Re: Stock Injection and the bailout

[David Farber <dave () farber net>]

Begin forwarded message:

From: Seth <sethb () panix com>
Date: October 6, 2008 10:01:55 PM EDT
To: dave () farber net
Subject: Re: [IP] Stock Injection and the bailout

For IP

Scott Alexander <salex () dsalex org> wrote:

> In particular, they explain that the original concept of a CDS was
> as an insurance policy.  Thus, if one held a bond, one could, for a
> percentage of the value of the bond, get a CDS that guaranteed to
> pay off the principal of the bond if the bond ended up in default.
> However, lack of regulation meant that 1) you didn't have to
> actually hold the bond to get a CDS (meaning that speculation became
> possible)

Regulation doesn't prevent that.  The commodities market is extremely
regulated, yet I can buy insurance against the price of gold going
down (a put option on 1000 ounces of gold), and all I need is to hand
my broker the cost of the option.  Nobody cares that most of the gold
I own is in my mouth.

> and 2) to issue the CDS, you didn't have to have reserves sufficient
> to cover the payout if the bond defaulted.

They could cover any one default.  (And the issuers of CDS contracts
tended to hedge them, sometimes by shorting bonds, sometimes by
shorting stock or buying puts.)  Ordinary insurance companies don't
have reserves sufficient to cover the payout if Chicago burns down
again, either.

> This was combined with a system where company B would get a CDS
> from company A, say for 2%.  If the bond issuer suddenly seemed
> shakier, B would turn around and issue a CDS to C on the same bond
> for 4%.  B now believes that it is earning 2% without needing to be
> concerned about paying off the CDS (since A will pay it in event of
> default).

Sometimes, B would just sell the contract (often back to A), and
takeout cash.  No risk remains.  (If B sold the contract to C, it
might still be monetized in a way that caused C to take credit risk
from A and not B.)

Seth




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