60 Minutes and 60 Trillion Dollars of Credit Swaps

Discussion in 'Business & Economics' started by coberst, Oct 7, 2008.

  1. coberst Registered Senior Member

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    60 Minutes and 60 Trillion Dollars of Credit Swaps

    Any business that is in the “insurance business” must meet certain regulatory laws, i.e. they must hold a certain ratio of cash to outstanding insurance in which to pay off possible claims.

    Certain ‘Investment Giants of Wall Street’ managed to get around this regulation by claiming that they were in the “Credit-Swap” business. They would basically insure certain types of highly risky investments and called these “swaps” rather than “insurance”. They sold the risky investments and then insured them thereby leading the investor to think that the investments were very secure because they were insured investments.

    “"The instruments themselves are at the heart of this mess," Grant says. "They are complex, in effect, mortgage science projects devised by these Nobel-tracked physicists who came to work on Wall Street for the very purpose of creating complex instruments with all manner of detailed protocols, and who gets paid when and how much. And the complexity of the structures is at the very center of the crisis of credit today."

    With its clients clamoring for safe investments with above average return, the big Wall Street investment houses bought up millions of the least dependable mortgages, chopped them up into tiny bits and pieces, and repackaged them as exotic investment securities that hardly anyone could understand.

    “People don't know what they're made up of, how they're gonna behave," Kroft remarks.

    "Right," Grant replies.

    But it didn't stop ratings agencies, like Standard & Poor's and Moody's, from certifying the dodgy securities investment grade, and it didn't stop Wall Street from making billions of dollars selling them to banks, pension funds, and other institutional investors all over the world. But that was just the beginning of the crisis.”


    No one seems to know how big this pool of swaps might be but it is estimated to be from 40 to 60 TRILLION dollars, that is to say this pool equals 4 to 6 times the GDP of the United States.

    You can watch this “60 Minute” video and also read the text at the following Internet site:

    http://www.cbsnews.com/video/watch/?id=4502673n
     
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  3. MacGyver1968 Fixin' Shit that Ain't Broke Valued Senior Member

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    I watched that on Sunday...very informative.
     
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  5. kmguru Staff Member

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    May be we should go back to the "greenback" as the new new currancy....
     
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  7. MacGyver1968 Fixin' Shit that Ain't Broke Valued Senior Member

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    How about the barder system? I don't think you can leverage a goat.
     
  8. Billy T Use Sugar Cane Alcohol car Fuel Valued Senior Member

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    Sure you can, with creative papers (sort of like the papers the banks made). Here is how:

    Keep your $50 male goat on short leash on other side of well traveled road from flock of she goats. When BMW or Cadilac comes by, cut leash and kick goat's ass. With luck the rich man's car will at least injure it. Then bring out you papers and blue ribbon showing goat won $500 at last months fair and is worth $15,000 as breeder, etc. If you settle for $5000 check, that is 100 to 1 leverage.
    Keeping face like this:

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    not like this:

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    will be the hard part.

    Richard Fuld, ex CEO of Lehman, dodged all the questions yesterday asked by Congressmen about the $484 million he walked away with being reasonable, his vast real-easte holdings, etc and was able to keep his looking like

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    I guess that is why he "earned" the pay.
     
    Last edited by a moderator: Oct 7, 2008
  9. MacGyver1968 Fixin' Shit that Ain't Broke Valued Senior Member

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    LOL...awesome Billy!
     
  10. nietzschefan Thread Killer Valued Senior Member

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    lmao Billy
     
  11. Read-Only Valued Senior Member

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    Cute little story - but won't work anywhere in the U.S.

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    Every single state has a law against "open stock." What it really comes down to is that the owner of the goat will always wind up paying for any damage - superficial or otherwise - caused by the impact with the animal which was allowed to be loose illegally.
     
  12. Jozen-Bo The Wheel Spinning King!!! Registered Senior Member

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    1,597
    Yes...lets shred those stupid credit and debit cards, after all, the banks are apparently falling apart and the whole system appears to be seduced by con men scum...

    Laws are only laws BY THE PEOPLE AND FOR THE PEOPLE...

    if the people don't want they law, don't follow it and don't bend over for the wannabe overlords pushing such. Honestly, our leaders are suppose to protect us from corruption, not expose us to it. If they do, then they aren't leaders, they are criminals! If the people no longer recognize and honor their bullshit, its only them spouting "it's the law, it's the law"...but it ain't no law if the common people overwhelmingly disregard it! I've seen laws made that weren't enforced- thus they pretty much didn't really exist except for on paper- something to wipe your ass with...
     
  13. Pandaemoni Valued Senior Member

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    3,634
    I am very familiar with the rating agencies...and in general the swaps were *not* the basis for the ratings. The swaps helped bump the rating of the more marginal pieces into investment grade, but most of the securities being traded and held by banks and pension funds were more highly rated than that, AAA, AA, A+, etc.

    The swaps were a problem for AIG and Lehman in that it had far too much exposure to them, but AIG, for example, held $14 billion in swaps in a $11 trillion marketplace. Swaps are a small part of a problem 100 times bigger.

    That said, the rating agencies did flub the ratings, but rating a security is an art, rather than a science, as you have to in part try to predict the future. The rating agencies tried to use conservative assumptions in their models, and they turned out to be no where nearly conservative enough. On the other hand, if rating agencies always went as conservative as they needed to in this instance, then (over the course of many problem-free decades) people would have come to assume that the ratings are BS.

    We already have a conservative measure of just how bad things can get, it's the "Risk Factors" section of the prospectus. There, in every single one, you will see dire predictions that you may lose money if you buy these securities. Generally, people have learned to ignore the Risk factors as being overly conservative nonsense from the lawyers.

    The rating agencies could have focused on the systemic risks posed by everyone going long is a single market—housing—and there they failed, but even there their failure was to have what looked like a realistic assessment of how bad a collapse might be.

    I get the sense that people are looking for the one thing to blame for the mess, and won't be happy until they find one thing that we can then ban, but the phenomenon was caused by several things, and most of them are not objectively bad ideas.

    Take, for example, the notion that insurance companies must have capital reserves to cover claims. That is a bedrock of insurance. Now consider the nefarious cheating of not doing that when it comes to swaps, which were definitely used like insurance. Terrible. Except, that it's not accurate and you need to consider it a bit. Imagine an insurance company writes fire insurance policies and collects premia, and then people's homes burn down. Imagine that the company has no assets (having spent the premia). That means that people, even families, are homeless and without possessions, living on the streets, some could be injured. That's terrible.

    Same for auto insurance. Say you buy some and are sideswiped by an uninsured driver. You could be killed or injured (perhaps permanently). You never know what the damages might be, and you never know if they other guy will have the insurance to cover his mistake (or to cover your own errors). If you drive uninsured and have a bad accident, you may never recover from it financially.

    Now imagine that Al agrees to pay Bob $1000/month for the next 12 weeks. Bob really wants that money, so he enters into a side agreement with Charlie. If Al stops paying, for any reason, Charlie will pay the money instead and Bob gives Charlie his right to go harass Al for the money he owes. Assuming Bob and Charlie know what they are doing, and only money is on the line, and both Bob knows (as he does) that both Al and Charlie may go broke at the same time, who cares? Why? That's a swap in the model being discussed. Charlie collects a little fee, and Bob is not cushioned from Al's credit risk because both Al and Charlie have to default for there to be an issue. Bob knows, going in, that the most he can possibly lose is $12000, assuming Al defaults right away. He can never lose more than that, so can gauge the risk to himself pretty well at the outset.

    Oddly, though, that is not a typical Credit Default Swap. They have more detail. Imagine the same setup with Al, Bob and Charlie. Now, though, imagine that Charlie has a credit rating of AA. The agreement between he and Bob says that if that rating falls to A- or lower (which is still very high), Charlie has to post collateral, in cash, in an account where Bob has control over it. That *is* a capital requirement. The difference is that the parties agreed that the capital requirement only kicks in if the rating falls below a certain threshold, and that threshold was set pretty high (BBB+, BBB and BBB-are still "investment grade" and that is below the As entirely; still A- is in danger of maybe not being investment grade if further downgrades occur).

    Whatever the benefit of capital requirements when insuring private contracts, if I, the person buying insurance, voluntarily waive the requirement in my contract because the "insurer" is in my view such a good credit, that's a pretty rational decision. Why would I waive it? because I pay lower fees to Charlie that way. If I have to force Charlie to post collateral, then I have to pay Charlie for the value of the contract plus the difference between the return Charlie earns on deposited collateral and the return it would have earned were it free to spend that cash. If I think "A-" is safe enough, I may not want to pay a premium for security from them. That's not Charlie tricking me or being bad, it's me making a decision that I'd have to live with about how much safety I am willing to pay for on a contract where my risk of loss of limited and easily quantified as it is.

    More to the point, what happened to AIG? The answer is not "they are broke." AIG has $14 billion is CDS's and their rating was reduced to A-, per the CDS terms they had to start posting collateral, in cash, and they can't do it because they do not have $14 in cash (they have more than that in assets over all, just not cash by itself). AIG is worth far more money than the amounts they could ever possibly owe under the Credit Default swaps, but their problem is that they can't find cash to post that collateral. once posted AIG will still own the collateral, they will just be prevented from spending up. So what they need to do is sell their less liquid assets (like various subsidiaries) to raise the amount they need as collateral.

    Having capital requirements in AIG's case would have prevented their CDS problems, but it would have made their CDSs more expensive. Contrary to the implication, it is *not* little old ladies and naive and easily newlyweds fund managers who decide to get CDS protection. Generally the people making the decision are pretty sophisticated, but they made the exact same mistake that everyone else did: They ignored the market risk of investing too heavily in one sector, mortgage loans.

    Why did people ignore that risk? Because mortgage loans were booming and the paying better than other alternative investments that looked comparably risky. Most analysts (to show what the experts are worth as prognosticators) though the bubble would deflate slowly, if at all. Instead it collapsed swiftly and more completely that most thought, catching a number of people off guard, including swap providers.

    The $40 to $60 trillion is the "notional principal amount" of credit default swaps outstanding, it's not generally the amount that would be exchanged under those contracts (hence "notional" rather than just "principal amount"). In the U.S. I'd guess there might be as much as more than $15 trillion in notional amounts out there at any one time.
     
    Last edited: Oct 8, 2008
  14. Read-Only Valued Senior Member

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    That's all well and good except you are still missing THE big picture - which is the grand total of all existing CDSs three weeks ago. It was a whopping $62 trillion - and ratcheted down to $55 trillion two weeks ago.

    To put that in some kind of perspective for you, that figure is nearly FOUR times the value of all stocks traded on the NYNX.

    So all smoke/mirrors and other issues aside, the CDSs still remain THE #1 cause of the banking/credit meltdown
     
  15. Carcano Valued Senior Member

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    Thanks for posting Coberst.

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  16. Pandaemoni Valued Senior Member

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    In notional principal, yes, not in actual amounts in play. "Notional" means "nominal." Also, that amount is all of them across every lending product, in the world. Every loan that is backed by was credit default swap (lots of them), mortgage loan, straight bank loan, student loan securitzation, credit card receivables securitization, if you add the swaps from every loan in the world up, you get a notional principal of about $60 trillion in credit default swaps backing them.

    In the US alone, there were $16 trillion of notional principal outstanding in CDS as of April, but the entire US mortgage loan market is $11 trillion by itself (booming though it has been). Add in credit card-receivables backed securities (about $2 trillion); trade receivables backed securities (@$3 trillion); lease receivable backed securities ( $1 trillion), to scratch the surface, and you quickly discover that the size of the U.S. debt markets is even more immense than the size of the CDS markets used to hedge those risks.

    You are making a mountain out of, perhaps not a molehill, but not much more than a hill.

    No, I disagree. They remain a side issue that got a few of the players in more trouble than they'd otherwise have been, but here's the thing: It's the devaluation of mortgage-backed securities (caused by the collapse of home prices) that is THE #1 cause of the credit crunch.

    The inability to value the RMBS assets triggered the credit crunch because lenders need to have reserves of capital to make loans, and securities you can't sell are worth $0 as reserve capital. They were a huge reserve asset prior to that time, and then they went valueless. The credit crunch was not insurance companies and financial counterparties scrambling to collateralize CDSs, it was lenders no longer extending credit (not to condescend, but my explanation does better explain why it might be called a "credit" "crunch" ) because they no longer had the reserves.

    In fact the decline in the real estate market and in the increasing volatility of RMBS led to the problems with CDSs. The problems with CDS did not precipitate the other two. CDSs only pay out if there are defaults on, to simplify a bit, securities being insured (and only hemmorhage money to the extent of those defaults). If the RMBS remained sound, so would have the CDSs for the most part.
     
  17. Pandaemoni Valued Senior Member

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    In notional principal, yes, not in actual amounts in play. "Notional" means "nominal." Also, that amount is all of them across every lending product, in the world. Every loan that is backed by was credit default swap (lots of them), mortgage loan, straight bank loan, student loan securitzation, credit card receivables securitization, if you add the swaps from every loan in the world up, you get a notional principal of about $60 trillion in credit default swaps backing them.

    In the US alone, there were $16 trillion of notional principal outstanding in CDS as of April, but the entire US mortgage loan market is $11 trillion by itself (booming though it has been). Add in credit card-receivables backed securities (about $2 trillion); trade receivables backed securities (@$3 trillion); lease receivable backed securities ( $1 trillion), to scratch the surface, and you quickly discover that the size of the U.S. debt markets is even more immense than the size of the U.S. CDS markets used to hedge those risks.

    You are making a mountain out of, perhaps not a molehill, but not much more than a hill.

    No, I disagree. They remain a side issue that got a few of the players in more trouble than they'd otherwise have been, but here's the thing: It's the devaluation of mortgage-backed securities (caused by the collapse of home prices) that is THE #1 cause of the credit crunch.

    The inability to value the RMBS assets triggered the credit crunch because lenders need to have reserves of capital to make loans, and securities you can't sell are worth $0 as reserve capital. They were a huge reserve asset prior to that time, and then they went valueless. The credit crunch was not insurance companies and financial counterparties scrambling to collateralize CDSs, it was lenders no longer extending credit (not to condescend, but my explanation does better explain why it might be called a "credit" "crunch" ) because they no longer had the reserves.

    In fact the decline in the real estate market and in the increasing volatility of RMBS led to the problems with CDSs. The problems with CDS did not precipitate the other two. CDSs only pay out if there are defaults on, to simplify a bit, securities being insured (and only hemmorhage money to the extent of those defaults). If the RMBS remained sound, so would have the CDSs for the most part.

    The only time I think you point is valid is in connection with "synthetic CDOs" as those were often crazy. "All the violatility of the regular RMBS market....but none of the assets or connections to real economic activity!" Synthetics are not the real cause either, but they are I think the next big villain when everone figured out that plain vanilla CDSs aren't the real issue.
     
    Last edited: Oct 8, 2008
  18. extrasense Registered Senior Member

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    Swaps seem to be the problem, since instead of preventing instability by mutual insurance - they have increased instability enormously by tying banks, so that the domino effect occurs.

    The first step must be to make all swap contracts null and void.

    eS
     
  19. TruthSeeker Fancy Virtual Reality Monkey Valued Senior Member

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    A lot of things actually caused the crisis. The simplest way to put it is with a balance sheet. Why don't we take a look at a "balance sheet of the crisis"?

    The problems with it are clear:

    1) Liabilities are UNDERSTATED thanks to the CDS. In principle, once you have a ratio of 70% of liabilities to equities you stop acquiring liabilities. However, the CDS allowed banks to by-pass that. Liabilities went over 70% to God knows what (around 90% maybe), which increased the risk exponentially. That kind of risk is unsustanable.

    2) Equity was overstated as a consequence of understated liabilities. The banks' shares were also overstated.

    3) Assets were grossly overstated as well. There were really not enough assets to serve as collateral. And that is what prevents a positive resolution for the foreclosures. Also, the valuation process of those assets is complex, if not non-existent altogether, as others have pointed out (and that's the only part I didn't know till this thread).



    Pretty basic, actually. The biggest problem in the whole picture is the limitation of the liability of the decision makers in those companies. If they were liable for their actions, they would not have taken such a risk!!! The lack of liability resulted in a lack of accountability - and that is what MUST change. The corporation is not a perfect entity by any means. Corporate regulation needs to change to make directors more accountable for their actions. Just look at my other thread about million dollar compensations, even as companies go bankrupt.
     
  20. Billy T Use Sugar Cane Alcohol car Fuel Valued Senior Member

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    Can you explain Why Brazil, with no dollar debt, $207billion in reserves, trade surplus, internal debt of just over a trillion which requires less than 4 months of GDP to fully pay off, liquid energy self sufficient, world's largest food producer, rich in fertile land with abundant fresh water, No. 1 exporter of many minerals, democratic, GDP growth greater than the inflation rate, maker of more cars (and most advanced "flex -fuel" types in the world) per capita (>3million vs. 175 million people) best mid size and corporate jets in the world, world largest volume of beef exported, shrinking income gap between rich and poor, improving education (still not good, but now 3 years more than 6 years ago for typical youth, and a few "world class" universities, free to all who can qualify), a stable currency (twice as strong against the dollar now as was 5 years ago, even with the recent weakness) is only at the bottom of the investment grade?

    Or conversely, explain why the USA is rated AAA, the top, when it is clearly so deep in debt that only printing press money will ever pay it off, and US is lacking most of the desirable characteristic named above, plus with world's leading prison and other social problems, like medical cost $3000/ person greater than in EU and yet 3 years lower life expectancy?

    Or more simply, especially considering the current mess,: Why these agencies should not be closed and their CEOs sent to jail for fraud?
     
    Last edited by a moderator: Oct 8, 2008
  21. TruthSeeker Fancy Virtual Reality Monkey Valued Senior Member

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    I have the same question, actually. It makes no sense.


    I suppose they think Brasil doesn't have any "experience"......

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  22. Pandaemoni Valued Senior Member

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    It is undeniable that credit default swaps can cause a daisy chain of instability, in the same way that if you hurricane flood insurance policies in Florida, and then there is a massive hurricane, it's going to hurt you, your reinsurer, and their reinsurer, but it's important to keep it in perspective. The relevant perspective is related to why the $62 billion in notional principal is BS.

    You buy a $500 million bond issuance. You pay Person A a fee quarterly to take the default risk. A does so, and a $500 million CDS is created. That obviously creates no issues for anyone save A and you. Now suppose that A gets nervous that he can't meet the obligations under the swap, what does he do? He might (and ususally would) but a credit default swap from Person B, and a second $500 million CDS is created (total, $1 billion). B may then do the same with Person C, C with D, D with E and so on. (Assuming we stop with Person E, we have $2.5 billion in notional principal of CDSs, but everyone is agreeing to insure only $500 million in real debt, and no one will ever have to pay, practically speaking, more than $500 million.)

    It is certainly true that if those bonds stop paying the bond holder, and none of A, B, C, D or E has enough money handy to pay off their contract, all five of them could be forced into bankruptcy, potentially. That would be bad, but there are two things (i) form your perspective, the one of the guy holding the real debt, you only have to hope that between the five of them there is $500 million (actually, less, as you'd never really have a claim for the fullaount of the bonds practically speaking) and (ii) the CDS documentation does tend to consider the credit ratings of the "insurer." People do not walk into these contracts only to be surprised by bankruptcies. You might choose to enter into a CDS with an unrated hedge fund, for example, but in that case you know full well what you are doing and how risky it is. Moreover, at each step in the chain, the long term unsecured credit rating of the counterparty you are getting insurance from is a reasonable measure of the risk you face. If you buy from Person A, a AAA-rated bond insurer, like Assured Guaranty Corp., you know what that rating means (and what the limitations of the ratings are). If Assured Guaranty bought reinsurance from an unrated hedge fund holding mostly financial assets, they would need to appreciate the risks there too, but that they roll the dice does not affect the validity of their rating (as the rating agencies have standards practices they are required to maintain).

    If your bond defaults there, you looked to Assured and they look to their hedge fund...but if the hedge fund goes belly up, Assured is well aware that it still need sot pay you. If Assured goes under as a result, the problem is not the CDS, the problem is that S&P must not have been doing a good job with the rating on Assured. (In this case, since the exposures to the risks of the mortgage markets were so obvious, I do think that the rating agencies should have thought harder about the systemic risks of a more major downturn, though it's unclear whether a more conservative approoach by them would be ideal. Lowered ratings and threats of lowered ratings earlier on, might have stemmed the tide in this case, but they also would have slowed economic activity in the good times. Would it be worth limiting economic activity over the course of problem-free decades in order to prevent corrections like the current one? Hard to say.)

    In the end, credit default swaps are not entirely the dodgy things you guys paint them to be. It's a tool. Like any tool, it can be misused, but used properly swaps are a perfectly fine hedging device. Periodically people get up in arms about the dangers of derivatives (which swaps are), and similar parades of horribles are raised each time about how dangerous they are. Regulation seems the more sensible answer to the problems, especially in light of how useful derivatives are as hedging instruments.

    In the case of credit default swaps, including capital requirements, as with regular insurance contracts, is worth considering as are a variety of other regulations designed to rain in abuses, but simply "declare all swaps null and void" is a bit of overkill. It's like banning all knives because sometimes people get stabbed. (You certainly do not want to ban "swaps" generally anyway, as they weigh in at, by notional value, a $400-$500 trillion (with a gross world product of about $70 trillion, it underscores what I was saying about notional values). The Credit Default Swaps are a tiny piece of the overall swap market.)
     
  23. extrasense Registered Senior Member

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    551
    "fine hedging device?"

    Apparently you do not understand the depth of the hole. Thre is no way out of it, unless we kill the swaps.

    Device or not device, it is fraud.

    eS
     

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