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Credit Default Swaps
Old 09-17-2008, 11:00 PM   #1
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Credit Default Swaps

In researching the definition of credit default swaps I came up with this little beauty. This is partially from the British Bankers Association Credit Derivites Report by way of Wikipedia and a banking dictionary.

"Derivatives, such as credit default swaps also create major distortions in the traditional indicators of value of stock and bond markets. Many people wonder, for example, why the indices, like the DJIA, S&P500, etc., seem to go up endlessly. Part of the reason is that big institutional investors no longer sell companies they feel are about to fail, no matter how obvious that impending failure may be. The securities, issued by such companies, may retain significant paper value, up until almost the very end. Instead of selling, investors can buy "insurance", in the form of derivatives, and keep holding their investments. This distorts the value of traditional market indices, because the decision to remove a failing company from the index, can be made well before the paper value drops to zero. This saves the value of the index. It creates the false impression that the index always rises. The underlying markets, for which the index was developed to reflect value, however, may be far more unstable than appearances indicate. False appearances of stability, in turn, allows securities markets to appear far less risky than they really are, encourage less knowledgeable players to speculate on derivatives, and allow broker/dealers, and some academics to claim that markets are far better investments, for the retail investor, than they really are. The overall affect is to reduce the perception of risk, itself. The risk still exists. The perception, however, reduces risk premiums, encouraging shoddy loan practices, and, in the end, may be the cause of runaway financial bubbles, when irrational exuberance gains traction, on the basis of inaccurate information."

I still haven't quite figured out how one can have a nominal value of bonds in the country and have a credit default swap value for those bonds that is tens times the value of the bonds themselves. But that will come in time.

b.
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Old 09-20-2008, 08:16 AM   #2
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Well it sounds like me may be headed to a period of greater transparency which will be good for the economy as a whole. If the above is true, however, the past period was probably unnaturally good for index investors since we will have experienced less turbulence than warranted.
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Old 09-20-2008, 10:33 AM   #3
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I still haven't quite figured out how one can have a nominal value of bonds in the country and have a credit default swap value for those bonds that is tens times the value of the bonds themselves. But that will come in time.

b.

That's because it doesn't. For every buyer of Credit Default Protection there is a seller. Assuming these counterparties are all solvent at the end of the day, shorts and longs net out to zero.

Comments suggesting that the CDS market is X times greater then outstanding bonds is talking only of notional size and doesn't recognize that each contract is made up of a perfectly offsetting short and long position.
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Old 09-20-2008, 12:15 PM   #4
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Credit default swaps are neat. They are intended to act as insurance against a default, or failure to repay, of a bond or similar loan. If you had bought bonds of, say, Lehman Bros., you could also have gotten a credit default swap for roughly a penny on the dollar to insure against the bond failure, back when Lehman was whole. The CDS seller would pay you the par value of the bond should the bond default.

Here's the neat part. You can just buy the credit default swap without the bonds. It's like taking out a life insurance policy on a complete stranger! If something unfortunate should happen to that business, putting its bonds in default, you can collect on the CDS.

Now, suppose you got together with some friends and bought CDS contracts on some company, like, oh say, Bear Stearns or Lehman Brothers Holdings. Then, suppose something unfortunate happened, like a massive selloff in the stock of those companies. Now, I bet the folks with bonds issued by those companies might pay considerably more than you did for those contracts.

Think of it this way. You, Vinnie, and a few other associates buy a term life policy with reassignable benefits on the old guy that runs the corner newsstand. A few days later, something unfortunate happens when a delivery truck smashes through the newsstand and puts the old guy in the hospital. Being as he is not expected to live, you approach the old guy's wife and offer to reassign the insurance policy to her in exchange for a modest fee, say 80% of face value. Hey, accidents happen.
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Old 09-20-2008, 12:48 PM   #5
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Think of it this way. You, Vinnie, and a few other associates buy a term life policy with reassignable benefits on the old guy that runs the corner newsstand. A few days later, something unfortunate happens when a delivery truck smashes through the newsstand and puts the old guy in the hospital. Being as he is not expected to live, you approach the old guy's wife and offer to reassign the insurance policy to her in exchange for a modest fee, say 80% of face value. Hey, accidents happen.
Same could be said for equity puts.
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Old 09-20-2008, 01:30 PM   #6
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Same could be said for equity puts.
Yup. Visibility of call and put positions is much better than that of CDS contracts, though. That helps.

Earlier this year, I noticed a large position in Oct 125 puts being opened up. I found that curious, as I had seen something similar a year ago in April 2008 contracts. Being a cautious person, and as I was already planning on selling my AAPL stock, I unloaded the last of it then, rather than wait for an unfortunate accident to befall the stock.
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Old 09-20-2008, 04:04 PM   #7
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"Derivatives, such as credit default swaps also create major distortions in the traditional indicators of value of stock and bond markets. Many people wonder, for example, why the indices, like the DJIA, S&P500, etc., seem to go up endlessly. Part of the reason is that big institutional investors no longer sell companies they feel are about to fail, no matter how obvious that impending failure may be. The securities, issued by such companies, may retain significant paper value, up until almost the very end. Instead of selling, investors can buy "insurance", in the form of derivatives, and keep holding their investments. This distorts the value of traditional market indices, because the decision to remove a failing company from the index, can be made well before the paper value drops to zero. This saves the value of the index. It creates the false impression that the index always rises. "
This is wrong on several fronts. The most glaring problem is the idea that an institutional investor can simply buy default insurance on a company "no matter how obvious an impending failure may be." The price of a CDS contract will reflect the "obvious impending failure" and be prohibitively expensive. Would you be willing to sell default protection on a company that was facing "obvious impending failure"? Well neither would other investors, without adequate compensation. Also, CDS trades impact the market prices of cash bonds they are designed to protect, and vice-versa. If they didn't, arbitrage profits would be available.
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Old 09-20-2008, 05:05 PM   #8
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Outstanding CDS on an issuer often, indeed usually, exceeds the total face amount of bonds they've issued. There's no particular reason they need to be linked.

In theory, half the people on this board could insure the other half against my house burning down. One house gets burned down, several hundred people collect against the loss. Same with an issuer defaulting. You don't need to own the bond to buy a CDS.
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Old 09-20-2008, 05:17 PM   #9
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Outstanding CDS on an issuer often, indeed usually, exceeds the total face amount of bonds they've issued. There's no particular reason they need to be linked.
That is the part many people missed in all this. The CDS pyramid.
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Old 09-20-2008, 08:14 PM   #10
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That is the part many people missed in all this. The CDS pyramid.
Except its not a pyramid . . . one buyer one seller, one short one long, perfectly symmetrical, every transaction. Just like calls and puts. The major difference is that people are more familiar with them so they don't ascribe all manner of nefarious characteristics to vanilla options.
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Old 09-21-2008, 02:19 AM   #11
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Except its not a pyramid . . . one buyer one seller, one short one long, perfectly symmetrical, every transaction. Just like calls and puts. The major difference is that people are more familiar with them so they don't ascribe all manner of nefarious characteristics to vanilla options.
Wouldn't it be a wonderful to mount a bear raid though? You would have to find a candidate that you thought had underpriced protection available. Buy it; then naked short hell out of the underlying.

The leverage is so astounding, and I think it is much harder to trace the contracts than with traded options, and much easier to be stealthy.

Ha
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Old 09-21-2008, 11:00 AM   #12
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Wouldn't it be a wonderful to mount a bear raid though? You would have to find a candidate that you thought had underpriced protection available. Buy it; then naked short hell out of the underlying.

The leverage is so astounding, and I think it is much harder to trace the contracts than with traded options, and much easier to be stealthy.

Ha
It happens, only the underlying in this case tends to be very illiquid, difficult to borrow (not a problem if you're going naked), and often times even more difficult to buy back. Also broker dealers have the option of saying "no bid", which makes pounding them into the ground a little difficult unless they are already circling the drain and everyone else is running for the exits too.
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Old 09-21-2008, 11:41 AM   #13
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"The most glaring problem is the idea that an institutional investor can simply buy default insurance on a company "no matter how obvious an impending failure may be."" Yrs to Go


But of course that is not what the report said at all. You re-worded that.The report recounts a situation in which the institutional investor already has protection and "no longer sell companies they feel are about to fail". That is a quite different matter.

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Old 09-21-2008, 12:28 PM   #14
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But of course that is not what the report said at all. You re-worded that.The report recounts a situation in which the institutional investor already has protection and "no longer sell companies they feel are about to fail". That is a quite different matter.

b.
I didn't interpret the quote the same way you did (and after reading it again, I still don't) but no matter. Even using your interpretation you have to assume that speculators don't rush to try to sell a security that is "obviously facing impending failure" . . . this is simply not true.

And besides, why wouldn't an institutional investor in the position you describe still sell the bonds and leave the short CDS position in place?
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False Impressions
Old 09-21-2008, 02:29 PM   #15
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False Impressions

Yrs To Go

I think the point is that we are now learning that traders were manipulating the swaps to give the false impression that the swap prices were reflecting a problem with the bonds themselves.

These same traders had already shorted the bonds.

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Old 09-21-2008, 07:49 PM   #16
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Yrs To Go

I think the point is that we are now learning that traders were manipulating the swaps to give the false impression that the swap prices were reflecting a problem with the bonds themselves.

These same traders had already shorted the bonds.

b.
Ummmm, didn't you say that the problem was that the swaps allowed bond prices to remain too high even when institutional investors knew the underlying was going to default? In your example the investor owned both the bonds and CDS protection and, therefore, had no incentive to sell the underlying (presumably resulting in overpriced bonds). Now I'm to believe that we've somehow "learned" that traders were manipulating swaps to give the impression that the bonds had problems, when apparently they did not . . . I'm sorry but I'm not really following you.

Perhaps a real life example would help.
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