Google “Trading of Credit Default Swaps.” I think maybe my confusion is that derivatives of CDS’s trade, and not necessarily the CDS’s themselves.

To echo Gawain..

Everybody, it’s important to understand the length of the time over which actual economic monoline losses will happen. Think cash here — put yearly claims payments on one side and premium income/portfolio income less expenses on the other side and compare the outcome. Really, keep this in mind: All the mark to market adjustments killing the banks are irrelevant to a bond insurer. The risk the monolines face is whether investors lose principal and interest on the underlying investments and trigger their guarantees. Even if the guarantee is called, the monolines pay out claims on principal only at the original redemption date so the NPV exposure is a fraction of the notional sums insured. And then there’s the possibility of asset recovery, too.

That means you need to look at these monolines on both an ongoing concern basis and in a runoff scenario. See what happens — even if it means, believe it or not, that these entities can make it as ongoing, though crippled, concerns.

What is the probability of a truly armageddon type of scenario in the housing market and the overall economy? Warburg did exactly this and figured that the conservative value during a runoff for MBIA would be about 30 dollars.

Another way to think about it is this: monline exposure can be compared to a written out-of-the-money put option to protect investors against extreme market events.

Now, the monoline business model is a complete wreck. And from a cash point of view, it could unravel for them, and fast.

But, to reiterate, so far we have had mark to market losses in a portfolio that is supposed to be kept until maturity. To date all the brouhaha has been about covenant triggers, valuations, and accounting entries — green eyeshade stuff. Of course, the level of capital required to maintain an AAA is far larger than that required to merely assure that claims are paid for the next year or two. But again, that’s a labeling issue, not an REAL economic issue.

The real economic losses will occur when claims are paid.

The MBIA conference call (and the attendant presentation) outlines the extent of mutual exposure among the monolines; it isn’t much (relative to the entire portfolio).

Also, the numbers sound more scary than they are: a 30 bn insured portfolio sounds HUGE, but default payments on the portfolio come only 12-15 months after a credit event, after deduction of the deductible (sometimes as much as 20%), are limited by reinsurance and recoveries on the collateral, and in any case are stretched out over a 30 year period. Thus, if an entire 30 bn portfolio were to fail today, a typical monoline might have to make its first payment in 12 months, and that payment may perhaps be 400 mln. And it would then acquire all the underlying assets and set about recovery, so the cost of these annual payments would eventually go down.

None of which is to suggest that the monolines have no problems; or to claim that their survival is assured. But I at least hold both monoline stock and debt.

The CDS that trade are typically written either on what in the trade is referred to as “single names,” meaning individual corporate issuers (say General Motors or Proctor & Gamble) or indices. The CDS here don’t fall into either category.

CDS are also written to credit enhance collateralized debt obligations. I’ve never heard of them being detached and traded separately (not that conceptually that couldn’t happen, but the trust agreement with the legal entity that owns the CDO assets would presumably prohibit that unless a substitution was made).

The CDS that the investment banks are discussing are ones they had written for them to hedge super senior CDOs they are holding. Again, since these would be one-off deals (in each case, the bank that was stuck with these tranches sponsored the issuing entity), so I doubt these would be traded, although the hedges might be adjusted as the markets continued to fall (hedges are almost never perfect; the investment bank might have reduced the size of its hedge by writing a CDS to the monoline, or conversely, has the monoline write more CDS if it though it needed to increase the hedge).

My understanding is that there has been quite an active market for CDS, and while the premium payer remains static, the ownership of the CDS can go through multiple iterations. If the insured walks away from the contract, how does that ultimately affect the CDS owner? Wouldn’t that make the contract itself worthless?

Thanks for the help. The unclear drafting of the WSJ piece suggested that the rescue group was contemplating unwinding CDS relative to CDOs (as in ones sponsored by the IBs) and I couldn’t get my mind around that, which got in the way of thinking through the simpler case of hedges on super-senior tranches.

bob,

The issue here is that there are still some holder who haven’t had to write the CDOs down because under their regulations, they aren’t required to (ie, they aren’t marked to market). But they would if they were downgraded, which is what a formal downgrade or removal of the monoline CDS. Pension funds fall in this camp.

And the other worry is that bond insurer downgrades would force sales of CDOs since certain types of holders can only hold investment grade paper (again pension funds and for different reasons, insurers; while both can hold non-investment grade assets subject to certain limits, they’ve generally used them up on alternative investments).

This just confirms what is now pretty widely known.

Having said all that, I agree that the negotiations are tricky. The difference in positions here is more than over the amounts involved: it involves the business model and viability of one counterparty. Easy to imagine scenarios in which they won’t reach agreement.

The banks should get anything from that mess? Really!

Caveat Emptor apply only to the individual, but not to the banks?

My breakfast is trying to force its way out of my digestive system.