tag:blogger.com,1999:blog-14963913.post3715078099948483605..comments2023-10-27T20:27:57.900-04:00Comments on Kid Dynamite's World: Abstract Thoughts on CDS and the Fallacy of Insuring Your Neighbor's HouseKid Dynamitehttp://www.blogger.com/profile/17475987512856310577noreply@blogger.comBlogger28125tag:blogger.com,1999:blog-14963913.post-79688342981247454532009-11-11T18:51:14.639-05:002009-11-11T18:51:14.639-05:00claps a does a happy dance about the educated comm...claps a does a happy dance about the educated comments and developing logical thought. Here's a few more to add..why wasnt GS allowed to fail when it profited from the demise of AIG from whom it had bought protection from? Let's re-open that old wound shall we? The mere writing of insurance at the wrong price (via a scheme orginated way back when by JPM) meant that the poker players at GS actually went to the tax payer for money, off table and not even in the casino. What's to stop a company overprotecting itself and buying bunches of protection on its own paper and then burying the market by issuing stupid amounts? Similarly, whilst intellectually I agree that betting on horses does not affect the outcome of a horse race, there are plenty of instances where crime affects the outcome of a horse race when the stakes get so high... anyway..i may be be illegally posting, im a little under the influence (beer)..is there a law against that, like there is for securities trading when drunk?hooligannoreply@blogger.comtag:blogger.com,1999:blog-14963913.post-44860555973954489882009-11-11T17:09:24.562-05:002009-11-11T17:09:24.562-05:00Kid-
Love this discussion. Great post.
I don...Kid-<br /><br />Love this discussion. Great post.<br /><br />I don't think this throws a stick into the spokes of your argument, but you may need to make some amendments before you formally submit your proposal to the big shots at the treasury you've been meeting with ;) <br /><br />Let's recall the ingenious Amherst Holdings CDS trade.<br /><br />In March 2009, Amherst owned a bond with only $29 million ($335 face) of the loans left outstanding, but half were delinquent or in default.<br /><br />Essentially, this bond looked like it was going to experience an event of default and trigger the referent CDS.<br /><br />Amherst, however, wrote, to use your phrase, a metric ass-ton of CDS against the bond and collected premiums that were in sum greater than the loan balances left on the bond. No ones knows the exact amount because nobody tracks the outstanding interest like the do on exchanges. The likes of JPM, BAC, and GS were the ones who purchased the CDS in what appeared to be an "easy-money" trade but of course... Amherst used the collected premiums to pay off the outstanding loan balances (only $27M now) on the bonds.<br /><br />With the bonds made whole, the banks were left holding worthless CDS and Amherst with a monster profit (an undisclosed amount). <br /><br />Obviously, this trade poses problems for CDS to continue trading over the counter, where nobody has a clue as to the outstanding notional value of CDS written against any bond. The first step to dealing with the ostensible "problem" with CDS, therefore, has to be a move to have them traded on an exchange. Only on an exchange could your proposal begin to have policy traction and CDS could be monitored as "reflections" of a companies health (hopefully, they'll replace the rating agencies). Right now, prices are captured by groups like Markit which both capture the CDS market data and make several CDS markets - which has obviously been a problem.Munchausenhttps://www.blogger.com/profile/13649181174784191812noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-21859372310883221432009-11-11T09:55:04.472-05:002009-11-11T09:55:04.472-05:00Dan - you're right - creditors actually don...Dan - you're right - creditors actually don't owe anything to debtors - but I didn't want to get into that argument. And in reality, although the sellers can "get burned" for overselling 5x the notional, what actually happened earlier this year was that the firm who oversold the CDS gamed the settlement auction by overpaying for the debt - so they took a loss on the debt (they overpaid) but as a result didn't have to pay out on the massive CDS they had written - in other words, they have exactly the OPPOSITE incentive as the CDS buyer does!Kid Dynamitehttps://www.blogger.com/profile/17475987512856310577noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-12846467602400949432009-11-11T09:40:55.886-05:002009-11-11T09:40:55.886-05:00Wait a second...
You're treating the CDS pric...Wait a second...<br /><br />You're treating the CDS price (of 1% in this case) as an after thought. Keeping it fixed is a huge factor and not just some "throw-in" assumption for the hypothetical.<br /><br />Beyond that--What's the going rate on a CDS for 5X the underlying loan for a healthy, normally functioning company? If it's 1%, of the notional purchased...then its highly doubtful that this CDS Purchaser/Underlying Creditor can lawfully affect the future health of the debtor. The debtor is relatively sound, no? <br /><br />[Like the homeowner who has a good job, lives below his means and owes 100k to BofA. How is BofA going to affect the financial future financial health of this borrower?] <br /><br />If the debtor's condition deteriorates, then yes, JoeHedgeFund can influence its future health, but that CDS for 5X the loan will also cost a lot more than 1%. <br /><br />The only way the danger of this "Perverse Incentive" manifests itself is if debtor's situation deteriorates--so rapidly between CDS premium payments--that JoeHedgeFund stands to get a windfall of $500 million on a premium he bought 8 months ago for 1%. <br /><br />Also, you state that most of the problems with respect to CDS lie with the the Sellers, as opposed to the buyers...<br /><br />OK, fair enough...but in your perverse incentive situation, it's the Sellers who are getting burned (ie punished) for making the poor decision to sell 5X loan at 1% to the Creditor. So what? [As long as we don't bail them out!]<br /><br />And finally...throughout this crisis there seems to be this sentiment that creditors owe a duty to debtors to make concessions when debtors cannot pay...be it on mortgage loans or the JoeHedgeFund example. You don't quite come out and say this...but it approaches the line of being implied. <br /><br />Creditors don't owe such a duty to debtors. [Unless Creditor was bailed out...then it's the Creditor's Creditor who may impose this duty.] <br /><br />The "Perverse Incentive" issue is not really problem that requires legislation. Yes, there are exceptions, but these can be dealt with through specific litigation as opposed to general legislation. <br /><br />The problem with CDS Players is that we pretend that they are sophisticated capital allocators (hate the phrase)...as opposed to being what they are: Hardcore Gamblers.<br /><br />These CDS players are like Pascal and Fermat, employing the newfound "Théorie des Probabilités" at a 17th Century Parisian Casino with bankroll straight from the Sun King (and levered an additional 50X courtesy of the Medicis)....<br /><br />Pascal has a wad of cash in one hand and a freaky French babe in another...he's wickedly drunk and has the vague recall of The Kingdom of God and a wager, one he liked to call "Pascals' Wager" (he goes third person when loaded)...<br /><br />He's not sure about all this (heavily accented) "decadence"...and he just wants to go home.<br /><br />But Fermat will have none of it! "Dude, you are so money..and you don't even know it! C'mon, let's go back to the table. We'll use this new "System" I came up with last night...it's called the Martingale. It is soooo de toute beauté! If we lose, we'll just double up on the next bet and we'll get our money back and then some. We can't lose!"<br /><br />Until they do.....Dan Duncanhttps://www.blogger.com/profile/16111192506419528406noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-18313272912404263812009-11-10T22:32:43.980-05:002009-11-10T22:32:43.980-05:00On additional thought: you use the example of buyi...On additional thought: you use the example of buying fire insurance on your neighbor's house and claim to have a financial interest in maintaining his property value to support yours. However, I would argue that you have created a moral hazard. Suppose you put your house on the market and sign a contract for sale. Now you can commit arson and collect on your neighbor. At the same time, what's to stop me from obtaining fire insurance on a home development project in the next subdivision over from me? My interest now is to slow the introduction of new supply to support my property value.<br /><br />My point is that while you can cite credible, realistic rationales for the option of insuring a non-interest assest, I believe that the creation of moral hazard is unjustifiable.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-14963913.post-55427122679003592462009-11-09T16:54:31.580-05:002009-11-09T16:54:31.580-05:00Like buying $100 worth of insurance on a $25 bet i...Like buying $100 worth of insurance on a $25 bet in Blackjack?<br /><br />The payoff seems to be greater.<br /><br />Sorry KD if I'm mixing analogies here but your posts have gotten me more interested in finance.Anonymoushttps://www.blogger.com/profile/18069654181152145893noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-57806371632977417162009-11-09T15:50:05.730-05:002009-11-09T15:50:05.730-05:00Mike - yes, but these are the very same institutio...Mike - yes, but these are the very same institutions who NEED to hedge via CDS because of their massive counterparty exposure.<br /><br />to prevent the chicanery you mentioned, we can easily add a second rule to Kid Dynamite's CDS Rules For Buyers that limits the amount of notional CDS exposure any one purchaser can buy - kinda like you have to disclose stock purchases ones you amass a certain stake...Kid Dynamitehttps://www.blogger.com/profile/17475987512856310577noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-44337976662585778262009-11-09T14:25:19.577-05:002009-11-09T14:25:19.577-05:00KD, one problem with your argument is that it appe...KD, one problem with your argument is that it appears that you're assuming that the corporations themselves aren't investing in CDS - at least in the case of RMBS/mortgage related industry we know that this was/is happening. <br /><br />So, <b>third party</b> CDS investors with zero ties to the entity they're betting against may not be able to effect any kind of change in the corp. for their financial benefit. But the corps. investing in CDS (or shorting) <b>themselves</b> most certainly can either directly, or through the use of subsidiaries.Mike Dillonhttp://www.getdshirtz.comnoreply@blogger.comtag:blogger.com,1999:blog-14963913.post-80036128160641506902009-11-09T13:04:52.986-05:002009-11-09T13:04:52.986-05:00thanks - i didn't realize they'd changed i...thanks - i didn't realize they'd changed it... must have been in the wake of Perry's actions with the Mylan Labs - King Pharma merger several years ago - that was the case i was thinking ofKid Dynamitehttps://www.blogger.com/profile/17475987512856310577noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-48964976497176845562009-11-09T12:17:21.538-05:002009-11-09T12:17:21.538-05:00@Kid - the SEC's Rule 14e-4 does take into con...@Kid - the SEC's Rule 14e-4 does take into consideration long put and short call positions when determining whether one is net long for tendering purposes.Unknownhttps://www.blogger.com/profile/04791501039072419077noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-9416300085594760802009-11-09T11:29:58.342-05:002009-11-09T11:29:58.342-05:00@cchilton - although, there is a problem with the ...@cchilton - although, there is a problem with the equity short tender rules - as we saw them exploited, just like the long bonds, long more CDS problem: we had the case where a hedge fund was long shares of stock, and had it hedged via puts or short calls, so that they had no economic risk, and yet still had voting rights...Kid Dynamitehttps://www.blogger.com/profile/17475987512856310577noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-14986713288744566592009-11-09T11:25:28.934-05:002009-11-09T11:25:28.934-05:00@cchilton - excellent idea. i like it. of course, ...@cchilton - excellent idea. i like it. of course, it will require all sorts of disclosures in terms of who owns what (i don't think those holdings are clear right now) - but i love the theoryKid Dynamitehttps://www.blogger.com/profile/17475987512856310577noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-81501712284870190582009-11-09T11:14:40.144-05:002009-11-09T11:14:40.144-05:00Why not apply the "short tender" rules c...Why not apply the "short tender" rules concept. The SEC has short tender rules that limit one's ability to participate in a common stock tender only to the extent one is net long the stock. Why not apply similar rules with CDS in the event of restructurings: a CDS holder would only have a seat at the table in a debt restructuring in proportion to their net long debt position. In other words if one holds more CDS than underlying debt you'd have no say.Unknownhttps://www.blogger.com/profile/04791501039072419077noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-43552522537015268352009-11-09T09:24:20.632-05:002009-11-09T09:24:20.632-05:00Taylor, that is a possible answer, although it can...Taylor, that is a possible answer, although it can create problems, because i'm adamant that there are many perfectly legitimate cases where someone might need to buy CDS even though he doesn't own the underlying debt (see: counterparty exposure above). at the same time, it seems reasonable to want to allow anyone who owns the debt to buy CDS - thus, it seems reasonable that we can utilitze more CDS notional than there are underlying debt notional outstanding<br /><br />ps - i don't think i said CDS are generally underpriced - i said that looking back we can see that they underestimated the probability of default. so - i guess, yeah - they WERE underpriced, not ARE underpricedKid Dynamitehttps://www.blogger.com/profile/17475987512856310577noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-85326594636764054702009-11-09T09:20:58.037-05:002009-11-09T09:20:58.037-05:00(Sorry for the double post)
Limiting CDSs outstan...(Sorry for the double post)<br /><br />Limiting CDSs outstanding to bonds outstanding would also help in finding correct pricing for the CDSs. You say they are generally under priced, the limitation would force buyers and sellers to correctly gauge the risk of default and price the security accordingly.Taylorhttps://www.blogger.com/profile/07713988433215125181noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-53912174520513415952009-11-09T09:14:37.604-05:002009-11-09T09:14:37.604-05:00Why not just say there can be no more CDS protecti...Why not just say there can be no more CDS protection than there are bonds. (If there is 500mm debt outstanding, there can only be 500mm of CDS outstanding), no matter who owns them?Taylorhttps://www.blogger.com/profile/07713988433215125181noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-79765746610603336882009-11-09T03:14:46.188-05:002009-11-09T03:14:46.188-05:00"It's actually simple, and it's actua...<i>"It's actually simple, and it's actually only one rule: SINCE a debtholder can effect the future health of a company, IF you own debt in a company, you cannot own CDS notional greater than your debt position. Following logically from that, if you own CDS in a company, you cannot buy debt in the company unless the notional value of the debt is at least at large as the notional value of the CDS."</i><br /><br />Gross or net notional? I assume you mean net CDS protection purchased, because otherwise the dealers, who generally run matched books, wouldn't be able to own debt in...well, pretty much any of the standard IG names.<br /><br />Obviously, there are way too many operational hurdles for your proposal to actually work (no offense), but it's an interesting conceptual starting point. I'd like to see the CDS market operate with exchange-like data reporting requirements for a little bit before we commit to reforms along these lines. I'd just rather us not commit to solving perceived problems that are based almost exclusively on anecdotal information, since we're really only gonna get one shot at getting CDS regulation right.Economics of Contempthttps://www.blogger.com/profile/17251622598490403638noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-74117284482237395572009-11-08T22:48:17.700-05:002009-11-08T22:48:17.700-05:00On burning down the house, it is done through comp...On burning down the house, it is done through complicity of investment bank proprietary traders and subsidiary mortgage servicers. Nearly all mortgage servicers to ABX reference entities are owned and controlled by the big players. It is beyond coincidence that every single mortgage servicer to ABX reference entities has been in recent years charged with mortgage servicing fraud, not only in state and federal courts but in FTC and OTS investigations resulting in “cost of doing business” settlements and supervisory agreements. Mortgage servicing fraud is one of the largest financial scams in history second only to credit default swap manipulation in which it is a key insider trading element. What exactly is mortgage servicing fraud? <br />It is the practice of fabricating or manufacturing defaults through numerous tactics such as:<br />1. not posting timely payments or to manipulate the date the payment is received in order to artificially create a late payment.<br />2. applying part of the payment to something other than principal and interest often a 'suspense account' creating a late payment or deficiency.<br />3. not posting or crediting timely payments at all <br />4. force placed insurance: charging homeowner for insurance when they have current policy in place. <br />5. malfeasance with property tax escrow account, paying property taxes late, adding their late penalty to homeowners' account without their knowledge<br />6. multiple charges for BPO's (broker price opinions) that in many instances never occurred such as the infamous BPOs billed at the time Hurricane Katrina was making landfall in the area. <br />The following federal actions concerning 3 servicers to ABX entities should clear up any questions you have on mortgage servicing fraud or predatory mortgage servicing as it is also known or you can simple Google "mortgage servicing fraud".<br />EMC Mortgage Corp. - http://www.ftc.gov/opa/2008/09/emc.shtm<br />Select Portfolio Servicing - http://www.ftc.gov/fairbanks<br />Ocwen Federal Bank - http://files.ots.treas.gov/93606.pdf<br />Mortgage servicing fraud is the incendiary they are burning down houses with. With such a willing accomplice and knowing that short bets are a rigged and sure thing small wonder there are many more CDS outstanding than actual underlying debt that the CDS are supposed to be insuring. Amazing how profitable insider trading can be when you've got your own servicers to do the dirty work and feed servicing data into trading desks. Bloomberg's Mark Pittman has a good read on origin of ABX Index: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aA6YC1xKUoek , though this is only a small piece of the big picture. There is a vast galaxy of single name CDS which can be customized to provide protection against non-performance of highly specific reference obligations permitting "speculators" to identify targets and let subsidiary servicers go to work on them.MutantCapitalismhttps://www.blogger.com/profile/10621739846312879284noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-53656265924532286792009-11-08T20:43:39.952-05:002009-11-08T20:43:39.952-05:00I loved the movie about Sirius XM: "Stock Sho...I loved the movie about Sirius XM: "Stock Shock" because it explains how the whole naked short selling stock market manipulation thing works-and how the company nearly went bankrupt. Good DVD. Amazon has it or stockshockmovie.com has a movie trailer.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-14963913.post-19996388921255590332009-11-08T20:41:21.649-05:002009-11-08T20:41:21.649-05:00i think your theory is sound, but cds (and short s...i think your theory is sound, but cds (and short selling) with regard to financial institutions seems like a special case. any bank or insurance company is, in essence, a confidence game, and cds is an elegant and easy way to trigger a run on a bank.Auddoghttps://www.blogger.com/profile/02798205923569975885noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-51056246171824345112009-11-08T20:13:27.675-05:002009-11-08T20:13:27.675-05:00I like your rule, but I think there needs to be on...I like your rule, but I think there needs to be one more: since CDs is essentially an isurance policy, sellers of CDS should be regulated like the isurance industry to ensure that sellers have sufficient resources to service the possible payouts.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-14963913.post-15746500983651015952009-11-08T16:53:23.684-05:002009-11-08T16:53:23.684-05:00@John - the argument for CDS is that they are (the...@John - the argument for CDS is that they are (theoretically) useful for hedging counterparty exposure: if you are a big manufacturer you might buy CDS on a supplier of yours who makes a key product in your chain, or you might buy CDS on a client who owes you a lot of money. <br /><br />ironically, we had so many years of such good times in the financial world, that the default risk being priced in was super low, and sellers of CDS sold, to use a technical term, a metric ass-ton of CDS. This created a whole new problem when they started to go bad: those who bought CDS on company XYZ from Firm AAA now had counterparty exposure to firm AAA as well! the counterparty risk wasn't eliminated - in fact, it may have been enhanced.<br /><br />that's why the key in regulating CDS is to make sure that the sellers can cover the insurance they are offering.Kid Dynamitehttps://www.blogger.com/profile/17475987512856310577noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-54909683903420531652009-11-08T16:08:11.651-05:002009-11-08T16:08:11.651-05:00also note that i did not address the perverse ince...also note that i did not address the perverse incentive that the sellers of CDS have - which are basically the mirror image of those of the buyers (ie, sellers can oversell CDS, then game the settlement of the contracts during default by overpaying for the debt - this actually happened - but it's a problem that should be cured when we regulate exposures that sellers can accumulate.<br /><br />@faust - thanks for the effect/affect correction. i'll get it wrong again.<br /><br />@RN: although markets are not efficient, they are efficient enough that short sellers do not drive a company's price to zero when the company's stock price should not otherwise be at zero. in other words, stocks go to zero when companies make bad business decisions and are insolvent - not because short sellers force the price to zero.Kid Dynamitehttps://www.blogger.com/profile/17475987512856310577noreply@blogger.comtag:blogger.com,1999:blog-14963913.post-11406709463964404162009-11-08T15:42:29.598-05:002009-11-08T15:42:29.598-05:00KD said: "people who blame short sellers for ...KD said: "people who blame short sellers for the demise of companies are generally nutjobs: short sellers cannot and do not effect the health of a company."<br /><br />Someone wanna teach this arrogant nutjob Business 101?<br /><br />Pushing down a company's stock price can directly increase its cost of capital.RNnoreply@blogger.comtag:blogger.com,1999:blog-14963913.post-31678177269892878822009-11-08T14:44:57.800-05:002009-11-08T14:44:57.800-05:00I would expect Goldman to load the debt on an expe...I would expect Goldman to load the debt on an expendable barge helmed by friends-of-goldman, then go purchase the $500M CDS. When the company goes down, the barge sinks too, and Goldman gets their winnings. If the company doesn't go down, the barge is eventually put to other similar uses.<br /><br />In other words, I don't believe for a single second that there aren't a multitude of ways<br />to redefine the method such that the regulation doesn't apply. And if that fails,<br />capture has proven it'll always be available.Anonymousnoreply@blogger.com