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Who Is Supposed To Pay Your Swap?

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February 16, 2008 – Comments (2)

There is a very good article on credit default swaps (CDS) in the New York Times.

First point, if you look at the graph they have, well, the credit default insurance market looks like bacteria growth in a petri dish.  If you were considering buying an equity, would you consider one where that graph looks like that?  What would you predict about what was going to happen to the equity?

I'd predict it was going to crash.  With an equity, it is pretty much self contained.  What the heck happens with these?

I remember reading about a hedge fund that made something like 1000% last year and after reading the article, well, good luck collecting that 1000%.

The article explains fairly well why these things are unlikely to pay their obligations. 

“This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.”

Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.

And this one describes what it is analogous to:

"It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim."

And the article tells me which banks I would not like to have money in:

Both factors have resulted in a market of credit swaps that now far exceeds the face value of corporate bonds underlying it. Commercial banks are among the biggest participants — at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter.

JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.

Here's the problem:

The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks’ books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.

This is an insane problem with them...

But one of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against.

The "value" of the CDS market is about 8 times the corporate bonds being insured...

But one of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against.

The article is an interesting read and helps to increase understand of these things that left me deciding it is just better to watch what happens when they unwind rather than being caught in the tsunami. 

 And, when you look at the market activity, these things have been trading more lately, simply insane.

 

2 Comments – Post Your Own

#1) On February 17, 2008 at 2:20 AM, dwot (45.58) wrote:

http://www.safehaven.com/article-9487.htm

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#2) On February 17, 2008 at 1:14 PM, Imperial1964 (98.24) wrote:

Go long corporate lawyers!

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