Credit Default Swaps, AKA: financial weapons of mass destruction

[girl gone mad]

In case you would like to know just where some of that $700,000,000,000 would be going:


The credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product represents over thirty percent of the credit derivatives market.

A credit default swap, in its simplest form (the unfunded single name credit default swap) is a bilateral contract between a protection buyer and a protection seller. The credit default swap will reference the creditworthiness of a third party called a reference entity: this will usually be a corporate or sovereign. The credit default swap will relate to the specified debt obligations of the reference entity: perhaps its bonds and loans, which fulfil certain pre-agreed characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction.

The relevant credit events specified in a transaction will usually be selected from amongst the following: the bankruptcy of the reference entity; its failure to pay in relation to a covered obligation; it defaulting on an obligation or that obligation being accelerated; it agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered obligation.

If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the credit event as well as (usually) providing some publicly available information validating this claim, then the transaction will settle.

This means that, in the case of a physically settled transaction, the protection buyer can deliver an amount of the reference entity's defaulted obligations to the protection seller, in return for their full face value (notwithstanding that they are now worth far less). In the case of a cash settled transaction, a relevant obligation of the reference entity will be valued and the protection seller will pay the protection buyer the full face value of the reference obligation less its current value (i.e. compensating the protection buyer for the decline in the obligation's creditworthiness).

Credit default swaps have unique characteristics that distinguish them from insurance products and financial guaranties. The protection buyer does not need to own an underlying obligation of the reference entity. The protection buyer does not need to suffer a loss. The protection seller has no recourse to and no right to sue the reference entity for recovery.

The product has many variations, including where there is a basket or portfolio of reference entities, although fundamentally, the principles remain the same. A powerful recent variation has been gathering market share of late: credit default swaps which relate to asset-backed securities or Credit Default Swaps on Asset-Backed Securities".

[girl gone mad]

1. I'll add some thoughts:

think of CDSs like the briefcases on "Deal or No Deal".

The banks advertised that most of these briefcases were full of $1,000,000, and one (or two at most) had a ticking time bomb.

Except, those odds turned out to be way off. They had calculated them using invalid assumptions and faulty mathematical models.

By the time the briefcases started blowing up in their faces, they had already accumulated piles of them.

Now they won't lend to each other because each is convinced that the other is sitting on a pile of exploding briefcases instead of briefcases full of $1,000,000.

This pile of bomb-laden suitcases is what Hank Paulson wants us to buy.

[TexasObserver]

2. OMG! Someone who understands!

Don't you love the line "we're going to buy paper with real value, may show a profit"?!

Paulson wants $700 billion to buy virtually worthless debt, and by moving it off the books of certain institutions, their viability goes up dramatically.

[girl gone mad]

4. Hey again..

Here I thought I was just talking to myself. :)

[Cessna Invesco Palin]

15. It's not exactly worthless.

A lot of the suitcases contain both the $1,000,000 AND the bomb.

[girl gone mad]

16. Right.

These banks were competing with each other to create increasingly complex models, many of which were based on faulty assumptions. The CDSs were traunched, levered and scrambled into Frankensteinian entities. This is why they're having a hard time marking to market, though I think that does need to happen.

[girl gone mad]

3. Well, I think this is an important discussion to have..

so I'm just going to keep having it with myself. :P

Some of these Credit Default Swaps are pretty complicated, but most are relatively straightforward. It's when you started mixing and matching them that you end up with a tangled mess.

Let's say:

security A is a mortgage
security B is a pile of mortgages
security C1 is the first dollar paid by security B (AAA rated paper)
security C2 is the last dollar paid (B rated paper)
security D is a portfolio of slices of C2's (A- diversified traunch)
security E is an insurance policy on the default of security D

now put in $1 Billion in real cash across 5 banks and leverage it up 30 to 1 so that there are 30 copies of each security. Then mix them up randomly and distribute.

After the banks skim off their "added value" cut (let's say $5 Billion), you end up with $25 Billion in assets on all of those balance sheets.

Then throw in a sudden bankruptcy. Now we're watching a feedback loop tear a financial black hole into the fabric of the economy.

[TexasObserver]

5. bad time of the day to keep a thread UP

And it's mainly the early morning/late night hand wringers around, so your use of facts and numbers will only confuse them.

[girl gone mad]

6. I'm a bad sleeper.

So I don't have much better to do at this hour.

It seems like my avocation just became a national obsession. I'm hoping the markets recover a bit today and cooler heads prevail. It would be great if we could finally elevate the level of discussion to somewhere above "why do you hate America?!1!".

[ContinentalOp]

7. But seriously...

Why DO you hate America? Why are you celebrating the coming great depression girl gone mad? :P

[girl gone mad]

10. It's the secret muslin terrorist in me.

Burn, baby, burn!

;)

[TexasObserver]

8. I've wanted the whole process slowed down, hearings on all points of views ....

This rush to get it passed CREATED the collapse of Monday because of expectations.

There will likely be an upward correction today. It was never as bad as the Bushies said it was.

[endthewar]

9. What are your thoughts on what should be done?

:hi:

[girl gone mad]

11. I think that we need to be cautious about throwing good money after bad..

I still like the idea of debt forgiveness in a debt-for-equity swap, as long as it is accompanied by a restructuring of the banks and prosecution of any and all criminal wrongdoers.

I also like proposals that involve taxing the fees on certain transactions and using other creative means to have the banks help pay for their bailout.

I have a hard time believing that $700 Billion will put a dent in the derivatives mess, but it's worth a try so long as we are not further burdening future generations and giving unchecked powers to Treasury. TARP just had too many loopholes and too much shady language.

[endthewar]

12. Why do you think Obama backs the bill if Warren Buffett hates CDSs?

[girl gone mad]

13. Obama is trying to get elected.

I can only venture a guess that he's been advised not to stick his neck out.

Buffet has given conflicting remarks on CDSs, but at some point he's said they should be outlawed, iirc.

[PA Democrat]

37. Yeah, he spoke out against them back in 2002.

I think he had made some money in them early in the game, but then started to get worried when he saw the huge growth of them and the growing risk.

[pnwmom]

14. Thanks for your post, girl gone mad. I'd love to know

if you happen to post about this again.

There are too many people posting furiously about this who know even less than I do (which isn't much).

[girl gone mad]

17. Another way to think of Credit Default Swaps..

is as unregulated, undercapitalized insurance policies.

The market for CDSs is approx. 55 Trillion dollars, which is greater that the GDP of the entire world. This is why we are seeing insolvency, and why a 700 Billion cash infusion won't stop the crisis.

[TexasObserver]

20. and THAT is why this $700 bil bailout merely buys a few months cover

[Kip Humphrey]

28. A third way to think of CDSs: 100% unregulated gambling.

[elehhhhna]

33. it sounds like plain old gambling to me.

[girl gone mad]

43. To a large degree.

Like, I take out an insurance policy on my neighbor's Ferrari.

It isn't as if 100% of these derivatives are worthless. A lot of the trades cancel each other out, some can still be profitable, but we won't be able to decipher the underlying value until we get disclosure. Then we can start to unravel the mess and restore trust.

[Agony]

18. no bailout with regulatory reform. kick

the MF's can use shock doctrine to shove their crap down our throats.
it is time to use their own weapon against them and take this as an opportunity to get reasonable regulations back in place.
Have you heard anybody talking about actually fixing the source of the problem yet?

(Milton Friedmanite's ... not what you were thinking, although now I am realizing same same)

Gramm-Leach-Bliley 1999
Commodity Futures Modernization Act 2000

[Agony]

39. no bailout withOUT regulatory reform... I meant to say. plus a kick opportunity

[Marie26]

19. And CDS's are protected from bankruptcy!

Thanks to the 2005 Bankruptcy bill. Make sure to thank your local GOP Congressperson.

[girl gone mad]

22. And some have less than no value.

Like if you're holding onto a $3000 derivative that exposes you to a liability of $30,000 and the deal goes wrong on you. It's a black hole of money.

[Agony]

23. Thanks for taking the time to post!

I LOVE AMERICA!

[Marie26]

24. Totally

A black hole of, what, $62 trillion dollars? You'd think that self-interest would stop banks from selling these things, if nothing else. But I guess greed overcame any more rational thoughts & the lack of regulation made these just a huge slush fund of easy money. That's extreme "lasseiz-faire" capitalism in action & this is the inevitable result. I wonder if the "free-market" ideologues are having second thoughts.

[Agony]

26. After reading this post ---->

http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=389&topic_id=4106676&mesg_id=4106676

I really appreciate your input!

I can't believe the crap you have to struggle to understand to be an effective citizen...

[Agony]

27. self delete

[Agony]

21. "Pounds of Flesh" I like the sound of that...

Stopping a Financial Crisis, the Swedish Way

"Sweden did not just bail out its financial institutions by having the government take over the bad debts.
It extracted pounds of flesh from bank shareholders before writing checks.
Banks had to write down losses and issue warrants to the government."

http://www.nytimes.com/2008/09/23/business/worldbusiness/23krona.html?_r=1&em&oref=slogin

I am not pretending to be a financial expert. We need a serious amount of transparency back in government and in the way our economy is run.

[girl gone mad]

25. How about a clause in the bill that specifies:

Any securities directly or indirectly tied to home mortgages originated between date X and Y (including but not limited to MBS, CDS, CDO, CLO, EIEIO, etc.) in United States jurisdiction, and not submitted to the SEC and fully disclosed to the public via web site xyz.com by date D will be declared null and void unenforceable contracts. Scare the cockroaches into the light, so to speak.

We don't have time to regulate before a vote on the bill, but we don't need very complicated regulations for immediate and complete disclosure. Then we'll have an army of free labor analyzing some of those securities. People who will be looking for profit (short or long), looking to blow the whistle and hopefully very quickly sorting out the winners and losers and figuring out which institutions we can all trust and who can trust each other.

[Agony]

29. I had a feeling you could figure this crap out.... nt

[lostnfound]

32. Great idea. nt

[slipslidingaway]

30. K&R n/t

[Two Americas]

31. thanks

Great information girl gone mad. Very concise and clear. Thanks.

[elehhhhna]

34. knr

[Karenina]

35. Another!

:kick:

[REACTIVATED IN CT]

36. K & R

Thanks for taking the time to explain this

Its so much easier to just accept the swill that the repugs are putting out there e.g. "the CRA is the root cause of this problem - forcing banks to lend money to minorities"

[moodforaday]

38. I wish DU had an option opposite to "ignore"

where I could be alerted to posts by a specific person. I've read a lot of your posts since Monday morning and just want to say thanks. Oh, and :kick:

[annabanana]

40. Thank you. This helps. Really.

I am a member of the "better bill, please" faction here these days. This is the kind of information that could steer the (less hysterical) discussions in that general direction.

[Agony]

41. "there must be an end to speculation with other people’s money"

how about we get back to some principals...

FDR said this in his first inaugural speech.
"Finally, in our progress toward a resumption of work we require two safeguards against a return of the evils of the old order; there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people’s money, and there must be provision for an adequate but sound currency."

So WTF are we doing with this stuff --->http://www.cboe.com/micro/vix/vixoptions.aspx volatility index? high volatility of volatility!?!! vol of vols? "catastrophe hedging" tool? series!1!!!1!

We NEED serious regulatory "rereform" (i can make shit up too)

[magellan]

42. Thank you for explaining this so well, girl gone mad

I wish we could send you to the Hill to demand a better solution.

k&r

[4 t 4]

44. If the seller has no recourse...

and they shouldn't because this is all made up bullshit, then why is it the right thing to do to give them 700 Billion dollars? Let the seller walk... Am I not understanding?
Credit default swaps have unique characteristics that distinguish them from insurance products and financial guaranties. The protection buyer does not need to own an underlying obligation of the reference entity. The protection buyer does not need to suffer a loss. The protection seller has no recourse to and no right to sue the reference entity for recovery.

[magellan]

45. Did you mean to reply to me? n/t