Credit Default Swaps

[Anonymous]

I'm trying to follow this Credit Default Swap thingy.....


Trouble Ahead: Massive Credit Default Swap Payments Come Due

Historic auctions next week will result in billions of dollars in liabilities

WASHINGTON, Oct 05, 2008 /PRNewswire via COMTEX/ --

WHAT: Holders of credit default swaps -- the financial vehicles with a worldwide face value estimated in excess of $50 trillion -- are bracing themselves for the fallout from the Lehman Brothers bankruptcy and the takeover of Freddie Mac and Fannie Mae by the United States government. Three auctions to be held next week will determine the amount of settlement payments required to be made under credit default swaps with Fannie Mae, Freddie Mac, and Lehman Brothers as the reference entity.

These auctions will be used to set values to be paid under thousands of agreements and are scheduled to take place on:

Freddie Mac October 6, 2008
Fannie Mae October 6, 2008
Lehman Brothers October 10, 2008 (TBC)

WHY: After these auctions, credit protection sellers are expected to be called upon to make payments that, in the aggregate, are extraordinary for the credit default swap market. Some estimate that the payments on Lehman's bonds alone will be $350 billion.

WHO: Given the unusual volume of these payments and the current difficulties in worldwide financial markets, the credit default swap payments may lead to stresses on vulnerable counterparties and to disputes over payments.

(more)

http://www.marketwatch.com/news/story/trouble-ahead-massive-credit-default/story.aspx?guid=%7B9F86B14D-12F4-46DD-8C9E-FB4610D8817F%7D&dist=hppr

[Anonymous]

A Look At Wall Street's Shadow Market

60 Minutes: How Some Arcane Wall Street Financial Instruments Magnified Economic Crisis

Oct. 5, 2008- excerpt

(CBS) "On Friday Congress finally passed - and President Bush signed into law - a financial rescue package in which the taxpayers will buy up Wall Street's bad investments. The numbers are staggering, but they don't begin to explain the greed and incompetence that created this mess. It began with a terrible bet that was magnified by reckless borrowing, complex securities, and a vast, unregulated shadow market worth nearly $60 trillion that hid the risks until it was too late to do anything about them.

And as correspondent Steve Kroft reports, it's far from being over.

"It started out 16 months ago as a mortgage crisis, and then slowly evolved into a credit crisis. Now it's something entirely different and much more serious.

What kind of crisis it is today?

"This is a full-blown financial storm and one that comes around perhaps once every 50 or 100 years. This is the real thing," says Jim Grant, the editor of "Grant's Interest Rate Observer." Grant is one of the country’s foremost experts on credit markets. He says it didn't have to happen, that this disaster was created entirely by Wall Street itself, during a time of relative prosperity. And they did it by placing a trillion dollar bet, with mostly borrowed money, that the riskiest mortgages in the country could be turned into gold-plated investments.

"A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails," he explains.

"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," Greenberger adds.

"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?" Kroft asks.

"A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument," Greenberger says.

But he says there was a big problem. "The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side. As bad as the mortgage crisis has been, 94 percent of all Americans are still paying off their loans. The problem is Wall Street placed its huge bets and side bets with all of those fancy securities on the 6 percent who are not.

"We wouldn't be in any of this trouble right now if we had just had underlying investments in mortgages. "

(James Grant) "Somehow, through, I will call it a criminal neglect and incompetence, the people at the top of these firms chose to look away, to take more risk, to enrich themselves and to put the shareholders and, indeed, the country, itself, ultimately, the country's economy at risk. And it is truly not only a shame, it's a crime."

http://www.cbsnews.com/stories/2008/10/05/60minutes/main4502454_page2.shtml

[Anonymous]

Fed May See Lending to Companies, States as Next Crisis Fronts

By Scott Lanman and John Brinsley

Oct. 6 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke may find the next fronts of the financial crisis to be just as chilling as last month's downfall of Wall Street titans: its spread to corporate America and state and local governments.

Companies from Goodyear Tire & Rubber Co. and Duke Energy Corp. to Gannett Co. and Caterpillar Inc. are being forced to tap emergency credit lines or pay more to borrow as investors flee even firms with few links to the subprime-mortgage debacle. California Governor Arnold Schwarzenegger says his and other states may need emergency federal loans as funding dries up.

(snip)

Even as confidence grew that Congress would pass the bailout, banks hoarded cash, indicating the proposed purchases of devalued mortgage assets may not be able to stop the credit crunch from widening.

(snip)

State and local governments having trouble meeting cash needs may push for help. Schwarzenegger told Paulson in an Oct. 2 letter that California and other states ``may be forced to turn to the federal Treasury for short-term financing'' if the crisis doesn't ease.

``If states can't access the credit markets because of market conditions, then the Treasury should consider providing it,'' said Ben Watkins, a member of the debt committee of the Government Finance Officers Association, a group of public finance officials.

Without funding, states ``can't operate the health-care system, schools, roads and other services they provide,'' said Watkins, who also serves as head of Florida's bond sales.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aktjzhZEdgfY&refer=home

[Anonymous]

From the Friday, October 10, 2008 issue of The Week magazine.

Briefing: Wall Street’s hidden time bombs

http://www.theweek.com/article/index/89404/3/3/Briefing_Wall_Streets_hidden_time_bombs

The financial meltdown engulfing Wall Street would not have happened without the advent of complex financial contracts known as derivatives. Why were they created, and why were so many supposedly smart people fooled?

What is a derivative?
In a very real sense, it’s a bet. A derivative is a contract in which an investor agrees to pay for either a commodity or financial instrument at a set price today, in return for the right to take profits if that asset’s value rises. Some derivatives, such as stock options and commodities futures, have been used for years and are considered completely benign. A farmer, for example, can agree to sell a ton of wheat he’ll harvest in three months to a major grain buyer for $1,000. That deal enables the farmer to lock in the price of wheat as he’s growing it. In exchange for that guarantee, the grain buyer gets an assurance he’ll have a steady supply of grain while also safeguarding against future price increases. Both sides, in other words, reduce risk and future uncertainties. But in recent years, a new, highly toxic form of financial derivative has spread like wildfire throughout the financial system, ultimately laying waste to some of Wall Street’s oldest and most prestigious firms.

What are these new derivatives?
They’re called credit derivatives, and were designed to serve as a kind of insurance against borrowers defaulting on their debts. Credit derivatives first appeared on the scene in the boom of the 1990s, but really became popular in the early 2000s, when Federal Reserve Chairman Alan Greenspan sought to stave off a post-9/11 recession by slashing interest rates from 6.5 percent to 1 percent. Money became very easy to borrow, and tens of millions of people bought homes or took out second mortgages, many of which were offered to financially shaky buyers at “subprime’’ rates. Those mortgages were then bundled into securities, and firms such as Lehman Brothers and Merrill Lynch created credit derivatives to protect investors in case the securities defaulted.

Why were these securities so popular?
They provided above-market rates of return, and because these complex instruments were so poorly understood, they seemed more solid—and less risky—than they really were. Investors thought that they were getting AAA-rated securities. The sellers—caught up in the assumption that housing prices would continue to rise indefinitely—also thought they were safe from losses. Each security involved hundreds or thousands of individual mortgages, chopped into pieces, so that the risk of default appeared small. And by selling them, investment banks and brokerage firms made hundreds of millions in upfront fees and premium payments. That’s why global insurance giant AIG also jumped into the derivatives game. “It is hard for us, without being flippant, to see us losing even one dollar in any of those transactions,” Joseph Cassano, then AIG’s head of credit derivatives, declared last year, expressing a common sentiment.

Was everyone so clueless?
No. Concern about financial derivatives first surfaced in the late 1990s, ... [Despite warnings, Congress] pushed through a law that explicitly exempted financial derivatives from federal regulation. By 2003, the pace of derivatives trading had exploded, leading Warren Buffett, one of the world’s most successful investors, to call derivatives “financial weapons of mass destruction.”

Why was Buffett alarmed?
Because the well-being of the entire global financial system rested in part on a hidden world of multitrillion-dollar bets that financial regulators couldn’t control or even monitor. Indeed, since 2000, credit default swaps became one of Wall Street’s most popular products, with firms such as AIG, Lehman Brothers, and Bear Stearns selling swaps covering trillions of dollars in bonds. At Cassano’s urging, AIG became the biggest player in the field, selling protection on $527 billion in bonds.

So what went wrong?
Home prices started to fall and interest rates started to rise. When rates rose, many subprime borrowers with adjustable-rate mortgages found themselves unable to make their monthly payments. They also couldn’t sell, because the demand for houses began to crash. Very quickly, as defaults mounted, the derivatives that had made so many bankers and investors rich lost their value. In turn, firms such as AIG and Lehman, which had guaranteed these securities, couldn’t meet their debts. It was a worst-case scenario, causing the collapse of many banks and investment firms. Despite the federal government’s rescue efforts, many financial executives worry that further damage is yet to come, because of bad debt hidden in other banks’ derivative holdings. “It’s not the corpses you can see that scare you,” says one Wall Street banker. “It’s the corpses you can’t see that could pop out at any time.”

<snip> more at the link

[Anonymous]

Thanks for posting this information. This stuff is incredibly hard to understand, and I've learned a lot from these articles.

[Anonymous]

You are welcome! I hope it's OK to post this financial stuff on the political forum... not sure where else to put it.

[jsteele]

Anonymous wrote:You are welcome! I hope it's OK to post this financial stuff on the political forum... not sure where else to put it.

Yeah, its cool. I'm also interested in reading the articles.

[Anonymous]

Didn't get a chance to listen to it yet but This American Life did a show explaining this over the weekend. The last one was excellent (very clear explanation for the lay person) so I'm sure this one should be good as well.

http://www.thisamericanlife.org/

[Anonymous]

Anonymous wrote:Didn't get a chance to listen to it yet but This American Life did a show explaining this over the weekend. The last one was excellent (very clear explanation for the lay person) so I'm sure this one should be good as well.

http://www.thisamericanlife.org/

Just listened to this and it is very clear and helpful.
And also scary.....

[Anonymous]

Is that the episode that slams Christopher Cox?

[Anonymous]

Fannie, Freddie CDS to recover at least 92 pct

Reuters, Monday October 6 2008 (Rewrites throughout)

http://www.guardian.co.uk/business/feedarticle/7845325

NEW YORK, Oct 6 (Reuters) - Sellers of protection on Fannie Mae and Freddie Mac will be repaid more than some had feared, based on initial prices in an auction to determine the value of the companies' credit default swaps on Monday.

Initial indications are that swaps on Fannie's and Freddie's senior and subordinated debt will recover at least 92 percent of the amount of insurance sold, and potentially several percentage points higher, based on results published by the auction's administrators, Creditex and Markit.

Some protection sellers had feared the contracts would recover much less, due to the low trading prices of some of the debt being used to settle the contracts. JPMorgan analysts last week said some of the swaps may recover as little as 85 cents on the dollar.

The settlement of Fannie Mae's and Freddie Mac's credit default swaps is one of the largest tests the $55 trillion market has ever seen as the volume of contracts outstanding on the companies, estimated to be hundreds of billions of dollars, far exceeds those of previous defaults.

(snip)... more at link

[Anonymous]

http://www.financialweek.com/apps/pbcs.dll/article?AID=/20081006/REG/810069975/1036

Question marks surround auctions on Fannie, Freddie default swaps

By Matthew Scott
October 6, 2008 4:01 PM ET

Today’s auction of credit default swaps connected to Fannie Mae and Freddie Mac is a vital step in valuing what the complex financial instruments are worth. The auctions may also give the financial markets a glimpse of whether the swaps provide proper credit protection against risk of default—or whether they actually destabilize credit markets.

The auctions are the result of the $200 billion bailout of Fannie Mae and Freddie Mac by the U.S. government last month. The placing of the two institutions into conservatorship created a “credit event” that requires the sellers of swaps with those reference institutions to make payouts to buyers.

Today’s auctions are critical because they set the price of the payouts on the swaps. If the payouts are too expensive, several more financial institutions may be in jeopardy of falling into bankruptcy.

(snip)

Similar auctions of credit default swaps have been held since 2005 with few problems. But today’s auctions—and those that will follow in the next few week—are tied to the string of financial institutions that failed in September.

Observers said that because Fannie Mae and Freddie Mac are under conservatorship and the U.S. government said it would back their bonds, the swaps being auctioned today still have some value.

“Those obligations still represent a right to future payment that will probably be made by the federal government,” said a securities lawyer who chose to remain nameless.

It is unclear how credit default swaps for Lehman Brothers and Washington Mutual will be valued, because those two businesses went into bankruptcy without backing from the U.S. government.

It is estimated that swaps payments on Lehman Brothers bonds, which will be auctioned on Oct. 10, could be worth $350 billion. Auctions for credit default swaps for Washington Mutual will be held Oct. 23.

(snip)... more at link

[Anonymous]

Anonymous wrote:Is that the episode that slams Christopher Cox?

I don't believe so. I think that was the first one explaining the subprime mortgage crisis. This is a new episode which explains a couple of things, and has a big section on the credit default swaps.

[Anonymous]

More interesting developments....With the credit crisis, banks have become unwilling to lend money, and businesses are finding it hard to make payroll and to order supplies. THAT'S BAD. In the next few days, a lot of these loans are up for renewal and if people don't get them, it will cau7se havok. (Or so I am coming to understand). A lot of people live paycheck to paycheck, and a lot of businesses operate pretty much that way, with few cash reserves. An interruption in getting a paycheck will be, well, NOT GOOD for a lot of people, immediately.

We'll see if this measure works:


Business loan bailout

Federal Reserve to buy loans crucial to business to unfreeze markets.

CNNMoney.com senior writer
Last Updated: October 7, 2008: 11:22 AM ET

http://money.cnn.com/2008/10/07/news/economy/fed_commercial_paper/?postversion=2008100711

NEW YORK (CNNMoney.com) -- The Federal Reserve announced a new program to help the battered market for short-term business loans - taking its closest step yet to lending directly to businesses.

The program addresses commercial paper, a form of short-term funding that is crucial to many businesses operations.

Commercial paper is sold by major corporations and most of the nation's leading financial institutions. They use the proceeds to fund day-to-day business operations. It is bought primarily by money market fund managers and other institutional investors.

Before the current credit crisis, there was nearly $2 trillion of commercial paper outstanding and was mostly issued for short terms - never more than nine months - and thus had to be renewed frequently.

For investors, it was considered a very safe investment to purchase and one that could be easily resold to other investors.

In the past month, the amount of money outstanding in commercial paper loans has fallen 11% to a seasonally adjusted $1.6 trillion on Oct. 1 from $1.82 trillion on Sept. 10.

The decline in available funding indicates only part of the market's problems, however. Investors have also become unwilling to buy longer-term paper - beyond a week or two - from even companies and financial institutions with top-flight credit ratings.

Federal Reserve officials speaking on background to reporters said that the overwhelming majority of the paper outstanding is coming up for renewal in the next several days and companies needing to use the money could face trouble when they try to renew it.

Experts in the field say the market really fell apart after Lehman Brothers, the nation's No. 4 Wall Street firm at the time, filed for bankruptcy on Sept. 15. The firm's collapse essentially wiped out the value of its commercial paper and scared money market managers out of the commercial paper market and into Treasurys.

Federal Reserve officials say they hope that the Fed's entry into the market will give money markets and other investors confidence to reenter the market because they know they will be able to sell that paper to the Fed as a backstop. So they hope the central bank will not have to actually buy much of the commercial paper in order to restore confidence in the market.

Fed officials said there is no limit to the amount of commercial paper it could buy. They said that market conditions - and the decisions of investors - will determine the extent to which the government will have to step in.

(snip)... more at link

[Anonymous]

awesome video to explain Credit Default swaps:

http://ca.youtube.com/watch?v=eb_R1-PqRrw

"Marketplace Senior Editor Paddy Hirsch gives a bubbly explanation of the intricacies of collateralized debt obligations those financial instruments that got us into this financial mess."