DTCC Claims Lehman Credit Default Swap Worries Overblown, Net Payments Only $6 Billion

Reader Tim sent us a link to a press release from The Depository Trust and Clearing Corporation which says that the net payout on Lehman credit default swaps will be comparatively minor, a mere $6 billion, versus the gross exposure, which has been widely reported as in excess of $400 billion. If this proves correct, that will be the best news we have heard for some time, since one of the unknowns hanging over the market has been the prospect of further bank failures resulting from Lehman payouts.

DTCC’s report, if accurate, is consistent with the industry’s claim that protection writers hedged their exposures, and in this market, the only effective way to do so was by entering into an offsetting swap).

The problem is that even if many of the trades were hedged, for any dealer, the quality of its hedges depends on the quality of its counterparties. Even though CDS protection-writing was concentrated among a short list of names (all big suspects), hedge funds were also writing protection. So way BigBank had $30 billion of Lehman CDS exposures, $15 billion each way. Let’s say 15% of the protection was written by hedge funds that can’t make good. That leaves a $2.25 billion failure, which multiplied by the payout, is a $2 billion loss. In this environment, any meaningful losses would be a source of worry.

A reader reported that the settlement date for the Lehman auction (held last week) is October 21, so we cannot be certain the market has passed this test until then.

From the DTCC (boldface theirs):

DTCC Addresses Misconceptions About the Credit Default Swap Market

The idea that the industry lacks a central registry for over-the-counter (OTC) credit default swaps (CDS) is grossly misleading and has resulted in inaccurate speculation on a number of matters, including the overall size of the market, its role in the mortgage crisis, and the size of potential payment obligations under credit default swaps relating to Lehman Brothers. The extent to which such speculation has fueled last week’s market turmoil is difficult to determine. The facts are these:

Central Trade Registry

In November 2006, The Depository Trust and Clearing Corporation (DTCC) established its automated Trade Information Warehouse as the electronic central registry for credit default swaps. Since that time, the vast majority of credit default swaps traded have been registered in the Warehouse. In addition, all of the major global credit default swap dealers have registered in the Warehouse the vast majority all contracts executed among each other before that date….

One of the many central servicing functions of the Trade Information Warehouse is to calculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written. Calculated amounts are netted on a bilateral basis, and then, for firms electing to use the service, transmitted to CLS Bank (the world’s central settlement bank for foreign exchange) where they are combined with foreign exchange settlement obligations and settled on a multi-lateral net basis. Currently, all major global credit default swap dealers use CLS Bank to settle obligations under credit default swaps. It is expected that all major institutional players in the credit default swap market will use the same process for settlement by the end of 2009.

The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents).

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  1. fred55



    two issues:

    (a) even if this is what it appears to be (its almost surely not), its still a problem because if A is a net payor of $X to B, it may well mean A owes B $Y and some C owes A $Z, both far greater than $X, and if C cannot pay A and thus A cannot pay B it will propagate out like a chain reaction…

    (b) you normally wouldnt hedge a protection sale by an offsetting contract because the terms are very nonstandard. for one things, the sweet spot of tenor is almost always 5 years so if you’re 3 years into a swap its far easier to “hedge” by just closing it out with your counterparty than finding someone to take the other side of a 3-year. you could hedge by shorting an underlying but thats not easy either. sometimes, yes, theres a hedge if someone is a protection buyer on a basket of 100 names and sells protection on a few of them.

    i dont believe the inference that all is clear. not at all. look at delphi.

  2. fred55

    also you’re forgetting baskets. someone might syndicate(very common) protection on a basket of 100 names x$10M per name, and tranche it, and the BBB piece would be “sold” to an investor as being able to withstand, say, 5 defaults by equity ahead of it…

    now if this BBB piece were sold as a bond, then its exposure is fully funded

    but a lot of them were done unfunded, where the counterparty simply swaps to take the protection on that tranche

    and those are almost always naturals looking to increase yield, and so won’t be hedged.

    now, they may already have had margin calls to post more coverage, but still…

  3. JP

    Only $6B? Great! Now we can let any of the banks fail (and ditch the TARP), since there’s no longer a systemic issue.

    Hooray! The crisis is over!

  4. Anonymous


    you seem to know a thing or two about the law. You think the US congress has constitutional authority to void or modify credit defaul swaps? I think so.

    The Supreme Court and lower courts have decided that the commerce clause of the US constition allows Congress to pass laws regulating INTRAstate commerce (eg, intrastate sales of wheat) because they indirectly impact INTERstate commerce.

    I think the ONLY point on which the Supreme Court might feel comfortable changing the law to prevent Congress from passing laws voiding or modifying pre-existing CDSs would be under the takings clause of the US Constitution. If the Supreme Court decided that contracts were protected “property”, and that regulations passed voiding or modifying them was a “taking” by the USG, then the Feds would have to compensate CDS holders.

    However, given that we are talking about old precedent, I consider there to be less than a 5% probability that an appellate court would prevent Congress from passing laws voiding or modifying pre-existing CDSs.

    Furthermore, if CDSs were void under law regarding gambling contracts, insurance by unauthorized insurers, or some other law that pre-dated the CDSs, then states would have authority to void CDSs. Regulators in NY and in London previously decided that CDSs were not insurance contracts. And those regulatory decisions generally prevent the regulators from making retroactive changes in the law. However, other states aren’t bound by that.

    Furthermore, as to the cross-border consequences of the US voiding CDSs, if the US persons are physically inside the US and all their assets are inside the US, then no foreign person would have the power to force enforcement inside the US. The only legal constraint on this would be if the US had a treaty in force with another country preventing this. I haven’t heard of any such treaty doing that. Finally, even if there is such a treaty, generally the USG has authority to void treaties if they are abused. The big daddy of conservativism, Ronald Reagan, had his administration tear up the US treaty with Netherlands Antilles when it was being abused. So there is precedent for that. But I doubt it is necessary.

    As I said before, Congress has Constitutional authority to resolve all the issues involved in the crisis, it just hasn’t had the political will to decide whose oxen get gored to feed the village. But if the village gets hungry enough, Congress will be pressured into deciding how people share the losses, be it directly through default, or indirectly through taxes or inflation.

  5. RK

    Re: DTCC claim of writer’s exposures hedged – I have
    a question. Who monitors, on a day to day basis, the posting of collateral by counter parties as the changing exposure risks fluctuate day by day? Who
    verifies the value of said collateral, day by day, and
    who guarantees it is not multiply encumbered? Does the DTCC do ALL THAT?

  6. fred55

    i am a lawyer, yes, but lets keep this simiple

    sometime ago (about 20-ish years) under the supremacy clause, the feds preempted state laws which were holding that derivative contracts were void and unenforceable as gambling contracts.

    sometimes states themselves can declare a contract void if for example it decides its insurance not a derivative but the distinction to the extent its ever been litigated is analyzed by insurance being characterized as a protection seller “hedging” his risk by exposing himself to thousands of similar risks representing a population, whereas a derivative contract hedges if at all with a similar offsetting position; in other words, you might hedge a long spx with a short oex but you cannot hedge the mortality risk on insuring joe’s life by buying insurance on susan’s, you have to do it by holding tens of thousands of policies.

    a math person (im a quant too) would say that a contract is insurance if its typical of a holding whereby you expect to make the expected return on your large population holding, not an outsize return on any one position (life).

    if you want to research the problem you state, research the new deal legislation whereby the federal govt declared contracts which enabled some payees to demand payment in gold instead of cash were made unenforceable.

    you are correct the takings clause in this case the 5th amendment not the 14th would apply.

    i leave it to you as you have the intelligence to do this and people should learn for themselves whether this would mean parties to swaps were entitled to RESTITUTION of the premia paid or were entitled to receive FAIR MARKET VALUE of the positions as held the moment they were “taken.”

    hint: this involves juridical questions of “legal” versus “equitable” remedy.

    so no its not a trivial issue at all.

    but this would never happen because it would completely destroy the financial economy, no one would ever enter into new kinds of contracts if they thought at any time they could be voided out, or the premium for that risk would be huge.

  7. Yves Smith


    I tweaked the post upon second thought before seeing your comment. I think the big risk here is the offsetting trades when provided by hedge funds, which probably only wrote one side to pick up what looked like free income.

    I have doubts about your argument that a dealer would hedge an exposure three years into a trade. Anyone running a big book would presumably hedge pretty pronto, within a day or two, IF their practice was to hedge (just because it was what you would expect does not mean it was policy, or that policy was adhered to, given the periodic blow-ups in banking).

    For normal derivatives trades, you slap on a delta hedge as soon as you possibly can. Since you cannot decompose the Greeks in CDS, I would assume that anyone who intended to hedge would do so quickly.

    Even then you’d see some basis risk, since CDS prices move around. But I would welcome commentary from industry participants.

    The biggest red flag about the DTC claim is that AIG, by press reports, appears to have run its operation pretty much as a naked protection writer. They were a very major player. That would therefore also imply that DTCC’s claim that it has a comprehensive view of the market bears some examination.

  8. fred55


    i used to buy (sell protection) these things for very wealthy private clients. been there, done that, got the t-shirt. im not saying you’re wrong, im saying its very very hard to delta hedge a cds cause the underlying reference bonds are not liquid enough to short in size and in small size the spread will kill you.

    these things are hedged by desks who have huge enough exposure that they hedge by what are called CORRELATION BOOKS.

    they hedge by using models that an exposure to, say, 200 names will be sufficiently close to some index that they can hedge the whole book by an index hedge (oversimplified).

    there is math for doing delta hedging when its clump and delayed but its so expensive it would make no sense to do it rather than just to close your position out.

    in fact a lot of the one-offs have requirements in them that every quarter the bank make you an offer and also give you an indication; typically we’d put that in so we could report valuations to subinvestors without violating securities laws.

    so when you read theyre hedged, remember that hedging may be CORRELATION hedging and the big risk there is CONTAMINATION

    or as they say, in a crisis all correlations go to 1.

    also those of us who were trying to be careful usually sold digital protection, meaning we specified in advance the severity rate to avoid messes like this, but that is another topic for another post.

    everything is (was) for sale in rome.

    and please, please believe me the game here was id have a client who wanted to put $100m in bonds and we’d syndicate a $500m 100×5 basket and lay off what we didnt want and most of the stuff rated A or above was taken on an unfunded basis like AIG, which usually took everything at 85% and below for 7 to 15bps premium.

  9. EvilHenryPaulson

    I don’t doubt that before Friday, much of the exposure had been hedged. However, in addition to the aforementioned potential problems I would like to introduce a simpler perspective.

    Based on the auction, and a $400bn notional amount outstanding, there must be $366bn in transactions to complete settlement.

    If there were a $6bn net exposure (I have also seen $8bn quoted), then that is only a 1 in 61 exposure which would make the whole affair the most pointless set of transactions possibly in the history of finance.

    At some point bets were made Lehman would not fail, and I doubt parties were able to defensively hedge themselves against Lehman’s inevitable collapse without paying a considerable price earlier.

    Secondly, if anything goes to plan with no counter party failures and only a 1.6% net exposure as per the $6bn figure then that still requires significant liquidity to complete, which as we all know is in short supply and therefore carries a significant price in itself

  10. Yves Smith


    I never said you would/could delta hedge CDS, In fact, I said the reverse. They are not like other derivatives.

    What you say about correlation hedging is consistent with some stories I read about correlation models blowing up.

    Nevertheless, DDTC made a very SPECIFIC claim, that the Lehman CDS contracts largely do net out on the individual dealer level. And they claim to be in a position to know.

    The settlement, I am told, is October 21. We will see soon enough if they were right.

  11. EvilHenryPaulson

    Appreciate your insight fred55, thanks.
    I want to add on to what I meant about the most pointless transactions in history.

    If everyone were so circularly hedged that net payout was 1.6%/$6bn, then there are still huge losses on Lehman debt out there. Citigroup alone is owed $138bn unsecured and is getting temporary relief from the NY Federal reserve.

    When a company like Lehman goes bankrupt, someone will have to feel the pain and whether it be on the bonds or on the CDS is just a detail.

    It must be said, I classify AIG getting $37bn more from the government to be a party feeling that pain as likely it was in part for the Lehman, and possibly WaMu settlements.

  12. Anonymous


    Thanks. You inspired me to re-read Lon Fuller’s classic article regarding damages, The Reliance Interest in Contract Damages”, as well as the gold cases you mention.

    I’m a lawyer too, but constitutional law is something I haven’t looked at since law school. Nice to have a smart guy/gal like you commenting.

    All that said, I’m not sure shutting down derivatives would be bad. Charlie Munger has been saying that for a couple years now, and mentioned the analogy of the UK shuting down public ownership of corporations for many years after the south sea bubble.

  13. Yves Smith


    DTCC never made any claims in its press release re collateral, it merely argued it could see the net exposures AND was responsible for determining payouts on registered agreements.

    And collateral posting requirements for CDS were a joke anyhow, typically mere cents on the dollar. These were bi lateral contracts, I doubt any monitoring mechanisms either (it would be costly and difficult for the protection buyer).

  14. Matt Dubuque

    Good discussion-

    Fred, clearly delta hedging is next to impossible here. This should be pretty clear to any person who has actively worked in the structured finance market. And no person is claiming that the positions are adapted as the deltas change dramatically by becoming gamma neutral, which is also impossible here.

    But, in terms of “correlation strategies”, the concern I have repeatedly expressed is that these “correlation” hedges assume a Gaussian distribution of pricing outcomes.

    And in that sense these correlation hedges have proven to be a truly illusory “hedge” because we have had so many pricing events five standard deviations from the norm. They are hedges in name only, and this is a critical factor in why so many “hedge” funds are crashing now. Their correlation “hedges” weren’t hedges at all, just like “risk free arbitrage” disappeared from the lexicon after the 1987 crash as a term to describe basket trading.

    In terms of the post at issue, after careful parsing I’m fully convinced it’s just an attempt to mislead the public. Consider this carefully worded excerpt below:

    “The payment calculations SO FAR PERFORMED by the DTCC Trade Information Warehouse indicate….”

    Yes indeed. “SO FAR PERFORMED”. First, none of them have settled and second it is extremely likely they have only performed, at most, only 25% of the calculations necessary to arrive at the correct figure.

    The art of dissembling. NEVER lie, but ALWAYS mislead through masterful parsing.

    In terms of your point about the remedies for restitution being an issue of whether a case is adjudicated under law (damages) or equity (specific performance, injunctive relief, etc.) I was taught a different approach in law school to this subject.

    I learned that there were actually THREE types of judicial relief: damages, equity (started around 1535 under Henry the VIII) and restitution, which actually had a distinct etiology of its own.

    Minor point, but I wanted to contribute it. Some of the best lawyers I know learned it your way, but there is a competent school of thought that divides judicial relief into three parts.

    Matt Dubuque

  15. Matt Dubuque

    Fred, just to be crystal clear, when I stated that delta hedging (much less subsequent position adjustments to stay gamma neutral as the deltas inevitably changed) was next to impossible in this context, I was NOT implying that you had asserted anything to the contrary.


  16. Anonymous

    “I learned that there were actually THREE types of judicial relief: damages, equity (started around 1535 under Henry the VIII) and restitution, which actually had a distinct etiology of its own.

    You and Fred55 may be saying the same thing using different words.

    There are three measures of money damages: expectancy, restition, and reliance. Expectancy damages are what a party was entitled to under a contract (eg, to paint a house for $1000); restitution is compensation for the goods/services they’ve provided (eg, plaintiff who already painted defendant’s house gets paid judges view of value for house painting); reliance is compensation for costs borne by the plaintiff (eg, plaintiff who painted house gets out of pocket costs). Aside from money damages, there is equitable relief that can be injunctive (eg, ordering defendant to paint a house) or declaratory (eg, clearing title that someone owns a house).

    I doubt it matters whether you or fred55 view these damages as falling into 2 or 3 or X categories.

  17. Anonymous

    fred55: most of the stuff rated A or above was taken on an unfunded basis like AIG, which usually took everything at 85% and below for 7 to 15bps premium.

    I had a little trouble in following that along to the end, any help in understanding it would be appreciated.

    What was taken at 85% and lower? Bonds rated Baa1/BBB+ and lower, repriced to the 85% and below, and then resold with a higher rating to earn the 7-15bps premium?

  18. Matt Dubuque

    Anonymous. You are correct. It is inconsequential. Fred is basically right on the money with all his points, except we may well differ as to whether the widely used “correlation hedges” are actual or illusory hedges. Same analysis goes with “statistical arbitrage”.

    I look forward to his response on that.

    But it is fun to debate the contrasting histories and you have clearly mastered the subject as well. Indeed my favorite book in law school was Murray on Contracts, who was the reporter for the Second Restatement who put forth precisely your version so eloquently.


  19. Anonymous


    I have heard that there have been large Sec Lending losses as big or bigger than Lehman’s CDS net settlement. The WSJ started to report on it and then it went silent. There is no ‘good’ news out there.

  20. Rod

    I’m quite surprised at this post.

    As far as I’m aware the result of the auction on Thursday was: Net Open Interest in Lehman CDS = $4.92 billion to sell, of which the seller pays 91.375% – ie about $4.6 billion. That’s it.

    By comparison the total NOI of Freddie/Fannie CDS was $1.241 billion but the seller only had to find less than 5%.

    Its worth taking a look at the CDS posts at Alea blog because frankly I’m way out of my league here, but to quote Alea, Lehman CDS are “no big deal”.

  21. Anonymous

    rod, You are quoting figures of the auction of Lehman bonds from which they determine how much CDS sellers have to pay out.

  22. FairEconomist

    If this is true, then the CDS market makes absolutely no sense at all. 6 bb net on 400 bb gross implies the average net CDS travels through 65 parties with offsetting trades. 65 fees for each transaction? That’s insane. The CDS market would be basically a fraud to generate fees. That would actually be a good thing, since the fee fraud wouldn’t contribute to contagion, but I find it very hard to believe.

  23. fred55


    if i take 100 theoretical bonds, all issuing instantly at par and from 100 different names (issuers) and a diverse number of industries, all the same exact maturity date…say thats $500M

    now assume each bond is pure zero coupon or else you need a lot of calculus

    holding the basket for the entire 5 years will produce a return on my $500M of anywhere from $0 to $625M (assuming 5% average yield to maturity, noncompounding, please lets keep this simple)

    however the probability distribution surrounding that result is nontrivial

    it is PRESUMED to be gaussian by the central limit theorem (also known as the law of large numbers)

    if we consider the binary outcome, heads or tails, H or T, in this case H = payment at maturity of any one bond at full value ($125), and T = payment at maturity of any one bond at $0 (100% default severity rate)…

    then we need to model the probability of having 0 defaults, 1, 2, etc

    there are a discrete number of default states possible at maturity, specifically 501

    IF repeat IF IF IF we assume the probability of any one bond defaulting is independent of the probability of any other bond defaulting

    and IF we assume that the probability of default of any one bond is the same as any other bond

    then this is a binomial distribution and converges very closesly to gaussian for 500 bonds

    HOWEVER notice the two assumptions

    they are HEROIC

    in real life, this is how it works:

    in collaboration (collusion) with the ratings agencies, the issuer gives you a basket of names based on criteria you supply, then you all three of you twiddle with it till you get the tranches and so on where you want

    you dont see the black box model and in fact the ratings agency supplies it to the underwriter

    for those of you who are securities lawyers you may note the ratings agency has just crossed the line into co-underwriting


    the ratings agency model is supposed to incorporate contamination risk (correlation risk), such as all the bonds in one industry are simultaneously imperiled

    also of course you have to take into account periodic cash flows and uneven risk timing

    nevertheless something you should know is what we call rolling down the yield curve or creep up in rating

    if we take the $625M aggregate payoff exposure, its very unlikely that 50% of the bonds will default over 5 years, so all these assumptions create break points starting at 100% (or 0%) down from the top, and so on

    so the first 5% to 10% of loss exposure is the riskiest…it might be able to withstand 10 to 15 defaults, just for example

    depending on how you build this…

    the probability of experiencing more than 10% aggregate loss (winding up with less than 90% of $625M) is very very small on the order of 1:1000 if you believe the model

    the probability of experiencing more than 15% is asymptotically 0

    therefore in the old days we would mark attachment points and say a ratings equivalent risk would attach like this

    BBB at 5%
    A at 7%
    AA at 10%
    AAA at 15%

    meaning if you were to be exposed to the risk of the losses from 5% to 7% ($12.5M after losses of $31.25M) you would have the equivalent risk of loss of holding a diversisfied bond portfolio of size $12.5M rating quality A

    the client i would have would take the AA piece for himself, the desk sponsoring this would broker out or retain the equity piece (usually first 5%, highest risk highest return scenario), a money fund offshore would take the AA piece, and AIG would take the AAA and greater piece

    meaning we would enter into a contract where AIG agreed to make good all lossses after the first 15%

    in return we would pay AIG 7bps to 20bps depending on the deal, multiplied by the size 65% of $500M

    what i just gave is the example of a synthetic, or CSO


    if the desk were to hedge this, say it just outright bought protection from my client for the AA piece, it would use a correlation model to find a subset of bonds and assume that those 10 or 20 bonds would offset the risk of the 100 or 200 names in this structure

    thats a correlation book (oversimplified)

    research the concept of CONTAMINATION (default in one triggers default in another in the same industry)

    as to damages

    restitution was not originally a creature of equity or of curia regis (law).

    in fact if you do work in D&O liability coverage you will find today insurers refusing to admit liability for restition awards on the theory that they sound in replevin not in damages. largely however this is a distinction without a difference, except the constitution was written in the 18th century and most surely does recognize a difference between law and equity, as in the 7th amendment right to a jury trial in actions AT LAW for more than $20.

  24. fred55

    sorry i forgot

    by rolling down i mean that if you took the risk on the A or AA piece in that example, about 3.5 years out the term structure of credit risk would be such that you were likely holding a piece that would be rated AAA as theres not enough time for defaults to occur to imperil it…

    you’d have achieved 85% of the potential return in 70% of the potential time and you would INDEED want out, these are not held to tenor, typically.

  25. Tyrone

    Net payments might not amount to much, but participants still have to write off the value of these contracts on their books, not?

  26. fred55

    i dont do gaap accounting im a tax lawyer but for federal income tax accounting a typical cds is started at the market meaning its value is ZERO (both sides in balance) and is marked to market periodically using something called contingent pricing which is not important but basically, they have to be marking to market or model along the way, depending on what side the swap is valued at (payor or receiver) as defulat risk changes periodically.

  27. Sev

    Awesome read. I think I’ll go take a bar exam now. Have you Lawyers ever thought about a law networking blogging syndicate to bolster your cases. It seems that if there was ever a solution to be found for this crisis it will be the internet that does it. If you could put the brainpower of the net behind your law practice you might just go .90 on cas wins.

  28. Anonymous

    Thanks a lot fred55. I could have got by without the full explanation, but I must say I did enjoy reading the whole thing in any event.

    I expect going forward we’ll see more projected models being used rather than observed correlations being used. There’s already a lot of research gauging the sensitivity and threat of certain factors to a business defaulting. eg: going beyond the credit ratings and weighting based on debt to capital, free cash flow, debt maturity exposure, etc.. that it should have been done a long time ago

  29. baychev

    DTCC is not an exchannge but a system for confirming CDS trades on which all active players participate, even hedge funds with operations staff. The problem this system addresses is untimely confirmation of trades. It used to take no less than a few weeks in pre DTCC time to confirm trades, some even arent for years. There was a push by ISDA to consider all trades on which payment is made as confirmed due to the huge mess.
    Technically speaking if a trade is not confirmed the protection seller may refuse to pay.
    A couple of years ago it was taking a few days to hedge positions as the market is not that liquid.

  30. SlimCarlos

    >> Nevertheless, DDTC made a very SPECIFIC claim, that the Lehman CDS contracts largely do net out on the individual dealer level. And they claim to be in a position to know.

    >> The biggest red flag about the DTC claim is that AIG, by press reports, appears to have run its operation pretty much as a naked protection writer. They were a very major player.

    >> When a company like Lehman goes bankrupt, someone will have to feel the pain and whether it be on the bonds or on the CDS is just a detail.

    >> It must be said, I classify AIG getting $37bn more from the government to be a party feeling that pain as likely it was in part for the Lehman, and possibly WaMu settlements.

    Yes, suppose AIG was the sucker in the room — the sink for the "missing net exposure" — and suppose the hole had already been moved onto the gov't's books.

    Does this fit the data points? Does this make any sense?

  31. doc holiday

    Damn — lots of various opinions on this arms length stuff with derivatives and counterparties. How nice of DTCC to step up to the plate and offer their opinion at the last second, I mean gosh, what have they got to lose?

    I’m going back and looking at previous examples for myself and IMHO there is a lot of uncertainty because these bets that have been made are probably not modeled in a way that was predictable or rational. How many people here think that these Lehman CDS were structured with this level of global financial stress?

    I trust DTCC as much as I trust SIFMA or Lehmans’s involvement with CME. This settlement process by DTCC should involve specific evidence of CUSIP and certificate data. This is not simple stuff and in this environment of distrust, the fine folks associated with any settlements need to provide more than a nod and wink, or public relation hype. Gimmie the facts and prove it!

    FYI example: JPMorgan shall pay the interest (if any) and principal on a Book-Entry Note to DTC in immediately available funds, which payment shall be by net settlement of JPMorgan’s account at DTC. JPMorgan shall pay Certificated Notes upon presentment. JPMorgan shall have no obligation under the Agreement to make any payment for which there is not sufficient, available and collected funds in the Account, and JPMorgan may, without liability to the Issuer, refuse to pay any Note that would result in an overdraft to the Account.

  32. GDM


    Generally great site and top-notch comment. Afraid you’re a bit off-base here, though.

    The big risk isn’t hedge funds, but insurance co’s and other investment-grade trading parties. Hedge funds must post daily additional margin when they are short CDS protection and it goes against them and are able to take margin back from their counterparty when the trade goes their way.

    The people who don’t have to post margin are insurance companies and AAA-rated synthetic CDOs, etc, and other highly rated traders. This can really only become a huge problem if one of these guys is short a large amount of protection and is unable to pay. And if that happens it’s unlikely to ripple through the system, because they will largely be unable to pay hedge funds and other investors. So the investors in those vehicles will suffer, but the odds of this being the flashpoint for another conflagration seem fairly small.

  33. fred55

    its overly simplistic, but because of the theoretically safe deep level of attachment points, aig indeed is the sucker in the room who was left holding the bag, as well as for euro banks who swapped with aig to reduce their liability exposure and have more synthetic capital, and yes its been reported the ecu boys pressured hank and ben to make sure aig was supported to keep all their banks from going down…

    so aig is now the garbage barge

    not far off the truth but dont forget that there are levered funds who sold protection to goose the returns on their cash

    this is no different from writing naked puts way out of the money and winding up with a 6 sigma event

    im 53. ive been thru a lot of 6 sigma events, in 1973-74, in 1987, in 1989, in 1998, in 2002, and now.

    isnt it amazing how many times a 6 sigma event can occur?

    the best way to think about this is from guys and dolls, where someone says, “my daddy told me once if some guy is coming down the street and bets you $50 he can make the jack of spades jump up out of this deck of cards and squirt you in the eye with cider, son, sure as im standing here, if you take that bet, you’re going to get an eyeful of cider.”

    it works until it doesnt.

  34. doc holiday

    This is part of the PR package and spin, IMHO:

    Official: Cuomo expands short selling probe

    The official said Friday ( Sep 26) that Cuomo has subpoenaed information from providers of market data in what could be a huge probe into one of the factors contributing to volatility in the stock and credit markets

    The subpoenas this week went to trading information companies Markit Group Ltd., Depository Trust & Clearing Corp. and Bloomberg LP.

    Markit Vice President John Dooley declined comment Friday.

    Spokesmen for Depository Trust & Clearing Crop. and Bloomberg didn't immediately respond to requests for comment on Friday.


  35. Anonymous

    Is The DTCC unregulated, like derivatives and rating agencies? Anyone know that here, i.e, are they self-appointed or politically sponsored?

  36. Genesis

    Guys and dolls, the entirety of the CDS market was a racket.

    A high-finance game of “pick pocket.”

    You buy a CDS from me for $100,000. I find a bigger sucker who will sell me the same CDS for $90,000. I now “made” $10,000 and I am hedged (of course this assumes the guy I bought it from can pay.)

    Now that other guy tries to find someone who will hedge his trade for $80,000. And on it goes. When the game starts to run out they get more exotic with how they hedge the position, but the fact remains that the reason for not wanting these trades on a central exchange with O/I and published bid/offer is that doing so instantly stops the “pick pocket” circular game and that’s where all the money has been made.

    This entire market is a pure sham and a fraud. It always has been and it got very popular because skimming a few percent off a $50 trillion notional value makes for big bucks and thus big profits.

    But never get into your head that the majority of these contracts were true hedges against underlying, or in fact were anything other than a high-finance con game, because they weren’t.

  37. Red Pill

    This is a very thoughtful discussion and exposes many subtleties in these obviously complicated and opaque markets.

    I would like to make this comment as someone trained as an engineer and as the type of person the “investment community” is used to funneling money mindlessly their way.

    No longer. I am not putting my hard earned money in any stocks, any funds, etc until this bull@#$! is dead and gone. As long as ridiculous conversations like those occurring above still happen, it is best that everyone who doesn’t understand these transactions (and due to opacity, I would guess very few do) stay away from this community.

    I look forward to the day when the DTCC is a pathetic shadow of its former self and we have a real economy again.

    And I expect the majority of the middle class to feel the same way. They just trusted the “professionalism” of this community.

    That trust was terribly misplaced.

  38. Anonymous

    fred 55 said: “IF repeat IF IF IF we assume the probability of any one bond defaulting is independent of the probability of any other bond defaulting

    “and IF we assume that the probability of default of any one bond is the same as any other bond

    “then this is a binomial distribution and converges very closesly to gaussian for 500 bonds

    “HOWEVER notice the two assumptions: they are HEROIC

    “the ratings agency model is supposed to incorporate contamination risk (correlation risk), such as all the bonds in one industry are simultaneously imperiled”


    Well said, fred.

    Although you didn’t spell out the implications of non-Gaussian reality, I infer that the ratings agency models which were “supposed to” incorporate contamination risk didn’t assume ANYWHERE NEAR the severity of this year’s 10,000-year flood.

    Funny how these 10,000-year floods can occur two or three times in a century (1907, 1929-32, 1987, 2008).

    Thus it seems that Gaussian math works fine in “normal” markets; but is useless in the too-frequent non-Gaussian crises.

    Since we don’t currently have the math to deal properly with these “fat tails” phenomena, many derivatives which incorporate Gaussian assumptions are inherently flawed (as are government bailout plans which can’t possibly value them correctly).

    If history is any guide, a further deepening of this crisis could lead to the banning of many derivatives. CDS’s seem like an obvious candidate — when the amount of protection written exceeds the value of outstanding bonds by a factor of ten, this is obviously speculation rather than hedging. But the same could be said about most of the futures markets.

    Do we face a “plain vanilla” financial future, with erstwhile quants driving trucks and frothing cappucinos? Or will Usgov get into the business of issuing exotic securities itself, seeing as it needs to raise a few trillion pesos? I’d be in the market myself for some interest-bearing T-notes with principal payable in gold.

    — Juan Falcone

  39. Anonymous


    I was one of the first people to do financial futures hedging in the early 80's, T-Bill’s, GNMA's, & Bonds) We did simple transactions like yield curve enhancements or coverage for physical bond tax swaps.

    When the yield curve went flat my book dried up and some of the technical boys started showing me some creative ways to keep my trades going. I went home told my wife that I was leaving the firm since I did not want to end up in jail.

    It took 20 years, but the creative types managed to crap out the whole game.

    If it takes a rocket scientist so explain a trade (with no universal agreement as to the explanation) and there is no performing underlying asset, it’s a Ponzi scheme

  40. polit2k

    Does this help anyone understand what is going on with this auction? Tim

    The surprise: no price support at pre-auction bond prices. (No inside bid exceeded 10%, and the inside market midpoint was 9.75%.) The relief: despite a substantial net open interest to sell bonds for physical settlement, barely half of which would have cleared at the inside market midpoint price, the excess supply was soaked up by limit order bids within the inside market’s spread, resulting in a final price of 8.625%. There was ample additional demand at slightly lower prices, implying that at least some dealers’ bids during the inside market phase really reflected a willingness to purchase plenty of bonds at their bid price.

    (See previous article: “Settlement Auction for Lehman CDS: Surprises Ahead?”)

    A closer look at the limit order phase shows us who is starving for liquidity and who thinks there is money to be made by buying and holding these bonds. Here are the net trades resulting from the auction, ordered from most bonds sold to most bought. (Keep in mind that many of these bids and offers were placed by dealers on behalf of their customers, so they don’t entirely reflect the trading strategies of the dealers themselves.) All volumes are notional.

    Net sellers first:

    Deutsche Bank sold $870m. They didn’t place a single limit bid above 8.5, and would have been net sellers at any price above 6. They would have been happy to take plenty at 4 or 5, though.

    Credit Suisse sold $705m. This is net of $50m for which they (or more likely one of their customers) were willing to pay the top price possible (10.75) in the limit order phase. Otherwise they didn’t have any interest above 8.5, and would also have been net sellers at any price above 6 (at which they were willing to soak up over a billion dollars’ worth!).

    Morgan Stanley sold $430m, similarly net of $50m of bids at 10.75. They wouldn’t have been net buyers at any price above the absolute minimum possible bid (0.125), suggesting that their bid of 8 during the inside market phase was more or less a sham. The interpretation that comes to mind – about which I have no inside information whatsoever, mind you – is that they simply don’t have the liquidity to play the “investment bank” game any longer.

    Goldman Sachs sold $376m or so; they got there by offering to sell $1470m and then buying up over $1 billion of that ($150m effectively bid at “any price from the 10.75 maximum down”, $675m via limit orders at the price set by inside market fixing, and the rest farther down the limit bid sequence). This seems to reflect their huge role as a dealer rather than any great appetite on their own behalf; they would have been net buyers at 8, but the bid that looks to me like Goldman’s “we’ll take it if no one else wants it” backstop is at 1.25. That isn’t the derisory bid that Morgan put in, but it doesn’t reflect a lot of willingness to scoop up a chunk of the ultimate Lehman liquidation either.

    BNP Paribas sold $370m; their inside market bid of 9 wasn’t backed up by any real participation in the limit order phase. They or a customer would have gone long at 2.125, and taken some more at 0.25, and that’s it. They mostly just wanted to unload the stuff.

    HSBC sold $157m (net of $30m bid at the inside market fixing). Otherwise they didn’t bid at all. Some market maker – especially since they were the highest bidder in the inside market phase.

    UBS sold about $83m; they would have been a much bigger seller at any price above 9, and would have been neutral at 8.5, substantial buyers at 8, and massive buyers at 6.

    Banc of America sold just under $78m. They were clearly in no position to backstop the market but did bid for another $15m at each price point all the way down to 4 (resulting in a crossover to being a net buyer at 7.875). They don’t have a lot of cash to play with, but at least they’re playing like they believe in the game.

    RBS sold $31m (after $160m of buy-back, probably mostly on a customer’s behalf); despite having bid on the high side at 9.25 during the inside market phase, they wouldn’t have taken any more back at any price. Another sham bid, if you ask me; but no surprise given that they seem to be on the verge of semi-nationalization.

    Citigroup sold $24m, net of a couple of small purchases and a big $500m bid (possibly on their own behalf) just below their inside market bid. They would have taken another $500m at 8.375 and kept on buying all the way down (with a real monster bid at 6.625). Who knows where they think they would get the cash; maybe someone is bidding through them on a disproportionate scale.

    And now the net buyers:

    Dresdner bought $75m, probably on others’ behalf; although they were one of only three bidders offering to buy during the initial physical settlement, the quantity was small at $30m and the bid was low at 8. However, they were willing to soak up supply if others were to have dropped out, starting just below that bid of 8 and continuing down to their big backstop at 1.375.

    Merrill Lynch bought $529m; they were the only dealer to end up on the opposite side from where they started (having offered $141m in the initial physical settlement), thanks to a $670m bid at 10.25. (Presumably that’s not their own trade, as they were among the bottom bidders at 8 during the inside market phase!) They would have bought more at 8.5 or below, but didn’t even bother to put in a shoot-the-moon bid near zero.

    Barclays bought $1210m, most of it with bids at the the price set by inside market fixing. They (or their customers) would have taken some more at lower prices, but their bid volumes peter out on the way down; they don’t seem to have been interested in mopping up a potential excess.

    That leaves JPMorgan Chase, the biggest buyer at over $1310m. They were by far the biggest bidder ($612m) in the initial physical settlement, and just kept on soaking it up; their bid for $500m at 8.625 wound up setting the final price. They were the one net buyer who would have kept on buying and buying and buying at prices not much lower than this – although there was plenty of other demand in this price bracket and, as previously mentioned, UBS would have started stepping in for real at 8. Doubtless there were lots of outside bidders using JPMorgan as their dealer, but evidently Chase trades heavily enough that they could have made this whole market themselves.

    In short, this auction was basically successful at clearing the market for physical settlement at a credible price (contrary to outsider expectations though it might have been). However, without Barclays (BCS) (the purchaser of Lehman’s assets) and JPMorgan Chase (JPM) (the Treasury’s agent in winding down Lehman’s trades), it would have been a very different story. (I wonder what combination of them has inherited trusteeship for all of the Lehman-created structured vehicles that issued CDS on Lehman itself?) The auction also seems to have provided a rare view into the actual trading behavior of the top broker/dealers, including apparent confirmation that Morgan (MS) and Goldman (GS) (not to mention RBS (RBS)) are seriously starving for cash.

    Source: Seeking Alpha http://seekingalpha.com/article/99527-settlement-auction-for-lehman-cds-surprises-behind

  41. Anonymous

    “If it takes a rocket scientist so explain a trade (with no universal agreement as to the explanation) and there is no performing underlying asset, it’s a Ponzi scheme”

    The wonderful Michael Price has a saying like this: there is nothing new under the sun — there is debt; there is equity; and everything else is a way for Wall Street to make money off investors.

  42. fred55

    to the gentleman above:

    there is a great deal of merit in the thought:

    “there are three classes of assets: (i) stocks; (ii) bonds; (iii) bullshit”

    its not entirely a bad thing. and i make my living in structured finance (but as a plaintiff’s or client’s lawyer, not the house).


    fundamentally this is VERY SIMPLE and worth the following read:

    PLEASE TRUST ME this will bring it all home to you

    in normal times consider a corporate bond, B, zero coupon, 5 years maturity, 10% simple interest. assume the reference risk free rate is 6.5%.

    if we assume a 50% severity rate (loss on default), then we have two outcomes for the bond:

    (i) $150, or (ii) $50

    our risk-free outcome would be $125

    now the expected value of our bond would be p*50 + (1-p)*150, where p is the probability of default

    if we assume liquid and complete markets, then there should be strong efficiency, and the expected value of both bonds should be the same, meaning the extra yield of B exactly compensate for the risk and nothing else like illiquidity or differential taxation (as we’ve assumed that away)

    therefore solving for p we find to make the bond B have an expectation of $125 p must equal 50%, or .50

    so that tell us that a spread to treasury in this example of 350bps implies a 50% default probability

    since we just saw IBM issue bonds at 8%, which is a spread to treasury i believe of 430bps, that tells us that the market-implied probability of default on the IBM bond is 50% (probability of default before maturity)

    ok since no one really BELIEVES that IBM has a 50% chance of default in 5 years…

    this implies the existence of a risk premium, meaning that investors are demanding more spread than is justified for arbitrage-free pricing

    or in other words, if you could borrow at treasury rates and invest in IBM bonds you would have a positive expectation

    ALL repeat ALL ALL ALL of structured finance that is not tax-motivated is motivated by isolating this supposed risk premium and capturing it for free

    the risk premium only exists in a market that is behaving according to the model that is used to predict the existence of the risk premium

    the probability that this kind of investing will blow up in time is exactly 1.

    it works until it doesnt.

  43. fred55

    oops math error. in my example the risk free value is 132.5 and so p must be .175 or 17.5% but the point is the same.

  44. doc holiday

    I guess I’m a little weak on understanding the mechanics of how an Enron, WaMu, AIG, Fannie or a Lehman structures their derivative sand castles — I mean does anyone in truth have the ability to understand the chaos here? I’ll help answer that — NO!

    Are these reference security hedges built to produce future cash flow streams or are these CDS-synthetics in place just to prevent bad bets from impacting future cash flow?

    IMHO, it seems like a crap load of Playstation teenagers dressed up for Halloween about 10 years ago, wearing suits and ties and then a group of alcoholic CEOs, passed out and then woke up to give these brats cart blanche to tweak Monte Carlo Risk Simulations — and then set them free to turbo charge any retarded bet they wanted to make. This essentially is Nick Leeson Squared or cubed, but since were talking $60 Trillion, more like square roots relating to entropy!

    FYI: Nicholas Leeson (born February 25, 1967) is a former derivatives trader whose unsupervised speculative trading caused the collapse of Barings Bank, the United Kingdom’s oldest investment bank.

  45. b

    Wrote this September 21:

    Solution: Declare All Credit Default Swaps Null And Void

    /quote/ The only way to eliminate these reasons is internationally concerted action to declare the legal obligations of all CDS’ null and void.

    At the same time:

    * all financial exchanges and markets of the world close for a week
    * CDS are declared null and void and new CDS creation is forbidden until new regulation is in place
    * the publicly dealt financial entities have seven days to figure out and publicly restate the value of their liabilities and assets excluding all CDS
    * a onetime windfall tax will be created that socializes overt advantages some entities will have from this
    * the proceed of that tax shall be used to prop up the capital of the big losers in a program comparable to the Reconstruction Finance Corporation of 1932. /endquote/


    /quote/There is precedence for this:

    “During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision.”/endquote/

    I believe that people who hope for “netting” are up to some surprises. Some greedy folks somewhere will be totally loopside in their bets and bring down the whole “netted” system.

    Maybe we can give this idea some more thought?

  46. Anonymous


    Re: in collaboration (collusion) with the ratings agencies, the issuer gives you a basket of names based on criteria you supply, then you all three of you twiddle with it till you get the tranches and so on where you want

    Last night at CR there was some good stuff on ratings agencies, e.g:

    Taking these two factors together, we conclude that the district court did not abuse its discretion in finding that Fitch was not entitled to assert the journalist’s privilege for the information at issue. For the sake of clarity, we note that we are not deciding the general status of a credit rating agency like Fitch under New York’s Shield Law: Whether Fitch, or one of its rivals, could ever be entitled to assert the newsgathering privilege is a question we leave for another day. Nor do we seek to amplify or interpret New York law beyond the facts of this case. We simply conclude that on these facts, the district court did not abuse its discretion by concluding that Fitch had not sufficiently shown that the information it sought to protect was gathered pursuant to the newsgathering activities of a professional journalist.

    Because we decide here that Fitch may not assert the privilege, we do not reach Fitch’s claim that the district court’s conclusion that ASB had, in any event, overcome the privilege should be reversed for the absence of statutorily-mandated “clear Ill and specific findings made after a hearing.” N.Y. Civ. Rights Law § 79-h(c), We also need not decide if Fitch has waived its privilege claim by disclosing some of the contested information to the OTS, or by failing to produce a privilege log in accordance with Fed. R Civ. P. 45(d)(2) and S.D.N.Y. Local Civ. R. 26.2(a)(2).

    We have considered all of appellant’s arguments. For the foregoing reasons, the order of the district court is affirmed.” The mandate shall issue forthwith.
    Kona | Homepage | 10.12.08 – 12:56 am |

  47. Anonymous

    JP Morgan was the big buyer…

    GS has been front running for the Fed for years. I guess it would have been too obivious for Paulson to use his firm to make this Lehman settlement work.

  48. Anonymous

    “Are these reference security hedges built to produce future cash flow streams or are these CDS-synthetics in place just to prevent bad bets from impacting future cash flow?”

    They are built to make fees for the facilitators who promote and implement the deals. It is just like the Lloyd’s reinsurance disaster in the UK. Back then, there were a bunch of brokers who made money selling insurance to companies, then selling reinsurance to the insurance companies, and then selling retrocession to the reinsurers. After you backed out the brokers’ fees, there wasn’t enough money left over for the actual parties to make money off these deals.

    You have the same thing this time, where the brokers made money originating loans (mortgages, LBO, or otherwise), packaging/selling the debt as asset backed securities (residential mortgage backed or otherwise), repackaging/reselling asset backed securities as CDOs, repackaging/reselling the CDOs as CDO^2, and repackaging the CDO^2 as CDO^3. They also made money selling credit default swaps to make this chain of repackaging and sales work.

    The intermediaries promoted this chain of repackaging using academic research regarding diversification of various securities, to support the idea if you pack junk debt together, senior slices of the debt become less risky than the underlying securities, and so, value is created. They misused academic research to the same degree as Michael Milken did in selling junk bonds.

    I’ve seen value investors like Seth Klarman criticizing this structured finance spiral since 1990, and criticizing various other structured products like portfolio insurance and SCARPs even before that. I’ve seen some regulators and academics also criticize the structured finance system.

    The promoters ignored the skeptics since they made money off this. The academics have mostly ignored the skeptics because they get paid as consultants to corporate america testifying as experts in various matters, international trade, international tax, etc. The politicians ignored — and in some cases actively suppressed — the skeptics because they receive big campaign contributions from industry.

  49. Anonymous

    ***Not one in a thousand commentators are getting to what I think is the most fundamental issue — that Bubbles are an inherent feature of fiat-currency regimes. Even without derivatives, you can still bid up the price of tulips, crude oil, Beanie babies, or what have you to Bubble levels. Deadweight losses proliferate, productivity dives, the authorities seek to inflate away the unpayable debt, poverty ensues.***

    sounds like one good argument for progressively increasing marginal tax rates.

  50. Anonymous

    “so we cannot be certain the market has passed this test until then”

    This guy is…funny.
    and it’s not the first time we witness this kind of stupidity.

  51. Anonymous

    GS has been front running for the Fed for years. I guess it would have been too obivious for Paulson to use his firm to make this Lehman settlement work.

    Yup, and DOJ attorneys would be afraid to investigate. SEC attorney Gary Aguirre was fired for trying to subpoena Morgan boss John Mack in investigating Mack’s dealings with hedgie Art Samberg. DOJ attorneys with no tenure or pension can’t afford to try to get fired for trying to subpoena Blankenfein. And although US Attorneys are presidential appointees with tenure, they can’t count on finding a job if they mess with the machine.

  52. maynardGKeynes

    This press release from DTCC is quite astonishing, for several reasons. First, as I understand it, DTCC is primarily a back room operation, not an exchange in any sense of the term. I have to wonder what business it has posting what is essentially an internal calculation of net money settlements in a public forum. To the best of my knowledge, DTCC has never played a role in the price discovery mechanism of public markets, and one wonders what is behind this seemingly ultra vires press release, and what its legal and regulatory authority is for issuing such a document. Secondly, if DTCC is indeed the central registry for over-the-counter (OTC) credit default swaps (CDS) that it claims to be, where has it been all this time? This issue of counterparty liability come up time and time again in recent years, most famously perhaps when Warren Buffett called the CDS market “weapons of mass financial destruction.” If the DTCC is really able to set the record straight on this incredibly central issue, why are we just hearing from it now?

  53. fred55

    No, I’m not smart enough to have a solidly likely idea to know how this plays out, except that the end of the world happens only once and this almost surely isn’t it.

    Personally, I’m not attempting to “play” it but if I had more disposable (highly risk tolerant) I suppose I might.

    In that case, as a short to medium term play, I would sell volatility. It does seem clear that markets cannot continue trading at this level of volatility.

    I’m not being coy, I’m being direct in telling you that if you know what I mean, I would sell small amounts of volatility with credit spreads so my losses were capped, and I would make sure to cross these trades on an exchange so I had nil counterparty risk.

    If you don’t know what I just meant, don’t do it, please.

    As for bread and butter 401k style investing, I guess you have to presume that in the long run there will be some kind of mean reversion…right now that means 8% annual returns on risky assets, and I think we’re about there in postwar times for multi-decade long periods.

    My suggestion is to remember, “This too shall pass,” and to try to learn as much as you can about simple, plain vanilla exchange-traded options and invest conservatively using them to reduce, rather than enhance, risk.

    In other words, I would rather own some form of SPX with a long term put and say a double on the first 5% annual return, capped at 10%.

    Beyond that there is too much unknown other than that I would be curious to know what would have happened to someone investing $1K per year ($10K now) from 1929 through 1954; I imagine it wasn’t so bad even though the market didnt turn around till 1942-ish.

    Fundamentally, we won’t get anywhere on a macro level until people are comfortable with risk. I’m afraid it may be the case that we have to wait till all the cowboys who will jump in every time some Eliot wave BS shows a curve 3 down and declare a bottom are consumed.

    Like wandering in the desert after the golden calf.

    But this is likely to play out in 10 years or less because of the baby boom population bulge that has now lost or is in danger of loosing two of the three legs of its stool: (i) medicare/social secureity; (ii) retirement savings; (iii) house equity. The solution has to be some form combining delayed retirement with even heavier taxation. Polical dyanamite.

    You DID ask…

  54. Anonymous

    Then this blogger would be right in calling the bottom of Friday in the middle of maximum fear!

    Here is quote from his lastest post:

    “Here is a recap of what happened over the last couple of days (Typical BOTTOM news as we wrote in previous post calling the bottom):

    1. Britain decided to partly nationalize its banks,
    2. Washington began mulling direct loans from the U.S. Federal Reserve to corporate America,
    3. Iceland closed its stock exchange as it slipped towards bankruptcy,
    4. the International Monetary Fund warned the world is on the verge of collapse, and urged the world’s developed nations to work together rather than take individual steps (which they say won’t work anyway, because the crisis had become a worldwide problem).

    5. And last but not least, this blog (financialtraders.blogspot.com) nailed live for its readers the top and the bottom of Friday’s market action with more than 100 ndx points when NDX ran from 1200 to more than 1300 in about an hour’s time only! :-)”


  55. doc holiday

    Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is the opposite of disinflation. It can refer to an economic policy whereby a government uses fiscal or monetary stimulus in order to expand a country’s output. This can possibly be achieved by methods that include reducing tax, changing the money supply, or even adjusting interest rates. Just as disinflation is an acceptable antidote to high inflation, reflation is considered to be an antidote to deflation (which, unlike inflation, is considered bad regardless how high it is).

    Also see: Helicopter Ben


    (3) an increase in swap authorization limits with the Bank of Canada, Bank of England, Bank of Japan, Danmarks Nationalbank (National Bank of Denmark), European Central Bank (ECB), Norges Bank (Bank of Norway), Reserve Bank of Australia, Sveriges Riksbank (Bank of Sweden), and Swiss National Bank to a total of $620 billion, from $290 billion previously.

  56. doc holiday

    maynardgkeynes said…,

    I'm with you dude, why would a backroom operation like DTCC step up to the mike to tell people that the future value of these private transactions went well?

    See Lady MacBeth In Hamlet: "The lady doth protest too much, methinks"

    >> To put this in perspective, would you want DTCC making public your private transactions and telling the world what you paid, what you made, what you lost? This is just more bullshit and this type of false and misleading information just causes less and less friggn trust and destroys market confidence! As I mentioned before, give us pure facts that have proper accounting and documentation!

  57. Anonymous

    There is no controlling authority with a CDS which is why it is never called what it actually is, an insurance contract. A insurance contract to insure a pile of shit so you can sell the pile of shit to make the commission.

    If some commissions were siphoned off to political pockets you can figure change or oversight will happen begrudgingly. In other words Congress knew all along how the game works.

  58. Anonymous


    I told a friend of mine that the only way to make money over the next decade is to go long Defense Attorneys and Securities Litigators.

  59. Anonymous

    “Fundamentally, we won’t get anywhere on a macro level until people are comfortable with risk. I’m afraid it may be the case that we have to wait till all the cowboys who will jump in every time some Eliot wave BS shows a curve 3 down and declare a bottom are consumed.”

    What is truly funny is that the quants are just as bad as the chartists that people criticize. And both of their systems work for the same reasons — herd mentality. However, whichever type of technician you’re dealing with — new school (ie, quant) or old school (ie chartists) — once their trades get too crowded they blow themselves up.

    Both kinds of technical work are only useful to people who are good judges of human psychology. If you lack that judgement, those strategies will destroy you, unless you’re making money investing other people’s money.

  60. fred55

    my advice to anyone dumb enough to take it is to invest money in what you know and can control. in your own business, in a friend’s business, in pooled real estate that you KNOW and can supervise, and understand that financial markets are merely casinos with net long term positive expectations about in line with the fundamental macroeconomic growth.

    its overwhelmingly likely things will work out in the long run.

    its absolutely certain we will all be dead in the long run.


    try to find structured products that are well understood and are not overly expensive for what you get and modify the risk/return profile

    for example, if you could find an fdic insured cd at a bank that gave you 80% participation upside in the spx and complete protection on the downside

    or the equivalent in an annuity from a HUGELY solid company in a state like NY with very heavy insurance co presence likely to pick up any annuity shortfall id go that way.

    you cant make enough money on investmetns without risk to retire on unless you already have enought to begin with.

    the issue is how to take risk you can handle.

    structured finance doesnt kill. the people who misuse it kill.

  61. fred55

    btw if i could legally quote here the idiocies ive heard coming from undewriters and pension managers and the like about what they buy and sell and why…

    its frightening

    they are not smarter than you. they are more educated in certain fields. they are better connected. but they are not smarter.

    in the end, given taxation, index investing will always be in the top 20% of manager performance, net net.

    but you may want to modify the index exposure with exchange traded options or similar super safe (as to counterparty) structured products that dont suck.

  62. Anonymous

    I appreciate the intelligent discussion here from Fred55 and all others. Thank you. I’m trying to understand all this. A couple observations: despite all the math, stats, etc., the fate of CDSs comes down to politics, as in a democracy, more or less.

    And I am still mystified how this huge market slipped by the SEC with all the security regulations from the 1930s, etc. This is more of a rhetorical question because I know there has been legislation between then and now. Instruments just designed to not be subject to any securities or insurance regulation seem to me that should automatically make them subject then and now. Again, something of a rhetorical thought. It just reels my mind.

    Keep it coming, naked capitalism. thx

  63. doc holiday

    The following is a great case as to why the banking industry and wall street in aggregate all thought they could transfer risk at the same time and thus not be connected to a systemic failure. The problem in this systemic failure was the inability for the system to model itself as part of a macro variable, i.e, the models were based on a micro focus on isolated derivatives which were not connected to the real world of macro investment chaos. These fools in denial failed to account for the collapse of the system, as they all worked in collusion to outrun regulations and accountability. They essentially have destroyed themslves by betting $60 Trillion!

    >> Credit Derivatives Settlement and other Operational Issues — May 2007

    Some see the credit derivatives as an explanation for the good resistance of banks during the corporate crisis of 2001-2002: “because many of the lenders to companies like Enron and WorldCom had hedged their risk, the corporate scandals did not spread to thebanking industry” . In this respect, credit derivatives tend to reduce systemic risk. Credit derivatives induce banks to increase and diversify their lending activity by enabling them to hedge their credit risk . As a result, liquidity in the banking industry increases.

    More generally, credit derivatives might have “increased and redistributed credit risk in an undesirable manner” . They were probably one of the reasons why the banks did not correctly monitor Enron. The risk takers in credit derivatives lack a direct relationship with the borrowers to monitor them adequately, and they are also“less skilled and experienced in evaluating risk” . Credit derivatives may even give incentives to a buyer of protection to force a borrower to default . In particular, some creditors that are willing to trigger the settlement of credit derivatives transactions may refuse any concession in an insolvency procedure, even when it would lead to the destruction of economic value.

  64. Matt Dubuque

    Nice discussion here and very extensive as well. This post has provoked a lot of interest.

    Fred55, we therefore seem to agree that there are far too many pricing events that we have seen in our experience that are 5 standard deviations from the norm (5 sigma events) to not question our basic CORRELATION assumptions based on Gaussian (or bell-shaped curve) distributions.

    It’s much more like a Cauchy space.

    HOWEVER, it’s one thing to have this meta-mistake implicit in all your valuation models.

    IT’S QUITE ANOTHER to HYPERleverage this mistake at ratios of 60 or 125 to 1 (as was the case with certain GSE positions).

    The combination of these two mistakes: 1) assuming Gaussian distributions in these pricing models AND 2) amplifying the effect of that meta-mistake by leveraging yourself to the gills in furtherance of your false assumption explains a clear majority of the shocking prices phenomena we see in The Crash of 2008.

    That’s my thesis. I’ll stick with it until something better comes along.

    Matt Dubuque

  65. bena gyerek


    i have worked closely with cds trading desks (as a credit structurer). some facts for you:

    the vast vast majority of cds are traded between the big dealers on standard terms. this is because (a) every time a dealer does a trade with a client as a market-maker, it immediately lays off the risk via an interdealer broker, (b) dealers also speculate (moderately within their risk limits) on reference credits by buying and selling cds between each other.

    cds trading desks always delta hedge. yes, it is often hard to short bonds when you have sold protection (although there is a positive “basis” that can be earned because of the difference in spread). but you can always buy bonds as a delta hedge when you have bought protection. more importantly, dealers also delta hedge by buying and selling cds on different maturities (although this can create discrepancies in their recovery exposure in case of default), or when they hedge correlation positions on synthetic cdos. cds in the interdealer market are traded on standard quarterly roll dates, which makes maturities much easier to match.

    dealers always enter into offsetting trades to square their book, they almost never ask existing counterparties to unwind existing trades. this is because you always want to hedge at the best price in the market via the broker screens. going to an existing counterparty and asking for an unwind will not get you the best price.

    cds traded in the interbank market are always traded on standardised terms. the smaller percentage of trades done with clients are much more often done on less standard terms that are favourable to the dealer compared with the dealer market. e.g. a dealer may buy protection from a client that is triggered by failure of the reference credit to pay on any payment obligation, but then sell protection in the dealer market triggered by failure to pay only on bonds of the reference credit. synthetic cdos / correlation business is only done with clients and represents a tiny fraction of total cds trades.

    in the case of lehman, don’t forget that all of the banks will have had big exposures to lehman as a counterparty on other derivative transactions (interest rate swaps, cross currency swaps, etc, as well as cds on other credits). the residual counterparty exposure that the banks need to hedge is hard to quantify, because it depends on “gap” risk. prior to a counterparty default, the banks are fully collateralised because they pay cash collateral to each other every day equal to their net exposure that day. the counterparty risk crystalises because the exposure can “gap” up between the time of the counterparty default and the time at which the bank is able to reestablish the defaulted transactions with new counterparties. this “gap” risk is very hard to quantify, but it is obviously much higher in the current market conditions.

    since the subprime crisis first appeared in summer 2007, banks have been significantly increasing the net cds protection they buy on each other in order to hedge more conservatively this residual counterparty exposure. that is the main reason that bank cds spreads blew out so much in the last 12 months. dealer banks have mainly been buying this protection from insurance companies and hedge funds (who are willing to speculate on the credit risk by taking a let long credit position).

    the 6bn number from dtcc closely tallies with the 4.92bn net notional amount of bonds offered by the dealer banks in the lehman auction arranged by isda on friday. these are presumably the bonds being received by the dealer banks from the hedge funds / insurance cos under the cds protection the dealers bought from them.

    but even the 6bn number from dtcc massively overstates the actual counterparty credit exposure of the banks to these hedge funds and ins cos under their cds hedges. bare in mind that these cds, like all over-the-counter derivatives, are marked to market and cash collateralised every day.

    immediately prior to the auction, lehman bonds were trading at 13c, which means that the hedge funds / ins cos would already have handed over cash collateral calculated at this price. the final price determined in the auction (which defines the cash payment on final cash settlement of the cds) was 8.625c. this means that the additional cash to be paid over by the hedge funds and ins cos = (13% – 8.625%) x 6bn = 262.5mm.

    so don’t expect any defaults on october 21

  66. fred55

    times change. people do not change. there is inherent mpossibility in legislating or regulating because what seem to be general purpose provisions either are too narrow to stop all the crap or wide in which case there are loopholes.

    please understand those of us who are in this field and who are honest ALWAYS disclose completely and fully:

    “this is the model we used. this is the set of assumptions that went into it. while we resaonably believe this will produce a profit, there can be no guarantee yadda yadda yadda”

    people do not read prospectuses. ive had people tell me they would never own derivatives who are invested in bond funds half of which are stuffed full of derivatives.

    im afraid all non-trivial systems must eventually blow up. this is blown up. the question is containing the damage and pushing the reset button.

    technically, what happens is something called ill-conditioning, or hyper sensitivity, or nonlinearity, or catastrophe, or chaos…

    when one small change can propagate out massive problems too qiuckly for anyone to deal with…

    its always been this way and always will.

    right now the markets believe there is no consensus fair risk pricing so no one is buying (taking on) risk at a price anyone is willing to pay. in this market, other than forced transactions, there is no observable consensus risk premium.

    in such a market, you cannot use quant to capture the excess risk premium.

    in normal markets, you can.

    i know of no way to guarantee that markets that are normal dont occasionally go too far and trip up. it may be inherent in human dynamics.

    since the solution must be political, go with whatever represents the majority.

    that means either be one of the favored few or at least be one of the group that gets favored in the bailout.

  67. Matt Dubuque

    Fred55, with respect to your views as to “wise investments”, over the LONG TERM, it seems that short vega (volatility) is the place to be.

    By long term, I mean likely (but by no means certain) through the end of this Thursday. The equivalent of five lifetimes as they might say in India.

    Come Friday, all bets are off. It’s time to change the “anchors”.

    This post is partially tongue in cheek, but also reflects my best view.

    Things seem likely (but by NO means certain) to be a BIT more stable through Thursday, but by Friday it is just too turbulent to predict at this point. So to that end being short vega (volatility) seems to be one of the safer bets around.

    Matt Dubuque

  68. doc holiday

    Think in terms of stock markets or CDS or any number of derivative models, which were engineered to limit risks in betting. Wall street bet the entire financial system and nobody knew it, or at least no one cared about total systemic collapse!

    “However complicated a machine we construct, it will … correspond to a formal system, which in turn will be liable to the Gödel procedure for finding a formula unprovable-in-that-system. This formula the machine will be unable to produce as being true, although a mind can see it is true. And so the machine will still not be an adequate model of the mind [Minds, Machines and Gödel].”

    “Gödel’s theorems are actually special, self-referential consequences of the requirement of consistency: in a consistent system, something must remain unprovable. One unprovable statement is the statement of that very fact, namely the statement which says of itself that it is unprovable (first theorem): you cannot prove a sentence which says that it can’t be proved (and remain consistent). Another unprovable statement in a consistent system is the statement of consistency itself (second theorem). In addition, if the formal system has a certain stronger form of consistency, the sentence which asserts its own unprovability, called the Gödel sentence, is also not refutable in the system.”


  69. fred55

    i should decline to believe its a cauchy distribution as under riemann conditions there is no expected value. it would be hard to price something like that.

    a poster above has it right. i would use different terms tho. i would say the following; i believe it captures what happened:

    in normal markets, if IBM issues $100B of credit at a certain aggregate spread, that spread encapsulates the market consensus risk.

    if it overissues, its spread will go up.

    if there is great demand for ibm debt, its price will go up and its spread down and that will be the market saying that it believes ibm is less risky now than before.

    but with a credit default swap, i can mathematically replicate the position of being long or short an ibm bond without buying or selling such a bond and without ibm having heard of me.

    if this were a situation of continuous underlyings, like buying options on IBM stock, there would be few cowboy speculators on the other side and my counterparty would be expected to run a balanced book so i really would be affecting the price of the stock, and the float would affect the implied volatility of the option.

    but in the case of cds, particularly structured, particularly aig, i can promise you from personal knowledge that aig and others warehoused the risk and to the degree they hedged it at all did so with inadequate correlation models, then didnt issue accurate enough financial statements, got whorish ratings from agencies paid for it, and so on.

    its not the math its the misuse of it to pretend there is safety when there is not.

  70. fred55

    i wouldnt have the guts to sell vega or theta this week. ive blown up in my lifetime doing so and dont need the experience again.

    everyone is entitled to blow up once. that makes you human.

    twice makes you stupid.

  71. Anonymous

    bena gyerek,

    Do you have an example of previous settlements from SEC to connect with your theory, “don’t expect any defaults on october 21” ???? Why don’t you post a real example from a settlement, like from Enron.

  72. Anonymous

    “in the end, given taxation, index investing will always be in the top 20% of manager performance, net net.”

    That is what I tell any joe 6 pack that asks me for investment advice. Most of them don’t like hearing this though. The returns from a reasonably safe mix of debt, equity and cash aren’t high enough for their taste. And they really shoot themselves in the foot investing in equities by panic selling after things drop significantly, and panic buying after things rise significantly.

  73. luther

    doc, great Gödel procedure post.

    reminds me of the ending of 2001 with HAL9000.

    some memorable quotes:

    HAL: I’ve just picked up a fault in the AE35 unit. It’s going to go 100% failure in 72 hours.

    HAL: I am putting myself to the fullest possible use, which is all I think that any conscious entity can ever hope to do.

    [on Dave’s return to the ship, after HAL has killed the rest of the crew]
    HAL: Look Dave, I can see you’re really upset about this. I honestly think you ought to sit down calmly, take a stress pill, and think things over.

    HAL: I know I’ve made some very poor decisions recently, but I can give you my complete assurance that my work will be back to normal. I’ve still got the greatest enthusiasm and confidence in the mission. And I want to help you.


    remember what happens next?

  74. bena gyerek

    anonymous @ 4.21

    no need. we already have all the details for lehman:


    like i said, the net amount of cash to be paid out is in the 200-300m range. i don’t think this will break any banks.

    the much bigger issue is the ongoing drain of hedge funds’ and insurance cos’ liquidity caused by cash collateral calls under all the other outstanding cds where they have been big net sellers of protection. as credit spreads blow up across the board, they have to hand over more and more cash to the banks they have sold hedges to. hence the need to dump liquid assets like stocks to raise the cash needed.

    now here is something much more interesting. when an ins co like ambac gets downgraded by a rating agency, its business model is bust. the value added by an ins co is its ability to lend its rating to a transaction. i believe cds also fall outside insurance cos’ capital adequacy rules (it is not technically an insurance contract), giving them a very perverse incentive to sell cds credit protection and not sufficiently provision against the potential lost.

    the losses the insurance cos are taking on these fire sales of liquid assets are likely to result in downgrades. but when an insurance co is downgraded, so are the assets it has insured, which means that the banks that bought this insurance suddenly have to allocate much more capital against those assets under basel ii. downgrades also typically trigger bigger cash collateralisation requirements for the insurance cos under existing cds and other derivative contracts (banks have the same problem when they get downgraded – a big problem for morgan stanley now who is on negative creditwatch from moodys this weekend, effectively a downgrade that may kill that bank on monday). this basically means the downgrade actually accelerates the cash drain on the company that was the root cause of the downgrade in the first place!

    so if you are looking for a big “event” risk, don’t worry about defaulted cds auctions / settlements, and watch out instead for insurance co downgrades.

  75. Anonymous

    I think it’s unusual that bena gyerek, is on here pumping up Lehman so much! Where were you about 4 months ago when Yves was doing Lehman stories here? Just thought you’d drop by today and do a little pumping?

  76. doc holiday


    That is funny, I forgot about that scene, so off to youtube!

    LOL — reminds me of the ending of 2001 with HAL9000.

    ROTFLMAO! Wall street lost the keys to the SPV and now they can’t get back inside the sand castle. This is the stuff of Alice In Wonderland!

  77. Anonymous

    bena gyerek,

    You really do not know what you are talking about, and I for one get annoyed when people pretend to be experts and tout nonsense. I know only a little about this market, but enough to know that some of what you are saying is rubbish, and it calls everything else into question.

    All the evidence is that CDS are NOT traded, that’s why the market got to be so large, you could not trade out of a position but had to enter into offsetting contracts or negotiate a settlement of an outstanding trade. They are not securities nor are they subject to a specific exemption from the SEC, and therefore cannot be traded.

    Similarly, there has been ample discussion above that CDS are not delta hedged. Fred55 addressed that point up at the top. Corporate bonds are too illiquid. In fact, investors now use CDS to construct synthetic corporate bonds due to the very limited trading in corporate bonds.

    So I ask you limit your comments to things where you have some bona fide knowledge, rather than force us all to guess whether your pronouncements are accurate or not.

  78. Matt Dubuque

    Famed mathematician and hedge fund manager Nassim Taleb, who has written textbooks on dynamic hedging for John Wiley & Sons and was called by recent Nobel Laureate Daniel Kahneman as one of the world's top intellectuals, squares off with Ken Rogoff in the following video, as hediscusses the fallacy of pretending Gaussian distributions in financial modeling is a competent strategy over time:


    Here is a short blurb on Taleb:


    Matt Dubuque

  79. Dave Raithel

    I’ve checked back more than once for a reply to FairEconomist’s observation that “If this is true, then the CDS market makes absolutely no sense at all.” Is the notional vs. the net in this case a fortuity or particular to the Lehman parties? (It’s going to be one of those outlier settlement events that only happens once in 1000 investment bank bankruptcies, so to speak…)

    If, in Fred55’s first post the payments from C to A so A can pay B are set in motion by the same “credit event” (Lehman default), then why aren’t all those parties’ CDS included in the notional amount of protection written on Lehman bonds? Is it because C should be considered more like a “re-insurer” and so it is protecting A, not the Lehman bond holder B?

  80. alan

    Just thought I’d post this up for anyone else is scouring the net for information on Lehman Re: 6bn or $400bn.


    Do we know who the net credit protection sellers are?

    The first immediate victim of Lehman’s CDS exposure was AIG and it resulted in a $85bn bail-out by the government, later increased by another $37.8bn. So we’re already talking about a multiple of the $6bn mentioned by DTCC in the beginning. And this is only one counterparty, the fallout can only increase.

  81. Anonymous

    late comment at the 11th hour…didn’d read every blog so maybe this has been covered…but…from a laymans point of view…what hapens if just one counterparty defaults? Does that lead to a damaging domino affect? seems everyone is assuming that all counterparties have the ability to front up and settle. Also, another question..Is this the first major CDS settlement invovling a co that has gone bust?

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