Re: good question Credit Default Swaps

[David Farber <dave () farber net>]

________________________________________
From:
Sent: Wednesday, April 02, 2008 7:29 PM
To: David Farber
Subject: Re: [IP] Re:  **please anonymise**  good question  Credit Default Swaps

Hi Dave,

** please anonymise***

to clarify a bit the discussion around CDS, as I've been working in IT
in banks and financial markets, I thought you might find this input
interesting


I am not a financial expert, but I've been working in banks for a
while now, and my understanding of the CDS as instrument is the
following
A CDS is best understood as an insurance policy.
The value of the premium you pay is linked but much much smaller than
the amount protected by it and proportional to the risk covered.
So as explained in the parent, if I lend USD1M to Mr X. and I want to
cover myself against Mr X defaulting, I'll pay Mr Y. a regular sum to
make sure that if X. stops paying, Y. pays instead.

Where it gets interesting is that you can trade CDS without having the
exposure (without having lent money), as a pure speculative product.
In that case, when buying, you're essentially betting that the risk of
Mr X defaulting (or, more often, the perception of the risk) will
increase and that someone will be interested in buying the coverage
from you at some point (for a higher price, obviously, as the risk has
increased). Being on the sell side works the other way around, thus
betting the credit worthiness will decrease.

As for most speculative products, this only works in liquid markets (a
liquid market is a market on which, if you want to sell or buy at the
market price, you'll get a deal rapidly) . If the confidence in these
products decreases, the liquidity of the market decrease and holding
these instruments can be considered as holding a time bomb as you
carry a risk that you haven't really evaluated for itself but rather
for its variation (or derivative).
For instance, many ABS and MBS (asset-backed and mortgage-backed
securities) are now rather illiquid products compared to a few months
ago. The credit crunch is often called in the banking industry the
liquidity crisis.


In terms of evaluating the financial weight of a product class, many
different metrics can be used. For instance interest rate swaps can be
measured based on the nominal (a fictional amount on which the
transaction is based), in which case it is a staggering amount of
money, or in terms of actual cash flows, in which case it is much more
"decent".
Similarly, in CDS, if we consider the amounts covered (especially as
the same debt can be covered several times, as the reality of the
coverage doesn't matter for speculative trading of these instruments),
the figure given may be correct. In terms of real money exchange,
though, the amounts are likely to be infinitely smaller.








On 2 Apr 2008, at 22:32, David Farber wrote:

> ________________________________________
> From: Rod Van Meter [rdv () sfc wide ad jp]
> Sent: Wednesday, April 02, 2008 5:09 PM
> To: David Farber; eric.cecil () gmail com
> Cc: ip
> Subject: Re: [IP] good question  Credit Default Swaps
>
> > IOW, how can you bet more than twice the amount of money than there
> > exists in the entire U.S. economy?
> >
> > ... I simply attempting to grasp what it means when someone says
> > $45 trillion is in play, but the U.S. economy = $22 trillion.
>
> I would be the *last* person to know anything serious about markets,
> but
> I think you've misunderstood something here: the value of the
> securities
> (the debt on the mortgages, right?) is only $7T, but the amount of
> trading of those securities was worth $45T.  That is, the average
> mortgage traded hands 45/7 = ~6.5 times in *one year*.
>
> So there is not twice the total size of the economy in debt "in play".
> This is equivalent to asking the total value of the stocks that get
> traded on the stock market in a year.  I have no idea what the number
> is, but it's a *lot* more than the total sales of all the companies.
>
> When a mortgage trades hands, obviously that's a financial
> transaction;
> I have no idea what number is added to the size of the U.S. economy --
> what "value" does that trade have?  If it were 100%, then the $22T
> total
> economy would have to be greater than $45T, right?  But nobody could
> afford to trade them at that rate.  It's probably a small fraction
> of a
> percent of the value of the loan, or the banks couldn't afford to
> trade
> them seven times a year.
>
> We're wandering a little far from IP's primary mission, but I'm
> curious
> what fraction of the total economy is "paper trading" of securities,
> consulting with lawyers, and other back-end economic activities that
> are
> not primary production.  (n.b.: I'm not saying that those are of no
> value; they are very valuable to our complete economy.  (If you don't
> believe in, say, the value of venture capitalism, look at a country
> without it.) But there must be some ratio of primary to secondary
> economic activity beyond which it's unsustainable -- *somebody* has to
> actually grow the food and build the automobiles.  The same argument
> applies to entertainment costs.)
>
>                --Rod
>
>
>
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