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  • Financial Crisis and Black Swans

    Nassim Taleb can always be counted on to have an interesting take on events.. I thought some may be interested in his take on the financial crisis. He believes that we need a big mind shift in how we evaluate risk in many areas... (being wary of predictions and conventional risk analysis and having a large dose of skepticism)

    Here is a YouTube video of a recent appearance of the Black Swan
    author on BBC. He thinks that we may be just at the beginning of the
    financial crisis as hedge funds have not even really started to get
    unraveled yet... (He is getting very popular as a 'modern thinker'
    and now gets $60,000 per lecture to groups which include NASA. He has
    a 4 million dollar advance for his next book) He basically thinks
    that we need to be more pragmatic in our thinking and get back to
    basics rather than relying too heavily on complex theoretical
    models...



    Global Financial Crisis in the words of Black Swan author

    The following is The Black Swan author Nassim Nicholas Taleb's edited
    passionate (some say "angry") appearance on BBC News (YouTube video).
    Take a look of this wikipedia link for what Nassim wrote about the
    global banking crisis and Fannie Mae in The Black Swan in 2006. By the
    way, Nassim considers this Sunday Times profile the most
    representative. And here is a 2008 Aug Portfolio interview of Nassim.

    The following is The Black Swan author Nassim Nicholas Taleb’s edited passionate (some say “angry”) appearance on BBC News (YouTube video). Take a look of this wikipedia link for …

  • #2
    Re: Financial Crisis and Black Swans

    Very interesting. The unwinding of the hedge funds was partly responsible for last week's record setting decline in the DOW.

    I agree that the measurements of risk variance blah blah is not understandable and should not be relied on. The basics of cash flow, net worth, customer base, profitability, management quality, legal liabilities, dividend payouts, and market cap are some of the main factors that should be relied on for investment decisions.

    Comment


    • #3
      Re: Financial Crisis and Black Swans

      hattip Rickk

      Australia's Big Four banks are all exposed to the default of Lehman Brothers via credit default swaps (CDS) - a noxious bull-market derivative which threatens further contagion in the ailing global financial system.

      National Australia, ANZ, Westpac, Commonwealth Bank and the nation's biggest insurer AMP are listed on the ISDA's (International Swaps and Derivatives Association) Lehman Protocol. The five have written "adherence letters'' to the ISDA asking the Association to act as their agent in settlement negotiations arising from the Lehman default.

      This Wednesday is the deadline for lodging settlement notices for CDS trades and October 20 is the date for settlement.

      BusinessDay contacted all four banks. Three were unable to provide meaningful details of their exposures and we were unable to contact Commonwealth Bank prior to deadline. Their total CDS exposures are dealt with later in this article.

      For those who have not had the pleasure, a CDS is a synthetic instrument which provides insurance on a company's debt. The global CDS market has a notional value of $US60 trillion-odd, there is no central exchange, no regulator to speak of, and no known reserving.

      That is, it is akin to an insurance market in which nobody has got around to setting aside any provision for losses which might arise - indeed which are arising now - in the event of a company's default.


      'Elephant in the room'

      Nor was anybody asked to - such has been the "play it by ear'' philosophy towards regulation of markets.

      Weekend announcements by the Group of Seven and assorted national authorities demonstrate the "play it by ear'' approach is now giving way to worldwide regulatory dictatorship.

      The market for CDS is often dubbed "the elephant in the room''.

      In theory, failures trigger recourse to swap issuers, but once the chain fails it means the system fails as linked trades begin to unwind.

      In theory CDS should ``net out''. Yet they are an ``over-the-counter'' product with no central exchange to facilitate netting.

      In other words, there is a $US60 trillion market for credit enhancement, entirely unregulated and which nobody seems to know much about, whose retail equivalent is borrowing with no more than a personal guarantee, and without having to stump up one red cent in collateral.

      The more bizarre examples of risk involve the likes of tin-pot hedge funds insuring giants like rescued insurer American International Group (AIG) for a fee.
      This is cowboy stuff which would not have been tolerated by the auctioneer in a Wild West horseflesh sale 200 years ago, let alone by the local sheriff.



      It is important to note that the Lehman CDS settlements are more of a loss transfer than a loss. In other words, there will be winners and losers. You can buy CDS credit protection and you can sell credit protection.

      So, provided no one party took on too much of the Lehman exposure, the spread of loss should render the default of Wall Street's former No. 4 investment bank containable.

      The rub lies in whether assorted parties can settle their obligations, and in what they have to sell to meet their obligations. Trading on Monday and Tuesday this week will go some way to revealing the damage.

      Domino theory

      The fear is of a potential domino effect. One wonders whether this was a significant factor in the Government's decision to guarantee all bank deposits yesterday.

      Are the banks in more strife than they make out or was Kevin Rudd simply keen to trump Malcolm Turnbull's call for a guarantee on deposits up to $100,000?

      This promises to be one hell of a week on world markets.

      The unwinding of Lehman CDS was a factor in the dramatic drop on world markets late last week and, as yet, no major party has toppled over.


      However, a weekend story in the Financial Times said the payouts on the $US400 billion of Lehman CDS is ``likely to be higher than anticipated after initial results from auctions to settle these CDS resulted in a lower recovery price''.

      ``The initial auction results were settled at 9.75 cents in the dollar, meaning banks and other investors who had agreed to make these payments in the event of Lehman's default will have to pay out 90.25 cents on the dollar.

      ``The final auction for Lehman credit default swaps (CDS) was due to settle in the New York afternoon. The final prices were likely to be lower than the initial ones because there were a lot more sellers of bonds to settle the auctions than buyers, according to traders.''

      More to CDS claims to come

      It all goes to the banks' proclivity to horde cash and their reluctance to deal with each other. The collapse of other institutions such as Washington Mutual and the banks in Iceland are likely to spawn a wave of credit derivative claims too.

      In some circles, the bail-out of US insurer AIG was put down to its enormous CDS default potential.

      It is not just banks who play in the CDS "cloud", it is insurance companies and shadowy, unregulated hedge funds domiciled in tax havens.



      It now appears the G7, led by the UK, is going to effectively stand behind their core banking systems and the CDS market may, at a pinch, be allowed to collapse. Who knows?

      Sovereign support will enable credit markets to continue to facilitate savings, mortgage lending, trade finance, foreign exchange and so forth. Without central bank support for the core functions of banking, civil society would cease to function.

      The drawback has been that while the stock exchanges have been telling us there is a problem, politicians in the West have been somewhat in denial.

      Recaps for banks

      There is an emerging consensus now, though, that collective action needs to be taken to recapitalise the banking system through temporary nationalisations and massive liquidity injections, perhaps accompanied by further rate cuts and probably assisted by guarantees on interbank transactions.

      Large-scale government intervention may not be particularly palatable but it is preferable to the other option: mayhem.


      The ad hoc response so far of plugging holes in the exploding dyke has failed, as evinced by the Paulson mates' bail-out proposal.

      Big government intervention has worked before in other markets such as Sweden and parts of Latin America and Asia and it will simply have to work for developed countries now. A ``muddle through'' is the most likely outcome.

      The risk, however, is to bonds. If there were a forced selling of bonds, the consequences would not bear contemplating.

      Whole countries have put themselves in the front line with their recent rash of guarantees. It is Columbus Day in the US on Monday so Australia will be trading in the dark without two days of action to look to in US bonds.

      Equities after all are more or less a warrant on a bond.

      Some glimmers

      There are some positive signs, however. The commercial paper market is loosening up, and the US Federal Reserve will take AAA paper.

      So even if the banks won't lend there are some corporates which can act as intermediaries. They may even find they have a new business, by endorsing paper handing it to the Fed and acting as a credit conduit. Someone has to do it.

      Back to CDS. It is no longer acceptable that banks - which now have an explicit guarantee on their deposits - continue to hide their tricky exposures.

      It was leverage, accounting chicanery and silly synthetic products devised, bought and traded by banks which landed the world in this maelstrom in the first place. It was the collapse of trust which made the problem worse.


      Yet the banks still conceal their exposures and muddle through with public relations about everything being fine.

      Nobody believes it now. And until the banks come clean the trust factor will continue to wreck confidence in the entire system. There are myriad rumours doing the traps, suffice it to say that lack of disclosure only makes things worse.


      CDS and Aussie banks

      A Citibank report from mid-July shows ANZ at the top of the CDS pile in Australia. It had $45.7 billion worth of CDS in its conduits.

      While all the banks used CDS to hedge their credit risk, ANZ actively traded them.

      In other words, as with its primacy in stock lending (of Opes Prime fame), it took the greater risks.

      As of March, the bank had some $23.4 billion in ``long'' CDS positions and $22.3 billion in ``short'' CDS positions.

      ``ANZ entered short CDS positions with counterparties who desired credit protection whilst simultaneously purchasing offsetting protection for a cheaper premium from different counterparties (we understand these counterparties were "monoline" insurers on around half of all occasions). The spread differential between the short premium and long premium generated trading income,'' says the Citibank report.

      When one such monoline insurer, ACA, was downgraded from investment grade to CCC in February 2008, ANZ was forced to recognise a provision of $226 million based upon a $1.5 billion notional contract value.

      ``In effect, they were saying that the long leg of the trade was not suitable in terms of providing insurance - as the rating of the insurer was sub-investment grade the hedge was no longer viable.''

      As with other financial stocks now underperforming their peers, ANZ partied hard in the good times by indulging too much in high-yield securities. Now it is clear they were not high-yield for nothing.

      Its rivals carry risk but not to the same degree.

      CBA has $5.9 billion ($3 billion bought and $2.9 billion sold), Westpac has $15.6 billion ( $9.4 billion and $6.2 billion) and NAB, which Citigroup rates second to ANZ on risk has $24.4 billion in CDS ($13.7 billion and $10.7 billion).

      This, of course, is all before we get to CDOs, CLOs, ABS and so on.

      There will be nasties to come, and before the banks come clean and tell us who their counterparties are, the mystery will continue to erode confidence.


      That said, the Federal Government's guarantee on deposits will circumvent the ultimate disaster scenario of a retail run on the banks and, in that, it is to be applauded.

      Times are tough, but some look for levity, as one joke doing the rounds goes:

      "This is way worse than a divorce ...I've lost half my net worth and I still have my wife."

      mwest@fairfax.com

      BusinessDay

      Australian banks deposits have been guaranteed. Now it's the time for the Big Four to reveal in full their risky exposures.

      Comment


      • #4
        Re: Financial Crisis and Black Swans

        credit default swap


        <iframe src="http://www.investorwords.com/player.php?id=5876" marginheight="0" marginwidth="0" frameborder="0" height="25" scrolling="no" width="25">Frames not supported</iframe>

        Definition

        A specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.

        This content can be found on the following page:

        http://www.investorwords.com/cgi-bin/getword.cgi?id=5876&term=credit%20default%20swap

        Comment


        • #5
          Re: Financial Crisis and Black Swans

          Commodity Rout Far From Ended as Recession Approaches (Update1)
          By Claudia Carpenter and Millie Munshi

          Oct. 13 (Bloomberg) -- The record 39 percent decline in commodities since July 3 is nowhere near finished, if history is any guide.

          The Reuters/Jefferies CRB Index of 19 commodities from coffee to silver would have to drop another 37 percent to reach the trough of the 2001 recession and 35 percent for the 1998 slide, when crude bottomed at $10.35 a barrel. The measure is 28 percent above its lowest during the economic contraction that ended in November 1982. Copper, after its biggest weekly loss in two decades last week, is still triple 2001 levels.

          While tumbling prices of oil, nickel and soybeans already crippled stock markets from Moscow to Sao Paulo and sliced Alcoa Inc.'s profits by 52 percent, investors say rising stockpiles of copper and slowing energy demand mean prices will continue to fall. The U.S. slowdown will last more than a year and be deeper than any in three decades, according to Harvard University economist Martin Feldstein, a member of the committee that charts American business cycles.

          more: http://www.bloomberg.com/apps/news?p..._FQ&refer=home

          Comment


          • #6
            Re: Financial Crisis and Black Swans

            Newspapers Axe Monday Editions as Paper Costs Rise, Ads Dwindle
            By Sarah Rabil

            Oct. 13 (Bloomberg)

            Comment


            • #7
              Re: Financial Crisis and Black Swans

              Intel, Microsoft Squeezed as $170 Billion Cut From Tech Budgets
              By Ian King and Katie Hoffmann

              Oct. 13 (Bloomberg)

              Comment


              • #8
                Re: Financial Crisis and Black Swans

                60 trillion dollars is a hard figure to get your mind around as are 'financial weapons of mass destruction'. The unraveling of this problem will be difficult as apparently no individual bank, insurance company, corporation, individual investor etc really has a good idea where they are going to be vulnerable.

                A main reason that credit is tight is that lenders don't know what their vulnerabilities are.. They don't know how vulnerable they are to losses of their own or how vulnerable people they lend to are to losses.

                An individual mortgage was bundled with thousands of others and then these bundles were split and re-split into smaller sections and then sold around the world so when something defaults no-one seems to easily know who owns what. Also they had tons of insurance (credit debt swaps) on these loans. Apparently they were called swaps instead of insurance as a ploy to help avoid regulation. But it also appears that the 'insurers' don't have the assets to cover the losses of their insured.

                Be careful out there.....



                CREDIT DEFAULT SWAPS
                Planting a financial minefield


                October 4, 2008

                I confess I had never heard of credit default swaps until this year. I saw the words in newspapers and magazines at the time of the Bear Stearns debacle, but they really did not grab my attention until names like AIG, Freddie and Fannie, and words like "bailout" started appearing in daily newspaper headlines.

                Then I figured I better do some research on credit default swaps. I plead guilty to being much too late in learning just how dangerous these things are, but then I am not in the banking business, or in regulating banks, or in writing for the business press.

                And, truth to tell, if I had done my research a year ago and let you in on what I found, it would not have made any difference. More than a few people who do write for the business press or for newspapers or magazines of general circulation, as I now know, were aware of the CDS threat and tried to alert us. Few of us paid attention, certainly not federal regulators, Congress or bank stockholders.

                With that preface, let me tell you, for future reference, a few things about credit default swaps, which Warren Buffet once described as "financial weapons of mass destruction."

                They were conceived in the 1990s, innocently enough, as a way holders of bonds and other fixed-income assets could protect themselves against loss of capital. And which would provide for others a new source of regular income.

                Let's say that you own bonds or maybe house mortgages you don't want to sell for one reason or another, but want to protect yourself against a decline in the value of your investment. Thanks to the ingenuity of your fellow capitalists, you can buy insurance against default.

                Your "premium" depends on the length of time you want to cover and the seller's opinion of the chance of default. The premium is lower, for example, for Triple A bonds than for BBB bonds, lower for a mortgage which is for 50 percent of the value of the building than for 95 or 105 percent.

                The buying or selling of credit default swaps is not regulated. The amount of money your friendly local bank, or a huge national bank, can lend is limited to a multiple of its capitalization, but nobody checks to assure that institutions selling credit defaults have the resources to pay off their losses if things go bad. And things did go bad when home prices started dropping and owners could not meet their mortgage payments.

                Even more disastrously, traders discovered you could sell credit default insurance for bonds or other income-producing products you did not even own, so that CDS became a major favorite for speculation and were heavily traded.

                And with the burgeoning subprime real estate mortgage market, hundreds of thousands of mortgages were bundled, sliced into packages, and sold all over the world to investors who would then buy credit default insurance.

                A bundle of home mortgages might go through dozens of hands, with buyers having little idea of the actual value of their investment. Putting a fair value on a credit default swap became an arcane exercise that required solving the equation reproduced here (see graphic below) from an article in Wikipedia, the online encyclopedia.

                According to the International Swaps and Derivatives Association, the CDS market in the summer of 2007 was a $45 trillion operation. (Right, trillion.) It surpassed $60 trillion this year, about three times as large as the entire U.S. stock market before the plunge of the last few weeks.

                Time magazine reported in May that the top 25 U.S. banks held more than $13 trillion in credit default swaps in which they were either the buyer or the seller.

                I am not qualified to say what role credit investment swaps played in the worldwide credit freeze-up. But it was major. And I am confident some of the prospective $700 billion bailout will go to compensate financial institutions for credit swap losses.

                I can only hope that none of it goes to the speculators and that there is something left over for the truly deserving, whoever they may be.


                Waldo Proffitt is the former editor of the Herald-Tribune. E-mail: wproffitt@comcast.net

                Comment


                • #9
                  Re: Financial Crisis and Black Swans

                  Wall Street Cedes M&A to Bank Collapses as Fees Decline to 2005
                  By Ambereen Choudhury and Elisa Martinuzzi

                  Oct. 13 (Bloomberg) -- The only bright light in mergers and acquisitions is looking more like a death star now that 60 percent of the $389 billion in takeovers since the beginning of September are the result of bank collapses.

                  -snip-
                  IPO Drought

                  The market for initial public offerings has dried up. There were no IPOs in the U.S. in September, the first month since July 2003 in which no shares were priced, Bloomberg data show. Globally, IPOs fell 81 percent in the third quarter to $10.7 billion, as investors shunned new securities. The period was the slowest in five years.

                  After marketing itself to investors for a month, Schott Solar AG, a German maker of solar equipment, shelved a 657 million-euro ($884 million) IPO on Oct. 8, citing the ``dramatic deterioration in international capital market conditions.'' The next day Germany's Deutsche Bahn AG postponed an IPO for its train-operating division, a 5 billion-euro sale. Enea SA, the Polish power distributor that planned a 3 billion-zloty ($1.2 billion) share sale in Warsaw, also withdrew its offering.

                  ``It is difficult to do deals in such a volatile environment,'' said Pat Guerin, 37, co-head of European mergers at UBS AG in London. ``There may be plenty of opportunities, but it still takes a brave buyer to make a big bet in the middle of this turbulence.''
                  -snip-

                  Comment


                  • #10
                    Re: Financial Crisis and Black Swans

                    more general information on credit default swaps -

                    DTCC Addresses Misconceptions About the Credit Default Swap Market

                    New York, October 11, 2008The idea that the industry lacks a central registry for over-the-counter (OTC) credit default swaps (CDS) is grossly misleading and has resulted in inaccurate speculation on a number of matters, including the overall size of the market, its role in the mortgage crisis, and the size of potential payment obligations under credit default swaps relating to Lehman Brothers. The extent to which such speculation has fueled last week’s market turmoil is difficult to determine. The facts are these:

                    Central Trade Registry
                    • In November 2006, The Depository Trust and Clearing Corporation (DTCC) established its automated Trade Information Warehouse as the electronic central registry for credit default swaps. Since that time, the vast majority of credit default swaps traded have been registered in the Warehouse. In addition, all of the major global credit default swap dealers have registered in the Warehouse the vast majority all contracts executed among each other before that date.

                    Size of the Market
                    • Reported estimates of the size of the credit default swap market have so far been based on surveys. These surveys tend to overstate the size of the market due to each party to a trade separately reporting its own side. Thus, when two parties to a single $10 million dollar trade each report their “side” of the trade, the amount reported is $20 million, which overstates the actual size by a factor of two since both reports relate to a single $10 million contract. When examining the outstanding amount of actual contracts registered in the Warehouse (not separately reported “sides”) as of October 9, 2008, credit default swap contracts registered in the Warehouse totaled approximately $34.8 trillion (in US Dollar equivalents). This is down significantly from the approximately $44 trillion that were registered in the Warehouse at the end of April this year.

                    Percentage of the Market Related to Mortgages
                    • Less than 1&#37; of credit default swap contracts currently registered in the Warehouse relate to particular residential mortgage-backed securities. Mortgage-related index products also have some components relating to residential mortgages and, as a whole, also constitute a relatively small fraction of total credit default swaps registered in the Warehouse.

                    Payment Obligations Related to the Lehman Bankruptcy
                    • One of the many central servicing functions of the Trade Information Warehouse is to caculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written. Calculated amounts are netted on a bilateral basis, and then, for firms electing to use the service, transmitted to CLS Bank (the world’s central settlement bank for foreign exchange) where they are combined with foreign exchange settlement obligations and settled on a multi-lateral net basis. Currently, all major global credit default swap dealers use CLS Bank to settle obligations under credit default swaps. It is expected that all major institutional players in the credit default swap market will use the same process for settlement by the end of 2009.
                    • The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents).

                    DTCC has long supported the U.S. and global capital markets as a critical part of their operational infrastructure.We stand ready to play a constructive role in whatever overall regulatory environment ultimately emerges for the credit default swap market. We do believe, however, that whatever environment emerges should be based on assessment of the facts as they stand, rather than speculation.
                    About DTCC

                    DTCC, through its subsidiaries, provides clearance, settlement and information services for equities, corporate and municipal bonds, government and mortgage-backed securities, money market instruments and over-the-counter derivatives. In addition, DTCC is a leading processor of mutual funds and insurance transactions, linking funds and carriers with their distribution networks. DTCC’s depository provides custody and asset servicing for more than 3.5 million securities issues from the United States and 110 other countries and territories, valued at US$40 trillion. In 2007, DTCC settled more than US$1.86 quadrillion in securities transactions. DTCC has operating facilities in multiple locations in the United States and overseas.
                    DTCC Deriv/SERV LLC, a wholly-owned subsidiary of DTCC, provides automated matching and confirmation for OTC derivatives contracts, including credit, equity and interest rate derivatives. According to major market participants, over 90% of credit derivatives traded globally are electronically confirmed through Deriv/SERV. The Trade Information Warehouse, a service offering of Deriv/SERV launched in November 2006, is the market’s first and only comprehensive trade database and centralized electronic infrastructure for post-trade processing of OTC derivatives contracts over their lifecycles, from confirmation through to final settlement.
                    For more information on DTCC and DTCC Deriv/SERV, visit www.dtcc.com.



                    Comment


                    • #11
                      Re: Financial Crisis and Black Swans

                      Apparently a number of us had not heard about CDSs until recently. I found this article to be most helpful in understanding exactly what they are.
                      ------------------------------------------------

                      In the early 1990s, in order to hedge their loan risks, J. P. Morgan & Co. [now JPMorgan Chase & Co. ( JPM )] bankers devised credit default swaps.

                      A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation's, or sovereign's (the ?referenced entity?), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan.
                      Typically, the insurance is for five years.

                      Credit default swaps are bilateral contracts, meaning they are private contracts between two parties. CDSs are subject only to the collateral and margin agreed to by contract. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most frighteningly, credit default swaps are subject to ? counterparty risk .?

                      If the party providing the insurance protection ? once it has collected its upfront payment and premiums ? doesn't have the money to pay the insured buyer in the case of a default event affecting the referenced bond or loan (think hedge funds), or if the ?insurer? goes bankrupt ( Bear Stearns was almost there, and American International Group Inc. ( AIG ) was almost there) the buyer is not covered ? period. The premium payments are gone, as is the insurance against default.

                      Credit default swaps are not standardized instruments. In fact, they technically aren't true securities in the classic sense of the word in that they're not transparent, aren't traded on any exchange, aren't subject to present securities laws, and aren't regulated. They are, however, at risk ? all $62 trillion (the best guess by the ISDA) of them.

                      Fundamentally, this kind of derivative serves a real purpose ? as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That's the economic purpose of insurance.

                      What happened, however, is that risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you've been reading about), but didn't actually own the underlying credits, now had a means by which to speculate on them.

                      If you think XYZ Corp. is in trouble, and won't be able to pay back its bondholders, you can speculate by buying, and paying premiums for, credit default swaps on their bonds, which will pay you the full face amount of the bonds if they do actually default. If, on the other hand, you think that XYZ Corp. is doing just fine, and its bonds are as good as gold, you can offer insurance to a fellow speculator, who holds the opinion opposite yours. That means you'd essentially be speculating that the bonds would not default. You're hoping that you'll collect, and keep, all the premiums, and never have to pay off on the insurance. It's pure speculation.

                      Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I'm speculating on an event. I'm making a bet.

                      The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It's bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools.

                      What's even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn't, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.

                      And this is only where the story begins.

                      What is happening in both the stock and credit markets is a direct result of what's playing out in the CDS market. The Fed could not let Bear Stearns enter bankruptcy because ? and only because ? the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they've been carrying at higher values because they could say that they were insured for those losses.

                      The counterparty risk that all Bear's trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. That was an untenable option.

                      The same thing has just happened to AIG . Make no mistake about it, there's nothing wrong with AIG's insurance subsidiaries ? absolutely nothing. In fact, the Fed just made the best trade in its history by bailing AIG out and getting equity, warrants and charging the insurance giant seven points over the benchmark London Interbank Offered Rate (LIBOR) on that $85 billion loan!

                      What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn't have.

                      In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

                      But there's more ? a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how.

                      The rest of the story will be illuminated in the next two installments. Next up: An examination of the AIG collapse, followed by a look at how bad things could get, and what we can do to fix the problem at hand. So stay tuned.

                      The salvage of human life ought to be placed above barter and exchange ~ Louis Harris, 1918

                      Comment


                      • #12
                        Re: Financial Crisis and Black Swans

                        The 'financial weapons of mass destruction' aspect seems to be showing itself with this 'counter-party' risk...

                        ie ""but the CDS shoe has yet to drop. Perversely the insured volume is greater than the $150bn total of Lehman debt. Some $400bn of CDS contracts were sold. Many were used by hedge funds to take "short" bets on the fate of the bank. The contracts nevertheless have to be honoured.""



                        Fears of Lehman's CDS derivatives haunt markets

                        It is a full week after bankers gathered in New York to start sorting out the derivatives mess left by the bankruptcy of Lehman Brothers. We still do not know who is on the hook for some $360bn of default insurance, or how much they will have to pay.

                        By Ambrose Evans-Pritchard
                        Last Updated: 9:41PM BST 16 Oct 2008

                        Ominous talk of big names and big sums continues to haunt global markets, thwarting efforts by the US and European authorities to unlock inter-bank lending. Traders have noted with acute interest that insurer AIG - now nationalised - says it will need another $38bn from the US government, on top of the $85bn bail-out it has already received. AIG is the world's biggest underwriter of credit protection.

                        Those on the wrong side of these Lehman debt contracts - known as credit default swaps (CDS) - must come up with the money by Tuesday, the next D-Day in the ever-fraught calendar of the credit markets. There has been a deafening silence so far.

                        There is no easy way of finding out who they are, so every bank and insurer is suspect. The $55,000bn CDS market is "completely lacking in transparency and completely unregulated" in the words of Chris Cox, the chairman of the US Securities and Exchange Commission.

                        The settlement auction on Lehman CDS contracts last week was in itself a bombshell. Creditors retrieved just nine cents on the dollar from the Lehman wreckage. As Naked Capitalism put it, the bank had "vaporised".
                        The biggest players at the auction were Goldman Sachs and Deutsche Bank but they were almost certainly transacting for clients.

                        The insurers of the debt -- a third are hedge funds -- will have to pay 91pc of the $400bn in contracts.

                        The Depository Trust and Clearing Corporation says the risks have been exaggerated in headline scare stories, insisting that the total sum to be paid will be closer to $6bn. It says most positions are "netted out".

                        "That's not credible," says Andrea Cicione, credit chief at BNP Paribas.
                        "They keep coming up with these number by 'netting' but we think the amount is going to anywhere from $220bn to $270bn. The chain broke in the CDS market when Lehman Brothers went down. We may now see other counter-parties defaulting," he said.

                        With hindsight, it is now clear the decision to let Lehman Brothers go bankrupt set off a melt-down of the world financial system, forcing North America, Britain, Europe, Australia, and now parts of Asia to rescue their banks. "A dramatic error," said Christine Lagarde, France's finance minister.
                        US Federal Reserve chair Ben Bernanke said this week that Washington lacked the legal power to take on the vast liabilties stemming from a Lehman rescue.

                        "A public-sector solution for Lehman proved infeasible, as the firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid, and the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman's acquisition by another firm. Consequently, little could be done," he said. The new legislation passed by Congress "will give us better choices."

                        In truth, both Congress and the US public wanted a scalp. Treasury Secretary Hank Paulson had to bide his time until it was clear to almost everybody that a domino collapse of the US banking system would lead to catastrophe. The Lehman collapse did the trick.

                        The list of companies admitting to losses on Lehman investments reveals the global extent of the damage. Dexia held ?500m of bonds, which may have caused its own need for a Franco-Belgian rescue days later.


                        Among the others with declared exposure: Swedbank $1.2bn; Freddie Mac $1.2bn; State Street $1bn; Allianz ?400m; BNP Paribas ?400m; AXA ?300m; Intesa Sanpaolo ?260m; Raffeissen Bank ?252m; Unicredit ?120m; ING ?100m; Danske Bank $100m; Aviva ?270m; Australia and New Zealand Bank $120m; Mistubishi $235m; China Citic Bank $76m; China Construction Bank $191m, Industrial Commercial Bank of China $152m and Bank of China $76m. Ultimately, some money may be recovered.

                        These losses are out in the open, but the CDS shoe has yet to drop. Perversely the insured volume is greater than the $150bn total of Lehman debt. Some $400bn of CDS contracts were sold. Many were used by hedge funds to take "short" bets on the fate of the bank. The contracts nevertheless have to be honoured.

                        Chris Whalen, head of Institutional Risk Analytics, says this creates a huge moral dilemna. Why should taxpayers now responsible for AIG foot the bill for huge windfall transfers to hedge funds?

                        "We need to shut this whole thing down. The people who don't own the underlying collateral and were just betting should be flushed away. It would be grotesque if the US authorities were now to subsidize speculators. The US political class is waking up to this," he said.

                        If so, the winners may have more trouble than they realize collecting their prize.

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                        • #13
                          Re: Financial Crisis and Black Swans

                          Tracking firm says bets placed on Lehman have been quietly settled
                          By Mary Williams Walsh Published: October 23, 2008

                          Hundreds of traders who placed bets on Lehman Brothers' creditworthiness before it went bankrupt have settled their positions "without incident," according to a company that tracks derivatives contracts.

                          The company, Depository Trust &amp; Clearing Corporation, processes large numbers of investment transactions. It said that only $5.2 billion had to change hands for all the traders to close out their positions, a much smaller amount than had been predicted a week ago.

                          As if to underscore the opacity of the market, American International said this week that it had to pay only $6.2 million to settle all of its credit-default swaps on Lehman's debt. The amount was much smaller than had been expected, given AIG's big presence in the market for credit-default swaps, and given that AIG required an emergency line of credit worth $85 billion from the Fed.

                          A spokesman for AIG, Nicholas Ashooh, said that the company had needed the big loan from the Fed because of its high level of exposure in other areas, but not on its derivatives trades on Lehman's debt. He said that AIG had written many derivatives contracts on Lehman's debt, but because they took opposing trading positions they almost completely canceled each other out during the settlement process.

                          "Lehman was not the source of our problem," Ashooh said. "Our issue really preceded that. We were already having problems when Lehman went under."

                          He said most of AIG's problems with the credit derivatives involved swaps that covered the financial strength of complex debt securities linked to the housing market.

                          Full article:
                          The salvage of human life ought to be placed above barter and exchange ~ Louis Harris, 1918

                          Comment


                          • #14
                            Re: Financial Crisis and Black Swans

                            > "Lehman was not the source of our problem," Ashooh said.
                            > "Our issue really preceded that. We were already having problems
                            > when Lehman went under."
                            > He said most of AIG's problems with the credit derivatives
                            > involved swaps that covered the financial strength of complex
                            > debt securities linked to the housing market.

                            can he please elaborate ? Don't we have a right to know more
                            about the source of this crisis, given that there was a $700B bailout
                            and elections ahead ?

                            how much worth of Lehman CDSs in each direction did AIG hold ?
                            how much worth of CDSs on all other companies/institutes/governments
                            in each direction in total ? (rough estimates are OK for now)

                            apparantly AIG sold much more CDSs on US-estate than it bought.
                            who were the other main sellers of house-CDSs ? Who were the
                            main buyers ?
                            I'm interested in expert panflu damage estimates
                            my current links: http://bit.ly/hFI7H ILI-charts: http://bit.ly/CcRgT

                            Comment


                            • #15
                              Re: Financial Crisis and Black Swans

                              AIG has tapped most of U.S. bailout credit line
                              Bloomberg News
                              October 24, 2008

                              American International Group Inc. has used $90.3 billion of a U.S. government credit line since it was bailed out last month, an amount that exceeds the size of the original loan meant to save the insurer.

                              AIG may need more than the $122.8 billion now available to the New York-based insurer, Chief Executive Edward Liddy said. The firm, which agreed on Sept. 16 to turn over majority control to the U.S. in exchange for an $85-billion loan, received access to an additional $37.8 billion this month.

                              AIG's latest balance was revealed Thursday by the New York Federal Reserve, and is up from $82.9 billion a week ago.

                              "This emphasizes the uncertainty for anyone trying to put a number" on AIG's cash needs, said Bill Bergman, an analyst at Morningstar Inc. in Chicago. The financial-products unit that caused most of the firm's losses "is a big black hole."
                              Liddy, the former Allstate Corp. CEO appointed by the government to run AIG last month, is selling businesses including U.S. life insurance, airplane leasing and consumer finance to repay the loan.

                              AIG, which averted collapse last month with the Fed loan, is dependent on "what happens to the capital markets," Liddy said Wednesday on PBS' "The NewsHour With Jim Lehrer."

                              The firm needed cash after credit downgrades forced it to post more than $10billion in collateral to clients who purchased guarantees on bonds that lost value.

                              American International Group Inc. has used $90.3 billion of a U.S. government credit line since it was bailed out last month, an amount that exceeds the size of the original loan meant to save the insurer.
                              The salvage of human life ought to be placed above barter and exchange ~ Louis Harris, 1918

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