Wall Streets Worst Invention Ever

geochem1st

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When it Comes to Naming Wall Street’s Worst Invention Ever, Credit Default Swaps Continue to Fill the Bill
By Martin Hutchinson
Contributing Editor
Money Morning

When it comes to naming a winner in the competition for “the worst product ever invented by Wall Street,” there is quite a list of worthy candidates. With just the current financial crisis alone there are such “inventions” as subprime mortgages, auction rate preferred stock and asset-backed commercial paper, which all have a good claim to this title.

There’s also the credit default swap (CDS).

While credit default swaps remain in second place to subprime mortgages in terms of total losses caused, there are plenty of reasons to crown these derivative securities as Wall Street’s worst offenders ever.

It won’t take me long to make my case. In fact, for “Exhibit A,” let’s just look at the collapse of U.S. insurance giant American International Group Inc. (AIG).

Misguided Missile

On Monday, the government announced that the already-hard-pressed U.S. taxpayer is being forced to put another $30 billion into AIG, bringing the total rescue package, thus far, to $180 billion.

For those with short memories, by far the largest portion of AIG’s losses has come in the $50 trillion credit default swap market, which was instituted only in 1995. Other Wall Street products have caused huge losses, but have spent decades growing before they did so, producing sober profits for many years before blowing up.

[Just yesterday (Tuesday), in fact, U.S. Federal Reserve Chairman Ben S. Bernanke verbally ripped AIG - saying the insurer operated like a hedge fund, while stating that having to rescue the insurer made him "more angry" than any other episode during the financial crisis - because of how its mishandling of credit default swaps led to the company's implosion.]

It is increasingly clear that CDS’s have produced profits only for the dealing community, and only for a few years. Even by Wall Street’s abominable standards, they thus have a rightful claim to be considered the worst financial “product” ever invented.

The bottom line: The credit risk spawned by the CDS market is much larger than the credit risk of loans on which CDS are written.

It’s no longer a question of hedging. It’s casino capitalism.

Inside View From an Insider

Back in the early days of the derivatives market, I spent five years running my employer’s derivatives desk: It was very simple stuff - mostly small transactions - and while we made money, the trades didn’t make either us or our employers rich.

However, we were always on the lookout for something new, because you can make good money on new types of transactions - without taking big risks. Needless to say, we looked at the possibilities of credit derivatives, for which there was an obvious need among the major international banks.

But there were two problems:

First, there was no obvious way of settling the things - each bankruptcy is unique, and the generally happen gradually, so it was difficult to determine how much to pay and when to pay it.
And second, the cash flows involved were totally skewed - a small annual payment versus the possibility of a huge payout on bankruptcy - so the amount of credit risk you’d build up between the two sides made the whole business uneconomic if you allocated risk correctly.
By the middle 1990s, the capital markets were so exuberant that dealers didn’t bother to solve those problems - they just ignored them. A $50 trillion credit derivatives market means there is $50 trillion of credit exposure on the dealer community, and no amount of collateral arrangements and fancy accounting can eliminate that fact. As for settlement, the dealers came up with an ingenious, but very un-foolproof scheme, whereby a mini-auction of the bankrupt credit would take place, so by buying a million or two in dodgy bonds you could corrupt the pricing of billions in credit default swaps that you held.

There are two other problems with credit default swaps CDS we didn’t think of in the 1980s.

First, AIG stayed almost entirely on one side of the CDS market - selling credit protection - because it believed it could do so, book the premiums up-front as income, collect bonuses based on the total premiums each year and never account for the risks on the actual derivative contracts themselves. After all, the swaps were being AAA-rated mortgage backed bonds.

(It would never have occurred to us in the 1980s that we could do this - we weren’t sufficiently in control of our auditors!).

From the point of view of AIG, the company, this was extremely stupid, though it had its advantages from the traders’ point of view. In the end, of course, it was all of us - the U.S. taxpayers - who were stuck paying the tab for a meal that others got to eat.

However, the second - and most serious - problem with credit default swaps is their potential use by short-sellers to cause bankruptcies.

Short-Sighted, Short-Selling

Short-selling of shares was banned for several weeks after the Lehman bankruptcy, the reality is that neither short share sales nor share put options offer anything like the potential of credit default swaps to profit from a bankruptcy - particularly the bankruptcy of a financial institution whose debt is several times its share capital. Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM), for example, each have around $1 billion in short positions outstanding in their shares. In the traded options market, Citigroup has a nominal $1.4 billion worth of put options outstanding while JP Morgan Chase has $2.1 billion - the cash value of those contracts will be a fraction of those figures.

What’s more, there are undisclosed amounts of over-the-counter equity options written between dealers. However, the volumes of credit default swaps were recently $65.7 billion on Citigroup and $62.4 billion on JPMorgan.

Now think about the arithmetic. To sell a share short, you risk all your capital - there’s no limit on how high a share of stock can rise. To buy puts, you deal only in a small market, and most puts are short-dated, so you would have to act quickly. With a CDS, however, you pay only an annual premium that is a small fraction of the principal amount involved, you acquire an asset that typically lasts several years, and you can deal in a market of over $60 billion - enough potential profit for even the greediest hedge fund.

Thus, credit default swaps make causing a “run” on a bank or investment bank enticingly profitable, with a profit potential that far outweighs the cost of undertaking the operation. Because the CDS market is much larger than the market for stock options - or even the share markets themselves - the product is a standing temptation to bad guys, and a danger to the banking system.

While there are a few CDS securities that genuinely hedge credit risk, almost all of them have no such benefit: They are gambling contracts, pure and simple.

For the taxpayer to bail out the victims with self-inflicted CDS wounds is as ludicrous as asking us to bail out the Las Vegas casinos.

But don’t laugh - that may well happen, yet.

Credit Default Swaps: A $50 Trillion Problem
 

Scooter2112

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Agreed.

And all the more reason to avoid (rather than encourage) irresponsible lending in the first place. (The solution to pollution is dilution). :rolleyes:

Ponder this, Geo... Would CDS have worked if more stringent lending laws had been in place? If all the greedy rich bastards cared about was money, would they purposely hand out risky mortgage loans unless they had a reason to do so?
 

Tuxedo Kaz

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As in depth as this article was (thanks for posting), what made me most amused was the phrase "misguided missile". If ever there was a summation of the economy, Wall Street, and Corporate America, that's it.
 

geochem1st

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Agreed.

And all the more reason to avoid (rather than encourage) irresponsible lending in the first place. (The solution to pollution is dilution). :rolleyes:

Ponder this, Geo... Would CDS have worked if more stringent lending laws had been in place? If all the greedy rich bastards cared about was money, would they purposely hand out risky mortgage loans unless they had a reason to do so?

CDS's do not work at all in a down market, period. Thats the fallacy here. There will always be a down market somewhere, that is capitalism.

The greedy bastards just cared about money. They did purposely hand out risky mortgages, and the reason why is that they were not responsible for the risk once the loans were sold, so they had no incentive not to crank out mortgages.

"Alan Greenspan says he is in a "state of shocked disbelief" that the concept of self-interest did not protect the banks from taking excessive risks and destroying themselves. But he, along with Tim Geithner and many others, are missing the fundamental flaw in the system. The bankers don't care about the banks; they care about the bankers."
 

geochem1st

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FT.com / Markets / Investor's notebook - Insight: Credit default swaps and amplified losses

Insight: Credit default swaps and amplified losses

By Satyajit Das
Published: March 4 2009 16:26 | Last updated: March 4 2009 16:26


At the quantum level, the laws of classical physics alter in intriguing ways. At the derivative level, the rules of finance also operate differently.

In October 2008, Alan Greenspan, acknowledged he was “partially” wrong to oppose regulation of CDS. “Credit default swaps, I think, have serious problems associated with them,” he admitted to a Congressional hearing.

CDS contracts on Freddie Mac and Fannie Mae were “technically” triggered as a result of the conservatorship necessitating settlement of around $500bn in CDS contracts with losses totalling $25bn-$40bn. Government actions were specifically designed to allow the companies to continue to fully honour their obligations. The triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default.

Practical restrictions on settling CDS contracts has forced the use of “protocols” – where the seller makes a payment to the buyer of protection to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through an “auction” system.

For Freddie and Fannie, the auction prices resulted in the following settlements by sellers of protection: Fannie – about 8.49 per cent for senior debt and 0.01 per cent for subordinated debt. Freddie – about 6 per cent for senior debt and 2 per cent for subordinated debt.

Subordinated debt ranks behind senior debt and is expected to suffer larger losses in bankruptcy. The lower pay-out on subordinated debt probably resulted from subordinated protection buyers suffering in a short squeeze, resulting in their contracts expiring virtually worthless. Differences in the pay-outs are also puzzling given that they are both under identical “conservatorship” arrangements.

In other CDS settlements in 2008 and 2009, the pay-outs required from sellers of protection have been highly variable and large relative to historical default loss statistics. This is driven by technical issues related to the CDS market. The auction settlement of Lyondell (around 80-85 per cent) reflected complications from the role of debtor in possession financing and complex collateral allocation mechanisms.

Skewed pay-outs do not assist confidence in CDS contracts as a mechanism for hedging. The large pay-outs are placing a material pressure on the price of existing bonds and loans exacerbating broader credit problems.

Low overall net settlement amounts may also be misleading. In practice, there is the “real” settlement where genuine hedgers and investors deliver bonds under the physical settlement rules and the “auction” where dealers who have both bought and sold protection and have small net positions settled via the auction.

In the case of Lehman, the net settlement figure of $6bn that was quoted refers to the auction. Some banks and investors that had sold protection on Lehmans did not participate in the auction choosing to take delivery of defaulted Lehman debt resulting in losses of almost the entire face value. CDS contracts can amplify losses in credit markets.

Lehman Brothers defaulted with around $600bn in debt implying a maximum loss to creditors of that amount. In addition, according to market estimates, there were CDS contracts of around $400bn-$500bn where Lehmans was the reference entity. Market estimates suggest only about $150bn of the CDS contracts were hedges. The remaining $250bn-$350bn of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200bn-$300bn) are additional to the $600bn.

The CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by up to 50 per cent.

Ludwig von Mises, the Austrian economist, said: “It may be expedient for a man to heat the stove with his furniture; but he should not delude himself by believing that he has discovered a wonderful new method of heating.”

As the global economy slows and the risk of corporate default increases, the identified issues are likely to complicate the problems of credit markets and banks generally. Most worryingly, recent proposals to regulate CDS markets show limited awareness of these issues.
 

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