Fannie Downgraded; Another Debacle: The CDS Credit Default Swap Market
Pots call Kettles Black... Goldman Sachs cut its Q1 earnings estimates on several investment banks & brokerages.
The firm also downgraded Fannie Mae, Freddie Mac and Washington Mutual to Sell from Neutral.
Splitting the Monolines... Fleck comments on how splitting the monolines will just create a pink elephant in the room; and points us towards an excellent analysis of
The CDS problem and the Credit Default Swap market.
Add CDS to the growing list of problems which will dwarf subprime; MBS mortgage backed securities; LBO leveraged buyout;
SBB stock buy back; ABCP asset backed commercial paper; muni auction term bonds and CDO credit default obligations.
Much like the illusory and fraudulent oil futures market, in which speculators have driven the price of crude over $100.
How? In 2004 alone, Futures contracts called for 212 times the actual global annual production on Brent crude.
In other words, production and actual deliverable product was exceeded by 212 times in speculative contracts.
Since 2000, the market for CDS has grown from $900 billion to $45 Trillion in contracts, twice the size of the entire US stock market.
The underlying bonds which these CDS contracts insure are worth $5.7 Trillion, for a ratio of almost 8 to 1.
Putting this into perspective, the whole US Treasury market is $4.4 Trillion, for a ratio of almost 10 to 1.
In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to
pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default.
It gets better... Whats it worth? companies use the CDS contracts for their original purpose, hedging or insurance against bad debt.
Since there is no exchange where these insurance contracts trade, and their prices are not reported to the public....how are the contracts valued?
Answer: Guesstimates from computer models or mark to fantasy, rather than mark to market Oh boy!!! That means...
Financial statements could be inaccurately reflecting a companies value...
a bank that has bought protection to cover its corporate bond exposure thinks it is hedged
and therefore does not write off paper losses it may incur on those bond holdings.
If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.
Since the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds
whose defaults the swaps were created to protect against, problems arise in the event of a default.
Actual defaulted bonds must be delivered to settle the contract. Since the number of bonds actually available is fewer than the contracts sold,
the defaulted bonds can get bid up in value by buyers of credit insurance scrambling to buy the bonds.
Further distorting the value of the contracts and the actual end loss per bond. So bottom line,
NOBODY really knows what these CDS contracts are worth on the books or in a truly open market.
It gets better... Who's On 1st? These instruments can be sold, on either end of the contract, by the insurer or the insured.
This means that the insurer can sell the contract to party C, who can sell it to party D, who can sell it to... party Z... you get the picture?
Your home hurricane insurance policy gets sold, your home gets destroyed by a hurricane,
you can't collect until you find the holder of your policy, and maybe, they can't even afford to pay your claims.
In August, 14% of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction
was unidentified in trade documents and remained unknown 30 days later.
It gets better... I'll betcha... I'm a big hedge fund, and I want to bet against a companys chances of sucess....
Prior to CDS, that play would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.
With CDS I can bet for or against the players with relative ease, raising the possibility
that undercapitalized participants could have trouble paying their obligations.
Who might have trouble? Around 30% of the contracts were written against indexes representing baskets of debt from numerous issuers.
Roughly 33% of the credit default swaps provided insurance against a default by a specific corporate debt issuer in 2006.
At the end of Q307, the top 25 banks held credit default swaps, both as insurers and insured,
worth $14 trillion and 16% of all CDS contracts were created to protect holders of CDO collateralized debt obligations.
Citibank is the leading holder of MBS backed CDO,
but in the CDS market; JPMorgan Chase, with $7.8 trillion, is the largest player;
Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.
The firm also downgraded Fannie Mae, Freddie Mac and Washington Mutual to Sell from Neutral.
Splitting the Monolines... Fleck comments on how splitting the monolines will just create a pink elephant in the room; and points us towards an excellent analysis of
The CDS problem and the Credit Default Swap market.
Add CDS to the growing list of problems which will dwarf subprime; MBS mortgage backed securities; LBO leveraged buyout;
SBB stock buy back; ABCP asset backed commercial paper; muni auction term bonds and CDO credit default obligations.
Much like the illusory and fraudulent oil futures market, in which speculators have driven the price of crude over $100.
How? In 2004 alone, Futures contracts called for 212 times the actual global annual production on Brent crude.
In other words, production and actual deliverable product was exceeded by 212 times in speculative contracts.
Since 2000, the market for CDS has grown from $900 billion to $45 Trillion in contracts, twice the size of the entire US stock market.
The underlying bonds which these CDS contracts insure are worth $5.7 Trillion, for a ratio of almost 8 to 1.
Putting this into perspective, the whole US Treasury market is $4.4 Trillion, for a ratio of almost 10 to 1.
In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to
pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default.
It gets better... Whats it worth? companies use the CDS contracts for their original purpose, hedging or insurance against bad debt.
Since there is no exchange where these insurance contracts trade, and their prices are not reported to the public....how are the contracts valued?
Answer: Guesstimates from computer models or mark to fantasy, rather than mark to market Oh boy!!! That means...
Financial statements could be inaccurately reflecting a companies value...
a bank that has bought protection to cover its corporate bond exposure thinks it is hedged
and therefore does not write off paper losses it may incur on those bond holdings.
If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.
Since the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds
whose defaults the swaps were created to protect against, problems arise in the event of a default.
Actual defaulted bonds must be delivered to settle the contract. Since the number of bonds actually available is fewer than the contracts sold,
the defaulted bonds can get bid up in value by buyers of credit insurance scrambling to buy the bonds.
Further distorting the value of the contracts and the actual end loss per bond. So bottom line,
NOBODY really knows what these CDS contracts are worth on the books or in a truly open market.
It gets better... Who's On 1st? These instruments can be sold, on either end of the contract, by the insurer or the insured.
This means that the insurer can sell the contract to party C, who can sell it to party D, who can sell it to... party Z... you get the picture?
Your home hurricane insurance policy gets sold, your home gets destroyed by a hurricane,
you can't collect until you find the holder of your policy, and maybe, they can't even afford to pay your claims.
In August, 14% of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction
was unidentified in trade documents and remained unknown 30 days later.
It gets better... I'll betcha... I'm a big hedge fund, and I want to bet against a companys chances of sucess....
Prior to CDS, that play would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.
With CDS I can bet for or against the players with relative ease, raising the possibility
that undercapitalized participants could have trouble paying their obligations.
Who might have trouble? Around 30% of the contracts were written against indexes representing baskets of debt from numerous issuers.
Roughly 33% of the credit default swaps provided insurance against a default by a specific corporate debt issuer in 2006.
At the end of Q307, the top 25 banks held credit default swaps, both as insurers and insured,
worth $14 trillion and 16% of all CDS contracts were created to protect holders of CDO collateralized debt obligations.
Citibank is the leading holder of MBS backed CDO,
but in the CDS market; JPMorgan Chase, with $7.8 trillion, is the largest player;
Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.
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