tag:blogger.com,1999:blog-4863014635257598503.post8145266602763485010..comments2024-02-27T22:18:53.706-05:00Comments on Zero Hedge: Some More Facts About How The CDS Market Will Be Misconceived To DeathTyler Durdenhttp://www.blogger.com/profile/00165439451205639523noreply@blogger.comBlogger5125tag:blogger.com,1999:blog-4863014635257598503.post-19608868540625322402009-02-09T11:55:00.000-05:002009-02-09T11:55:00.000-05:00Tyler, Thank you for the article. I have a few fo...Tyler, Thank you for the article. I have a few follow up observations/questions to your article. I look forward to your comments.<BR/> <BR/>1. What accounts for the huge decline in outstanding CDS? Given well documented operational issues, and that both buyers and sellers would need to agree to close out an existing contract, and that huge losses/gains would have been crystallized, this drop seems odd. Why would buyers of protection want to close out contracts ahead of a spike in corporate default rates (whether via index or single name exposure)? As you point out, they would be less hedged as a result.<BR/><BR/>2. The "net" exposure probably understates the risk much as the "gross" exposure overstates it. To accept the net exposure as an appropriate risk measurement is to accept that all counterparties are equally credit worthy. Yet, already some of the largest intermediaries (US and Euro commercial banks) are on life support. The failure of a large intermediary would be instantly devastating. The failure of a smaller counterparty would pass risk to these intermediaries as their exposure would move from "hedged" to "naked". CSAs have probably worked well to mitigate risk in a relatively benign default environment (5% defaults in 2008) but what happens when defaults move above 10% per annum?<BR/><BR/>3. Government support is hardly a cure to counterparty risk. Essentially the weakest countries (Iceland, Ireland, Belgium, etc.) would just be passing on the risk of their government guarantees to the "healthier" countries and their taxpayers. What is JPM's exposure to Allied Irish, Glitnir, Fortis, etc.? Why would any countries taxpayers accept the risk of other countries banks via CDS contracts?Chrishttps://www.blogger.com/profile/02061410508818867860noreply@blogger.comtag:blogger.com,1999:blog-4863014635257598503.post-71725963806250194732009-02-01T17:38:00.000-05:002009-02-01T17:38:00.000-05:00Btw, i saw your comment about neg basis as caused ...Btw, i saw your comment about neg basis as caused by bond repos. I respectfully disagree. You are right the repos are scarce in general, but the issue here is the CDS repo side, not the cash side. If the latter were the case, you would see overbought bonds (due to inability to short cash) resulting in tighter spreads to FV and to synthetics (and a resulting + basis). I am convinced basis still has to do with scarce liquidity provided to accounts by PBs and B/Ds, who are unable to put on enough CDS to where implied risk matches, i.e. artifical lack of demand pushing yield/risk tighter to FV.Tyler Durdenhttps://www.blogger.com/profile/00165439451205639523noreply@blogger.comtag:blogger.com,1999:blog-4863014635257598503.post-617300011357412322009-02-01T17:30:00.000-05:002009-02-01T17:30:00.000-05:00from what i have heard existing contracts will hav...from what i have heard existing contracts will have the option of moving from OTCC, but any new contracts will have to be on the TCC (by participating dealers, so in theory a dealer has an opt out clause, which will likely be frowned upon). and yes you are right about the second part - counterparty (liquidity as I like to call it) risk would be gone in TCC, which would make the cash-cds basis market much more realistic.Tyler Durdenhttps://www.blogger.com/profile/00165439451205639523noreply@blogger.comtag:blogger.com,1999:blog-4863014635257598503.post-77351015836700620382009-02-01T17:19:00.000-05:002009-02-01T17:19:00.000-05:00I've been thinking about how outstanding CDS will ...I've been thinking about how outstanding CDS will be affected if (when?) majority of trading moves to a clearing house. First, is it safe to assume that outstanding net will be moved to the clearing house? This seems to be pretty unfair to protection sellers. Second, if outstanding stays OTC without central clearing, does the creation of a clearing house and a large percentage of trade moving there reduce systematic risk enough that it would reduce counterparty risk on the previous outstanding CDS? I think this is what you're implying will happen, thereby resulting in reduced basis in outstanding.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-4863014635257598503.post-43783650891859574132009-02-01T15:07:00.000-05:002009-02-01T15:07:00.000-05:00"Another way to think of net is how the general pu..."Another way to think of net is how the general public thinks of gross: it is the total amount of cash that would change hands if every single reference entity were to suffer an event of default with a 0% recovery. And the total amount is a paltry $2.6 trillion, at least when juxtaposed to such previously hyperbole as $50 + trillion."<BR/><BR/>In the case of AIG, I view the chain of events as follows:<BR/>1) Tsunami of foreclosures begins, leading to gross uncertainty as to how many foreclosures there would be and how much housing prices would fall. If I'm correct, that meant that there was uncertainty in both:<BR/>A: The number of defaults<BR/>B: The amount which would be paid in the event of a default. The lower housing prices go, the more insurance there is to be paid on a foreclosure.<BR/>2) AIG was downgraded because of the uncertainty of A and B.<BR/>3) AIG had a capital call, and needed to raise money.<BR/>4) They went to the government for a bridge loan, to avoid selling assets at fire sale prices. This is what Liddy actually said in November. He did not say that he couldn't sell the assets.<BR/>The CDS and CDO problems are part of a larger Calling Run. That is, anyone who had investments with the lenders on these poor mortgages started demanding cash if they could, worrying that at some point the money might run out. The TARP plan actually hindered everything by raising the price of Toxic Assets and giving the owners of these investments the hope that the government might, somehow, provide a better deal than John Paulson. This is somewhat like the difference between the terms Buffet got and the government got on similar investments. Underneath everything, is the foreclosure tsunami, which is a Calling Run ( Debt-Deflation ). This problem will lead to some real and very large losses, no matter what insurance there is on these foreclosures. Since the foreclosures must, to some degree, offset the losses on the mortgages, it's hard for me to see them, qua insurance, as the problem. Where third parties are concerned, my understanding is that those have been working since they were marked-to-market. In that case, I'm still wondering how CDSs are causing the problem. To the extent that CDOs are, that seems a problem of liquidity, which I believe is largely induced by the holders unwillingness to absorb huge losses. My view, but I'm not an expert.<BR/><BR/>Don the libertarian DemocratDonald Pretarihttps://www.blogger.com/profile/14493535232127084725noreply@blogger.com