Derivatives Plan Leaves Open Question of ‘Naked’ Default Swaps

geochem1st

V.I.P. Member
Joined
Mar 21, 2008
Messages
27,748
Reaction score
40,930
"Credit-default swaps do “perform a useful function” in the economy, Frank said in a July 23 interview on Bloomberg Television. There may be “alternatives to banning naked credit- default swaps” if most derivatives are moved to a regulated exchange, he said.

“If we can get rules where almost every derivative is traded on an exchange, and those that aren’t because they are just too unique” are backed by extra capital, he said, “then that may do it.”

**Barney Frank is clueless. :rolleyes: Without the banning of Naked CDS's it's back to buisiness as usual. Naked CDS's is how Wall Street turned into Las Vegas or Atlantic City. I can take out a bet that your house will burn down, and get the insurance payout if it does, without having to own your house or have an vested interest in it.


" Underlying Debt

Credit-default swaps are derivatives that were created primarily to protect lenders and bondholders from company defaults. A short position is an investment in which the trader tries to profit by betting a stock price will fall. Naked contracts or positions are those in which the buyer doesn’t own the underlying asset or stock on which the trading is based.

As much as 80 percent of the $26.4 trillion credit-default swap market is traded by investors who don’t own the underlying debt, according to Eric Dinallo, who stepped down this month as superintendent of the New York State Insurance Department.

Derivatives are contracts used to hedge against changes in stocks, bonds, currencies, commodities, interest rates and weather. "

Derivatives Plan Leaves Open Question of ?Naked? Default Swaps - Bloomberg.com
 

Brian Butler

Senior Member
Joined
Dec 18, 2008
Messages
1,469
Reaction score
32
"Credit-default swaps do “perform a useful function” in the economy, Frank said in a July 23 interview on Bloomberg Television. There may be “alternatives to banning naked credit- default swaps” if most derivatives are moved to a regulated exchange, he said.

“If we can get rules where almost every derivative is traded on an exchange, and those that aren’t because they are just too unique” are backed by extra capital, he said, “then that may do it.”

**Barney Frank is clueless. :rolleyes: Without the banning of Naked CDS's it's back to buisiness as usual. Naked CDS's is how Wall Street turned into Las Vegas or Atlantic City. I can take out a bet that your house will burn down, and get the insurance payout if it does, without having to own your house or have an vested interest in it.


" Underlying Debt

Credit-default swaps are derivatives that were created primarily to protect lenders and bondholders from company defaults. A short position is an investment in which the trader tries to profit by betting a stock price will fall. Naked contracts or positions are those in which the buyer doesn’t own the underlying asset or stock on which the trading is based.

As much as 80 percent of the $26.4 trillion credit-default swap market is traded by investors who don’t own the underlying debt, according to Eric Dinallo, who stepped down this month as superintendent of the New York State Insurance Department.

Derivatives are contracts used to hedge against changes in stocks, bonds, currencies, commodities, interest rates and weather. "

Derivatives Plan Leaves Open Question of ?Naked? Default Swaps - Bloomberg.com

I have a feeling that this post describes exactly what went wrong with the economy, and that the use of too much credit and the existence of money-making schemes that deal only with virtual things and not real ones, needs to be stopped.

Unfortunately, the language of this post is above my head and outside of the area in which I can conjure up enough interest to study the concepts and definitions necessary to understand what Geo- obviously knows. Therefore, I really wish someone could explain this post and similar material in 50 simple words or less. :) Excuse my ignorance.
 

SKATTERBRANE

Banned
Joined
Nov 26, 2008
Messages
21,430
Reaction score
12,391
I would vote for Geo to be the Treasury Secretary, but not so sure about the "Global Warming Czar."
 

PraXis

V.I.P. Member
Joined
Dec 14, 2007
Messages
24,931
Reaction score
24,451
[ame=http://www.youtube.com/watch?v=-CT6HIDPbPc]YouTube - "Banking Queen" by Congressman Barney Frank[/ame]
 

VictorB

Nothing left to do but smile, smile, smile
Super Mod
V.I.P. Member
Joined
May 31, 2007
Messages
50,164
Reaction score
167,844
fail-owned-wheel-fail.jpg
 

geochem1st

V.I.P. Member
Joined
Mar 21, 2008
Messages
27,748
Reaction score
40,930
I have a feeling that this post describes exactly what went wrong with the economy, and that the use of too much credit and the existence of money-making schemes that deal only with virtual things and not real ones, needs to be stopped.

Unfortunately, the language of this post is above my head and outside of the area in which I can conjure up enough interest to study the concepts and definitions necessary to understand what Geo- obviously knows. Therefore, I really wish someone could explain this post and similar material in 50 simple words or less. :) Excuse my ignorance.

Can't do it in under 50 words or less but a story sometimes helps :)

A simple understanding of the Credit Default Swaps (derivatives special case) will follow after this post.

A Simple Explanation of the Derivatives Markets

Heidi is the proprietor of a bar in Detroit. In order to increase sales, she decides to allow her loyal customers -- most of whom are unemployed alcoholics -- to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi's drink now pay later marketing strategy and as a result, increasing numbers of customers flood into Heidi's bar and soon she has the largest sale volume for any bar in Detroit.

By providing her customers' freedom from immediate payment demands, Heidi gets no resistance when she substantially increases her prices for wine and beer, the most consumed beverages. Her sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes these customer debts as valuable future assets and increases Heidi's borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral.

At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then traded on security markets worldwide. Sold and resold over and over, each time for more money. (leveraging)

Naive investors don't really understand the securities being sold to them as 'AAA' rated secured bonds are really the debts of unemployed alcoholics. Nevertheless, their prices continuously climb, and the securities become the top-selling items for some of the nation's leading brokerage houses who collect enormous fees on their sales, pay extravagant bonuses to their sales force, and who in turn purchase exotic sports cars and multimillion dollar condominiums.

One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due his negativity), decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar.

Heidi demands payment from her alcoholic patrons, but being unemployed they cannot pay back their drinking debts. Therefore, Heidi cannot fulfill her loan obligations and claims bankruptcy. DRINKBOND and ALKIBOND drop in price by 90%. PUKEBOND performs better, stabilizing in price after dropping by 80%. The decreased bond asset value destroys the banks liquidity and prevents it from issuing new loans.

The suppliers of Heidi's bar, having granted her generous payment extensions and having invested in the securities are faced with writing off her debt and losing over 80% on her bonds. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 50 workers.

The bank and brokerage houses are saved by the Government following dramatic round-the-clock negotiations by leaders from both political parties. The funds required for this bailout are obtained by a tax levied on employed middle-class non-drinkers.
 

geochem1st

V.I.P. Member
Joined
Mar 21, 2008
Messages
27,748
Reaction score
40,930
Just what exactly is a Credit Default Swap?


The explanation is quite simple. Let’s say I buy a a PUKEBOND from Heidis Bar. I bought this bond because I think Heidi will make money and be able to pay me back with interest. However, there is still some risk that Heidi will default and the PUKEBOND will be worthless. If I spent a great deal of money on this bond I may not want to take the risk that I will be left with nothing so I decide to buy insurance just in case Heidi goes bankrupt.

I call up Bank 'CDS's R US' and ask them if they will sell me insurance against Heidis PUKEBOND. Bank 'CDS's R US' might decide it’s worth the risk and tell me they will insure it for a 2% premium. Now if I bought a $1 million bond then I have to pay $20,000/year to Bank 'CDS's R US' for insurance against that PUKEBOND. However, if Heidi goes bankrupt then I can still collect my $1 million from Bank 'CDS's R US'. This insurance purchase is called a Credit Default Swap (CDS).

At this point it’s no different than fire insurance on your house. You pay your premium and if your house burns down then you collect your money from the insurer. Obviously this seems like a fairly reasonable way to do business. But there’s a catch. Unlike fire insurance, I don’t have to actually own the the house in order to insure it. I can by insurance on Joes house down the block.(this is known as a 'naked' CDS). Pretty crazy? It gets worse.

In this example if I think Heidi is going down the tubes I can buy insurance against Heidis PUKEBONDS from Bank 'CDS's R US' even if I don’t actually own the bond. This is pure speculation and Bank 'CDS's R US' is no longer insuring against real assets - they are offering up pieces of paper (derivatives) that could potentially cost them many times over the bond’s face value.

But why is this such a problem you say? If Bank 'CDS's R US' is offering insurance they must certainly have some level of reserves to pay in case people start making claims against them right? Well therein lies part of the problem. The CDS market is completely unregulated and Bank 'CDS's R US' is not required to have a certain percentage of reserves before issuing their insurance. It would be similar to an insurance company selling vast amounts of fire insurance with no way to actually pay people back in the event of a loss.

To make the problem worse, Bank 'CDS's R US' not only sells the insurance but also is out buying insurance from other banks in order to hedge their risk. So here’s the real problem in our financial market, if I bought insurance against Heidis Bar I am counting on Bank 'CDS's R US' to pay up in the event of a default. In other words, I am transferring my risk from Heidi to Bank 'CDS's R US'.

And since Bank 'CDS's R US' also bought some insurance themselves they are counting on Bank 'We Suck More' to pay up if necessary. And this chain reaction goes on and on until every bank is somewhat interdependent on every other bank in the CDS market all of it stemming form a bond that I don't own. If Bank 'CDS's R US' (or 'We Suck More' or any other bank) defaults on their insurance then I won’t get my money. And since I probably was selling insurance as well, and I was counting on my Bank 'CDS's R US' money, I won’t be able to pay off my insurance either. And the problem amplifies until a vast number of the banks in this market are completely wiped out. And remember there are no underlying assets that are worth anything because I didn’t actually have to own the bond to get insurance against it - these are simply pieces of paper being bought and sold. And this is how Heidis Bar claiming bankruptcy is able to take down the Global Financial System.

So when you hear the term credit crunch - this is what they are talking about. Nobody is lending money because they fear they may need the cash to pay out on some of this insurance they sold. Or if they only bought the insurance they are worried that their insurance company will default and never actually pay them on their claim. And nobody knows who is in the most trouble because this insurance isn’t bought and sold on the open market. These transactions are literally made via phone calls and e-mail.

This CDS problem is exactly why the government keeps pumping money into AIG. They were a big player selling this insurance and they don’t have the money to pay up now that claims are coming in. And the government is worried that if AIG defaults then everyone else who was counting on them to pay up will have to default as well.

So why aren’t some of the smaller banks and credit unions having the same problems? Well, they weren’t in business of buying and selling this insurance. And since they don’t have to worry about who will and won’t be paying them back they don’t have to horde their cash - that’s why many of these smaller institutions still have a lot of money to lend.
 

Latest Threads



Top