Does anyone know: Can a credit default swap be "naked"?

[HamdenRice]

Can you purchase a cds without owning the underlying security?

That would be a lot like short selling.

Anyone?

Anyone?

Bueller?

[prayin4rain]

1. yeah i think they get swapped right down the line n/t

[HamdenRice]

2. I don't understand nt

[prayin4rain]

6. sorry, i guess that was a little unclear....

i just mean i think anyone can bet on the risk, not just the people who have a stake in the risk. i think it has become more like betting on a sporting event than insurance.

[dkf]

3. YESYESYES.

This is exactly the problem that Ben Stein was writing about.

It is a must read.

http://finance.yahoo.com/expert/article/yourlife/109609;_ylt=AihYXGa_2tf9PJDeCl.2G0S7YWsA

[HamdenRice]

4. WTF??? That's insane

It's bad enough that they were used to ensure REAL securities.

WTF were they thinking?????

Stein says that even he didn't know this until very recently.

Btw, I had read it earlier today. That's why I had the anyone? anyone? Bueller comment in there.

[dkf]

5. Think ENRON.

[HamdenRice]

7. Wait a minute. He says you didn't have to own a mortgage

He doesn't say you didn't have to own a mortgage backed security. That's two different things.

Is he really saying what we think he's saying?

[dkf]

9. You don't have to own the bond to get the credit default swap on it.

Its like an insurance policy that you can put out on your next door neighbor instead of yourself.

[htuttle]

10. It's like taking out a life insurance policy on a stranger...

...with yourself as the beneficiary, or as another poster described it, taking out fire insurance on your neighbor's house.

I'm not sure doing either of those things is illegal, btw. Insurance policies are basically just bets.

[Cessna Invesco Palin]

15. It's definitely illegal to do it with normal insurance.

Think of the possibilities for abuse such a system would have. It's slightly less dangerous in the situation of "insuring" a bond because the bond isn't easily manipulated in the same way you could easily burn down your neighbor's house.

[htuttle]

18. I don't think that's true (cf 'dead peasant insurance')

http://moneycentral.msn.com/content/Insurance/P64954.asp

Dead peasants' insurance pays your employer a secret, tax-free windfall when you die. Insurers have sold millions of policies to companies such as Dow Chemical.

By Liz Pulliam Weston

Right now, your company could have a life insurance policy on you that you know nothing about. When you die -- perhaps years after you leave your employer -- the tax-free proceeds from this policy wouldnt go to your family. The money would go to the company.

Whats more, the company might use this policy to pay for retirement benefits and other perks not for you or your fellow workers, but for your companys top executives.

http://www2.tbo.com/content/2008/apr/11/wal-mart-got-millions-workers-life-insurance-polic/

But yes, it is ripe for abuse, in any case.

[HamdenRice]

21. Yeah companies take life insurance out on employees a lot

I haven't seen dead peasant, but lots of key employee life insurance payable to the company. In either case they have a "stake."

I think it is state by state, and that some states do require the insured to have a stake of some sort. Otherwise it gambling.

[Carni]

30. OMG That is wrong on many levels!

I had never heard of the above--how insidious!

That must come in handy for companies that poison their enployees with toxic substances and then end up settling claims further down the road :(

How long has this practice been going on?

[Wilber_Stool]

16. I posted this today.

Financial institutions are allowed, through total lack of regulation, to buy and sell credit default swaps, or insurance they will be paid in event of default, on financial instruments in which they have no financial interest.

Start with a simple example. Assume I know the young son of the couple next door likes to crawl into closets and play with matches. I therefore see a reasonably good shot at "winning the disaster lottery" so to speak, by buying fire insurance on their $200,000 house.

In simple terms, I now have a financial interest is seeing that disaster occurs. If the house, for whatever mysterious reason, burns down an insurance company will pay me the insured value of the house - even though I suffered no loss, financial or otherwise. My neighbor's misfortune is thus magically transformed into my good fortune. A polite way of saying I was paid $200,000, the insured value of my next-door neighbor's house, after I paid the $400 insurance premium.

more:

Article at: http://www.opednews.com/articles/1/CREDIT-DEFAULT-SWAPS--THE-by-Chuck-Simpson-080924-49.html


http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=389&topic_id=4094550&mesg_id=4094550

[HamdenRice]

22. The problem with the Opednews article

is that it takes the analogies so far, it never explains the actual contract. It also says that the cds purchaser can affect with price of the security without explaining how.

Then it concludes by recommending the solution is for everyone to take all their money out of the banks and cause the system to collapse.

You can see what it was dismissed as lunacy.

[MrCoffee]

8. How did CDS's get so wildly hyperinflated? How was valuation established?

Were they just pulling numbers out of a hat?

[dkf]

11. Its deregulated so you can go to town on them.

I read about some hedge fund that had written swaps on 1.5 billion of Lehman Bros bonds, but only had assets worth $200 million. What a joke.

I'm not sure how they get priced, but I guess they get traded.

[htuttle]

12. More than one party can get a CDS on the same security

So the total amount of CDS exposure on a single security could easily be many times the valuation of that security, since it would have to be paid to all of the parties who bought it.

[HamdenRice]

13. But it seems the issuers are insulated from the huge risk by corporate limited liability

In other words, most issuers of cds issued them through subsidiaries. If all the cds policies are called upon, the most the parent corp can lose is the subsidiary.

So Stein's analysis is a little hysterical. For example, cds theoretically could not take down say AIG but only the subsidiary of AIG that wrote the cds contracts.

On the other hand, it would mean that trillions of cds contracts in the market are worthless, which might trigger other defaults, and collateral calls.

Does that make sense?

[htuttle]

14. Yes, makes sense

If a bookie can't cover the payout on that 200:1 winner at the Belmont, it's the bookie's ass that's in the sling, not the mob he works for.

But as you point out, if the betters used that payout as collateral for a loan from a shark, they're in big trouble, too.

[redqueen]

17. You just read that today?

Quite an eye-opener re: CDS's role in this, eh?

[HamdenRice]

20. No I read it when it came out, but it's full of misnomers

Stein keeps saying you don't have to own the mortgage, as though he's talking about credit enhancement inside the trust. He meant to write, you don't have to own the mortgage backed security, which is completely different.

[redqueen]

23. Does it change your outlook on the role the CDS's played in creating this mess?

I thought I'd read you state before that they weren't that much of a cause so much as a symptom...

[HamdenRice]

24. No because it's the decline in the price of bonds that cause the cds problem

not vice versa.

From what I've read elsewhere, also the cds were written by subsidiaries, so the parent company's (eg AIG, Lehman) exposure is limited by corporate limited liability. In other words, all AIG could lose would be the subsidiary, but the cds counter parties would not be able to go after the parent.

So if a Lehman sub wrote for example (pull out of hat) $500 billion in cds, but that was written by a non-guaranteed subsidiary capitalized at $1 billion, all Lehman could lose is $1 billion in the form of shares of the sub. That's normal for corporate bankruptcy -- unless the parent idiotically guaranteed the sub or committed fraud by saying it was standing behind the sub when it wasn't. But then again, I've been looking into the guts of recent Bear Stearns mbs prospectuses the last day or so and am finding unimagined idiocy. Enron was caused not by securitization (which the press blamed it on), but idiotic guarantees Enron made on securitizations, stuff that was supposed to be unheard of.

Assuming that parents did not guarantee cds writing subs, I think Ben Stein is getting it backwards. The risk of cds isn't to the companies that wrote them (AIG, Lehman); it's to the rest of the market. So in the example above, there would be now $499 billion in bonds that people think are insured but that aren't.

That could cause all kinds of collateral calls because some lender thinks a bond he took as collateral was guaranteed, but it isn't. That's the indirect way that cds could actually be a cause rather than a consequence of declines in mbs bond prices.

[redqueen]

26. Interesting...

thanks for all your posts on this issue, btw. Very educational. :)

[Carni]

29. I THINK (on top of all that)

I hope I am describing this properly...but let's say a group has CDS's and they are on the end that is set to benefit if the loan defaults--

Well if I am understanding it correctly (hope I am) then that same group could actually short the stock of the company that they will profit on (via their CDS interests if that company defaults on some interest they hold a CDS on)

Again if I am understanding this correctly (and it is so confusing that it's difficult)hedge funds were doing this, so large amounts of money could be manipulated around the markets...

So they short stock (destroying the company)and then they could collect on the other end because they profited off of loan defaults of whatever entity they held a CDS on (that they drive into the ground by shorting in huge numbers)

Can anyone with a better financial brain tell me if I have the above even close to correct?

Whatever it is they were doing I sure as hell can't figure out how it was legal!

[avaistheone1]

19. These credit swaps sound like a shell game to me.

[PA Democrat]

25. I will look later for the source, but my understanding was yes.

Someone had done an estimate of the value of CDSs to MBSs ratio and I thought it was something like 5 to 1. Pretty frightening if true, isn't it?

[Carni]

27. I believe so

I have read things to that effect but I am not positive because I am still confused about CDS's

[Marie26]

28. YES

That's why it's just a huge casino for the multi-billionaires - & that's why the CDS market has grown over $33 trillion dollars just this year. It's exactly like short-selling; betting that these mortgages will fail. The buyers are big-shot hedge funds, speculators, etc. & there's SO much money flowing into these CDS & so little regulation that you have to consider the possibility that the CDS speculators are actually the ones driving down the market in order to cash in.