"Skepticism about the Business Fixed Investment Handoff."
Where did this handoff theory/fantasy originate? I have XM in my car and I've heard it intermittently from the pump and dump crew on CNBC, but nobody ever said why it would happen, only that it would happen or that they hoped it would happen. Did it ever have any factual basis?
Equity funds trading credit derivatives seen risky Many equity funds are inexperienced with credit derivatives and may be using the securities in inappropriate ways, Hennessee said ...
Equity funds have been purchasing protection on corporate debt, sub-prime mortgage-backed fixed income securities and indices...
The notional amount of credit derivatives outstanding grew 52 percent in the first six months of 2006 to $26 trillion, from $17.1 trillion at the end of 2005...
As I look at that chart, it seems that the recessions happened whenever non-residential went down about a year after residential investment. But there are so many things about our current political situation that seem like a replay of 1974, which the chart shows was the beginning of a deep recession.
Is history about to repeat itself in a 1974 redux?
The argument has been that retained earnings (aka "cash") is the readiest form of finance for investment. No bankers or investors to worry with. With the capacity use rate up, cash high and growth steady, the argument was that the fundamentals support an increase in capital spending. Since capital spending tends to grow much faster than GDP in the best periods, the prospect was for a very big lift from capital spending. It is probably no coincidence, through, that capital spending has cooled along with GDP, since they are coincident. Sorry.
I don't know why a capital spending boom was held forth with such conviction in an expansion that was the smoothest on record. There should have been no secret about capital needs, since there was never a growth surprise. Richard Fisher's favorite assertion, that our capital base is now the entire globe, also argues against a boom in capital spending. Anecdotally, I have the impression that a fair share of recent capital demand has been for energy saving equipment and trucks. Not the sort of spending that leads to greater production.
dr strangemoney, are you as puzzled as I am by these people buying a CDS to hedge a security? I keep getting told it's the secretive hedge funds that are buying the residuals, not the "respectable" equity funds. How can anybody afford additional credit insurance on a senior tranche? Don't we have to conclude that either the CDS pricing is absurd or the original credit enhancement of the security is absurd or both? Or that these "respectable" funds are in fact buying more junk tranches than we thought?
Yes, the relationship between residential and nonresidential appears very strong and consistent. Someone with access to the raw data should determine the time lag in nonresidential that give the highest correlation coefficient. That's difficult to see on the time scale of this graph. Is the delay between residential and nonresidential about 9-15 months? If that's true, nonresidential should start heading down early next year(?)
Could someone with access to the raw data do some smoothing? I see lots of instances of -25% followed by +50% and such.
My calibrated eyeball tells me residential spending has a time horizon of 1 quarter and non-res 3 quarters with both responding to similar instantaneous circumstance but with different timeframes.
k harris - I understand those arguments about why a spending boom could or should take place (though there are counterarguments that there is still a lot of extra capacity left over from the tech boom, or that companies don't see anywhere to invest and that is why they have so much cash and are buying back stock at record rates, or that all investment is taking place elsewhere in the "dollar zone", meaning China). I'm just wondering if there was ever a datapoint or survey that indicated there would be a boom. My hunch is that the predicted boom was always either hope or spin by/from the market pumpers.
Thankyou Tanta for that grounding remark.
It's not like the Fire Dept investing in more hoses or increasing the Life Insurance of its members or even adding an astrologer to its forces to get a jump on those fires simmering away already in that other world just waiting to break out on certain proprietary dates.
No, it's like the arsonist in a very crowded market needing to clear the air and find something, (maybe these fire hoses!), anything to light the next fire before the competition beats him to it...or worse, uses those fire hoses against him.
Hedge funds it seems to me are more at the mercy of other hedge funds than they are about unfortunate fluctuations that arise in the general market place. These funds constitute a size that is no longer innocent in shaping those fluctuations.
the data right now is mixed. my company is aggressively spending cash for acquisitions and to improve worn capital. no we're not going crazy draining the bank but the spigots are more open then they have been in a while. i think 2007 will show some clearer direction.
Here's a question about CDSs I haven't been able to answer: what will happen when a bond crashes and CDSs have been written to 500% of the bonds? I have read that most CDSs require that the defaulted bonds be turned over on payment by the writer of the CDS.
I have read that when Delphi went bust, their were something like $10B in CDSs written on $1B in bonds. Somehow, therough the intervention of some derivatives association, the problem was resolved through some sort of auction(?). That doesn't seem like much of a solution....
As to the question of capital spending, it appears that it is not high on the priority list of corporate America. In the first half of the year more than 80% of net income for S&P 500 firms was returned to shareholders in the form of either share repurchase or dividends. S&P has not released the figures for the third quarter, but it is likly share repurchase continued at a high rate (i.e. over $100 billion, a level that was spend in each of the last 3 quarters). I saw that Exxon alone spend $8.6B on repurchases in the third quarter.
It is interesting that the implied volatility of the chart has decelerated significantly in the last 40yrs, the swings are much less violent, perhaps this is due to the efficiency of the previous Fed regimes in providing a modicum of maturity and perspective to there work. (credit where credit is due). However, perhaps that recent stability has created the platform for future instability....
Bob, I absolutely cannot wrap my mind around that part. I come from the non-rocket science mortgage bidness, where whatever transaction is going on--making a home loan, hedging a pipeline with an overnight Ginnie repo, whatever--I don't part with my money until I have evidence that the borrower has title to the collateral and both the right and the ability to convey it to me first if necessary. So when I am confronted with CDS trades at 10X multiples of the face value of the bonds, I'm Dorothy in Oz. I have to assume that nobody actually wants to take the impaired asset in the event of default, which would imply that the goal in those "auctions" is to be the one who doesn't win--like the financial equivalent of bleeding trump. Or else it means that the holder of the derivative of the derivative of the derivative has more optimism about credit performance than I do trading a loan my own company originated. I may need to take another Benadryl, but I'm still not sure it'll make sense afterwards.
Perhaps someone with more sophistication than I've got can explain this one to us.
Maybe I am just a layperson, but lets assume that there are 10 'insurance' policies on my car and if I crash, one pays off upon 'delivery' of the totaled car. The other 9 do not. It appears to me then, that one company is very unlucky and the others are very lucky in getting to keep the premiums without paying.
Lets assume that I write a CDS with x% risk, if 10 other folks write simular CDSes then my profit margin goes up with a unanticipated reduction of risk. I've gotten x% risk premium for a risk that has just now become x%/10 risk in reality.
OK, vader, but I'm still confused. You aren't paying 10 different sets of premiums on your car for 10 policies. You're paying one set of premiums to the contractual insurer, who will have to pony up for the entire loss should you mistake the front door of the local bank for the drive through lane (and go ahead, it's OK by me). If the contractual insurer creates a derivative of your original policy and sells it for a discount, each increase in "coverage" results in more dilution of premium. So somebody at the 10th position receives a tiny premium in return for the likelihood of never having to take over the junk car. But the original insurer has to take it, even though it has diluted its premium. So we can safely assume that your auto insurer is either insane or is ripping you off in premiums, right?
So I get back to my original question: if I own a subprime mortgage security, which has x yield over y credit support, why am I paying enough for additional default insurance (putting a set of suspenders on the supposed belt) that there's enough for 10 derivatives? Either I have to believe that the credit support built into the security is a joke, and my yield is at much more credit risk (not duration risk) than it ought to be, or I'm giving up so much yield in buying additional insurance that I could just buy a damn low-yield low-risk Fannie Mae MBS instead and skip the grief.
I'm sorry, but this all just sounds to me like too many people in too many conference rooms looking at too many powerpoints prepared by too many consultants agreeing to spend too much money hedging risk that shouldn't be there.
Yeah, dc1000, I can see it from that side. I just can't see it from the perspective of the premium payer. I'm buying expensive insurance from a counterparty who is going to discount its premium, the process continues through x iterations, and none of it actually increases my coverage since I only need one party to take the bond off my hands in the event of default. So my original counterparty is reducing its financial strength--which I rely on for it to be able to deliver on the contractual terms--and my risk premium is feeding 10 players downstream who provide no additional coverage to me. Why am I doing this?
I was looking at it from the best view point I could. I was also looking at it from the viewpoint of the seller of insurance not the buyer.
Lets look at from the viewpoint of the buyers. Me I want to protect myself against the financial loss of my car, my wife who does not trust me to buy insurance buys another policy, my kid knowing my driving record buys a policy in the hope that he can sell the policy at a later time for a profit. The bank buys one just in case I let mine lapse. So in this case, you have 4 buyers each buying for their own reason, only one of whom can collect. With perfect knowledge, there would only be one policy written, after all only one will collect. But without the knowledge that the same incident is covered by other parties, the urge to buy is rational.
In the Delphi case, it is apparent that some were writing them for the income and others were buying for other reasons all ignorant of the fact that there were 10x of the things out there. What happened in the Delphi case was that those who owned a Delphi CDS bid up the defauling bonds in order to 'cash in' on his CDS. Others made cash settlements.
It is hard to understand what happened in the Delphi case assuming that folks had the knowledge of the 10x over sell, but it is apparent that they did not or did not care.
I made a assumption that may be in error, that the premiums for the CDOs remained the same and did not increase because so many of them were on the market. The real risk here is that a fund would sell the CDO at 1/10 of the actual risk premium and those be exposed not to a potential free profit but a much greater loss due to insufficent fees to justify the risk.
It is hard to say what the 10x insurance means. The guy that buys 10 of the suckers to cover 10 sets of his bonds might be in competation for the few sellers that are liquid enough to pay off and then be in a competation against those buying junk bonds and presenting it to those few viable sellers.
Tanta, I could be wrong here but aren't most CDS trades cash settled? The other 9 transactions are just people betting (like Las Vegas) The sellers (probable short term winners/ long term losers) are pocketing the premiums which enhance current earnings or fund performance.(Good bonus this year) The buyers are pure speculators who are willing to take short term losses since they feel they will win big in the long term. (Based on current low prices)
Thinking about credit derivatives makes my head hurtand I get the feeling that goes double or triple for most central bankers, who view them as the nitroglycerine of modern finance, powerful, useful, and highly unstable (and destabilizing). I am less concerned than they about the adverse consequences of the CD market, although the well-documented shoddy back office practices are worrisome. I have not made a detailed study of the implications of CDs for the stability of the financial system, but they are facing one problem that I do know a lot about.
Specifically, some of the recent credit blowups (e.g., Delphi, Calpine) created a situation where the supply of bonds deliverable against credit derivatives contracts was far smaller than the open interest in these contracts. This has caused disruptions in the market, and raised the specter of squeezesand squeezes are my meat.
Heres the basic issue. Many credit derivatives call for the bonds of a bankrupt firm to be delivered to settle the contract. For instance, if I sell default protection against company Xs bonds, if X goes belly up I have to settle my credit derivative position by delivering Xs bonds. Well, what happens when there are $10bn of CDs outstanding, but there are only $1 bn of bonds available to be delivered against them? In the case of Delphi, things were even more extremethe open interest in Delphi CDs totaled $25 billion, but there were only $2 billion of Delphi bonds available for delivery against the CDs in the event of a default. (There is some uncertainty over what goes into this $25 billion. It may be all in single name Delphi credit default swaps. It may include, however, Delphi notionals included in collateralized default obligations and default index swaps, both of which are written on multiple names.)
If the market is competitive, that isnt an issue. It happens in futures markets all the time. It is not unusual for the maximum open interest in a futures contract to exceed the deliverable supply by orders of magnitude. A competitive futures market can liquidate quite nicely under those conditions as long as there isnt too much concentration in long positions. The futures contract will settle at the marginal cost of delivery/marginal value of the deliverable asset with few deliveries being made. (The lack of a centralized market mechanism for trading credit derivatives may make the liquidation process somewhat more cumbersome, but the main parties all have each others phone numbers, so liquidation of a large open interest under competitive conditions still shouldnt be that challenging.)
A consequence of the heavy CDS issuance, explained better in Vader's post is that the low current premiums imply a good chance one or several hedge funds or financial institutions selling CDS will be both heavily levered and unhedged. If defaults spike this would cause a Amarath type collapse. The long term impact of this would be higher yield spreads over Treasuries for junk securities and mortgages
vicjim is right, people make bets on CDSs just like they were options or something. Most of the buyers have no intention of holding the bonds, they are just making a leveraged bet on the direction.People who bought CDSs for subprime-mortgage-backed bonds six months ago have done very well because defaults are up, etc.
Most of the writing of these has been done by hedge funds.
vicjim, your explanation makes sense to me and I had assumed that that was how it worked (at least in the corporate bond side), but the Delphi situation made it sound (with that "auction") as if the other 9 transactions actually involved some theoretical obligation to take the defaulted paper in a physical settlement.
Vader, thanks for the link; that explains the Delphi thing better. I do like the line "shorting credit is expensive," because that was my original point about credit swaps on collateralized securities rather than corporate bonds.
Most financial futures settle for cash, but some don't. Australian bank bill futures (equivilent of Eurodollar futures) are physical delivery, and there have been occasional significant squeezes in these contracts when the open interest nearing maturity is too large. With central clearing and documented open interest, physical deliver futures are magnitudes easier to manage than the otc contracts, yet I've seen some messy settlements. Nitro might be an optimistic view of credit derivatives in a stressed environment - more like neutron bombs. At least the buildings housing the ibanks and hedge funds trading these little gems will be left standing. Maybe that will be a good time to buy Manhattan real estate? Hmmm. Maybe not.
I would guess there is a big difference on how the market clears depending on how it is structured.
A->B->C->D Series structure... one debt with many CDS contracts in a chain of transactions.
A->B
A->C
A->D Parallel structure... one debt, many independent CDS contracts tied to one transaction.
A->B
A->C
A->D
B->C
B->D
C->D 'Net-like' structure... one debt, CDS contracts going in all directions.
I can see a series structure clearing somewhat orderly. A parallel structure somewhat messy. The 'net' model could be a disaster.
Does anyone know what the predominant structure is (assuming some of all are present).
Also, for some one to take out a CDS, do they have to have an 'interest'? If they don't have an interest, doe they have to report to the 'interested parties' that they have taken out a stake in the transaction?
Say party A borrows from party B who buys CDS insurance from party C... all now with interest in the original transaction... can party X buy a CDS from Y on the A->B transaction WITHOUT having a direct interest? If so do X & Y have to report this to A & B? Or for that matter, report it to anyone?
Just thinking like a Soprano, you know nothing personal.
I did not see a case of a dirative based off of a cds. So I think the only transactions are the party - counterparty type. Keep in mind that the party does not have to own the debt, just be willing to pay to insure against its demise. They could be hedging or speculating.
On CDS and Delphi; This is a good article on what happened: Delphi Defied
As Anonymous noted, a party doesn't have to own the debt to buy insurance (with Credit Default Swaps).
Example: I own a car and pay insurance every quarter. If the market was like the CDS market, dryfly could also buy insurance on my car and pay every quarter (maybe he thinks I'm a poor risk)!
If I total the car, I give the car to the insurance company and they pay me. But dryfly gets paid for the car too. The problem is he doesn't have a car to give the insurance company - so they have to agree on the value of the wrecked car before they can pay him off.
That is what happened with Delphi. A bunch of people clearly thought the ratings were wrong for Delphi's bonds, and they bought default insurance without owning the bond. When Delphi defaulted, these people were supposed to turn in the bonds - but they didn't have any - so they had to agree on a price before the cash settlement.
"Skepticism about the Business Fixed Investment Handoff."
Where did this handoff theory/fantasy originate? I have XM in my car and I've heard it intermittently from the pump and dump crew on CNBC, but nobody ever said why it would happen, only that it would happen or that they hoped it would happen. Did it ever have any factual basis?
Equity funds trading credit derivatives seen risky
Many equity funds are inexperienced with credit derivatives and may be using the securities in inappropriate ways, Hennessee said ...
Equity funds have been purchasing protection on corporate debt, sub-prime mortgage-backed fixed income securities and indices...
The notional amount of credit derivatives outstanding grew 52 percent in the first six months of 2006 to $26 trillion, from $17.1 trillion at the end of 2005...
Business & Financial News, Breaking US & International News | Reuters.com
Shouldn't be too much longer before derivatives get a good recession testing.
As I look at that chart, it seems that the recessions happened whenever non-residential went down about a year after residential investment. But there are so many things about our current political situation that seem like a replay of 1974, which the chart shows was the beginning of a deep recession.
Is history about to repeat itself in a 1974 redux?
Tom DC,
The argument has been that retained earnings (aka "cash") is the readiest form of finance for investment. No bankers or investors to worry with. With the capacity use rate up, cash high and growth steady, the argument was that the fundamentals support an increase in capital spending. Since capital spending tends to grow much faster than GDP in the best periods, the prospect was for a very big lift from capital spending. It is probably no coincidence, through, that capital spending has cooled along with GDP, since they are coincident. Sorry.
I don't know why a capital spending boom was held forth with such conviction in an expansion that was the smoothest on record. There should have been no secret about capital needs, since there was never a growth surprise. Richard Fisher's favorite assertion, that our capital base is now the entire globe, also argues against a boom in capital spending. Anecdotally, I have the impression that a fair share of recent capital demand has been for energy saving equipment and trucks. Not the sort of spending that leads to greater production.
dr strangemoney, are you as puzzled as I am by these people buying a CDS to hedge a security? I keep getting told it's the secretive hedge funds that are buying the residuals, not the "respectable" equity funds. How can anybody afford additional credit insurance on a senior tranche? Don't we have to conclude that either the CDS pricing is absurd or the original credit enhancement of the security is absurd or both? Or that these "respectable" funds are in fact buying more junk tranches than we thought?
Yes, the relationship between residential and nonresidential appears very strong and consistent. Someone with access to the raw data should determine the time lag in nonresidential that give the highest correlation coefficient. That's difficult to see on the time scale of this graph. Is the delay between residential and nonresidential about 9-15 months? If that's true, nonresidential should start heading down early next year(?)
Could someone with access to the raw data do some smoothing? I see lots of instances of -25% followed by +50% and such.
My calibrated eyeball tells me residential spending has a time horizon of 1 quarter and non-res 3 quarters with both responding to similar instantaneous circumstance but with different timeframes.
Bill, the lag between RI and non-RI with the highest correlation is 3 quarters, followed closely be 4 quarters and then 5 quarters.
YoY RI went negative in Q2 2006, so if non-RI follows the typical pattern, it will go negative sometime between Q1 '07 and Q3 '07.
Best Wishes.
k harris - I understand those arguments about why a spending boom could or should take place (though there are counterarguments that there is still a lot of extra capacity left over from the tech boom, or that companies don't see anywhere to invest and that is why they have so much cash and are buying back stock at record rates, or that all investment is taking place elsewhere in the "dollar zone", meaning China). I'm just wondering if there was ever a datapoint or survey that indicated there would be a boom. My hunch is that the predicted boom was always either hope or spin by/from the market pumpers.
Thankyou Tanta for that grounding remark.
It's not like the Fire Dept investing in more hoses or increasing the Life Insurance of its members or even adding an astrologer to its forces to get a jump on those fires simmering away already in that other world just waiting to break out on certain proprietary dates.
No, it's like the arsonist in a very crowded market needing to clear the air and find something, (maybe these fire hoses!), anything to light the next fire before the competition beats him to it...or worse, uses those fire hoses against him.
Hedge funds it seems to me are more at the mercy of other hedge funds than they are about unfortunate fluctuations that arise in the general market place. These funds constitute a size that is no longer innocent in shaping those fluctuations.
the data right now is mixed. my company is aggressively spending cash for acquisitions and to improve worn capital. no we're not going crazy draining the bank but the spigots are more open then they have been in a while. i think 2007 will show some clearer direction.
Here's a question about CDSs I haven't been able to answer: what will happen when a bond crashes and CDSs have been written to 500% of the bonds? I have read that most CDSs require that the defaulted bonds be turned over on payment by the writer of the CDS.
I have read that when Delphi went bust, their were something like $10B in CDSs written on $1B in bonds. Somehow, therough the intervention of some derivatives association, the problem was resolved through some sort of auction(?). That doesn't seem like much of a solution....
As to the question of capital spending, it appears that it is not high on the priority list of corporate America. In the first half of the year more than 80% of net income for S&P 500 firms was returned to shareholders in the form of either share repurchase or dividends. S&P has not released the figures for the third quarter, but it is likly share repurchase continued at a high rate (i.e. over $100 billion, a level that was spend in each of the last 3 quarters). I saw that Exxon alone spend $8.6B on repurchases in the third quarter.
It is interesting that the implied volatility of the chart has decelerated significantly in the last 40yrs, the swings are much less violent, perhaps this is due to the efficiency of the previous Fed regimes in providing a modicum of maturity and perspective to there work. (credit where credit is due). However, perhaps that recent stability has created the platform for future instability....
Bob, I absolutely cannot wrap my mind around that part. I come from the non-rocket science mortgage bidness, where whatever transaction is going on--making a home loan, hedging a pipeline with an overnight Ginnie repo, whatever--I don't part with my money until I have evidence that the borrower has title to the collateral and both the right and the ability to convey it to me first if necessary. So when I am confronted with CDS trades at 10X multiples of the face value of the bonds, I'm Dorothy in Oz. I have to assume that nobody actually wants to take the impaired asset in the event of default, which would imply that the goal in those "auctions" is to be the one who doesn't win--like the financial equivalent of bleeding trump. Or else it means that the holder of the derivative of the derivative of the derivative has more optimism about credit performance than I do trading a loan my own company originated. I may need to take another Benadryl, but I'm still not sure it'll make sense afterwards.
Perhaps someone with more sophistication than I've got can explain this one to us.
Maybe I am just a layperson, but lets assume that there are 10 'insurance' policies on my car and if I crash, one pays off upon 'delivery' of the totaled car. The other 9 do not. It appears to me then, that one company is very unlucky and the others are very lucky in getting to keep the premiums without paying.
Lets assume that I write a CDS with x% risk, if 10 other folks write simular CDSes then my profit margin goes up with a unanticipated reduction of risk. I've gotten x% risk premium for a risk that has just now become x%/10 risk in reality.
Blah blah blah.... use this to make money. short stocks!!! CAT DE and anything having to do with buisness spending
OK, vader, but I'm still confused. You aren't paying 10 different sets of premiums on your car for 10 policies. You're paying one set of premiums to the contractual insurer, who will have to pony up for the entire loss should you mistake the front door of the local bank for the drive through lane (and go ahead, it's OK by me). If the contractual insurer creates a derivative of your original policy and sells it for a discount, each increase in "coverage" results in more dilution of premium. So somebody at the 10th position receives a tiny premium in return for the likelihood of never having to take over the junk car. But the original insurer has to take it, even though it has diluted its premium. So we can safely assume that your auto insurer is either insane or is ripping you off in premiums, right?
So I get back to my original question: if I own a subprime mortgage security, which has x yield over y credit support, why am I paying enough for additional default insurance (putting a set of suspenders on the supposed belt) that there's enough for 10 derivatives? Either I have to believe that the credit support built into the security is a joke, and my yield is at much more credit risk (not duration risk) than it ought to be, or I'm giving up so much yield in buying additional insurance that I could just buy a damn low-yield low-risk Fannie Mae MBS instead and skip the grief.
I'm sorry, but this all just sounds to me like too many people in too many conference rooms looking at too many powerpoints prepared by too many consultants agreeing to spend too much money hedging risk that shouldn't be there.
tanta - isnt all b/c of leverage? meaning who cares how small a portion of the premium you get if you are levered up from zero to get it?
Yeah, dc1000, I can see it from that side. I just can't see it from the perspective of the premium payer. I'm buying expensive insurance from a counterparty who is going to discount its premium, the process continues through x iterations, and none of it actually increases my coverage since I only need one party to take the bond off my hands in the event of default. So my original counterparty is reducing its financial strength--which I rely on for it to be able to deliver on the contractual terms--and my risk premium is feeding 10 players downstream who provide no additional coverage to me. Why am I doing this?
doesn't having 10 different players involved somehow increase the likelihood you'll get your new car when the tree falls on it?
(personal note, a tree smashed through my roof in 4 different places this last weekend! god bless insurance)
I was looking at it from the best view point I could. I was also looking at it from the viewpoint of the seller of insurance not the buyer.
Lets look at from the viewpoint of the buyers. Me I want to protect myself against the financial loss of my car, my wife who does not trust me to buy insurance buys another policy, my kid knowing my driving record buys a policy in the hope that he can sell the policy at a later time for a profit. The bank buys one just in case I let mine lapse. So in this case, you have 4 buyers each buying for their own reason, only one of whom can collect. With perfect knowledge, there would only be one policy written, after all only one will collect. But without the knowledge that the same incident is covered by other parties, the urge to buy is rational.
In the Delphi case, it is apparent that some were writing them for the income and others were buying for other reasons all ignorant of the fact that there were 10x of the things out there. What happened in the Delphi case was that those who owned a Delphi CDS bid up the defauling bonds in order to 'cash in' on his CDS. Others made cash settlements.
Link
It is hard to understand what happened in the Delphi case assuming that folks had the knowledge of the 10x over sell, but it is apparent that they did not or did not care.
I made a assumption that may be in error, that the premiums for the CDOs remained the same and did not increase because so many of them were on the market. The real risk here is that a fund would sell the CDO at 1/10 of the actual risk premium and those be exposed not to a potential free profit but a much greater loss due to insufficent fees to justify the risk.
OT- Dont know if you saw the loan officer survey from the fed:
http://www.federalreserve.gov/boarddocs/snloansurvey/200610/fullreport.pdf
It was interesting to see that no significant credit tightening for loans was yet seen..
[I meant CDS not CDOs in my previous]
DC1000
It is hard to say what the 10x insurance means. The guy that buys 10 of the suckers to cover 10 sets of his bonds might be in competation for the few sellers that are liquid enough to pay off and then be in a competation against those buying junk bonds and presenting it to those few viable sellers.
Tanta, I could be wrong here but aren't most CDS trades cash settled? The other 9 transactions are just people betting (like Las Vegas) The sellers (probable short term winners/ long term losers) are pocketing the premiums which enhance current earnings or fund performance.(Good bonus this year) The buyers are pure speculators who are willing to take short term losses since they feel they will win big in the long term. (Based on current low prices)
More on the Delphi CDSs
Thinking about credit derivatives makes my head hurtand I get the feeling that goes double or triple for most central bankers, who view them as the nitroglycerine of modern finance, powerful, useful, and highly unstable (and destabilizing). I am less concerned than they about the adverse consequences of the CD market, although the well-documented shoddy back office practices are worrisome. I have not made a detailed study of the implications of CDs for the stability of the financial system, but they are facing one problem that I do know a lot about.
Specifically, some of the recent credit blowups (e.g., Delphi, Calpine) created a situation where the supply of bonds deliverable against credit derivatives contracts was far smaller than the open interest in these contracts. This has caused disruptions in the market, and raised the specter of squeezesand squeezes are my meat.
Heres the basic issue. Many credit derivatives call for the bonds of a bankrupt firm to be delivered to settle the contract. For instance, if I sell default protection against company Xs bonds, if X goes belly up I have to settle my credit derivative position by delivering Xs bonds. Well, what happens when there are $10bn of CDs outstanding, but there are only $1 bn of bonds available to be delivered against them? In the case of Delphi, things were even more extremethe open interest in Delphi CDs totaled $25 billion, but there were only $2 billion of Delphi bonds available for delivery against the CDs in the event of a default. (There is some uncertainty over what goes into this $25 billion. It may be all in single name Delphi credit default swaps. It may include, however, Delphi notionals included in collateralized default obligations and default index swaps, both of which are written on multiple names.)
If the market is competitive, that isnt an issue. It happens in futures markets all the time. It is not unusual for the maximum open interest in a futures contract to exceed the deliverable supply by orders of magnitude. A competitive futures market can liquidate quite nicely under those conditions as long as there isnt too much concentration in long positions. The futures contract will settle at the marginal cost of delivery/marginal value of the deliverable asset with few deliveries being made. (The lack of a centralized market mechanism for trading credit derivatives may make the liquidation process somewhat more cumbersome, but the main parties all have each others phone numbers, so liquidation of a large open interest under competitive conditions still shouldnt be that challenging.)
more at
link
A consequence of the heavy CDS issuance, explained better in Vader's post is that the low current premiums imply a good chance one or several hedge funds or financial institutions selling CDS will be both heavily levered and unhedged. If defaults spike this would cause a Amarath type collapse. The long term impact of this would be higher yield spreads over Treasuries for junk securities and mortgages
vicjim is right, people make bets on CDSs just like they were options or something. Most of the buyers have no intention of holding the bonds, they are just making a leveraged bet on the direction.People who bought CDSs for subprime-mortgage-backed bonds six months ago have done very well because defaults are up, etc.
Most of the writing of these has been done by hedge funds.
vicjim, your explanation makes sense to me and I had assumed that that was how it worked (at least in the corporate bond side), but the Delphi situation made it sound (with that "auction") as if the other 9 transactions actually involved some theoretical obligation to take the defaulted paper in a physical settlement.
Vader, thanks for the link; that explains the Delphi thing better. I do like the line "shorting credit is expensive," because that was my original point about credit swaps on collateralized securities rather than corporate bonds.
Most financial futures settle for cash, but some don't. Australian bank bill futures (equivilent of Eurodollar futures) are physical delivery, and there have been occasional significant squeezes in these contracts when the open interest nearing maturity is too large. With central clearing and documented open interest, physical deliver futures are magnitudes easier to manage than the otc contracts, yet I've seen some messy settlements. Nitro might be an optimistic view of credit derivatives in a stressed environment - more like neutron bombs. At least the buildings housing the ibanks and hedge funds trading these little gems will be left standing. Maybe that will be a good time to buy Manhattan real estate? Hmmm. Maybe not.
more like neutron bombs
Or would that be 'neutron bonds'?
One question:
I would guess there is a big difference on how the market clears depending on how it is structured.
A->B->C->D Series structure... one debt with many CDS contracts in a chain of transactions.
A->B
A->C
A->D Parallel structure... one debt, many independent CDS contracts tied to one transaction.
A->B
A->C
A->D
B->C
B->D
C->D 'Net-like' structure... one debt, CDS contracts going in all directions.
I can see a series structure clearing somewhat orderly. A parallel structure somewhat messy. The 'net' model could be a disaster.
Does anyone know what the predominant structure is (assuming some of all are present).
Also, for some one to take out a CDS, do they have to have an 'interest'? If they don't have an interest, doe they have to report to the 'interested parties' that they have taken out a stake in the transaction?
Say party A borrows from party B who buys CDS insurance from party C... all now with interest in the original transaction... can party X buy a CDS from Y on the A->B transaction WITHOUT having a direct interest? If so do X & Y have to report this to A & B? Or for that matter, report it to anyone?
Just thinking like a Soprano, you know nothing personal.
Some more urls on cds
http://www.skora.com/default.pdf
Credit default swap - Wikipedia, the free encyclopedia
Articles on credit derivatives
I did not see a case of a dirative based off of a cds. So I think the only transactions are the party - counterparty type. Keep in mind that the party does not have to own the debt, just be willing to pay to insure against its demise. They could be hedging or speculating.
On CDS and Delphi; This is a good article on what happened: Delphi Defied
As Anonymous noted, a party doesn't have to own the debt to buy insurance (with Credit Default Swaps).
Example: I own a car and pay insurance every quarter. If the market was like the CDS market, dryfly could also buy insurance on my car and pay every quarter (maybe he thinks I'm a poor risk)!
If I total the car, I give the car to the insurance company and they pay me. But dryfly gets paid for the car too. The problem is he doesn't have a car to give the insurance company - so they have to agree on the value of the wrecked car before they can pay him off.
That is what happened with Delphi. A bunch of people clearly thought the ratings were wrong for Delphi's bonds, and they bought default insurance without owning the bond. When Delphi defaulted, these people were supposed to turn in the bonds - but they didn't have any - so they had to agree on a price before the cash settlement.
I hope this was clear.
Best to all.