Re: Credit Default Swaps

[David Farber <dave () farber net>]

________________________________________
From: hal () halstucker com [hal () halstucker com]
Sent: Wednesday, April 02, 2008 12:57 PM
To: David Farber
Subject: Re: [IP] Credit Default Swaps

Dear Prof. Farber:

An interesting instrument indeed. It's not very clear how much exposure JPMorgan would have had directly to a Bear 
Stearns bankruptcy, as JPMorgan was, I believe, also writing its own CDS. It seems more a matter of how much a Bear 
Stearns meltdown would have affected the market overall. My understanding is that Bear had a portfolio of approximately 
USD 30bn in credit default swaps, both as a buyer and seller of these instruments, meaning they would have either owed 
premiums to a seller if they were buyers of the CDS contract, or would be liable for payout in case of a default, if 
they were the sellers. The Fed apparently stepped in because it feared the repercussions of a $30 billion blowout on 
the overall market and promised to backstop any losses a buyer of Bear Stearns might incur up to the $30 billion. I 
work as an editor for a subsidiary of the Financial Times and one of our reporters had a source tell her that, while 
JPMorgan's party line was that they were only offering $2 per share because they had no time to do proper due 
diligence, the real reason for the low, low share price they offerd was the CDS time bomb in Bear's portfolio.

While this is scary enough, what is truly frightening is the way these instruments have been traded with virtually no 
oversight over the last decade. Warren Buffet, God love him, quite famously called credit derivatives "financial 
weapons of mass destruction." CDS seems to have been bought and sold by individuals who had very little understanding 
of what they were buying and how they worked and, well, we're now seeing the results. They were essentially designed as 
a kind of insurance policy that could be purchased to cover bond risk, i.e., I buy $50m in bonds and I also buy a CDS 
contract that will pay me the face value if my bonds default. Sounds simple enough, right? Because these instruments 
are unregulated, however, they've become beloved of speculators betting for or against a company's creditworthiness. 
Wikipedia has a very good page on CDS, which provides an excellent overview of the both the workings and the insane 
complexity of these things. The page points out that the amount of CDS written on a bond issue may eventually dwarf the 
actual value of the bonds. So if a $1bn bond issue defaults, with creditors ultimately perhaps receiving $.40 on the 
dollar in a settlement, there may be $10bn worth of CDS outstanding, which means someone is on the hook for $6bn. 
http://en.wikipedia.org/wiki/Credit_default_swap

Sounding a bit like the savings and loan meltdown of the late 1980s? There are a lot of similarities - where S&Ls were 
freed by the Garn St. Germain act to invest in all kinds of risky deals the S&L bankers didn't understand, here bankers 
at commercial and investment banks, trying to compete with the returns investors were getting (or thought they were 
getting) from hedge funds, apparently turned to all sorts of risky deals they only kinda, sorta understood. And there 
are more flavors of derivatives out there than anyone can keep track of. Ever hear of liquidity puts? According to the 
New York Times, neither had Robert Rubin, former Treasury Secretary and now a senior executive at Citigroup. 
Comforting, isn't it? Part of the market woes we're now experiencing seem to come as much from sheer panic as from any 
actual losses, though those have been substantial. The subtext of much of this seems to be, "Okay, we drank the 
subprime Koolaid, and maybe that won't kill us. But we drank so many other flavors of Koolaid as well....."

I know it's cliche, but who better to quote than that oft-quoted economic sage Yogi Berra - "This is like deja vu all 
over again." For the fourth (or is it the fifth) time in my middle-aged life.

-----Original Message-----
From: David Farber [mailto:dave () farber net]
Sent: Wednesday, April 2, 2008 09:16 AM
To: 'ip'
Subject: [IP] Credit Default Swaps

________________________________________ From: Andrew C Burnette [acb () acb net] Sent: Wednesday, April 02, 2008 9:02 
AM To: David Farber Subject: Credit Default Swaps Dave, for IP if you wish. Credit Default Swaps Heard an interesting 
broadcast on Marketplace (a PRI radio program; April 1, 2008) on the issue of Credit Default Swaps. Interesting aspect 
is that nearly 45T USD of these are "in play" in the market. According to the discussion, The Bear Sterns buyout may 
have been a self saving mechanism for JPmorgan, as the risk of Bear Stern's failure becomes a risk of collapse for the 
holders of these guarantee certificates. Perhaps JP Morgan saw a risk exposure due to their own trades with Bear 
Sterns. Very interesting financial instrument, intended to spread risk around ("probably the most important instrument 
in finance," according to former Fed chair Alan Greenspan), however, when many begin to suffer, there's little 
assurance that any of the other holders of these swaps may be actually able to back up a default. From the program 
transcript: The value of the entire U.S. Treasuries market: $4.5 trillion. The value of the entire mortgage market: $7 
trillion. The size of the U.S. stock market: $22 trillion. OK, you ready? The size of the credit default swap market 
last year: $45 trillion. http://marketplace.publicradio.org/display/web/2008/04/01/credit_default_swaps_q/ 
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