Charles Davì

You’re Trespassing On My Credit Event

In Politicized Economy on November 20, 2008 at 9:10 pm

Insurable Interests

When you purchase fire insurance on your own home, you are said to have an insurable interest. That is, you have an interest in something and you’d like to insure it against a certain risk. In the case of fire insurance, the insurable interest is your house and the risk is fire burning your house down. Through an insurance policy, and in exchange for a fee, you can effectively transfer, to some 3rd party, financial exposure to the risk that your insurable interest (house) will burn down.

When you purchase protection on a bond through a credit default swap, you may or may not own the underlying bond. As such, you may or may not have something analogous to an insurable interest. David Merkel over at The Aleph Blog brought this issue to my attention in a comment on one of my many rants about credit default swaps. Although you should read his article in its entirety, his argument goes like this: just like you wouldn’t want someone you don’t know taking out a life insurance policy on you (because that would give them an incentive to contribute to your death), corporation ABC doesn’t want swap dealers selling protection on their bonds to those who don’t own them (since these buyers would profit from ABC’s failure). Technically, ABC wouldn’t want protection being sold to those that have a negative economic interest in ABC’s debt.

Courting Disaster

We might find it objectionable that one person takes out an insurance policy on the life of another. This is understandable. After all, we don’t want to incentivize murder. But we already incentivize creating illness. Doctors, hospitals, and pharmaceutical companies all have incentives to create illnesses that only they can cure, thus diverting money from other economic endeavors their way. More importantly, even if you don’t accept the “it’s no big deal” argument, insurance contracts have a feature that prevents the creation of incentives to destroy life and property: they are voluntary, just like derivatives.

In order for you to purchase a policy on my life, someone has to sell it to you. And like most businesses, insurance businesses are not engaged in an altruistic endeavour. So, when you come knocking on their door asking them to issue a $100 million policy on my life, they will be suspicious, and rightfully so. They will probably realize that given the fact that you are not me, $100 million is probably enough money to provide you with an incentive to have me end up under a bus. And of course, they will not issue the policy. But not because they care whether or not I end up under a bus. Rather, they will not issue the policy because it’s a terrible business decision. They know that it doesn’t cost much to kill someone, and therefore, as a general idea, issuing life insurance policies to those who have no interest in the preservation of the insured life is a bad business decision. The same applies to policies on cars, houses, etc that the policy holder doesn’t own. As is evident, the concept of an insurable interest is simply a reflection of common sense business decisions.

You Sunk My Battleship

So why do swap dealers sell protection on ABC’s bonds to people that don’t own them? Isn’t that the same as selling a policy on my life to you? Aren’t they worried that the protection buyer will go out and destroy ABC? Clearly, they are not. If you read this blog often, you know that swap dealers net their exposure. So, is that why they’re not worried? No, it is not. Even though the swap dealer’s exposure is neutral, if the dealer sold protection to one party, the dealer bought protection from another. While the network of transactions can go on for a while, it must be the case that if one party is a net buyer of protection, another is a net seller. So, somewhere along the network, someone is exposed as a net buyer and another is exposed as a net seller.

So aren’t the net sellers worried that the net buyers will go out and destroy ABC? Clearly, they are not. The only practical way to gain the ability to run a company into the ground is to gain control of it. And the only practical way to gain control of it is to purchase a large stake in it. This is an enormous barrier. A would be financial assassin would have to purchase a large enough stake to gain control and at the same time purchase more than that amount in protection through credit default swaps, and do so without raising any eyebrows. If this sounds ridiculous it’s because it is. But even if you think it’s a viable strategy, ABC should be well aware that there are those in the world who would benefit from the destruction of their company. This is not unique to protection buyers, but applies also to competitors who would love to take ABC over and liquidate their assets and take over their distribution network; or plain vanilla short sellers; or environmentalist billionaires who despise ABC’s tire burning business. In short, ABC should realize that there are those who are out to get them, whatever their motive or method, and plan accordingly.

Hands Off My Ether

The fact that others are willing to sell protection on ABC to those who don’t own ABC bonds suggests that any insurable interest that ABC has is economically meaningless. For if it weren’t the case, as in the life policy examples, no one would sell protection. But they do. So, it follows that protection sellers don’t buy the arguments about the opportunities for murderous arbitrage. So what is ABC left with? An ethereal and economically meaningless right to stop other people from referencing them in private contracts. This is akin to saying “you can’t talk about me.” That is, they are left with the right to stop others from trespassing on their credit event. And that’s just strange.

  1. “Yes, like Charlie Munger, I believe that gambling should not be legal on public policy grounds. Credit default swaps are not insurance as the regulators define today, but they should be regulated as insurance, and only financial guarantee insurers should be allowed to insure it, and those seeking insurance should prove insurable interest, or the contract is null and void.”

    Here was my position on Oct. 19th:

    “Now, suppose I buy insurance on a house I don’t own. Does that pass the smell test? I didn’t think so. Case closed.”

    Here’s you:

    “Derivative contracts can indeed be linked to any objectively observable and measurable event, e.g., the occurrence of a hurricane. These types of things exist. They’re called “weather bonds.”

    Then, I read your post on Derivatives:

    “Okay. I’m fine with this. One guy, fixed interest, another guy, floating interest. Isn’t there going to be a clear winner or loser here? Before, in our hedged example, I could both sides making out, although I’m incompetent to do the math. Now, it looks like a wager.

    “Before A entered into the swap, A was exposed to the risk that LIBOR would increase by any amount. After the swap, A is exposed to the risk that LIBOR will fall under 8%. So, even though A makes fixed payments, it is still exposed to risk: the risk that it will pay above its market rate of financing (LIBOR).”

    Maybe this is some sort of quantum logic I don’t understand, but it looks to me like A has simply changed his terms. And here’s my problem: Why? I don’t see why there isn’t a straightforward way of doing this unless it is still a hedge for A, but there seems to be a clear win or loss, so what’s the hedge? In other words, why not simply have insurance? If this happens, I pay you this? That seems clean and simple.

    “Essentially any risk that has an objectively observable event and an objectively measureable associated magnitude can be assigned a financial component and allocated using a derivative contract. There are derivative markets for risks tied to weather, energy products, interest rates, currency, etc.”

    Why? It sounds like saying that one can bet on anything that has a clearly defined winner or loser or a clearly defined score. What am I missing? Insurance, I understand. I pay you money to pay me money if something happens. I understand bonds. I loan you money, you pay me interest for a time and then give me money back. I understand betting. We pick a winner or loser based on our supposed knowledge, and one of us wins. I understand hedging, in that it seems to be a way of getting a better term on some investment for a fee to the hedger, say. But this last investment seems like a wager. I bet that the market goes one way, you bet that it goes the other. I’m sorry, but unless I’m missing something, and I’m sure that I am, that seems like betting, and not investing.

    But I’m no Paul Erdos. There was a great book about him called “The Man Who Loved Only Numbers”, a book on me would be called “The Man Who Couldn’t Even Understand Simple Explanations”.

    I think that some of us have an intuitive feeling that abstracting the financial component out of insurance seems like a wager, since it isn’t supposed to rebuild a house, or protect a mortgage. Also, the underlying impetus seems to be to avoid capital requirements on insurance. In other words, it’s inherently riskier, and used to avoid sensible rules of insurance. Finally, if we find out that the actual CDS’s on houses were not well enough understood to realize that the national housing market could collapse, as opposed to weather related disasters which are usually confined to a specific area, then adding investments on top of actual CDS’s seems crazy.

    From my perspective, although I understand your explanations, I still have a hard time following the more intricate investment strategies, and wondering why you need to use these investment instruments, when there are so many other more straightforward investments available. In other words, there’s a feeling that the complexity of the investment is meant to hide either fees or some other aspect of the investment.

    Since I don’t believe in outlawing gambling, and actually believe that some trading in stocks and bonds is more like gambling than investing as I understand it, I don’t want these investments banned. But ideas like a clearinghouse to assure pricing and extra capital requirements seem reasonable, except that I feel these products might die since their appeal was the lack of regulation. And, frankly, I believe that investors will keep looking for ways to beat capital requirements, although that might take a bit of time to occur.

    One final point. I do feel that managers and sellers of these products did misrepresent them. I have no personal evidence of this, but I would personally investigate that, rather than worry about these investments which everyone should now know are very risky. But, for me, I accept that people are responsible for these problems, as opposed to the investment instruments used.

  2. Hi Don. I know it’s not a popular sentiment, but I think gambling vs investing is a false dichotomy. A life insurance company is gambling that in aggregate policy holders will pay more in premiums over their lifetimes than the company will pay out in claims. Buying a stock is gambling that the price will go up or you will be paid a dividend. Making a loan is gambling that the borrower will pay you back with interest.

    Investing has a positive connotation. It’s a good thing to do with your money. Gambling has a negative connotation, so it should be discouraged. Applying these two terms to things that are the same can cause some cognitive dissonance.

  3. Don: “But ideas like a clearinghouse to assure pricing and extra capital requirements seem reasonable”

    There is not lack of prices in the market for CDS contracts, nor any disagrement on how they are priced.

    Firms already set aside capital on their OTC contracts, the clearing house will in fact release them from these capital requirements, in return for posting collateral to the clearing house.

    It is academic whether the amount of collateral posted is higher or lower than the regulatory capital requirements that exist now.

    My opinion is that the clearing house will make zero net difference to the current situation.
    – Almost all trades are visible now at DTCC
    – Any others can be received from the banks if asked for
    – The clearing house would not make any difference to the crash in mortgage backed securities

    Bill.

  4. I have to agree with Bill. The swap dealers already act like a quasi clearing house, given collateral requirements and the ISDA auctions. Granted, an actual clearing house would probably offer greater administrative efficiency, but the paranoia surrounding the CDS market is misplaced in any case, with or without a clearing house.

  5. “As is evident, the concept of an insurable interest is simply a reflection of common sense business decisions.”

    I don’t know how it is possible for you to substantiate this point of view — at least in the realm of insurance contracts. Common law established the requirement of “insurable interest” centuries ago. In order to claim that such laws are unnecessary because no insurance would be sold without them, you would have to find a country where there is no requirement for “insurable interest” and demonstrate that contracts without insurable interest do not exist in that country.

    As your argument stands, you have taken a contract that is outlawed in this country and claimed that we don’t see these contracts because no business would choose to enter into such contracts.

  6. Bill “Don: ‘But ideas like a clearinghouse to assure pricing and extra capital requirements seem reasonable’

    There is not lack of prices in the market for CDS contracts, nor any disagrement on how they are priced.”

    The problem with the prices in CDS markets is that they are not available to the public. If we could all see the prices in the same way that we can see stock prices on the NYSE and option prices on the CBOE, I think everybody would be much less concerned about the problem of gambling.

  7. I substantiate it by pointing out that the incentives of the insurers are aligned with anyone who has an “insurable interest.” Since they want to make money, they will act on those incentives.

  8. And some CDS price information is available to the public:

    http://www.indexco.com/

  9. Don,

    Derivatives only make explicit the complexity that already exists in the world. Sure, some derivatives could be used to hide relevant financial information. But every tool can be used for malicious purposes. Derivatives facilitate the transfer of very specific risks to those willing to assume them. This is a profound development in finance and should be encouraged, not branded as “gambling.” Investors are risk takers, that is a fact of life. If you want to call them gamblers, then you are missing the point. They are skilled. Gamblers are not.

  10. Re: substantiating the view that laws against insurance without insurable interest are unnecessary.

    You appear to be assuming that there is nobody who wants to collect insurance premiums, take off for an extended vacation in Bermuda and allow the firm back in the US to go bankrupt. I don’t know about you, but I’ve met people who would be happy to run that gig.

    Re: public prices

    We all appreciate that index price information is public, but to consider that information sufficient is like saying that all the public should know about the stock market is the level of the Dow and the S&P 500 (as if the fact that Citigroup’s heading toward zero is not valuable information).

    Re: “They are skilled. Gamblers are not.”

    I take strong exception to your derogatory view of gamblers.

  11. Wow. Thanks for the responses. You’ve all made good points. What I was trying to do is focus on what people are bothered about with these products. I’ve already admitted on my own blog to loosing the debate with Erdosfan. I can live with that.

    On clearinghouses, here’s a quote from a post I did today:

    “A case in point is the mammoth global derivatives markets. Despite wild swings in prices, derivatives exchanges have not contributed one iota to market instability. This is because exchange-traded contracts are centrally cleared and trader defaults – which are rare because of continuously adjusted margin requirements – are absorbed by well-capitalised clearing houses. Compare the 2006 collapse of hedge fund Amaranth, whose derivatives exposures were on-exchange, with the 2008 collapses of Lehman Brothers and AIG, both of which had large exposures in non-cleared, over-the-counter CDSs. Amaranth’s derivative defaults had trivial systemic ripples, while those of Lehman and AIG created major shockwaves. AIG invisibly built up huge under-collateralised sell positions on the back of a faulty credit rating. Yet if those contracts had been transacted on a trading platform with central clearing, margin calls would have short-circuited the strategy well before the company’s September collapse. US and European regulators (whose institutions comprise the vast bulk of OTC trading) should require central clearing once volume barriers in a contract are breached. This will not prevent an institution from losing large sums in derivatives trading, but will stop its default from spreading big losses to others that may be far removed from the original transactions.”

    This is the argument for an Exchange or Clearinghouse. It’s pretty convincing to me.

    On gambling, I said in my earlier posts that gambling often takes knowledge, as, for example, gambling on sports. On stocks, I wasn’t saying that all stock purchases are gambling, but some are. Believe me, in the late 1990’s, I knew people who bought stocks with no real knowledge, hoping they would go up. That’s different than assessing a company, investing in a fund, etc.

    The sports analogy I first used has turned up in a number of discussions of this issue. It’s the difference between playing a game, and betting on a game. Some people find that insurance should have a purpose. My house burns down, you pay to rebuild it. When you abstract the financial aspect of it out, I pay you this, then you spend that, some people believe that that side event has no social purpose, such as rebuilding my house. Since it’s just a financial dealing, it’s just two people putting money down hoping for different outcomes.

    Now, follow me here just so that I can try and make this understandable to myself as well as others: All of us have money. We choose where to invest it. Although there’s no law against people buying CDSs, there no law forcing it. So, when people look at what’s being invested in by others, they wonder why someone would invest in this transaction as opposed to a business,bond,something productive. The productive CDS was taken out by the lender of the mortgage, these side deals add no value, other than allowing to people to bet against each other, purely for financial gain. That’s a lot of what I’m reading.

    My personal problem flows from a post like this from Megan McArdle:

    “because CDS are so poorly understood. As someone with a front-row seat to this crisis, let me say that there are people who trade CDS and do not understand crucial details of contract terms and bond seniority, and I’ve often seen trading by major banks that takes place in ignorance of recent, public and relevant corporate news. “Which is precisely what you’d expect from shops that use CDS for speculative and not hedging purposes, but still dismaying.

    The big point, though, is that if CDS insiders have occasional gaps in their understanding, then it’s frightening to think of bank management and government regulators acting with even less understanding. Moreover, street-side participants in CDS have realized that they are counterparties to obligations they often don’t understand, and this has certainly played a role in both a) their unwillingness to extend credit and b) their inability to get credit from lenders who are uncertain of what their CDS obligations mean.”

    I’m having a hard time understanding how selling and trading investments that you don’t understand isn’t either fraud, negligence, or fiduciary mismanagement.

    That’s my problem. I don’t believe it was the instruments. As this quote from Brunnermeier suggests:

    http://www.princeton.edu/~markus/research/papers/liquidity_credit_crunch.pdf

    “Structured financial products can cater to the needs of different investor groups. Risk can be shifted to those who wish to bear it, and it can be widely spread among many market participants, which allows for lower mortgage rates and lower interest rates on corporate and other types of loans. Besides lower interest rates, securitization allows certain institutional investors to hold assets (indirectly) that they were previously prevented from holding by regulatory requirements. For example, certain money market funds and pension funds that were allowed to invest only in AAA-rated fixed-income securities could invest in a AAA-rated senior tranche of a portfolio constructed from BBB-rated securities. However, a large part of the credit risk never left the banking system, since banks, including sophisticated investment banks and hedge funds, were among the most active buyers of structured products (see, for example, Duffie, 2008). This suggests that other, perhaps less worthy motives were also at work in encouraging the creation and purchase of these assets.”

    The benefits:
    1) Getting around regulations
    2) Spreads and lowers risk

    In hindsight, it is clear that one distorting force leading to the popularity of structured investment vehicles (SIVs) was regulatory and ratings arbitrage. The Basel I accord (an international agreement that sets guidelines for bank regulation) imposed on banks an 8 percent minimum capital requirement (capital charge) for holding loans on their balance sheets; the capital charge for contractual credit lines was much lower. Moreover, there was no capital charge at all for ―reputational‖ credit lines—noncontractual liquidity backstops that sponsoring banks provided to SIVs to maintain their reputation. Thus, moving a pool of loans into off-balance-sheet vehicles, and then granting a credit line to that pool to ensure a AAA-rating, allowed banks to reduce the amount of capital they needed to hold to conform with Basel I regulations while the risk for the bank remained essentially unchanged.”

    So, let me explain. My interest in is Human Agency. Why people do things. That makes my interest unique, I guess, and I come to places like this one to understand better what happened. Then I try to explain to myself on my blog, purely because I’m a writer, and I love to write.

    When I do these posts, I’m hoping that others like me will visit these sites to better understand what’s happening.

    I’m not frightened of CDSs or CDOs any more because of this site, but I am still dubious of some of the strategies used with these investments, and whether there is some misconduct. I hope that post has given you a little evidence of why, and how some average people feel about this, even though, I personally, don’t find the abstraction all that troubling.

  12. Excuse me, “losing the debate”. These boxes are hard for me to write in.

  13. Piggybacking on Don’s last question, I have this not-fully-formed idea that one reason you might choose a CDS over some other instrument is to effectively short a company more cheaply. Instead of directly shorting the stock you can bet against the company’s bonds with a CDS for less money. If this is true, then a big upside would be more information available in pricing because shorting would be less disadvantaged with respect to going long than usual.

    I’m still trying to get my head around a lot of this. Am I completely insane? Also, Don, I’m really interested in the agency question myself and the process you’re going through to understand it is helping me out as well. Thanks.

  14. There are other potential insurance frauds: I buy a house with a large mortgage, buy cheap second hand fittings, insure contents ‘new for old’ and then take out two insurances on the structure, one in the USA one in London. “Accidentally on purpose” there is a fire, and with one insurance I pay down the mortgage and with the other I rebuild and with the contents I get to give my wife a new kitchen…
    The problem with dual insurance is very apparent with banks. The FDIC already insures bank deposits for the very good reason that no bank can survive a run, even if it was solvent ahead of the run. If you add CDS to the mix then there is potential double insurance of the bank. And a widening of bank CDS causes bank runs, which the FDIC insurance is precisely there to avoid.

  15. Perhaps we should run some numbers. Take company A, hedge fund 1 (insurance writer) and hedge fund 2 (short speculator).
    Comapny A has $100m of liabilities.
    at 10.00 fund1 writes $5m of CDS on A at 300bps to a dealer.
    at 11.00 fund2 asks fund1 for a quote on $300m of CDS on A.
    Should fund1 do that deal at 300bps? Surely not, because the size of the deal is scary. Why should fund1 synthetically lend to A three times what all other creditors have lent? So it quotes 700bps.
    Then fund2 can leak to the press that A is in trouble (‘see how their credit is declining’) and can run a short on both the debt and the equity of A. If A’s bankers and clients also take fright because of the same CDS price info, A is toast.
    But in this case the problem is not A’s business but the lack of desire of fund1 to do a deal the size that fund2 wants.
    So when we read that AAA CMBS CDS are at record highs, is that information about the probability of default or about a bet by speculators that it is not possible to double or triple the size of the CMBS market via CDS? Because the only people who should write CDS are those who would naturally buy the physical bonds.

  16. In reply to Don,

    1) Amaranth was an active user of OTC derivatives, I would dispute that their *entire* portfolio was on-exchange.

    2) AIG hasn’t collapsed yet😉

    3) The reason Amaranth caused little pain in the market was the size of their portfolio, not the product mix. They were a medium sized fund who posted collateral on all their OTC positions to the major dealers. The collateral would have offset some of the losses from their bankruptcy.

    4) There are a number of shortcomings of the “move to clearing”:
    a) Not all products will move there, especially the structured products such as CDOs, which are too complicated to risk manage and process within a CCP.
    b) A single CCP doesn’t process all trades for each firm. A dealer like Lehman will have been trading at many exchanges around the world, posting margin. Hence not one single CCP will have a coherent risk view of Lehman, and therefore would not reduce the possibility of default, nor give any early warning.

    5) On ‘understanding the CDS trade’: I haven’t seen any claims in the market that whole swathes of traders mis-understood how a CDS contract operated. The suggestion that ‘people’ executed CDS contracts seems to suggest naivety in the market by professional persons who really should know better. No private individuals can invest in OTC contracts, it’s just not allowed by the regulators and not via any major dealer. Even hedge funds invest as a corporate legal entity, not as Joe Trader personally.

    6) I do agree, trading something you don’t understand is foolish. But I disagree this is a major factor in the current crisis.

    7) I think there should be some clarity about CDSs and CDOs:

    a) A CDS on a single name (such as GM) and a single obligation (a specific GM bond) is a well understood product. Pricing and risk management for these is working properly.
    b) A CDS on an index (such as CDX) allow you to take a view on the credit worthiness of a specific market section or region. These are also being priced and risk managed properly.
    c) A CDO is a complex structure containing multiple securities, split into layers, sold to many investors, linking them through to the asset back securities such as MBSs. CDOs have gone badly wrong, as the assumptions on default rates were not cautious enough, i.e. the massive rates of default on mortgages undermined the layers of risk a CDO packaged.
    d) An SIV is another form of a CDO, suffering the same problems as CDOs.

    That’s it for now, I think Don’s posts are thought provoking, and I’m glad he did them. My feeling is that the OTC market wasn’t the primary cause of the current crisis, but has introduced (unwanted) secondary effects which are unfortunate. This doesn’t justify eradicating the OTC market.

  17. In reply to Joe:

    The price for protection on a single name CDS is freely available in the professional market, where the professional traders execute trades. There seems to be a strand in this discussion that prices are not publicly available, but why would they be?

    Lets say a CCP published an end of day protection price for BigCo. The following day, any buyer of protection on BigCo in the professional market, would want to achieve that reference price, or better, given they know when they would be worse off by paying too high a price.

    If all traders knew a reference price, why would anyone quote differently? therefore prices would converge, and the supply of prices diminish, leading to the end of OTC trading in credit protection.

    Maybe this is what the government in the US and regulators feel should happen. If you take this through to it’s conclusion, this would be the end of the OTC market, and the end of the idea that you can get different prices for the same product (a CDS) from different suppliers who have their own reasons to offer a higher or lower competitive price.

    The OTC market needs to remain as-is, or come to an abrupt end. Does this logic make sense?

    Bill

  18. I’d like to say that I’m finding the comments, as this blog, of exceptionally high quality and interest. You’re really helping me. Cheers, Don

    PS They’re so good, I really do have to ponder them for a while.

  19. Agreed, thank you all for your thoughtful comments. It’s refreshing to see reason rather than banter.

  20. Bill: “7) I think there should be some clarity about CDSs and CDOs:”

    I have to admit, I find your definitions misleading. It’s my understanding (feel free to correct me if I’m wrong), that the vast majority of 2006 and 2007 vintage CDOs were hybrid and therefore that recently CDOs and their managers sold large quantities of CDS protection. Now I’m not claiming that they ever sold a big fraction of the CDS on the market, but there is a connection between CDOs and CDS that needs to be acknowledged.

    If there’s any published data on the fraction of hybrid vs. cash CDOs on the market or on the size of the synthetic exposure in hybrid CDOs, I would love to know about it.

    Bill: “If all traders knew a reference price, why would anyone quote differently? therefore prices would converge, and the supply of prices diminish, leading to the end of OTC trading in credit protection.”

    I don’t understand the problem. Very few people seem to feel that the stock market is a failure. What’s wrong with having prices converge to a single price? In a mark-to-market world wouldn’t that be a lot better than having to guesstimate the value of your balance sheet by picking and choosing between different dealer quotes?

    Nothing prevents a market maker on the stock market who believes that the posted price is fundamentally wrong, from posting a better one.

    What is lost by converging to a single price — besides the profits market makers can make by trading on proprietary price information? In economic terms, this proprietary information is just a kind of monopoly power that our regulations have granted to market makers for reasons I don’t understand.

  21. Hi Acc,

    1) On definitions.

    A Credit Default Swap in my world is a contract where the underlying is either on a single reference entity / obligation, or on one of the Markit Indices such as CDX or iTraxx. A CDS is a straighforward contract and almost fully automated via the DTCC Warehouse and CLS.

    A CDO (whether vanilla, hybrid or with caramel swirls) is a highly structured bespoke product, and quite different from a CDS.

    I do agree that hedging a CDO can be achieved using CDS contracts, and there is a direct trading link between the two.

    2) On pricing

    If you and I went down to a fruit market to buy oranges, and there were multiple sellers, given that an orange of a similar size, is a standard product, you would expect that the sellers would arrive at a common price as the price differential would soon evaporate as the cheapest seller would win all the business.

    If on the other hand we look to buy a complex multi-room home entertainment system with support for multiple file formats, wireless connectivity, integration with your XBox 360 and PS3, plus it made a nice cup of tea, you would expect quite different prices as each seller would provide different technology solutions from Panasonic, Sony etc. leading to a non-standard product and customised pricing.

    I guess what I’m saying is that the raison d’etre of the OTC market is to offer a customised price for a customisable product.

    I contradict myself though as the CDS contracts in the market now *are* standardised😉

    If I am an OTC market maker, I might offer a better price or worse price to the counterparty, depending on a) credit lines b) their ‘riskiness’, c) whether we provide prime brokerage d) “other”😉

    Is it right that protection on a single reference entity should be the same for all sellers in the global market? I don’t know the answer, but an empirical answer is contained within the trade warehouse which has the data to show the variance in pricing over the past 5 years or so.

    Good points though, Bill.

  22. Hi,

    Is there some particular reason why you publish contracted versions of your postings in the RSS feed? Would you consider publishing your postings in their entirety?

    Thanks.

    –Samir

  23. The only practical way to gain the ability to run a company into the ground is to gain control of it. And the only practical way to gain control of it is to purchase a large stake in it.

    A fatal flaw in your argument is one needs to gain control to sink a company. If a company’s life blood is its financing rate, it is easier to sink it by increasing the financing rate until it is uneconomical to continue operating. Take an independent broker dealer – if its spreads start widening, momentum guys (fast money, hedgies…) get on board and buy protection and supply and demand being what it is, spreads go wider. Financial firm goes to raise $$ and have to pay a higher premium. Margins approach zero, confidence waivers > BSC and LEH occur.

    As well, while swap dealers net their positions, they often use correlation books to do so. Hasn’t worked out well so far. Then there is always counterparty risk and the sunday netting party.

  24. Bond Guy,

    The only way to drive up the cost of protection is to buy a ton of protection. Doing that will “raise eyebrows.” Second, you assume that whatever effects the cost of protection have on the cost of debt will last long enough to actually inhibit the ability of a firm to finance with debt. If you’re a firm that relies heavily on financing, you should have stable lines of credit in place for exactly this reason.

  25. […] favour of the right to go nude – Sam Jones, Charles Davi and Craig Pirrong, Moorad Choudhry (and again), various FT letter writers, investment banks, hedge […]

  26. Hi, if there are 2 parties to the swap, why is there a NET outstanding at all, and why does it not net to zero? Is it due to accrued, but then again that does not work either! Thanks!

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