Inventor of Credit Default Swaps is a Key Architect of Carbon Derivatives

[Dad]

Originally Posted by Roguish Lawyer

Not at great length, but people who blame derivatives, swaps and other financial instruments for the collapse of the economy typically don't even know what these things are. Generally speaking, people should be free to enter into whatever transactions they want to, subject to traditional common law restrictions like prohibitions on fraud.

Complex financial instruments are not boogeymen. They are just contracts entered into by big boys and girls. Discussions like the one you posted are irrational and a danger to our liberty IMO.

I would really like to hear your opinion on what caused the meltdown if all of the above mentioned are innocent financial instruments. Hell, senior management on Wall St didn't understand them. I believe it was either Fuld or Blankfein who publicly admitted it!

[Roguish Lawyer]

Originally Posted by Dad

I would really like to hear your opinion on what caused the meltdown if all of the above mentioned are innocent financial instruments. Hell, senior management on Wall St didn't understand them. I believe it was either Fuld or Blankfein who publicly admitted it!

The instruments didn't cause anything, the investors did. I'm not an expert on this stuff, but I believe that investors put too much faith in the rating agencies, which failed miserably in assessing risk. People thought real estate values would go up forever, which made no sense.

People should not overreact to what happened. Markets correct these types of problems on their own. There was a need for intervention to prevent a complete loss of confidence in payment systems (like credit card networks), but we've gone far beyond what was necessary. Now all of this intervention and new regulation will have unintended consequences and make the situation much worse than it needs to be.

[nmap]

Originally Posted by Roguish Lawyer

Counterparty credit risk is an ordinary consideration for parties entering into these transactions. It can be and typically is hedged. Pension money is subject to ERISA and, to my knowledge, can't be invested in these instruments. The government should mind its own business.

Yes, it is covered by ERISA. But note this: LINK

Per Bloomberg, 2007, "Pension funds, others" took on 18% of the riskiest portion of the CDOs issued. (Table, page 3 of the PDF). Sounds like a problem of some sort to me; however, YMMV.

[Sigaba]

Originally Posted by Roguish Lawyer

The instruments didn't cause anything, the investors did. I'm not an expert on this stuff, but I believe that investors put too much faith in the rating agencies, which failed miserably in assessing risk. People thought real estate values would go up forever, which made no sense.

RL--

I'm just trying to follow your train of thought.

Is it your position that investors are solely responsible for doing their homework to decide if an investment is worth the risk and that if they take "short cuts" by looking at the data produced by third parties (such as credit ratings), that they are still responsible for their choices?

Under normal conditions, what role, if any, do you see the federal government playing in regulating the derivatives market?

[CSB]

Ah, but again, credit default swaps sound like a good idea, and they are, if the "counterparties" are required to:

1 - Have an "insurable interest" in the default, and;

2 - Are required to bank a reserve against losses.

For those just joining in: A credit default swap is little more than me selling you a contract on the order of "If Ford Motor Company goes belly up, I'll pay you one gazillion dollars."

Well, if you are a supplier of electronic ignition systems to the Ford Motor Company, that's the kind of "insurance" you may want to invest in. After all, if Ford goes into bankruptcy, they probably aren't going to buy a lot of electronic ignition systems (or pay for the ones you have already delivered).

But if Dad, Rougish Lawyer, NMap and others also decide to go to the investment bank and buy one of those "Credit Default Swaps," they aren't investing. They are gambling. They have nothing to do with electronic ignition modules. They are just placing a bet, as if they were in a Las Vegas casino, that Ford will file for bankruptcy. But unlike a true insurance company, the bank isn't required to keep a reserve ... they can sell credit default swaps and pocket the cash until the cows come home. Then, when Ford really does file for bankruptcy, they (the investment bank) can also file for bankruptcy, unless thay have a few gazillion dollars handy to pay up every purchaser of the credit default swap.

And when -- as some investment banks did -- the bank itself buys credit default swaps in case IT has to pay off on its contracts, you end up with the situation best described by the analogy:

Interlocking credit default swaps are like mountain climbers who rope themselves together. That way, if one fall off the cliff, the others pull him back up. The problem is what happens when half of the climbers fall off the cliff. They pull the rest off the cliff, too.

And since credit default swaps are "private contracts" between businesses, they are almost totally unregulated and totally undisclosed on the company books, despite the potential for huge losses if the particular economic situation they cover turns to shit. No one knows who has secret "credit default swaps" sitting in a desk drawer somewhere, requiring the XYZ bank to pay the National Bank of Whatifkastan billions of dollars if some (God only knows) event happens (the price of oil rises, the price of oil drops, the price of oil stays the same...).

[Roguish Lawyer]

Originally Posted by Sigaba

Is it your position that investors are solely responsible for doing their homework to decide if an investment is worth the risk and that if they take "short cuts" by looking at the data produced by third parties (such as credit ratings), that they are still responsible for their choices?

Yes.

Originally Posted by Sigaba

Under normal conditions, what role, if any, do you see the federal government playing in regulating the derivatives market?

None other than normal enforcement of contracts, fraud rules, etc. This stuff is all disclosed up the yin yang, and you're stupid if you make this type of investment without knowing what you're doing.

[Roguish Lawyer]

Originally Posted by CSB

But if Dad, Rougish Lawyer, NMap and others also decide to go to the investment bank and buy one of those "Credit Default Swaps," they aren't investing. They are gambling. They have nothing to do with electronic ignition modules. They are just placing a bet, as if they were in a Las Vegas casino, that Ford will file for bankruptcy. But unlike a true insurance company, the bank isn't required to keep a reserve ... they can sell credit default swaps and pocket the cash until the cows come home. Then, when Ford really does file for bankruptcy, they (the investment bank) can also file for bankruptcy, unless thay have a few gazillion dollars handy to pay up every purchaser of the credit default swap.

The derivatives in the news are not the sort of thing Joe Sixpack buys at Schwab. They typically are hedges made by very smart people who know what they're doing -- the gambling analogy is completely out of context and unfair. Southwest Airlines, for example, hedged its fuel exposure and continued to do well when prices went through the roof. Banks making lots of fixed-rate loans have exposure to rising interest rates, so they have a legitimate interest in hedging that exposure. These are calculated business moves made by very sophisticated investors. It's not a game. The fact that investment banks trade in the stuff doesn't make it monopoly money -- that's what they do for a living, and they're not stupid people.

Originally Posted by CSB

And since credit default swaps are "private contracts" between businesses, they are almost totally unregulated and totally undisclosed on the company books, despite the potential for huge losses if the particular economic situation they cover turns to shit. No one knows who has secret "credit default swaps" sitting in a desk drawer somewhere, requiring the XYZ bank to pay the National Bank of Whatifkastan billions of dollars if some (God only knows) event happens (the price of oil rises, the price of oil drops, the price of oil stays the same...).

This stuff is always disclosed by public companies -- go pick up a 10-K and you'll see it discussed. And the suggestion that it is "totally unregulated" is also false. All contracts and all business activity is regulated by the common law. There is no benefit to anyone if the government gets more involved in this stuff. If a company makes a bad investment, it eats the loss and management has to deal with shareholders. Nothing wrong with that, but there's a lot wrong with the government mucking up the markets.

[Dad]

Originally Posted by Roguish Lawyer

The derivatives in the news are not the sort of thing Joe Sixpack buys at Schwab. They typically are hedges made by very smart people who know what they're doing -- the gambling analogy is completely out of context and unfair. Southwest Airlines, for example, hedged its fuel exposure and continued to do well when prices went through the roof. Banks making lots of fixed-rate loans have exposure to rising interest rates, so they have a legitimate interest in hedging that exposure. These are calculated business moves made by very sophisticated investors. It's not a game. The fact that investment banks trade in the stuff doesn't make it monopoly money -- that's what they do for a living, and they're not stupid people.




This stuff is always disclosed by public companies -- go pick up a 10-K and you'll see it discussed. And the suggestion that it is "totally unregulated" is also false. All contracts and all business activity is regulated by the common law. There is no benefit to anyone if the government gets more involved in this stuff. If a company makes a bad investment, it eats the loss and management has to deal with shareholders. Nothing wrong with that, but there's a lot wrong with the government mucking up the markets.

CSB is absolutely correct about theCDS's not being reported. My understanding is that is one reason it was so difficult to free up credit--one bank didn't know how much another bank held of that crap so wouldn't risk loaning them money. Please feel to correct me if I am wrong.

[The Reaper]

Exactly.

How do you know that your bank, mutual fund, or investment broker was dealing in derivatives?

That is buried way down in the fine print of the report, if you could decipher it at all.

Maybe a plain language disclosure statement should be required?

TR

[Roguish Lawyer]

Originally Posted by The Reaper

Exactly.

How do you know that your bank, mutual fund, or investment broker was dealing in derivatives?

That is buried way down in the fine print of the report, if you could decipher it at all.

Maybe a plain language disclosure statement should be required?

TR

You read the report. It's in plain language. When people choose not to read legal documents, they are still charged with knowledge of the information that was provided to them. Caveat emptor!

[Roguish Lawyer]

From Bear Stearns 2007 10-K (just a few examples):

Second sentence of the entire document:

The Company is a holding company that through its broker-dealer and international bank subsidiaries, principally Bear, Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp. ("BSSC"), Bear, Stearns International Limited ("BSIL") and Bear Stearns Bank plc ("BSB") is a leading investment banking, securities and derivatives trading, clearance and brokerage firm serving corporations, governments, institutional and individual investors worldwide.

Page 5:

Structured Equity Products. The Company offers to institutional customers, and trades for its own account, a variety of exchange-traded and OTC equity derivative products. These products are transacted, as principal, with customers for hedging, risk management, investment, financing and other purposes. These transactions are in the form of swaps, options, and structured notes, as well as more complex, structured trades which are customized to meet customers' specific needs. Derivatives enable customers to build tailor-made risk/return profiles, customize transaction terms, develop packaged solutions to a problem, implement trades that otherwise could not be executed and to transact
business with standardized documentation. The Company, through BSSC and other subsidiaries, provides, directly or through third-party brokers, futures commission merchant services for customers and other Bear Stearns affiliates who trade contracts in futures on financial instruments and physical commodities, including options on futures.

Page 7:

Credit-Related Securities and Products. The Company trades, makes markets and takes proprietary positions in both dollar and non-dollar investment-grade and non-investment-grade corporate debt securities, commercial loans, sovereign and agency securities as well as preferred stocks in New York, London and Tokyo. The Company offers hedging and arbitrage services to domestic and foreign institutional and individual customers, utilizing financial futures and other derivative instruments. The Company also acts as a dealer and participates in the trading of credit derivatives for customers worldwide and for its own account. These transactions are in the form of credit default swaps and options, total return swaps, credit-linked notes and additional structured trades which are customized to meet the specific needs of customers. In addition, the Company offers its domestic and international customers quantitative, strategic and research services relating to fixed income securities and credit derivatives.

Pages 15-16:

Item 1A. Risk Factors.
In addition to the other information contained in this Form 10-K and the exhibits hereto, the following risk factors should be considered carefully in evaluating our business. . . .

Our businesses may be adversely affected by fluctuations in interest rates, foreign exchange rates, and equity and commodity prices. In connection with our dealer and arbitrage activities, including market-making in OTC derivative contracts, we may be adversely affected by changes in the level or volatility of interest rates, mortgage prepayment speeds or the level and shape of the yield curve. Increasing interest rates may cause a decline in the volume of mortgage origination activity and therefore securitization activity. Declining real estate values could also reduce the level of new mortgage loan originations and securitizations. When we buy or sell a foreign currency or a financial instrument denominated in a currency other than U.S. dollars, exposure exists from a net open currency position. Until the position is covered by selling or buying the equivalent amount of the same currency or by entering into a financing arrangement denominated in the same currency, we are exposed to a risk that the exchange rate may move against us. We are also exposed to equity price risk through making markets in equity securities, distressed debt, equity derivatives as well as specialist activities. We may be adversely affected by changes in the level or volatility of equity prices, which affect the value of equity securities or instruments that derive their value from a particular stock, a basket of stocks or a stock index. Additionally we may be exposed to widening credit spreads and/or increasing interest rates which creates a less favorable environment for certain lines of business. Credit spread risk arises from the potential that changes in an issuer's credit rating or credit perception could affect the value of financial instruments. The markets for energy and energy-related commodities are likely to continue to be volatile. Use of standard commodity contracts (many of which constitute derivatives) can create volatility in earnings and may require substantial credit support, some of which may be in the form of cash collateral, increases to which may result in the event of an adverse change to our credit ratings. Wide fluctuations in commodity prices might result from relatively minor changes in the supply or demand for these commodities, market uncertainty and other factors beyond our control, including natural disasters and changes to the legal and regulatory landscape.

The current global credit crisis, inventory exposure, and potential counterparty credit exposure, may continue to adversely affect our business and financial results. During 2007, higher interest rates, falling property prices and a significant increase in the number of subprime mortgages originated in 2005 and 2006 contributed to dramatic increases in mortgage delinquencies and defaults in 2007 and anticipated future delinquencies among high-risk, or subprime, borrowers in the United States. The widespread dispersion of credit risk related to mortgage delinquencies and defaults through the securitization of mortgage-backed securities, sales of collateralized debt obligations ("CDOs") and the
creation of structured investment vehicles ("SIVs") and the unclear impact on large banks of mortgage-backed securities, CDOs and SIVs caused banks to reduce their loans to each other or make them at higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper or other short-term unsecured sources was negatively impacted. As prices declined and delinquencies increased, investors lost confidence in the rating system for structured products as rating agencies moved to downgrade CDOs and other structured products. In addition, investors lost confidence in commercial paper conduits and SIVs causing concerns over large potential liquidations of AAA collateral. The lack of liquidity and transparency regarding the underlying assets in securitizations, CDOs and SIVs resulted in significant price declines across all mortgage-related products in fiscal 2007. Price declines were further driven by forced sales of assets in order to meet demands by investors for the return of their collateral and collateral calls by lenders. Many banks and institutional investors have also recognized substantial losses as they revalue their CDOs and other mortgage-related assets downward. During the second half of 2007, the economic impact of these problems spread on a global basis and disrupted the broader financial markets. The combination of these events caused a large number of mortgage lenders and some hedge funds to shut down or file for bankruptcy. The deterioration and recognition of substantial exposure through derivatives and policies written by monoline insurers resulted in the downgrade of certain of these monoline insurers. Several of these monoline insurers also reported significant losses. Further downgrades of these monoline insurers or their failure could result in additional significant write-downs at many financial institutions and could have a material adverse effect on the broader financial markets. Financial institutions have entered into large numbers of credit default swaps with counterparties to hedge credit risk. As a result of the global credit crises and the increasingly large numbers of credit defaults, there is a risk that counterparties could fail, shut down,
file for bankruptcy or be unable to pay out contracts. The failure of a significant number of counterparties or a counterparty that holds a significant amount of credit default swaps could have a material adverse effect on the broader financial markets. It is difficult to predict how long these conditions will continue, whether they will continue to deteriorate and which of our markets, products and businesses will continue to be adversely affected. As a result, these conditions could adversely affect our financial condition and results of operations. In addition, we may be subject to increased regulatory scrutiny and litigation due to these issues and events.

[Roguish Lawyer]

These types of disclosures didn't start after the credit crisis, by the way. I'm having trouble cutting and pasting from the Bear Stearns 10-K for 2005, but it totally lays out derivatives and hedging activity, including the specific nature of the trading and the dollar amounts of the holdings.

[Roguish Lawyer]

Can't cut and paste from this either, but if anyone wants to see how fulsome AIG's disclosures were on this stuff before the credit crisis, click here:

http://www.ezonlinedocuments.com/aig...AIG_AR2005.pdf

These claims of hidden stuff, nondisclosure, etc. are complete %^$^%$ made up by a bunch of pinkos and you guys are falling into their trap. Wall Street is the heart of capitalism and it should be left alone.

[6.8SPC_DUMP]

Originally Posted by Roguish Lawyer

Not at great length, but people who blame derivatives, swaps and other financial instruments for the collapse of the economy typically don't even know what these things are. Generally speaking, people should be free to enter into whatever transactions they want to, subject to traditional common law restrictions like prohibitions on fraud.

Complex financial instruments are not boogeymen. They are just contracts entered into by big boys and girls. Discussions like the one you posted are irrational and a danger to our liberty IMO.

Well, if nothing else being labeled a threat to American Liberty is a hell of a motivator… I'll get started on going into some length on the issue after dinner.

It's ironic that criticism of the excesses of a derivatives market, which has grown by 600+ trillion in two decades, you call commie talk.

What's the result of our failure to maintain soundness in the financial system?

Commie talk: The global governance of world banking has been shifted from the G-8 nation’s to the G-20 as of the Pittsburgh G-20 Summit in 2009 Link

Originally Posted by Roguish Lawyer

These types of disclosures didn't start after the credit crisis, by the way. I'm having trouble cutting and pasting from the Bear Stearns 10-K for 2005, but it totally lays out derivatives and hedging activity, including the specific nature of the trading and the dollar amounts of the holdings.

Respectfully, you are glazing over the important differences separating different forms of derivatives, that are necessary to be an informed investor.

Over-the-counter (OTC) credit derivatives are forward contracts not futures contracts. They are not traded on open exchanges, to assure accurate valuation and competitive pricing, and there are no margin requirements.

Instead, the OTC derivatives are privately traded between two parties without going through a "clearing house" so the Counter-Party Credit risk is increased a great deal, because you are simply taking the company's word for their valuation.

From Bear Stearns 2007 10-K, Pages 15-16

We are also exposed to equity price risk through making markets in equity securities, distressed debt, equity derivatives as well as specialist activities. We may be adversely affected by changes in the level or volatility of equity prices, which affect the value of equity securities or instruments that derive their value from a particular stock, a basket of stocks or a stock index. Additionally we may be exposed to widening credit spreads and/or increasing interest rates which creates a less favorable environment for certain lines of business. Credit spread risk arises from the potential that changes in an issuer's credit rating or credit perception could affect the value of financial instruments.

IIRC Bear Stearns admitted to over $13 Trillion of derivative credit liability in 2007 and only maintained their AAA-rating through a counter party which they owned...

You don't see a problem with our country allowing a company to rake up close to a year's GDP in debt and then say there is zero risk of default because we own a company that will bail us out?

What's even more astounding is that their share price was frozen at $2.00 while the government continued to pump money into it, until JPMorgan Chase bought it, when they reported a derivative credit liability of close to $80 Trillion themselves.

Originally Posted by SkiBumCFO

I would also argue that in a capitilist society Investment Bankers are critical - not really non productive (though my wife might disagree). A problem we will never be able to overcome is that it is impossible for a govt regulatory authority to completely understand and monitor Financial Derivatives. Congress didn't even bother to try but that's another matter. They are way too complex and you cant take a moderately paid govt regulator and ask him to figure out what a highly compensated MIT phd has designed. This stuff will happen as long as we live in a capitalist democracy and i gotta tell you there aint no better way to live even if we do have a little bit of volatility in our lives.

Thanks for your POV Mr. SkiBumCFO. I am in 100% agreement with you that demonizing all Investment Bankers is counterproductive.

However, I don't agree that many of the "creative financial innovations” going around today are beyond the possible scope of Government oversight and regulation. Particularly, ones which stemmed from laws being scaled back that previously made them illegal.

IMHO many forms of derivatives are not the result of, or path to, real economic growth. Just my .000002

[Roguish Lawyer]

So 6.8, do you also believe we should regulate guns since they have been used to murder people? Sorry, but I am hearing nothing but calls for undefined government regulation of private transactions that frankly are none of your business.