alstry (35.70)

Credit Default Swaps for Fools

August 27, 2009 – Comments (8)

Wall Street tries to make credit default swaps out to be some very complicated financial instrument that only high level mathematicians can understand.  Actually, the only thing complicated about CDS is the mathematical computations used to determine their value so the unsuspecting buyer can't figure out whether they are getting hosed or not.  In truth, a CDS is simply an insurance policy.....generally insuring whether the underlying debt will default triggering payment.

Insurance is simply a bet which pays off on the occurance of an underlying contemplated event.  Swaps are not much different than homeowners insurance covering your house if it gets damaged by fire or life insurance paying off if you die.

But unlike traditional insurance, SWAPS have very little regulation and don't have many of the safeguards built into the traditional insurance policies like "an other insurance clause" limiting the liability up to the amount of the value of the value of the property.  It would be bad social policy if we let homeowners insure their homes for 10X the replacement value because it would not be unlikely that an epidemic of fires would burn down houses around the nation.  In addition, we don't let the insured inflict the event  which causes the triggering event.....such as preventing payment on a life insurance policy if the insured commits suicide....you can figure that one out.

SWAPS on the other hand can actually promote mal behavior.  Think of SWAPS like life insurance on a patient about to go through a protracted surgical procedure.  However, the buyer and seller of the life insurance can be the surgeon and he/she can buy and sell at any time even during the procedure.  The price of the life insurance depends on the prognosis of the patient at any given time...so the better the outlook the cheaper the insurance, the more dire, the more expensive to purchase the policy.

Think about the incentive for the surgeon.  From strictly a financial perspective....if he were a buyer of the life insurance on his patient, he would want to purchase when the outlook for the patient was strong......but think about the incentive for the surgeon at that point when the patient is knocked out and under the surgeons knife?  Conversely, if the surgeon was the seller of the swaps, he would want to sell the insurance when the patient's outlook was the most dire(the premiums would be the highest), but he would want to make sure that his skills pull the patient through in the end so the policy never pays off.  In this case, the surgeon could be incentivized to put the patient into a critical condition, sell a bunch of insurance, and miraculously pull the patient through because of his expertise and training.

In either case, the surgeon controls the outcome of the patient and the environment/conditions at which the swaps are priced and sold and whether or not they payoff.  Could you imagine if we allowed surgeons to purchase or sell life insurance on their patients this way?....it might increase business for med mal and criminal lawyers.

Credit Default Swaps are not too much different than the scenario just described...but instead of the surgeon it is the banks/hedge/private equity funds and the patient is replaced by the corporations or entities(ie municipalities) borrowing money.  In this case, as a buyer of the SWAPS, the banks would have the incentive to purchase them when financial condition is most favorable.....and if it controlled the line of credit or other debt facility, make sure not to renew it when the corporation needed some assistance to trigger the default event.  On the other hand, if the bank were the seller of the SWAP, make sure that the underlying debt NEVER defaults by simply refinancing the debt.

As a seller of the SWAP, the bank could let a money losing business survive indefinitely by serially refinancing the debt.  The problem is if you are a competitor to that business, you can't continue to lose money without going out of business and firing all of your employees.  This situation is occuring in a number of industries today such as homebuilding where thousands of private homebuilders have been unable to continue to operate at losses like the public homebuilders who have continually extended their loans after multiple covenant violations.

IN EFFECT, SWAPS INCENTIVIZED BANKS TO OVER LEVERAGE BUSINESSES AND BANKRUPT THEM OR REFINANCE THEM DEPENDING  ON WHETHER THEY(or friendly entities) WERE A BUYER OR SELLER OF THE SWAPS.

Since the bank was in control of the outcome of the event....they effectively created an instrument that profited from the over leveraging and destroying of companies and industries.  They are truly as Buffett characterized, financial weapons of mass destruction that were in full control of the banks to profit as they pleased with little regard to the destruction a particular company/industry and ultimately our economy.

Since SWAPS are unregulated, they are very difficult to track and why many advocate all SWAPs be traded over an exchange creating a visible paper trail.  SWAPs have become so common that it is not unusual that the premiums generated by selling SWAPs can exceed the underlying debt with the payoff being much more than the debt.

Ask yourself, in light of the above...could this deal have been SWAP influcenced?

Bondholders of newspaper and television station owner Tribune Co. are asking a bankruptcy court judge to allow them to scrutinize the company's 2007 sale to real estate mogul Sam Zell. The bondholders say the deal loaded the company with debt and caused it to file for Chapter 11.

In a filing late Wednesday in Delaware court, bondholders say the "fraudulent" deal imposed an "unsustainable debt burden" on an already declining business. They say the banks which arranged Zell's leveraged buyout "now concede that the transaction was a 'mistake'."

The bondholders aim to halt Tribune's exit from Chapter 11 protection under a plan they say will give "all but a sliver" of the publisher to the very banks they claim caused its demise.

http://finance.yahoo.com/news/Tribune-bondholders-seek-to-apf-1474216656.html?x=0&sec=topStories&pos=2&asset=&ccode=

AND THE BANKS GET THE COMPANY TOO?.............................;).....only in America.