Credit Default Swaps, some background on them,
it sheds some light on the movements of the markets.
A bit lengthy.
" Bye Bye Ms. American
Pie Credit Default Swaps, part of that land of legalized Gambling Market for the Big Boyz have in important day of destiny today.
Today, Monday Oct 6, 2008 is the day that those swaps written on Fannie and Freddie bonds are to be marked to a make believe market determining the value of those swaps. After today's value setting some will owe money and some will be owed money, potentially LOTS of money. Final CASH settlement (or delivery of bonds) on all of those positions will be in just over a week.
By the end of today some of the more leveraged players in that end of the Gambling Market for Big Boyz may (will?) have "blown up" and have left craters in the landscape called Derivatives.
Many of those who may (will?) blow up in the initial wave already know they are going to "blow up" today, the reason that for the last several days one allegorical song has been repeatedly been going through my head. ...
"So Bye Bye Ms. American Pie
Drove my chevy to the levy
but the levy was dry
Them good ol boys drinkin whiskey and rye
Singin "This'll be the day that I die" Singin "This'll be the day that I die"....
First how big is the Credit Default Swap market, a market where people gamble on whether bonds will default or not default?
It is a market that has grown very quickly with current Notional Values estimated to be about $54 Trillion.
Of course that is not the amount really at risk, from the outside that is hard to determine, but an estimate of $2 to $5 Trillion may be in the ballpark (25:1 to 10:1 leverage).
One important thing to keep in mind about Credit Default Swaps that few outside Wall Street understand ... no one who bought or sold one ever needed to actually own the bond or want to own the bond that the Swaps were being written against.
Think of it like a side bet by everyday citizens, say Jack and Mark, on a football game. They use the football game as an event to bet against but neither one plays for the teams, owns them etc..
Because these are side bets the value of the Credit Default Swaps in the system can EXCEED the total debt that they are written in reference to!! (although in many cases one of the parties DID own the underlying security and was trying to protect their investment).
In the case of today's price setting of the value of the Fannie and Freddie Swaps how much CASH money is going to be changing hands over the next week or so? From the news reports there are between $400 to $600 Billion (net) of Credit Default Swaps outstanding on these two entities, probably towards the upper end of that range (I am going to use the higher figure as I talk about these below).
If the bonds end up trading overall at 90% of their "bet" value that would mean that $60 Billion in CASH would have to be delivered to the those who bet the value of the bonds would decline ... PRONTO!!
If the amount is less, say 70%, that amount owed would skyrocket to $180 Billion in CASH.
Some of those guys on the "levy ... drinking whiskey and rye" today, actually probably sitting in a private club in London or New York drinking top shelf stuff, KNOW they are about to be "blown up" today which of course is why they are out drinking.
When they do officially blow up at the end of today and can not fulfill their obligations those losses that they can not pay off are then going to flow to someone else who may not know that they have some swaps that are "...8 miles high and falling fast..." and about to fall right into their lap as they explode.
Voila, what an unwelcome surprise from out of the blue!!
If an entity that owes payment on one of these Credit Default Swap contracts "blows up" and can not pay off their obligations then the losses are going to go in one of two directions. (first a little detour: many of those now holding either the obligation to pay or the right to receive payment were not the original swap parties. The current obligor or obligee may have bought that swap contract second hand from someone else. From the limited information available to the public it appears that in fact there has been a very active market in reselling these contracts)
If the an entity that "owes" bought that "Owes" swap from someone and it was "With Recourse" then those losses could flow back through the chain of ownership of previous owners of that "Owing" swap and the last previous entity that previously owned it now owes the amounts that final obligor owed but could not pay. It is my understanding that this may NOT be the case with most swap contracts.
On the other hand if an "Owes" swap contract that was sold by it's previous owner such that there was "No Recourse" then the previous owner is in the clear. Now however the person who expects to be paid is NOT going to get the money that they thought they were going to get!! (same result if the "owing" party was the original party on the "Owe" side of the swap)
One thing that is certain, someone WILL take it on the chin if a Swap Obligor can not pay on their swap obligation once final settlement occurs during the next week or so, possibly creating an unanticipated shortfall for the entity who either has to now pay or the entity who was expecting to be paid.
Hopefully those who can not fulfill their payment obligations will be few and the dollar amounts, if they do occur, will be small.
Also, one can hope that if parties do go broke today as a result of the setting of value of these Fannie/Freddie Swaps and thus send some of their their losses to someone else it doesn't start a cascade of failures through an entire group of undercapitalized players. (It is difficult from the outside to get a handle on who the parties are who trade/own or owe/are owed money in the Swap market. From the little bit of information available it appears that for this particular Swap market about 1/3 of the trades are by Hedge Funds, who as a group may well be the least capitalized players in this particular game).
The risk for the markets is not just that the party who "owes" may not have enough assets to pay off what they owe but also the fact that those needing to pay out CASH money over the next week may need to be selling OTHER assets in order to raise the money needed to fulfill their CASH payout obligations.
One of the big risks for today's Credit Swap Default value setting is that it can lead to a wave of selling all sorts of assets by the Big Boyz so that they can both raise cash to meet their obligations AND to keep their portfolio positions and risks balanced. (A lack of balance in a portfolio raises risks so the Big Boyz players are always buying and selling as things move up and down so that they can remain within their risk parameters. Sometimes trying to maintain steady risk parameter by the big players means that selling begets selling, the most notable example of which was the internal dynamics of the 1987 crash when to control risk the big players had to sell into a declining market which of course pushed the market down even further faster.)
The questions that those of us on the outside can only ask, but probably will not know the answer to until after the fact are: How much risk exists for the insolvency of some of Big Boyz as they have the amounts as to what they owe set to an amount greater than their assets?
How much more asset selling will need to be done to cover the cash requirements for the CASH payments that will need to be made over the next several days once the values are set today? (one must assume that the ones who are going to owe money have been liquidating assets in anticipation of their payment day so this may actually be a relative non-issue)
How much portfolio rebalancing and risk rebalancing is going to be needed to be done by the Big Boyz over he next several days in order to rebalance their positions as these Fannie/Freddie Swaps are taken out of their portfolios and how will that affect the markets?
How much will the banking system itself be affected by the large money transfers that are going to need to be made. Are some banks at risk due to loans to Hedge Funds, or through third parties then to Hedge Funds, that suddenly do a belly flop? (banks that may be affected are not just limited to US banks but may include other banks around the world, particularly European banks). [Linguistically, we'd be watching the World Bank which has been a huge conduit for US Treasury debt paper and the BIS which is a clearinghouse as leading indicators of global systemic stability. - G]
How much were banks themselves playing in these markets? Darnn, I am hearing that song again: ...
"So Bye Bye Ms. American Pie
Drove my Chevy to the levy but the levy was dry
Them good ol boys drinkin whiskey and rye
Singin "This'll be the day that I die"
Singin "This'll be the day that I die"....
Darnn, Lehman's value setting is coming up on Oct 10 and Washington Mutual's on Oct 23.
This all could just be a Yawner ... or it could end up being the ride of everyone's life.
Paulson and Bernanke though sure seemed to be in a major league panic last week wanting to get LOTS of money approved for unstated reasons before even a couple of more days elapsed. Do they know something that those of us out in fly-over country can only speculate about? "
eb
---
AI
