Preview: The Rosetta Stone questions about Credit Default Swaps

[HamdenRice]

Ok, this is a super condensed version of what I've found and will be posting about later today. Actually it's a quiz that will help you understand what's going on with the cds market and why it is so destructive.

The puzzle of cds was what seemed to be the irresponsibility of the financial firms that sold them as insurance but did not use reserves of premiums the way most insurance companies do. If I am going to ensure a bond, let's say a Lehman bond of $10,000 for its face value, why would I do so without putting some reserves away in case the bond went bad?

Were they stupid? Or did they overestimate the ability of their models to protect them? Or did they underestimate what would happen if they all followed their models at the same time?

So here are the two questions that are the Rosetta Stone of the role that cds play in the current crisis. If you can answer these Rosetta Stone questions, you will comprehend exactly why cds are so bad, and are an old problem dressed up in new clothes:

1. If you had ensured a Lehman $10,000 bond under a credit default swap, and you had no reserves and no capital, and discovered that Lehman might be getting risky, that you might have to pay up the face value of the bond to the person you had ensured, what simple trade could you do that would perfectly protect you, down to the penny, in a near perfect hedge? In fact, even before Lehman went bad, what might you have done in the market as a seller of cds to protect your position?

2. If there are many other actors who also had given credit default swap insurance to bondholders of that same series of Lehman bonds, what would the effect be if you all carried out the same strategy (the answer to question 1) at the same time?

If you can answer those questions, you will see through the smoke and mirrors and understand the real danger of the credit default swap market.

Anyone?

Anyone?

Bueller?

I would ask that you not recommend this post or cross post this until I get my longer analysis up. Also, You're on scout's honor not to plagarize this idea.

[rateyes]

1. Buy the bad debt that you are insuring?

No one to pay but yourself. But, that doesn't answer question 2, so I doubt I got it right.

[HamdenRice]

2. No, but you're getting close

Anyone?

Anyone?

Bueller?

[rateyes]

3. Well, make sure you post to me when you reveal it. I do want to

know the answer to that question. Seems like to me that the buyers of cds manipulated to market to make it fail on purpose.

[HamdenRice]

4. Anyone? anyone? Bueller? nt

[rateyes]

5. Time to tell. nt

[EmeraldCityGrl]

6. Understanding little of this, but trying to think like the sociopaths on

Wall Street, " If you had ensured a Lehman $10,000 bond under a credit default swap, and you had no reserves and no capital, and discovered that Lehman might be getting risky, that you might have to pay up the face value of the bond to the person you had ensured, what simple trade could you do that would perfectly protect you, down to the penny, in a near perfect hedge? "

If at all possible I would try to insure or protect my potential loss, I would attempt to insure my insurance policy. I'm just throwing this out there, but were they reinsuring the credit
default swaps?

As to the second question, if all parties insured their insurance policies, there would be a giant house of cards all collapsing on the same original debt.

[HamdenRice]

9. "I would attempt to insure my insurance policy"

If you can figure out how you would do that, you win!

[girl gone mad]

7. You can read through a thread I posted of CDSs a couple of weeks ago..

back when DU was arguing over the bailout.

I'll see if I can find it.

ETA: here: http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=389x4129938

[HamdenRice]

8. Anyone? Anyone? Bueller?

Think about it. These guys said they could insure debt securities without putting aside reserves.

Theoretically, they were right, if the market behaved as normal, and there were no "collective action" problems -- ie game theory problems that arise when a solution that is logical for the individual is illogical for the collective group.

What could you do on the day that you sell a credit default swap that would perfectly protect you -- down to the penny -- without you putting a penny in reserves?

And if you figure out what that is, you could also show how the very act of insuring against the default of the underlying bond made the default of the underlying bond more likely to happen.

You'll understand why this is fire insurance on a home that burns down the home -- or maybe the entire neighborhood.

Hint: It's a trade.

Put on your thinking caps, figure out what the trade is, and you'll understand the market meltdown.

[girl gone mad]

10. It just depends on how the CDS was structured.

Several products permit investors to hedge recovery risk separately from default risk in derivative contracts. In a straightforward CDS contract, the protection seller (insurer) is exposed to recovery rate risk upon default of the underlying reference asset. A fixed recovery rate CDS, however, eliminates the uncertainty on the recovery rate by fixing a specific recovery value over the maturity of the CDS contract. After a credit event, the protection buyer is entitled to a cash settlement equal to 100 minus the pre-specified, fixed recovery rate.

A recovery lock is a cash-neutral forward contract that fixes the recovery rate irrespective of the settlement price of the underlying reference asset. In practice, a recovery lock is structured by means of two opposite trades on the same reference entity. Protection sellers hedge themselves against recovery rate risk of their long position in a straightforward CDS by purchasing protection through a fixed recovery CDS. If the implicit recovery rate of the conventional CDS contract concurs with the fixed recovery rate, the premium payments on the transactions wash out and net to zero. In this case, if the reference entity defaults, the protection buyer of the fixed recovery CDS delivers the defaulted debt to the recovery seller and receives compensation equal to 100 minus the pre-specified, fixed recovery rate, which, in turn, pays off the compensation claim under the issued plain vanilla CDS contract. If the premium payments of the two trades differ, for example the actual recovery of the underlying asset drops below the fixed recovery rate at the time of default, the protection buyer reinvests higher premium income from the short position of a straightforward contract into fixed recovery rate protection on a larger notional value.

[DemReadingDU]

12. You trade me yours, I'll trade you mine?

:shrug:

[westerebus]

11. Door number 3 ?

Short sell?

[HamdenRice]

14. Ding ding ding !!!! Now tell us ...

what do you sell short and why? And what is the effect on the market?

[westerebus]

15. You know this hurts my brain, don't you?

I suspect you would short the company you brought the insurance on. Pushing it to a lower value to cover the cost of the insurance by profiting from the short selling. Every body piles on is the answer to the second question when they realize what your doing. If it works for you,it works equally well for them as the risk is diminished. Am I close, professor?
Sorry, it's almost midnight and it's been a long day.

[Jim__]

13. Reinsure the bond?

Lehman (or someone) is paying me to insure the bond. I can pay someone else, or a group of other people, to pick up the insurance. If I structure this correctly, I can make a little money and eliminate all my risk - I've completely re-insured the face-value of the bond for less than I was originally paid.

[Alpharetta]

18. this answer gets my vote

Just go find a new counter-party.

[girl gone mad]

16. Hamden, if you really want to understand the derivatives market..

here's a book I would highly recommend:

Traders, Guns & Money: Knowns And Unknowns in the Dazzling World of Derivatives by Satyajit Das

http://www.amazon.com/gp/product/0273704745/ref=olp_product_details?ie=UTF8&me=&seller=

I read this a couple of years ago. It's a quick read, quite interesting and funny. I think it might help with some of the questions you seem to have, in layman's language.

[Coes]

17. well?

I'm still interested.

"...had ensured a Lehman $10,000 bond under a credit default swap..." -> can you decrease the value of that bond somehow? And thus have to pay up less?

If not, then I guess you would have to find some insurance for this insurance itself...

[WMD2]

19. Save Ferris - I'll take the Ferrari

Simple ... sell short enough Lehman stock to hedge your credit default swap position. Any drop in the stock price will be a gain for your hedge and offset the loss on your swap. If there are many, many others pursuing the same strategy, the stock will tank and everyone will head for the exits and dump the stock leading to an eventual run on the bank.

Cameron: The 1961 Ferrari 250GT California. Less than a hundred were made. My father spent three years restoring this car. It is his love, it is his passion.
Ferris: It is his fault he didn't lock the garage.

[JohnWxy]

20. Short the securities the CDS is supposed to insure the holder against default of.

That's why they are so dangerous to an orderly market.