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October 03, 2008

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cathyf
Cathyf, if I'm reading things correctly, there are a lot of credit events other than actual no-pay default that can allow a CDS to be exercised, many or most of which have probably already happened --- rating downgrades, for example.
Right. The point about the CDSs is that they are out-of-the-money puts. There's deep out-of-the-money, really deep out-of-the-money, and lotto-ticket deep out-of-the-money. The problem is that at a valuation of zero, even the lotto-ticket CDSs pay off. The further up out of zero you can get the underlying MBSs, the more CDSs move back out of the money.

The durations of the MBSs are actually pretty short (years in single digits.) I'm not sure of the details, but once a certain percentage of the mortgages pay off (whether through default, or through the homeowners selling the house and paying the remaining principal in full, or the homeowners refinancing) then the MBS doesn't have enough mortgages to be diversified anymore, and so they have to unwind it some way. At which point any unexercised CDS expires worthless. So you don't have to keep things propped up for 30 years, more like 5-7.

cathyf
I hate that commercial with a pleased as punch couple crowing, "I owed the IRS $120,000, but after calling X, I now owe $7000. Rewarding irresponsibility doesn't seem a good way to see less of it.
Well, given that the IRS practices loan-sharking, and the debt could have easily started out as $5000, and could have been that the couple and/or their tax preparer read some convoluted tax law in some completely reasonable way that was different from the IRS's reasonable interpretation, well, I'm not so concerned about the IRS knocking down the amount due.
Pofarmer

Credit default swaps are not unlike me being able to insure your house, not with you, but with someone else entirely not connected to your house, so that if your house is washed away in the next hurricane I get paid its value. I’m speculating on an event. I’m making a bet.

So, hold on here. Some of this credit default swap action could be on assets the person purchasing the CDS doesn't own????

That's a little crazy.

Pofarmer

Yeah. Just like it has been in the past. Goes to the bank's stockholders first, then eventually to the people who buy new mortgages, by forcing the rates up.

Which is why I asked up above. What can kick in the interest rate swaps?

Pofarmer

I can just see me buying insurance on my neighbors car then forgetting to set the parking brake on my concrete truck across the driveway.

Rick Ballard

"Some of this credit default swap action could be on assets the person purchasing the CDS doesn't own?"

Not 'some'. 'A lot' is more accurate and 'most' may be even more accurate.

"What can kick in the interest rate swaps?"

The 'credit event' is stipulated within each CDS. BK, payment default, a change in credit ratings, types of receivership or restructuring aside from BK - any of those could be named within the swap.

The degree of commodities liquidation coupled with the very heavy sell off into what would have been a good rally on Friday indicate the level of uncertainty associated with those auctions next week. There will be a slew of BKs and dissolutions occurring for the next 2-3 weeks and there is no way the credit markets stabilize until the dust clears.

Pofarmer

Thanks Rick.

I was looking through one of either your's our Gmax links the other day, and saw this huge amounts out their on "interest rate swaps" and it just looks like the next bomb to go off.

cathyf

Rick, do you know if (in general) the credit events that put a CDS in the money are just credit events of the counterparty? Or do they trigger on a restatement of the default risk of the mortgages themselves?

Rick Ballard

Cathy,

I don't "know" in the sense that I don't know what all is covered in all cases in all CDS. I know that the vast majority of CDS are written on the counterparty - not the instrument. The instrument carries its own set of events and "guarantees".

Pofarmer

No wonder Warren Buffet called these things "Financial weapons of mass destruction."

Rick Ballard

Pofarmer,

There is about an even chance that this is going to destroy the Euro and with it the European Union. The 'weak' dollar is supported by a growing population playing by 'rules' that still have a modicum of clarity - desite the earnest efforts of the Ivy League bien pissants to become as clever as L'Ecole Polytecnique grads in destroying the society in which they live.

Deutsche Bank and Credit Suisse were very big in the MBS issuers market - and very bad at selecting loans for their pools. Add the madness of the 'real estate boom' in Europe - where the population will be decreasing shortly and the relative scope of Europe's problem becomes clear.

Pofarmer

Well, dang. Exports due to the lower dollar is what's been propping us up over the last few months. With the dollar resurgent, well, this could get ugly.

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