Comments on: The Economist’s Cheery View of Credit Default Swaps http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html Mon, 23 Nov 2009 02:08:55 -0500 http://wordpress.org/?v=2.8.4 hourly 1 By: mickslam http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7161 mickslam Mon, 21 Apr 2008 16:12:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7161 TallIndian,<br/><br/>You are correct in your thumbnail sketch on how clearing works, but you are missing important details that might help to sway your opinion.<br/><br/>Clearing is going to provide three essential elements that are not inplace right now. <br/><br/>1. Daily settlement<br/>2. 3rd party risk evaluation<br/>3. Consistent margins<br/><br/>Also, they provide the protection that you are so skeptical of. If you are not familar with futures style clearing, then clearing CDS won't make any sense to you. As far as I know, there have been no defaults on futures style clearing in the U.S. <br/><br/>The interaction between daily prices, proper margining-access to account, and clearing members absorbing losses is crucial to understand. Most swaps only pass cash flows at set intervals, while clearing houses do it every day. This mitigates the losses, assuming that we are not looking at 1 day events. So, barring one day events, losses don't pile up. they are paid out day by day. <br/><br/>Additionally, the clearing houses can simply take money from accounts that are owned by the clearing firms. Yes, they just take money whenever they want to cover potential losses and realized losses.<br/><br/>Plus, a futures style clearinghouse is a zero-sum game. Every loss has to have an equal winner. TallIndian,

You are correct in your thumbnail sketch on how clearing works, but you are missing important details that might help to sway your opinion.

Clearing is going to provide three essential elements that are not inplace right now.

1. Daily settlement
2. 3rd party risk evaluation
3. Consistent margins

Also, they provide the protection that you are so skeptical of. If you are not familar with futures style clearing, then clearing CDS won’t make any sense to you. As far as I know, there have been no defaults on futures style clearing in the U.S.

The interaction between daily prices, proper margining-access to account, and clearing members absorbing losses is crucial to understand. Most swaps only pass cash flows at set intervals, while clearing houses do it every day. This mitigates the losses, assuming that we are not looking at 1 day events. So, barring one day events, losses don’t pile up. they are paid out day by day.

Additionally, the clearing houses can simply take money from accounts that are owned by the clearing firms. Yes, they just take money whenever they want to cover potential losses and realized losses.

Plus, a futures style clearinghouse is a zero-sum game. Every loss has to have an equal winner.

]]> By: Anonymous http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7139 Anonymous Mon, 21 Apr 2008 00:12:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7139 or to put it in more acceptable terms: all CDS that don't satisfy new regulation (e.g. collateralized at notional value), have to be rolled back at previous day market price.<br/><br/>Got something better?<br/><br/>n or to put it in more acceptable terms: all CDS that don’t satisfy new regulation (e.g. collateralized at notional value), have to be rolled back at previous day market price.

Got something better?

n

]]> By: Anonymous http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7138 Anonymous Mon, 21 Apr 2008 00:07:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7138 There are exactly two solutions to prevent systemic failure caused by CDS, once defaults start ticking up:<br/><br/>1) Merge all the parties so net worth of contracts is zero<br/><br/>2) Announce one day that all CDS have to be rolled back at current market prices.<br/><br/>Only 2) is feasible. I'm waiting..<br/><br/>norman There are exactly two solutions to prevent systemic failure caused by CDS, once defaults start ticking up:

1) Merge all the parties so net worth of contracts is zero

2) Announce one day that all CDS have to be rolled back at current market prices.

Only 2) is feasible. I’m waiting..

norman

]]> By: Anonymous http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7137 Anonymous Mon, 21 Apr 2008 00:04:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7137 Yves,<br/><br/>I've been looking for an answer to this to no avail, would greatly appreciate one:<br/><br/>In event of default, does the insurer have to pay total nominal amount of (oversubsribed) CDS, or only the total of outstanding defaulted underlying bonds of the company that went belly up?<br/><br/>That kind of makes a big difference, don't it?<br/><br/>norman Yves,

I’ve been looking for an answer to this to no avail, would greatly appreciate one:

In event of default, does the insurer have to pay total nominal amount of (oversubsribed) CDS, or only the total of outstanding defaulted underlying bonds of the company that went belly up?

That kind of makes a big difference, don’t it?

norman

]]> By: john c. halasz http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7121 john c. halasz Sun, 20 Apr 2008 19:30:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7121 I think Yves already implied this, but one obvious source of the continuing expansion of the CDS market amidst the general credit crunch is the need to correct for badly mispriced prior contractual commitments. If you'd written a CDS at 50bp a year ago that's now selling for 250bp, you'd want to get an new position somehow to hedge your loss exposure. In social psychology, such behavior is called "forward flight", typical of overgrown adolescents, if not outright sociopaths. I think Yves already implied this, but one obvious source of the continuing expansion of the CDS market amidst the general credit crunch is the need to correct for badly mispriced prior contractual commitments. If you’d written a CDS at 50bp a year ago that’s now selling for 250bp, you’d want to get an new position somehow to hedge your loss exposure. In social psychology, such behavior is called “forward flight”, typical of overgrown adolescents, if not outright sociopaths.

]]> By: Anonymous http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7110 Anonymous Sun, 20 Apr 2008 16:45:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7110 Only a 2% exposure, only $1.24 Trillion, that is still a significant real loss and would have a major impact on markets worldwide.<br/>tsk Only a 2% exposure, only $1.24 Trillion, that is still a significant real loss and would have a major impact on markets worldwide.
tsk

]]> By: Anonymous http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7106 Anonymous Sun, 20 Apr 2008 13:56:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7106 at this point, the chain reaction seems critical and it doesnt matter if their is a clearing house or not at this point to systemic "domino" risk.<br/><br/>After the "massive default reset" a clearning house is an excellent idea to promote transparency, stability, accountability and responsibility. at this point, the chain reaction seems critical and it doesnt matter if their is a clearing house or not at this point to systemic “domino” risk.

After the “massive default reset” a clearning house is an excellent idea to promote transparency, stability, accountability and responsibility.

]]> By: TallIndian http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7098 TallIndian Sun, 20 Apr 2008 05:01:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7098 mickslam,<br/><br/>perhaps, i'm missing something. Right now, Bank A has exposure to Banks B thru Z on various CDS. If Bank A defaults, Banks B through Z have to eat this loss.<br/><br/>Under the CCorp scenario, Banks A through Z now become Members A through Z. <br/><br/>Member A defaults, and Members B through Z have to eat this loss.<br/><br/>True, Member B-Z will also get any collateral posted by Member A as margin.<br/><br/>I just don't see C or LEH as having the capital to post signifcant margin and also be on the hook if GS runs into problems.<br/><br/>Whole thing sounds like a Basel II regulatory/accounting arbitrage to actually lower the capital they have to set aside for their current CDS books. mickslam,

perhaps, i’m missing something. Right now, Bank A has exposure to Banks B thru Z on various CDS. If Bank A defaults, Banks B through Z have to eat this loss.

Under the CCorp scenario, Banks A through Z now become Members A through Z.

Member A defaults, and Members B through Z have to eat this loss.

True, Member B-Z will also get any collateral posted by Member A as margin.

I just don’t see C or LEH as having the capital to post signifcant margin and also be on the hook if GS runs into problems.

Whole thing sounds like a Basel II regulatory/accounting arbitrage to actually lower the capital they have to set aside for their current CDS books.

]]> By: mickslam http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7097 mickslam Sun, 20 Apr 2008 04:47:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7097 My point exactly. How does this reduce the risk to the system?<br/><br/>Member A can't meet a margin call, so Members B thru Z absorb this loss.<br/><br/>This is some kind of solution?<br/><br/><br/>Yes, it is. The people that make the money have to cover for the person that can't cover their losses. <br/><br/><br/>Plus, I am guessing the margining is going to be dramatically different. I know the Clearing orgs take their institutional integrity very seriously, from direct conversations with them. It is really their core business. My point exactly. How does this reduce the risk to the system?

Member A can’t meet a margin call, so Members B thru Z absorb this loss.

This is some kind of solution?

Yes, it is. The people that make the money have to cover for the person that can’t cover their losses.

Plus, I am guessing the margining is going to be dramatically different. I know the Clearing orgs take their institutional integrity very seriously, from direct conversations with them. It is really their core business.

]]> By: Knute Rife http://www.nakedcapitalism.com/2008/04/economists-cheery-view-of-credit.html#comment-7096 Knute Rife Sun, 20 Apr 2008 04:06:00 +0000 http://www.nakedcapitalism.com/2008/04/the-economists-cheery-view-of-credit-default-swaps/#comment-7096 The problem with CDSs is that they're insurance policies that are treated like securities. Consequently, not only are they not priced anyway near to accurately in fact, there is no way they can be. How do you write an actuarial table for, say, a portfolio of short positions over unknown iterations, each with an unknown discount and commission structure? The problem with CDSs is that they’re insurance policies that are treated like securities. Consequently, not only are they not priced anyway near to accurately in fact, there is no way they can be. How do you write an actuarial table for, say, a portfolio of short positions over unknown iterations, each with an unknown discount and commission structure?

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