Credit Default Swaps: Down Economy
Credit Default Swaps: Down Economy
The Federal Reserve Bank of New York will meet tomorrow with banks and investors in credit-default swaps to gauge progress on an initiative to create a clearinghouse to curb risks in the market, a spokesman said.
The group in July set an end-of-year deadline to have a central system in place to absorb a failure in the $54.6 trillion market in which banks and investors privately negotiate contracts that protect against losses on fixed-income securities.
The Fed will hold a meeting with “a small number of banks and buy-side firms” to discuss progress being made on creating a central counterparty, said a New York Fed spokesman who declined to be identified.
We are going to start hearing a lot more about these in the coming weeks and months.
The Rest is Up To You…
Michael Porfirio Mason
AKA The Peoples Champ
AKA The Seventh Letter
The Guide to Getting More out of Life
http://www.thegmanifesto.com
Scarface – Push it to the limit
06/10/2008 at 11:20 pm Permalink
MPM,
You’ve touched on the core of what is the reason for the financial collapse over the past few weeks.
The sad thing is, most people watching their CNNs and MSNBCs have no idea why they’re losing their shirt and will be led like chickens to the slaughter in the next few months. It will only get worse.
To explain what’s going down, let me first drop a bit of economic background. All around the world, banks must comply with what are known as Basel regulations. These regulations determine how much capital a bank has to have in reserve. The amount of reserve a bank needs depends on the quality of the loans on its books. The more risky your loans on books, the more capital you need.
What AIG (the main company to blame) did, was to get around these Basel rules by issuing out unregulated insurance contracts, known as credit default swaps, that didn’t require ANY collateral or real capital to back it up. I’ll get back to all this.
Here’s how the hustle worked. Say you’re a heistman (wall st. bank) that had a lot of extra goods (deposits) lying around. You’ve got some nice jewelry in the stash and figure that you could earn some extra cash if you were to rent it out and have someone else temporarily hold on to them. There are some broke folks (subprime borrowers) a few blocks down the street that are trying to look hood rich and will pay you damn near all of their disposable income to wear your bling. The only problem is, you don’t really trust these broke folks. And even if you did trust them, you’d only loan out about 1/3 of your stash (total deposits) to make sure you had enough of the stash in your house (capital reserves) just in case things fucked up.
One day the nighborhood boss (AIG) comes to you with a proposition. His lieutenants (mortgage companies) have been selling weed, DVDs, fake Louis Vitton bags to the broke folks for years. He’s almost always gotten his money back. He trusts that they will pay him back, because he’s got their respect and he knows their history.
The neighborhood boss (AIG) proposes that HE rents out your jewelry to the broke neighborhood folks. In fact, since you don’t really trust his people, what he’ll do is he’ll back up his word with an IOU (CREDIT DEFAULT SWAPS!!!) for just 2% of however much jewelry you want to loan out. If anyone in the neighborhood doesn’t pay the boss back, he’ll cover your entire losses out of his own pocket if you’ve got the IOU.
Now you’re loving this shit! You can earn the high rent (interest rate) by loaning out your jewelry (deposits) to the broke neighborhood folks (subprime borrowers), but you’re being backed by the neighborhood boss’s (AIG) IOUs (credit default swaps). You DEFINITELY trust the neighborhood boss because he’s old school from the days of Freeway Ricky Ross and has seen them all come and go. He’s got a solid rep.
In fact, you trust the boss so much, that you’re gonna loan out 95% of your stash. You KNOW he’s good for the payback, so why not make rent on as much of your stash as possible?
Well after a few months it turns out the neighborhood folks didn’t really have enough money to pay the rent for the bling. Between food, heat, bills, they just didn’t have the cash to keep up the hood rich lifestyle. And they all engraved their names on your jewelry so you can’t just take the jewelry back.
You’re pretty pissed about how that went down, but you’re not too worried yet. Remember that the neighborhood boss (AIG) sold you some IOUs just in case, so you plan on getting you’re money back.
Well as it turns out, you weren’t the only heistman (bank) the neighborhood boss was dealing with. He was doing business with hundreds of heistman across the country and giving out IOUs. The only problem was he didn’t have enough cash to back up all of these IOUs.
Now all the heistman are coming at the neighborhood boss with guns blazing AT THE SAME TIME asking for their goods back, but the boss doesn’t have nearly enough. He thought everyone would have paid him rent on time so he could keep up the hustle, but it didn’t turn out like that. Shit is about to get real ugly.
The local mayor (US gov’t) sees that a major war is about to break out in his neighborhood that’s going to take lives. If this war goes down, most of the heistman are going to get shot, the neighborhood boss DEFINITELY will get shot, and a lot of the neighborhood folks will get shot in the cross fire.
To ease the situation for a while, the mayor says he’ll pay off the heistmen and the neighborhood boss with some money he’ll raise by doubling property taxes next year.
At first the heistmen are cool with this proposal. Everybody stays alive, for now.
But then they start to wonder, how will they survive next year when the neighborhood folks have no money to rob?
07/10/2008 at 6:34 am Permalink
its terrible that they will regulate the CDS market, it will compress spreads and margins for the dealers and alpha for the counterparty propping the trade. pre-clearing house, spreads traded more or less where you could get someone to trade at. Post clearing house, I fear all levels will be posted and you wont be making any more large margins. it’ll survive but the people will make less.
weesh.
07/10/2008 at 10:58 am Permalink
Do you have a Private mortgage insurance (PMI) policy? If you do your PMI insurer has passed along their risk by buying a credit default swaps (CDS) to protect them in the event you have your home that your home is taken away from you. CDS and PMI are the same thing. Make people wanting to buy a home put at least 20% down if you don’t like them. nomedals.blogspot.com
07/10/2008 at 4:30 pm Permalink
Great comments.
Carry on.
– MPM