http://www.ft.com/cms/s/0/6b1945e6-caf9-11de-97e0-00144feabdc0.html “I think that trying to make safer credit default swaps is like trying to make safer asbestos,” he writes in a recent letter to investors, adding that CDSs create “large, correlated and asymmetrical risks” having “scared the authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets... [more]
http://www.ft.com/cms/s/0/6b1945e6-caf9-11de-97e0-00144feabdc0.html
“I think that trying to make safer credit default swaps is like trying to make safer asbestos,” he writes in a recent letter to investors, adding that CDSs create “large, correlated and asymmetrical risks” having “scared the authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay”.
CDSs are “anti-social”, he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company. This strategy became prevalent in recent years and remains so, as holders of these so-called “basis packages” buy both the debt itself and protection on that debt through CDSs, meaning they receive compensation if the company defaults or restructures. These investors “have an incentive to use their position as bondholders to force bankruptcy, triggering payments on their CDS rather than negotiate out of court restructurings or covenant amendments with their creditors”, Mr Einhorn says.
His remarks are particularly interesting as he belonged to the club of hedge fund managers who attracted the wrath of such senior executives as Dick Fuld of Lehman Brothers and John Mack of Morgan Stanley, whose companies were targets of CDS trades.
Mr Einhorn is not alone in expressing concerns over CDSs. Similar reservations are being shared by a growing number of responsible players, including prominent bankruptcy lawyers, as credit insurance plays a role in more Chapter 11 filings, such as AbitibiBowater, General Growth Properties and Six Flags.
That said, most measures contemplated today are trying to make CDSs safer, not seeking to eliminate them altogether. For example, among the biggest risks in the CDS market is that a counterparty won’t be able to pay out on a CDS agreement which normally comes into force when the target company files for Chapter 11.
That risk can be doubly dangerous with the possibility that the target of the insurance and the counterparty backing the CDS both get downgraded or default.
Such a possibility is more than theoretical, especially after the cautionary tale of AIG, which sold more than $440bn in CDSs with no offsetting positions at all. The Federal Reserve had to step in when the toxic assets that AIG sold protection on were downgraded and AIG, the insurance giant itself, was downgraded and unable to post the collateral it owed to counterparties.
Today, a central clearing house is increasingly being embraced “as the best solution to counterparty and liquidity risks”, Matthew Leeming, analyst at Barclays Capital, writes in a recent and thoughtful report, adding: “Centralisation of counterparty risk at least places the market in a situation where it can start to measure the risk and adequately capitalise against it.”
But growing numbers of market participants, along with the more vocal Mr Einhorn, believe that many of the proposed solutions to the risks posed by the market, such as a centralised clearing house, themselves pose further risks.
In his letter, Mr Einhorn disputes the notion that a central clearing house will act as a panacea for the other big problems the market poses including counterparty risk and the risk of contagion or a daisy chain of counterparty failures.
“The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialised risk by moving the counterparty risk from the private sector to a newly created too big to fail entity,” he notes.
That’s because it is almost impossible to adequately capitalise against such developments. “There is no way a clearing house could demand enough collateral,” he says. “The market can be so big and discontinuous that it is very hard to figure out the correct amount of collateral.”
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Response by marco_m
over 16 years ago
Posts: 2481
Member since: Dec 2008
is it the gun or is it the person?
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Response by Riversider
over 16 years ago
Posts: 13572
Member since: Apr 2009
CDS does not mitigate risk, it magnifies it, on a global scale. The volume of bets on a reference obligation can exceed it by multiples. These are side-bets, nothing more.
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Response by marco_m
over 16 years ago
Posts: 2481
Member since: Dec 2008
volume doesnt matter since everything gets cash settled. go back to sleep
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Response by liquidpaper
over 16 years ago
Posts: 309
Member since: Jan 2009
The notion of allowing CDS w/out ownership in the underlying asset is - in my opinion - dangerous. CDS as a genuine form of protection against asset devaluation seems to me to be legit. But obviously, this isn't the way things have played out is it - a la John Paulson who was able to - quite within the law as written - make some +/-$10mn a day for an extended period of time.
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Response by marco_m
over 16 years ago
Posts: 2481
Member since: Dec 2008
so if you own a put, do you have to own the stock ?
For the world's largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives -- yet that same business may eventually destroy JPM.
The key thing for the public and the Congress to understand is that the "profits" earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy.
Apart from the fact that CDS seems to increase the overall risk in the financial system by multiplying the actual legs of risk and, of course, the opportunities for gain and loss associated with a given cash basis – bonds, collateralized debt obligations, or any reference asset – the practical problems with CDS contracts come from several basic flaws in the regulatory, legal and business model for these instruments, deliberate flaws that include:
•
An archaic, bilateral clearing scheme that has only recently begun to be reformed,
•
A deliberate lack of standardization and price transparency that advantages the CDS dealer,
•
No common central counterparty to guarantee all trades and to hold collateral, and thus no effective limit on dealer leverage, and
•
A schizophrenic pricing methodology that has little connection to the several different types of underlying market and credit risk contained in CDS contracts
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Response by liquidpaper
over 16 years ago
Posts: 309
Member since: Jan 2009
marco_m: I assume u were asking me that question above. I am pragmatic not idealistic about this. If puts had the same leverage attached to them and disruptive ability my answer would be yes. But because they don't my answer is no. For me it is not about establishing a rule for the sake of the rule, it's about understanding the implications of CDS, and then crafting regulation in the best way to minimize unintended consequences.
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Response by w67thstreet
over 16 years ago
Posts: 9003
Member since: Dec 2008
WTF? Seriously if CDS were so great, why don't you and I marco start a mortgage lending business. We'd just have a signature loan program and then we'd just off load the risk by buying a CDS on our company.
What a f'n great idea!!!!!! Ooooops. Isn't that how we got into this mess.
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Response by Rhino86
over 16 years ago
Posts: 4925
Member since: Sep 2006
CDS is fine...unless the operation is housed at an institution that is deemed too big to fail. At that point its private gain with socialized loss. The other problem is that its technically just a way to take risk and skirt capital requirements. If it were just hedge funds trading this shit around then it wouldnt matter...oh wait unless the hedge fund got too big to fail, like Long Term.... Yeah CDS is a problem.
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Response by Riversider
over 16 years ago
Posts: 13572
Member since: Apr 2009
CDS reminds me a little of the portfolio insurance of 1987. Everyone thought they had a strategy that mitigated risk ,yet when everyone did it, the whole thing failed. With CDS firms can engage in the riskiest of strategies believing they have offloaded the risk, and yet counter-parties fail. Before you saw the risk, so you watched it, with CDS you're not really sure where it is....
Even worse Goldman created CDO'S called ABACUS in which client's weren't customers but counter-parties taking the credit risk Goldman didn't want on cmbs, rmbs and such. It's hard to see how this benefits the economy.
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Response by Riversider
over 16 years ago
Posts: 13572
Member since: Apr 2009
The other problem with CDS is there's no transparency. The 13 dealers have a great deal more information than the customers. It's like going to a casino and thinking you have a 50/50 shot.
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Response by marco_m
over 16 years ago
Posts: 2481
Member since: Dec 2008
we mock what we dont understand
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Response by liquidpaper
over 16 years ago
Posts: 309
Member since: Jan 2009
speak for yourself. i try to mock everything.
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Response by Riversider
over 16 years ago
Posts: 13572
Member since: Apr 2009
we mock what we dont understand
We support what pays out salary.
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Response by positivecarry
over 16 years ago
Posts: 704
Member since: Oct 2008
There's a pretty disturbing chart on the notional value of CDS relative to the world economy on boombustblog.com too lazy to find it.
is it the gun or is it the person?
CDS does not mitigate risk, it magnifies it, on a global scale. The volume of bets on a reference obligation can exceed it by multiples. These are side-bets, nothing more.
volume doesnt matter since everything gets cash settled. go back to sleep
The notion of allowing CDS w/out ownership in the underlying asset is - in my opinion - dangerous. CDS as a genuine form of protection against asset devaluation seems to me to be legit. But obviously, this isn't the way things have played out is it - a la John Paulson who was able to - quite within the law as written - make some +/-$10mn a day for an extended period of time.
so if you own a put, do you have to own the stock ?
http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=360
For the world's largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives -- yet that same business may eventually destroy JPM.
The key thing for the public and the Congress to understand is that the "profits" earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy.
http://www.rcwhalen.com/pdf/cds_aei.pdf
Apart from the fact that CDS seems to increase the overall risk in the financial system by multiplying the actual legs of risk and, of course, the opportunities for gain and loss associated with a given cash basis – bonds, collateralized debt obligations, or any reference asset – the practical problems with CDS contracts come from several basic flaws in the regulatory, legal and business model for these instruments, deliberate flaws that include:
•
An archaic, bilateral clearing scheme that has only recently begun to be reformed,
•
A deliberate lack of standardization and price transparency that advantages the CDS dealer,
•
No common central counterparty to guarantee all trades and to hold collateral, and thus no effective limit on dealer leverage, and
•
A schizophrenic pricing methodology that has little connection to the several different types of underlying market and credit risk contained in CDS contracts
marco_m: I assume u were asking me that question above. I am pragmatic not idealistic about this. If puts had the same leverage attached to them and disruptive ability my answer would be yes. But because they don't my answer is no. For me it is not about establishing a rule for the sake of the rule, it's about understanding the implications of CDS, and then crafting regulation in the best way to minimize unintended consequences.
WTF? Seriously if CDS were so great, why don't you and I marco start a mortgage lending business. We'd just have a signature loan program and then we'd just off load the risk by buying a CDS on our company.
What a f'n great idea!!!!!! Ooooops. Isn't that how we got into this mess.
CDS is fine...unless the operation is housed at an institution that is deemed too big to fail. At that point its private gain with socialized loss. The other problem is that its technically just a way to take risk and skirt capital requirements. If it were just hedge funds trading this shit around then it wouldnt matter...oh wait unless the hedge fund got too big to fail, like Long Term.... Yeah CDS is a problem.
CDS reminds me a little of the portfolio insurance of 1987. Everyone thought they had a strategy that mitigated risk ,yet when everyone did it, the whole thing failed. With CDS firms can engage in the riskiest of strategies believing they have offloaded the risk, and yet counter-parties fail. Before you saw the risk, so you watched it, with CDS you're not really sure where it is....
Even worse Goldman created CDO'S called ABACUS in which client's weren't customers but counter-parties taking the credit risk Goldman didn't want on cmbs, rmbs and such. It's hard to see how this benefits the economy.
The other problem with CDS is there's no transparency. The 13 dealers have a great deal more information than the customers. It's like going to a casino and thinking you have a 50/50 shot.
we mock what we dont understand
speak for yourself. i try to mock everything.
we mock what we dont understand
We support what pays out salary.
There's a pretty disturbing chart on the notional value of CDS relative to the world economy on boombustblog.com too lazy to find it.
bottom line is that cds are here to stay.