Thursday, 16 October 2008 02:00

Do you who's going to screw who next week?

I
spent the majority of my Wednesday spreading my bearish positions
further around the European banks (the balance was catering to my beautiful, yet demanding 2 year old daughter). Let me give you a glimpse into some of the
reasons why. First a glance at the home page of Bloomberg.com yields...

1. U.S. Stocks Plunge Most Since Market Crash of 1987 on
Recession Concerns-
Sounds like a market crashing to me.

VIX Index of U.S. Options `Exploding' Amid Growing Concerns
About Economy-
Hey doesn't this hypervolatility almost always precede a major market crash?

Bernanke Says Fed May Take New Role in Trying to Curb
Asset-Price Bubbles
- Which
contradicts the story below. If you want to prick asset bubbles, you
can start by not letting them form, such as in allowing banks to
conceal the losses of assets on their books - in essence inflating
those asset values.

SEC Clears U.S. Banks to Postpone Writedowns on Value of
Some Securities-

And so it begins, the obfuscation of
true market values of assets held on bank's books. They can't fool me though.
Now, preferred stock is to be called debt. When is debt to be called preferred stock.
When are we going to be notified if or when the assets a bank is holding and
paid for with leverage have dropped in value by 70%. Doesn't that make the bank
worth less. Maybe not, after all stock is really debt, right?

S&P May Downgrade $280.1 Billion of Alt-A Mortgage Debt
Amid Delinquencies -
But it doesn't really matter because
if you read the article above, banks don't have to write it down now. You know,
if I run into the middle of the highway, as long as I close my eyes so I can't
see the cars I'll be just fine.

Bush Says U.S. Taxpayers Will Get Back `Most' of Money Under
Bank Rescue-
Of
course they will. Bush and his cronies have ever been the bastion of
credibility (Reggie Middleton says, "Don't believe Paulson": S&L 2.0 - bank failure redux, Is Paulson to be trusted, or is this Bush Administration Shock and Awe, 2.0? and Reggie Middleton asks, "Do you guys know who you're messin' with?"). Just look at bullet point one above: all of those levered equity
securities bought at the top of the stock bull run from 2003 to 2007 will
generate tons of return for tax payer as they overpay to buy them up.

What does all this have to do with my buying of the European banks bear positions? Well, most are still much, much too optimistic about the financial sectors prospects here. The Monday rally was an opportunity to go shopping, and shopping I did, for price and value diverged even farther. While I won't divulge what I bought, I will share a little anecdotal research (more empirical research on this may be available to professional level subscribers next week). Before we go on, if you haven't read Interesting Lehman email, it is must reading to fully grasp the weight of the rest of this article.

The Lehman collapse has yet to be felt

The final number of enrolled bidders for
Lehman's debt auction, according to ISDA, was 358, among them the biggest
debt and derivatives dealers in the business. The final CDS settlement is 8.625%. of each dollar protected. Keep this
percentage in mind as I go through a list of companies that allegedly
have "de minimus exposure" or have had their positions "substantially
netted out". I use quotes because: a) these were the actual words
quoted by company reps, b)this is bullsh1t, the losses are real and
someone has to take them so I ask "How was this exposure netted out?",
and c) the recovery rate is close to zero, "de minimus" indeed. Keep in
mind the percentage quoted and realize that Lehman was the 10th largest
writer of CDS in the WORLD!

This smattering is not even scraping the
surface of what will take place next week. A rough estimation, this is
about 20% or less of the total creditors outstanding exposure on the hook.

Note and update:

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We looked into exposure of Citibank and The Bank of New York
Mellon Corporation to Lehman’s debt and securities. Upon deeper analysis and
search, we observed that the exposure of these companies to Lehman is that of
administrative nature only and doesn’t represent any loss due to possibility of
non-payment of debt money by Lehman.

This was also recently clarified by Citibank in response to
Chapter 11 bankruptcy filing by Lehman disclosing exposure to the failed
investment firm.

Following was the clarification by Citibank:

Chapter 11 bankruptcy filing does not represent exposure to the
failed investment firm. "Citibank N.A. is listed in the Lehman Brothers
bankruptcy filing as an indenture trustee for bond debt of approximately $138
billion under Lehman Brothers Holdings Inc. Senior Notes," Citigroup said
in a statement. "Citi wishes to clarify that our role in this issue is
administrative in nature and does not represent exposure for Citi to Lehman.
Any assertions to the contrary are false."

Citigroup and Bank of New York Mellon are trustees to $138 billion
of Lehman Brothers' bonds, the biggest on the list of unsecured creditors,
according to a petition filed in New York bankruptcy court on Monday. Banks are
trying to calm employees and clients in the wake of Lehman's bankruptcy filing
Monday

We have, therefore, separately collated information on names and
exposure of entities in the US having exposure to Lehman. We are going to share
this list with you in a couple of hours. The list contains entity-wise details
of total exposure, estimated loss (in absolute amount and as % of equity). This
required a lot of manual efforts since a ready list was not available from any
source.

We shall be highlighting and sharing name of 5-6 companies having
potential exposure to Lehman, which have not witnessed significant fall in
their valuation in last 3 months. The guiding factor will be (among others)

·
Highest exposure as% of their respective equity

·
Share price above $15

·
Not significant fall in share price in last 3 months.

This report will be available to the professional subscribers when released.


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Lehman CDS exposure (millions)

2Q2008

2007

BNP Paribas

n/a

597,578

Natixis

n/a


202,928

Deutsche Bank

1,138,090

1,193,131

Braclays


729,556

557,967

UBS* net exp. substantially closed out?

652,972

757,271

Societe Generale


473,329


487,959

Credit Agircole

383,995

364,178

Credit Suisse


277,362


331,807


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Exposure of some life insurance
companies

Primus Financial CDS
exposure

Washington Mutual

$16.1 mn

Lehman Brothers

$80 mn

Fannie Mae and Freddie
Mac

$215 mn

FPIC Insurance Group Inc

Lehman Brothers

$4.1 mn

AIG

$2.1 mn

WaMu senior debt

$2.1 mn

Morgan Stanley

$2.5 mn

Zenith National Insurance

Number of companies,
including AIG (both fixed income and equity), plus fixed-income investments
in Citigroup, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley
and Wachovia

$100.7 mn

Below, that is a "B" not an "M", as in Billions!


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Lists of debtors- Largest
unsecured claims

Citibank

Bond Debt

$138 billion

The Bank of New York
Mellon Corporation, as indenture trustee under the Lehman Brothers Holdings
Inc. Subordinated Debt

Bond Debt

$12 billion

The Bank of New York
Mellon Corporation, as indenture trustee under the Lehman Brothers Holdings
Inc. Junior Subordinated Debt

Bond Debt

$5 billion

AOZORA

Bank Loan

$460 mn

Mizuho Corporate Bank,

Bank Loan

$289 mn

Citibank N.A. Hong Kong
Branch

Bank Loan

$275 mn

BNP Paribas

Bank Loan

$250 mn

Shinsei Bank Ltd.

Bank Loan

$231 mn

UFJ Bank Limited

Bank Loan

$185 mn

Sumitomo Mitsubishi
Banking Corp

Bank Loan

$177 mn


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Bank Leumi (Israel's
largest bank)

WAMU Debentures

$27 mn

WAMU CDS

$23 mn


Here is a primer on the CDS risk that I am alluding to (from previous
posts). The rampant credit and counterparty risk is literally out of
control. I think there is hundreds of billions of dollars of worthless
paper sitting on derivative, loan and bond trading desks around the
globe. Even if I am wrong, most of these banks make decent shorts via
the macro argument anyway.

And back to the basic problem

The CDS insurance
contract created primarily to transfer credit risk from bond investors
to other parties may be insurance companies or hedge funds to protect
against the default risk. However, as depicted in the chart below, the
financial institutions may sell and resell the insurance contracts
among themselves creating the ‘entanglement of credit risk’.
This also makes it difficult to identify who bears the ultimate risk.
This reselling of insurance contacts to another party has created a
near untraceable credit risk web among the market participants.

image001.jpg

Source: The New York Times


The growth in CDS market in the last few years has
outstripped that of the US
equity and bond markets

The credit
derivatives market has grown at a remarkable pace as reflected from the
tremendous increase in total notional amount outstanding over the last few
years. The total notional amount of credit derivatives as of June 2007 increased
to US$42.6 trillion, an increase of 109% over the US$20.4 trillion reported in
June 2006. This has been driven by both the rise in single name CDS and the multi
name CDS instruments. The significant rise in the multi name CDS (traded
indices) has notably surpassed the growth in single name CDS. Single name CDS’ total notional amount
outstanding has increased from US$7.31 trillion in June 2005 to US$24.2
trillion in June 2007 while the multi name CDS has grown from US$2.9 trillion
in June 2005 to US$18.3 trillion in June 2007.

image002.jpg

Source: Thomson Research

Last modified on Thursday, 16 October 2008 02:00

29 comments

  • Comment Link Phil V Monday, 20 October 2008 11:38 posted by Phil V

    the acquisition of indonesian bank for $600M change the thesis at all on HSBC?

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  • Comment Link M Saturday, 18 October 2008 23:29 posted by M

    http://www.telegraph.co.uk/finance/financetopics/financialcrisis/3225213/AIG-trail-leads-to-London-casino.html

    [i]In contrast to standard practice, however, AIG Financial Products did not hedge its exposure to a possible fall in the CDS market. In a footnote to AIG’s 2007 accounts spotted by Forbes magazine, the company declared: “In most cases AIGFP does not hedge its exposures to credit default swaps it has written.” [/i]

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  • Comment Link M Saturday, 18 October 2008 11:07 posted by M

    http://brontecapital.blogspot.com/2008/10/why-lehman-mattered.html

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  • Comment Link Reggie Middleton Saturday, 18 October 2008 09:28 posted by Reggie Middleton

    Not quite, but close.

    [quote]2. As most trades (I believe all trades in the current environment) will have been collateralized most of the pain has been felt already[/quote]
    They [b]should [/b] have been collateralized, but we really don't know what has happened since these are all private, unregulated OTC transactions without and exchange and an enforced, standardized set of rules. ISDA agreements modified, remodified??? If this was an exchange than it would be a different story.

    [quote]Hedgefunds are in dire trouble[/quote]
    I think many are.

    [quote]And my main point:
    5. We are not talking about trillions of net exposure, but about 8 billion or so. Not a small amount, not a small problem, but not a trillion dollar amount

    All parties in the global equity, credit and interest rate markets that have any sort of risk management will have had to take back a lot of risk and therefore close positions at any cost causing more volatility. This is because the current volatility has created a history of crazy market movements in all directions with will be part of VAR for the coming 1 to 5 years. Hedge funds will bleed even more due to the reducing risk appetite.[/quote]

    Well, I still haven't come to the only 8 billion or so conclusion, but even so, there still the butterfly effect M. All of the major money center banks have placed their bets on prime brokerage and asset management as the key to drive revenues and profits through this malaise.
    [quote]Hedge funds are in dire trouble as ALL their bets are running against them[/quote]
    Their goes the pipe dreams of the prime brokerage bets, which many paid a pretty penny to smoke.

    [quote]their clients are (wisely) pulling money out [/quote]
    And those asset management dreams go up in smoke, leaving the lucrative M&A, private equity and proprietary trading revenue streams (jokingly chuckling in the background :D )

    [quote]where many counterparties suddenly had to come up with cash and collateral to prepare for this settlement [/quote]
    I am sure that many of the prime desks got stuck right along with the hedge funds. You see, when two people lie together in a bed, very rarely does only on leave with a venereal disease.

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  • Comment Link M Saturday, 18 October 2008 09:11 posted by M

    1. Failure of Lehman caused widespread problems
    2. As most trades (I believe all trades in the current environment) will have been collateralized most of the pain has been felt already
    3. Hedgefunds are in dire trouble as ALL their bets are running against them (ever heard of the 30y asset swap spread debacle? Complex interest derivatives books have lost billions globally due to the movement of the 30y swap points in the last two, three weeks and are still losing) including that their clients are (wisely) pulling money out
    4. It has already happened, the CDS settlement date is not the reason for the trouble, though the rapid movement of the CDS value has created problems in the last four weeks where many counterparties suddenly had to come up with cash and collateral to prepare for this settlement
    And my main point:
    5. We are not talking about trillions of net exposure, but about 8 billion or so. Not a small amount, not a small problem, but not a trillion dollar amount

    All parties in the global equity, credit and interest rate markets that have any sort of risk management will have had to take back a lot of risk and therefore close positions at any cost causing more volatility. This is because the current volatility has created a history of crazy market movements in all directions with will be part of VAR for the coming 1 to 5 years. Hedgefunds will bleed even more due to the reducing risk appetite.

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  • Comment Link Reggie Middleton Saturday, 18 October 2008 05:23 posted by Reggie Middleton

    From the original [url=http://www.reuters.com/article/bondsNews/idUSLH15542620081017?sp=true]Reuters[/url] article:

    [quote] "The mark-to-market on the CDS is margined daily as a credit event draws near, and that mitigates a large, lumpy payment at the end," said Peter Goves, another Citigroup strategist.

    In the Lehman case, the largest collateral payments would have been required in the four or five days following the bankruptcy filing in mid-September, when spreads on senior debt widened from around 700 basis points on the five-year contract to around 7,000 basis points, based on the then market view of an estimated 30 percent recovery, Hampden-Turner said.

    NO NASTY SURPRISE

    The cash settlement CDS auction on Oct. 10 set final recovery on the CDS at an even lower 8.625 percent.

    But by that time, market expectations had already fallen to close to that level, around 10 cents on the dollar.

    "The auction was not a huge surprise, worse than expected but only slightly," said Puneet Sharma, a credit strategist at Barclays Capital. "If you are a solvent institution or a counterparty to a solvent institution, then you would already have collateral close to that amount."

    For a few hedge funds or other leveraged investors who sold protection on Lehman (LEHMQ.PK: Quote, Profile, Research, Stock Buzz), however, Tuesday could prove to be a strain.

    Funds typically use leverage to obtain the collateral they provide on CDS contracts.

    So while the CDS counterparty is already holding collateral to cover his payment, other lenders to the hedge fund may end up the losers.

    If the only event in the market were the Lehman failure and the resulting payment of $8 billion on its CDS, that alone would probably not be enough to cause any funds to collapse, Barcap's Sharma said.

    But in the current environment, "the stresses that hedge funds are facing because of volatility are unprecedented," he said. "The number of margin calls from the commodity, equity, credit, volatility and other positions are going to be enormous."

    For some investors, Tuesday's payment "could be the final straw", he said. (Editing by Paul Bolding) [/quote]

    Now, in this environment, not many, if any of the I banks are solvent. I can attest to that. The process also wasn't that gradual if you look at the CDS spread chart, it actually was a sudden spike.[img]http://media.rgemonitor.com/images/blogs/image002_512_04.jpg[/img]

    As eloquently stated by the articulate Ms,[url=http://www.rgemonitor.com/economonitor-monitor/254052/lehman_cds_payout_on_october_21_360bn_or_6bn]Elisa Parisi-Capone[/url], whom I know you have conversed with: [quote]Furthermore, standard CDS cash flow pricing models such as this one (see ISDA)

    PV(Expected spread payments)= PV(Expected default losses)



    (where PV = present value), require the assumption of a default probability and a loss-given-default value (LGD) [= 1-recovery value]. The historical recovery value is 40%. Delphi’s recovery value reached 64% in a similar auction in 2005. Compare this with the ultimate 8.7% recovery value of defaulted Lehman bonds on October 10. Did Lehman net protection sellers expect such an outcome? Have they been adequately compensated for that outcome with collected CDS premium income?



    3) Collateralization of Net Exposures: Here’s an example: When a CDS investor wants to unwind an existing CDS contract he can enter an offsetting trade either with his original counterparty, or with a third party. If the offsetting trade occurs with the original counterparty, the market and counterparty risk exposure between the two cancels out as do the collateral requirements. If the investor enters an offsetting trade with a third party, collateral must be posted with both counterparties and the investor is exposed to counterparty risk on both sides. This is why investors have incentives to deal with one counterparty rather than many and thus tend to use large dealers. It also explains the exponential growth of this market in the face of limited capital/collateral availability.



    By entering as many bilateral transactions (across the entire interest rate, equity credit derivatives spectrum) with the same counterparty as possible, the collateral margins can thus be lowered. This means that the while the net bilateral exposure might be kept low, simultaneously all eggs are being put in one basket. If that basket disappears, all eggs are gone at once and the collateral put aside for that eventuality might turn out to be marginal as was the bilateral net exposure. Renewing all trades somewhere else is costly.



    As reported in Michael Gibson’s paper (Fed Board), according to the 2006 ISDA Margin Survey, 63 percent of all counterparty risk exposure on credit derivatives was collateralized by large dealers. For hedge fund counterparties, a larger share is likely to be covered by collateral. However, Bliss/Kaufman caution that “collateral frequently is re-hypothecated, that is collateral received from one counterparty is then used to satisfy demands for collateral by another counterparty.” Lehman’s bankruptcy administrator PWC noted recently with respect to Lehman’s hedge fund clients that had pledged equity securities as collateral, which Lehman then loaned to other investors: “in that case, clients may cease to have any proprietary interest in that collateral."[/quote]

    I would also like to add that since these are all over the counter, privately negotiated and administered products, if there was a universal shortage of collateral, there would not necessarily be a uniform method of dealing with it. The UBS/Paramax case comes back to mind. I believe there are litereally thousand of such situations abound.

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  • Comment Link M Saturday, 18 October 2008 04:05 posted by M

    Reggie,
    the cash is raised to come up with collateral. See more background here: http://www.aleablog.com/lehman-cds-settlement/

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  • Comment Link shaun noll Friday, 17 October 2008 14:13 posted by shaun noll

    i'm not trying to be a fear monger, i'm here to learn and am happy to add any info that i can about anything i wrote about, i dont claim to be anybody other than a student of the markets. was there some particular part of my money market ramble that you were hoping i could clarify?

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  • Comment Link Reggie Middleton Friday, 17 October 2008 10:40 posted by Reggie Middleton

    M:
    I am glad you are contributing to the conversation. The largest writers of CDS are the insurers, and unfortunately, the highest concentrations of risk are with the "alleged" insurers who are not regulated by the state and were not forced to hold reservers. I have shorted MBIA and ABK since the 60's, to the single digits thus I have no more financial interest in them, but Ambac is potentially losing over half its equity on just the Lehman exposure. I have been through the books (or what was alleged to be their books), and it is quite possible that WaMu may bring down close to the 2nd half of their equity. The hedge funds and investment banks are going to feel this through the domino effect. I may be wrong, but I doubt so. I can already see everybody preparing, raising cash in and adverse cash raising environment.

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  • Comment Link M Friday, 17 October 2008 09:01 posted by M

    You mention a few wild things, let me adress some of those:
    1) a major counterparty has disappeared
    This event already took place on the 15th of September. Everyone who had any exposure as a counterparty against Lehman will have left or right made sure that that risk has been replaced with a similar trade (or in another way) with a different counterparty. That explains for a large part the wild markets in bonds, credit and interest rate derivatives and equity. However, this proces was wild but short, and was over in a few days. Much more important was the function of Lehman in the markets, for instance in bond settlements and cp issuance. Also their UK branch seems to have done some illegal stuff with collateral pledged to them that now bring a lot of hedgefunds in problems. So in short, yes there was some impact of the disappearance of Lehman as a counterparty, but that has been dealt with already. Much more sever was the disappearance of Lehman as a provider of services, as they had a very dominant position in certain areas. Last but not least, the many funds, banks and individuals that holded the actual debt of Lehman were hurt the most, especially if they never hedged that with CDS or other means of insurance.
    2) The netting does not work
    The netting of risk on Lehman had nothing to do with the disappearance of Lehman as a counterparty. Company A and B have netted their risk on Lehman, and Lehman is not a party in this netting.
    3) The monoliners
    The monoliners again have nothing to do with the CDS settlement of Lehman unless they have bought or sold protection on Lehman. For the rest I agree with you that they probably should be downgraded but that there is a lot at stake for a lot of companies regarding their credit rating.
    4) The disappearance of a counterparty has impact on the netting process
    It does not. The remaining counterparties will look for ways to rehedge their risk with each other or other counterparties. However, all these events do set the CDS spreads running, which means that the NPV of the trades will increase and everyone with any exposure will need to start pledging more and more collateral. Just like with an option, you don't necessarily need the underlying of the CDS in order to execute a CDS. Therefore a CDS can be executed with limited capital requirements. However, capital requirements can rise quickly if the NPV of the CDS goes haywire. That is what is happening to AIG, they seem to be long many companies and all CDS spreads have run out a lot. They need to come up with collateral for those positions that in the past they did not need.
    5) The moneymarket funds structures
    Sorry, I have no clue what you are talking about. In order not to be a fear monger, it would help if you can explain the situation in more detail.

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  • Comment Link M Friday, 17 October 2008 08:34 posted by M

    Payout is as soon as feasable once a default has taken place, not waiting for maturity of the bond or whatever else the underlying was.

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  • Comment Link shaun Thursday, 16 October 2008 20:10 posted by shaun

    i dont want to be a fear monger, but alot of money market funds use a sort of structured investment vehicle that takes fixed rate bonds further out the yield curve, then packages them and issues a floating rate note for money market funds, for instance the SWVXX has one called yellowjacket that had a credit event when i believe it was Lehman failed, and now they have to mark this down, the danger is that as these vehicles are liquidated not everyone is holding these at the same value, for instance, SD county i believe, had some cash in this same yellowjacket vehicle, and is allegedly valuing it much much much lower than the Schwab money fund is.

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  • Comment Link Daniel Gold Thursday, 16 October 2008 19:38 posted by Daniel Gold

    From the standpoint of an ordinary investor, how much at risk are my sweep accounts at my brokerages? Are all money market funds at risk of collapse if the CDS dominoes start to fall?

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  • Comment Link Jon Burgoyne Thursday, 16 October 2008 17:50 posted by Jon Burgoyne

    If a CDS is issued as insurance against a default on a bond, if the bond defaults, does the CDS have to payout the full value of the bond immediately, or can it wait until the bond would have matured until it pays out, or can it pay out over time from now until the bond would have matured?

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  • Comment Link shaun Thursday, 16 October 2008 14:11 posted by shaun

    i think you're missing the implications that Reggie pointing out if one of the biggest counterparties in the CDS game disappears. then the netting doesn't work and many assets that are probably valued with the credit rating of the insurance provider would now take huge write downs. i think it is no coninceded that the mono line insurers remain AA even though they are clearly garbage, one of the reasons i see this minimal credit rating decrease in the face of insolvency is that many cash funds are limited to only holding A or AA assets, including all the muni funds, also, many of the variable rate demand notes and such that are traded are only putable to a bank if the credit rating does not become severly impaired, so if ABK gets downgraded hugely, then the liquidity in those is broken and your 7 day average maturity in these cash funds now automatically becomes a bond with maturity of 2033, and i have yet to recieve a clear response, but it is my understanding that many many muni money funds hold a great % of their assets in these VRDNs, i know that just in the SWKXX schwab muni fund, 70% of their assets are "credit enhanced" they provided no guidance on what the quality of the underlying is but the majority of the VRDN market is low or unrated quality bonds that are held up by their insurance, also, many of the Tender option bonds, TOBs, structure is based on AA underlying or A underlying or better, so those could also unwind, and since they take in long fixed rate and sell short floating rate, when short floating rates get fu*ked up like right now, many of them will or are being forced to unlever, throw in a major credit event and it will be some old testament $hit going on with fire and brimstone as these guys try to liquidate into the worst muni bid in the last 20 years!
    this is one of the reasons that yields on some of these muni money funds were/are so high, again, i've yet to recieve clear answers to my questions from any of the money fund PMs but with them avoiding me i fear the worst,

    so anyway, that was a huge off topic ramble but important to note one of the affects that few people see of losing one of the major players in the CDS market, basically though, if one of the large players go the idea is that it cascades throughout the balance sheets as your hedges are now garbage because that netting process you mention is now FUBAR'd, so while i agree that perhaps the notational value over estimates the potential risks, just taking the net exposure ignores the fundamental issue that would be the catalyst to a meltdown. it is also no coincedence that now mark-to-market accounting is being fudged, no doubt so that the banks and everyone have to re-mark their assets without many of their hedges will not wipe them all out

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  • Comment Link Truth08 Thursday, 16 October 2008 12:50 posted by Truth08

    So this is just like selling options. You can collect premia and make money for a long time, but if the market moves against you significantly, you're screwed. LTCM should have taught us that computer models based on the unlikelyhood of 100 year events can become meaningless when these events actually happen. Like the adage goes, markets can remain irrational longer than you can remain solvent.
    [url]http://www.thetruthshallsetyoufree.net/?p=41[/url]

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  • Comment Link Phil V Thursday, 16 October 2008 12:38 posted by Phil V

    Isn't it very dangerous to short banks who are now officially an arm of the government? The europeans have a very different attitude towards capital markets than we do in the US...(well, they DID!)

    Aren't there european insurance companies who'd be jucier targets, or are they too well-reserved to deserve an attack?

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  • Comment Link M Thursday, 16 October 2008 11:51 posted by M

    Reggie, I admit CDOs is not my thing. However, when talking about `simple` CDSes I object to taking the total notional value of all contracts as the net exposure of the whole world. People do the same to interest rate derivatives, but you can not add up all the notionals but you have to look at the net exposure against a underlying across all contracts for any counterparty.
    Example: If counterparty A buys protection (100m) on company C from counterparty B, and three weeks later counterparty A sells protection (100m) on Company C to counterparty B, the two trades just net out. +protection and - protection = 0 protection for both A and B. Leaves you with the insurance fee, which will (especially in these days) have been different. The difference will typically be accrued to the end of the contract or the default event, whichever comes first. If you just look at notional, you see a 200 million outstanding notional for both parties, and if you than add up both counterparty exposures you see a 400 million outstanding notional against company C for both parties together. Help, 400 million exposure, the whole world seems to scream. But in actual life the real exposure is zero, zip, nada. Because the contracts net out and the A and B will have agreed not to settle anything to avoid complications.
    Of course, if there are more trades like the UBS one, and brokers thus have fake hedges and will have unwilling counterparties to settle with, things can get very messy. And I admit not to know exactly how CDOs work and how they will have a role in all of this. My main point is about the notionals of the trade being used, as in my example, to create a gigantic mountain of dirt about to fall over, whilst in reality that is not the case.

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  • Comment Link shaun Thursday, 16 October 2008 11:48 posted by shaun

    will be looking forward to the update on this big time reggie.

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  • Comment Link FGR Thursday, 16 October 2008 11:23 posted by FGR

    ok: there will be a lot of payments & failures in cascade because of CDS. but a CDS is not adding $ to the system. for everyone which needs to pay something, somebody is receiving something. its a zerosum game.
    if a big option writer cant pay then a big option buyer wont make money...
    the only loss for the whole system, is for those buyers of the bust company cash bonds or loans.

    BUT, the pb is there would be govt intervention: any body whos on the wrong side will be made whole by the government etc.. so that Zero-sum game is aspiring a lot of cash that isnt really needed and disappearing..
    so that in that case, the CDS losses effectively compound the losses from the cash market....
    and then all the most pessimistic numbers about losses in the financial industry (3 trillion $ for mr roubini) would be way under
    the final mark.

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