Finally, a Clear Explanation of Credit Derivatives

2 posts / 0 new
Last post
Finally, a Clear Explanation of Credit Derivatives




"In layman’s terms the CDS is essentially an unregulated insurance policy."

I've been asking for an explanation like this for about 18 months.

So, the Mortgage Backed Security (MBS) is a bundle of mortgages, typically 1000. The credit default swap (CDS), a fancy way of saying, insurance, without the insurer having to have any reserves beyond their firm's credit rating.

As far as how many of these things were bought and sold, i see 2 ranges of numbers. $45-$62 trillion in some articles, $400 trillion in others. I am unable to reach the authors who use the bigger numbers. Plus, if i'm going to worry, i'd rather 'worry accurately'. Contemplating $45 to $62 trillion worth of business contracts (in the process of defaulting) is enough.

As one financial writer pointed out, some of the numbers used to describe derivatives are for the total amount ever written, some of the contracts have expired.

Anyway, call it about $50 trillion. How much of that is mortgage-backed securities (losses on MBS were estimated in a Bloomberg article in the range of $1.2 & 1.6 trillion). So that's LOSSES, what's the total amount ? That's not a number that occurs often in print.

So, $50 trillion in credit derivatives outstanding, a combination of MBS', CDS', and "other".

As far as the lack of transparency - why CAN'T we get the numbers ? Enron-style accounting. it's un-regulated. That it is so difficult to get a clear statement of the total amount of credit derivatives, broken down by category, is not a coincidence. A hedge fund is not a publicly held corporation, you can't look at them bleeding red ink as easy as a Yahoo finance income statement for GM.

However, by and large the hedge funds have not been bleeding red ink. The average salary of the top 30 hedge fund managers (ranked by salary) for $2007 - $500 million.

Now, if a hedge fund sold this kind of insurance and is $2 trillion in the hole - so what ? Shy should we care ?

Well, the events of 2008. It affects public companies, like where we keep our checking account. If you can't pay your rent because your landlord's bank can't collect on checks from your bank, that's what's been happening. The letters of credit that accompany shipping containers at port areas like Long Beach, have been coming up against more and more, "we don't accept letters of credit from that bank". So the cargo sits on the dock until the matter gets resolved.

The drop in the stock markets, is part of the public face of it.

Final Question - so what i would like to know is, to what extent is the liability associated with derivates, has that liability been assumed by the government, when they take on the "toxic" mortgage backed securities ? Remember, they're not taking on the good stuff. they're taking on the bad stuff.

- - - - - - - - - - - - - - - - - - - - - - - - -

"A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" makes periodic payments to the "seller" in exchange for the right to a payoff if there is a default[3] or credit event in respect of a third party or "reference entity".

In the event of default in the reference entity:
the buyer typically delivers the defaulted asset to the seller for a payment of the par value. This is known as "physical settlement".
Or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation. This is known as "cash settlement".

While little known to most individual investors, credit default swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults -- a buyer doesn't necessarily have to own a bond to buy the credit default swap that insures it. When traders buy swap protection, they're speculating a loan or bond will fail; when they sell swaps, they're betting that a borrower's ability to pay will improve.

Banks and other institutions have used credit default swaps to cover the risk of default in mortgage and other debt securities they hold.

CDSs are financial devices that allow banks to spread the risk of default and enable hedge funds to efficiently speculate on the creditworthiness of countries (governments), companies or consumers. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle. This practice has the potential to put investors into webs of relationships which are not transparent.

In layman’s terms the CDS is essentially an unregulated insurance policy.[7] It guarantees the performance of a security instrument , e.g., a mortgage. The buyer of the CDS pays the maker a fee or “premium” (think insurance) for protection against a loss. Historically the US Treasury has not classified derivatives as “insurance,” and therefore they trade free of any government regulations. Because of that, the firm selling the CDS is not required to set aside any reserves from the premiums received to insure against possible future loss claims. This obviously makes the sale of the Credit Default Swaps extremely profitable and default loss payments very expensive.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements."

- - - - - - - - - - - - - - - - - - - - - - - - -

another decent explanation, concentrates more on mortgage geometry

[ 19 October 2008: Message edited by: SwimmingLee ]

[ 19 October 2008: Message edited by: SwimmingLee ]