REIT due diligence......but there it is. Last modified:
2008-02-16 21:43:29 by oxfordrick
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Knob Posts: 262 Incept: 2007-07-24 Banned
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Because these contracts are sold and resold among financial institutions, an original buyer may not know that a (((new, potentially weaker entity has taken over the obligation to pay a claim.))) Is "INSURANCE" going to be the crux of the collapse? Didn't non-payment,ill handling,fine print,etc. of insurance claims bring a proud Louisiana city to desolation just a few short years ago? ---------- Rip off all the warning labels & let natural selection take its course. 2008-02-16 21:32:36
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Rrman Posts: 3194 Incept: 2007-10-27
Baton Rouge, LA
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so i guess we need to get out of sds, qid and dxd?
2008-02-16 21:38:07
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Oxfordrick Posts: 2550 Incept: 2007-07-09
san diego
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Counterparasite risk. Just as in Delphi above, CDS will be gamed. The John Paulson hedge fund sold its ABX BBB play (probably to Bear Stearns) because he was concerned he would not be able to reap the proper rewards of his fine play. Welcome to the Wild West! Be prepared for disappointment all who would play long CDS protection uderstand that nobody, no government and no court will help you to receive profits that are earned from impoverishing the mainstream! (Rant ends) 2008-02-16 21:40:50
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Realistic Posts: 2673 Incept: 2008-02-15
California
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My girlfriend thinks I'm crazy when I tell her about this stuff. I've been following this since 2006. She started asking if I was going loony, lol. Then she was like, a recession won't affect me! She is 21 by the way. Then I reminded her that we haven't even lived through a recession on our own yet! Then she went....really? The sad state of America's affairs :(
---------- "Insolvent Banks refusing to accept IOUs from an Insolvent State would be laughable if it weren't so damn pitiful." - LOL Damn... 9 percent plus unemployment, and ma bell being investigated... help I'm in the 80s! - Jeffrey_thomason Last modified:
2008-02-16 21:57:47 by realistic
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Ck_dexter Posts: 1147 Incept: 2007-07-19
SE PA Online
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won't we have some notification before it hits qid, sds, etc? Like JP Morgan Chas e getting blown up? Or will it all happen in one day? ---------- "This market smells like ass" ~KD, numerous times, week of 11/9 2008-02-16 22:00:15
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Madman Posts: 1287 Incept: 2007-09-13
ct,USA
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Question: is this exposure to CDS`s listed on the balance sheets of the IB`s? and if so is it shown as an "asset"??? how is this exposure accounted for??. I have been trying to follow the possible ramifications of this type of exposure but the numbers are incrsdible! it is difficult to rap my head around. IF these multi TRILLIONS are carried as assets then disaster is a given beause it seems to me that even a MODEST write down ( read failure ) of only 5 to 10 percent would put an end to the banking system as we know it!! think about it, 2.5 to 5 TRILLION of write downs?????
---------- "America will never be destroyed from the outside. If we falter and lose our freedoms, it will be because we destroyed ourselves." -- Abraham Lincoln - Corporations have been enthroned, and an era of corruption in high places will follow, and the money power of the country will endeavor to prolong its reign by workin 2008-02-17 11:50:07
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Drchaos Posts: 1646 Incept: 2007-09-03 sandy eggo, kallyfornyia
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Insurance is intrinsically prone to fraud. They're going to do to one another what consumer insurance (house/medical) have been doing to ordinary people: take in premiums, abscond with money, and then weasel out of paying claims. It's 'legal arbitrage'. Imagine all the "insurance" gets funneled to the legal obligation of Lenny The Gardener (in practice an obscure holding company in the Caymans) to pay back. And Lenny says "money? gots none here. Whatcha gonna do?" This is why, back in the normal world, we have insurance regulators and things like the Options Clearing Corporation and SEC regulation. Some economic structures are simply prone to fraud. In years past we were intelligent and recognized such things and fixed them, but today the "deregulation uber alles" crowd has managed to convince people letting the crminals run stuff is a good thing. ---------- USA 2008: crony capitalism dressed up in Ayn Rand's trampsuit Last modified:
2008-02-17 13:16:32 by drchaos
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Alex2008 Posts: 725 Incept: 2008-01-06
Banned
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I'm sorry we can't seem to find the name of your insurance company. And even if we could we really don't think they have the money to pay your claim anyway. **** you and have a nice day.
2008-02-17 13:43:26
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Kelly Posts: 418 Incept: 2007-07-23
Seattle
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CDS market $45.5 trillion. Where is this $45.5 trillion liability sitting? IB's? Mainstream banks? Hedge funds? That is a massive amount. ---------- It's immoral to let a sucker keep his money. - Canada Bill Jones, 19th century poker player 2008-02-17 15:24:27
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Laswyguy Posts: 4901 Incept: 2007-07-25
Orange County, CA
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back of the napkin math says, even a modest 40% average recovery rate, at 6% default rate (low of 8.2% in 2002) would result in 1 trillion in losses. We did end 2007 at a 26 year low of 1.1%. So assumes it takes 3 years to get to 6%, we'd should have $300B a year in losses for the insurers.
---------- "think Macro, invest Micro" "In a recession weak hands gets smoked and strong ones eventually prosper. In a depression everyone gets smoked." 2008-02-17 15:45:20
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Apollo_69 Posts: 458 Incept: 2007-09-02
Londontown
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i thought the 45.5T was just the notional derivative value of the swaps not the actual liability? with the lack of regulation it's all going to end horribly from the sounds of it.
2008-02-17 15:51:51
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Ponzi_unit Posts: 4155 Incept: 2007-09-05
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Realistic, here's what you tell her: Get ready for the biggest sale ever. It's not going to happen this year but it will happen in a few years. Just like layaway. 2008-02-17 15:53:46
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Financeguy Posts: 4720 Incept: 2007-08-10
Charlotte
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$45 Trillion is the notional amount. Who knows what the counterparty default losses could be. We are talking about CDS which are not exhange traded, they are contracts between two parties regarding credit risk. Equity options that we all trade through the exchange are a totally different animal. The OTC derivatives (CDS is one example) is the risk that we are talking about here. In my mind the question of ultra-short risk would be the extent that they are using OTC derivatives as opposed to market traded.... ---------- "Granted, if you are not into Barbara Streisand and creme brulee, South Beach could be a tad lonely." Eleua 2008-02-17 17:10:46
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Kelly Posts: 418 Incept: 2007-07-23
Seattle
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Thanks for clarifying.
---------- It's immoral to let a sucker keep his money. - Canada Bill Jones, 19th century poker player 2008-02-17 18:38:25
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Rrman Posts: 3194 Incept: 2007-10-27
Baton Rouge, LA
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so the ultrashorts etfs wouldnt be affected?
2008-02-17 18:40:17
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