why are "credit default swaps" a good thing?

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pha...@prweb.com

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Dec 15, 2008, 11:06:58 PM12/15/08
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From what I understand "credit default swaps" otherwise known as CDS
contracts have been widely used by hedge funds and others to speculate
on the viability of banks, other financial institutions such as
brokerage houses, and auto manufactures.

These bets on various companies were not made on any regulated
exchange and no one knows the exact size of the problem; I've heard it
said that "Credit default swaps" are similar to homeowners insurance,
because the buyer pays a premium and, in return, receives a sum of
money if a specified event occurs. However, unlike homeowners
insurance the buyer of a CDS contract does not need to own the
underlying security, in fact the buyer does not even have to suffer a
loss from the default event.

So I was wondering what is the justification for credit default swaps
owned by an outsider who does not own the underlying security? In
other words how does a third party CDS benefit the economic system?
I'd think that third party CDS are inflationary and add uncertainty in
the market.

A follow up question, if third party CDS are bad why not have a well
crafted tax rule which would nullify the value of the CDS, in other
words have congress make a special tax law that states the tax of a
third party CDS at 100%. I'd think if it was possible to not penalize
owners of of CDS contracts who own the underlying security and target
those institutions that are just hoping to hit the lottery, that this
would help out the auto and banking industries that are under threat.

Basically what I'm asking is it possible to create a tax law to solve
the problem of "credit default swaps" held by speculators, much like a
laser guided bomb can destroy a bunker without much collateral damage.

Michael Coburn

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Dec 16, 2008, 3:09:25 PM12/16/08
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There is not a lot wrong with Credit Default Swaps or Interest Swaps or
the rest. The problem is the lack of visibility and the lack of a
regulated exchange requirement. At any time in regard to other "futures"
contracts (and that is exactly what these are) there is a a regulated
exchange that must assure liquidity and the ability to pay. Things like
AIG taking out "LONG" bets on the world and sucking on the premiums while
not covering the other side of the "bets" would not happen on a regulated
exchange.

--
"Those are my opinions and you can't have em" -- Bart Simpson

James A. Donald

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Feb 10, 2009, 6:29:02 AM2/10/09
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On 16 Dec 2008 20:09:25 GMT, Michael Coburn
<mik...@verizon.net> wrote:
> There is not a lot wrong with Credit Default Swaps or
> Interest Swaps or the rest. The problem is the lack
> of visibility and the lack of a regulated exchange
> requirement. At any time in regard to other "futures"
> contracts (and that is exactly what these are) there
> is a a regulated exchange that must assure liquidity
> and the ability to pay. Things like AIG taking out
> "LONG" bets on the world and sucking on the premiums
> while not covering the other side of the "bets" would
> not happen on a regulated exchange.

You assume the regulators to be wise and good. Most
proposals to regulate CDS are proposals to rig the CDS
market - they don't like speculators betting that
institutions are going to fail. So chances are they
would allow AIG to do what it did - to bet that all is
going to be well, but would forbid people to bet that
the shit will hit the fan.

Recall all the heated outrage coming from Finland, when
the CDS market signaled that they though that Finland
was running a ponzi?

The proposals to regulate the CDS market are proposals
to prevent that sort of signal.

--
----------------------
We have the right to defend ourselves and our property, because
of the kind of animals that we are. True law derives from this
right, not from the arbitrary power of the omnipotent state.

http://www.jim.com/

James A. Donald

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Feb 10, 2009, 6:23:25 AM2/10/09
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On Mon, 15 Dec 2008 20:06:58 -0800 (PST), pha...@prweb.com wrote:
> So I was wondering what is the justification for credit default swaps
> owned by an outsider who does not own the underlying security? In
> other words how does a third party CDS benefit the economic system?
> I'd think that third party CDS are inflationary and add uncertainty in
> the market.

Recall a short time ago mortgage backed securities were trading as
triple AAA. Many far sighted people figured that they way were
worthless crap. So they took out a CDS betting that the credit backed
securities would collapse - which of course tended to depress the
price of credit backed securities. To maintain the pretense that they
were actually worth something, AIG had to issue guarantees - which
sent AIG down the tubes.

As a result, the mortgage based securities were revealed to be
worthless crap a fair bit before most of the defaults came through,
considerably lessening the damage.

Similarly, with Finnish debt. It is a discovery process. People who
think they know what is going to happen bet on what is going to
happen. If they are right, they make money, if wrong the lose money -
but in the process they blow away the bullshit, forcing the truth to
be revealed.

Which is precisely why so many people want to shut down the CDS
market.

pha...@prweb.com

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Feb 13, 2009, 9:53:22 PM2/13/09
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On Feb 10, 3:23 am, "James A. Donald" <jam...@echeque.com> wrote:

I'm still on the fence about the benefit of third party credit default
swaps, on one hand I see them as being a mechanism that exposes really
bad ideas in an indirect way.

By this I mean the dollar amount bet on credit default swaps are a
proxy measure by a market player exposing a bad idea such as giving
NINJA loans out to basically anyone with a pulse. But I can't
reconcile that benefit of discovery while the SEC (at least under the
Bush administration), sat thing out on the side lines, with the idea
that an unregulated CDS market worth perhaps upwards of 60 trillion
(which are high end estimates I've seen mentioned more than once in
the financial time).

Personally the black hole effect of CDS is one of the big
uncertainties in the economy that is going to be interesting to see
how it works itself out.

BTW just wondering what other people are doing to create or are
adapting various models to see how well they fit the economic
firestorm the world is now in.

I kinda got it stuck in my head that its possible to use percolation
theory which is a branch of mathematical physics that describes how a
fluid propagates through a medium that is affected by the fluid as the
analog of an economic firestorm; the first step in model adaption
would be to replace "credit" for "fuel load" then I'll substitute
"interest rates" for "wind conditions" and so on down the line. After
that I'm thinking it would be neat to incorporate fractal geometry
(basically look at the fractal dimension) to get an idea about the
"Ecological" health of the financial system. This novel approach IMHO
would be a pretty cool tool for an "amateur" economist/investor to
analyze financial markets. As a teaching tool what I envision is
something akin to the game of Life on a world map, where various
amounts of credit would grow, become unsustainable because the debt
could not be serviced, then there would be an economic firestorm to
indicate the economic system is de-leveraging.

I don't have an ecnomics or finance back ground, basically I'm just
along for the ride, trying to figure out whats happening. So awhile
back I started working on a page on my site that actually tries to put
what's happening to the economy in terms and experiences people not
really into economics, might actually understand and relate to.

http://phaster.com/_peak/_peak_expectations.html

Check it out and tell me what ya think... kinda hoping if I made any
major errors, people reading it over would let me know!

DanB (Previously DB)

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Feb 14, 2009, 10:22:44 AM2/14/09
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pha...@prweb.com wrote:
>
> http://phaster.com/_peak/_peak_expectations.html

Hay p,
Here is my problem with 'this can be fixed'. We have lost the great pool
of new capital for the consumer, the housing ATM. And a fix would
require the creation of a new source of capital. There isn't one. Even
if there were, we would only have put off an even greater reckoning.
Total debt in this country has ballooned to over 350% of gdp.

http://lakeweb.com/money/creditmarketdebt_GDP_07.pdf

Growth in the current paradigm requires new capital and investments. An
increase in the total level of debt. There is no impetus to borrow and
invest in a time where every sector of the economy is contracting. This
is why deflation is insidious. It feeds on it self because the lack of
financial activity creates more lack of financial activity. The greater
the level of total debt, the greater the unwinding once it begins.

Considering the numbers, the Great Depression may be a comparative cake
walk. The revolving credit of the 20s consumer and margin stock buying
pushed total debt to much less than we have now.

Best, Dan.

James A. Donald

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Feb 19, 2009, 5:02:02 AM2/19/09
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On Fri, 13 Feb 2009 18:53:22 -0800 (PST), pha...@prweb.com wrote:
> By this I mean the dollar amount bet on credit default swaps are a
> proxy measure by a market player exposing a bad idea such as giving
> NINJA loans out to basically anyone with a pulse. But I can't
> reconcile that benefit of discovery while the SEC (at least under the
> Bush administration), sat thing out on the side lines, with the idea
> that an unregulated CDS market worth perhaps upwards of 60 trillion
> (which are high end estimates I've seen mentioned more than once in
> the financial time).

A little while before Finland when bust, the Finns were outraged that
the Credit Default Swap market was predicting that Finland would
imminently go bust. The Finnish government called the CDS market
"Saboteurs" and "Financial Terrorists"

When Finland did go bust, as predicted, the CDS market swallowed it
smoothly, moving stupendous sums of money about, doing what the IMF
and all the central bankers had conspicuously failed to do.

The CDS market is doing what the regulators should do,
but don't do.

david.ll...@gmail.com

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Mar 5, 2009, 8:20:57 AM3/5/09
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>
> The CDS market is doing what the regulators should do,
> but don't do.
>
> http://www.jim.com/


Jim,

I agree with you attitudinally at any rate: sending fools to the wall
is a good thing for us all.

On the other hand, we should probably do a bit more to get the fools
before they can do their damage, and this should be what regulators
do. The Bushies, a bunch of kidlets sadly let loose in a very
dangerous playroom, didn't do this, and that's a damn shame.

FWIW, I was a junior with a Big Five accounting firm a few years ago.
(That shows how long ago it was, in the early nineties, when the Big
Eight were just on the start of their well deserved slide down to
becoming the Big Three.)

Knowing very little about swaps, but having a little bit more in the
way of brass balls than anybody else on the audit team, I asked the
head trader of a ver-ree major bank (('ll stop being cute, it was the
Toronto HQ of Fuji, the local tentacle of a bank that I think the
Japanese government should have thrown into bankruptcy 25 years ago --
which would have saved the Japanese people a great deal of tsuris.)
how he monitored his position. He told me. He wrote down all his
trades on a long sheet of paper in two columns (which he blithely
characterised as "short" and "long," with no demonstrable contact with
reality) and if the two columns were the same length at four in the
afternoon he knew he was OK.

I think this level of competence was, and is, pretty common in the
financial industry.

-dlj.

James A. Donald

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Mar 7, 2009, 6:43:43 AM3/7/09
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On Thu, 5 Mar 2009 05:20:57 -0800 (PST), david.ll...@gmail.com
wrote:

> >
> > The CDS market is doing what the regulators should do,
> > but don't do.
> >
> > http://www.jim.com/
>
>
> Jim,
>
> I agree with you attitudinally at any rate: sending fools to the wall
> is a good thing for us all.
>
> On the other hand, we should probably do a bit more to get the fools
> before they can do their damage, and this should be what regulators
> do. The Bushies, a bunch of kidlets sadly let loose in a very
> dangerous playroom, didn't do this, and that's a damn shame.

And what has Obama been doing?

Recall that it was the democrats, who controlled congress, who
protected the misconduct of Freddy and Fanny.

Recall also that Madoff paid off the democrats a lot more than the
republicans, perhaps because the SEC answers to congress, which was
democrat controlled.

The core problem is that no matter which party is in power, regulators
have an incentive to encourage irresponsible conduct if that conduct
directs money to either important voter blocks (in this case to
hispanics) or the well connected (in this case to wall street) and
that conduct most likely will not cause disaster until after the next
election.

Thus regulators not merely fail to restrain bad conduct, but
forcefully encourage. The worst behaved bank was Washington Mutual.
Washington Mutual became a big bank through regulator sponsored
takeovers - the regulators backed Washington Mutual because Washington
Mutual dispensed money to key voter blocks, and the regulators backed
Madoff because he dispensed money to key regulators and congress.

The rise of and rise of the worst behaved bank of them all, Washington
Mutual, was directly sponsored by regulators as a reward for bad
behavior.

> I think this level of competence was, and is, pretty common in the
> financial industry.

Typical of state sponsored cartels.

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