CDO pyramid gambling, my thoughts after watching the 60 minutes
Once I was very surprised to find out how few people really understand the numbers behind derivatives and options. Most of the practitioners are liberal arts graduates after crash course in finance & accounting (MFE/MBA), and at the investment houses they are supplemented by a larger bunch of theoreticians. The result is not surprising. For the last two to three years the most issued CDS was the synthetic CDO. One of the ways of creating this was using credit default swaps as assets to support the tranches. This instrument is misunderstood by the media. The synthetic CDO's do not buy the credit default swaps they issue them to someone who wants to buy protection. These CDS receive regular premium payments that are used to pay the interest to the CDO's note holders.
~$70T is the size of expected market for 2008 (about $60T was in 2007)
Generally speaking the numbers on the notionals of these derivatives sound staggering. However, most of these contracts are used as hedging contracts. The value at risk on a particular risk is significantly lower. As example, XYZ Capital may have sold 100 contacts and bought 99 contacts. Their net position would only be 1. Whilst the counterpaties of these contacts may vary, the net of the whole position is still relatively small. If a counterparty was long 5 contacts against XYZ Capital then on bankruptcy the Mark To Market value of the contracts is released (to the nearest close of business to the filing for bankruptcy). The contact should not lose significant value. The main issue is that the risk the contact gave before bankruptcy will disappear and it is this risk that the a counterparty now has to hedge. However, as long as XYZ Capital managed their market risk professionally, then most counterparties against other counterparties will be able to net off their risks in new contracts in the markets. This is not done without volatility and there will be some losers and some winners. The point is that this is not the main cause of credit contagion. The main problem is caused much earlier by derivatives. Most derivatives are over-the-counter done in one-off contracts the banks write for their counterparties. This makes the contract opaque and the markets become illiquid quickly at the sign of trouble. It also makes the risk taking game, a game of poker, where the egos of senior managers becomes the driver of the business. "We're the best player at credit defaults swaps!". This type of mentality leads to banks taking risk where they shouldn't. Most of the current issues could have been avoided if the regulators enforced exchanges for standard contracts sooner. Frankly speaking, it seems quite beyond belief that such huge markets could exist without a clearinghouse. Once again, it is hard to see how responsible regulators could allow this to happen. In truth, the absurd gigantism of the derivatives markets in relation to their actual underlying commodities or securities is of no conceivable economic value. What we need are hedgers, and speculators willing to provide the hedge for a fee. The rest ought to be eliminated. There are plenty of casinos, racetracks and bookies; no need to threaten the real economy with your gambling.
CDO gambling
~$70T is the size of expected market for 2008 (about $60T was in 2007)
Generally speaking the numbers on the notionals of these derivatives sound staggering. However, most of these contracts are used as hedging contracts. The value at risk on a particular risk is significantly lower. As example, XYZ Capital may have sold 100 contacts and bought 99 contacts. Their net position would only be 1. Whilst the counterpaties of these contacts may vary, the net of the whole position is still relatively small. If a counterparty was long 5 contacts against XYZ Capital then on bankruptcy the Mark To Market value of the contracts is released (to the nearest close of business to the filing for bankruptcy). The contact should not lose significant value. The main issue is that the risk the contact gave before bankruptcy will disappear and it is this risk that the a counterparty now has to hedge. However, as long as XYZ Capital managed their market risk professionally, then most counterparties against other counterparties will be able to net off their risks in new contracts in the markets. This is not done without volatility and there will be some losers and some winners. The point is that this is not the main cause of credit contagion. The main problem is caused much earlier by derivatives. Most derivatives are over-the-counter done in one-off contracts the banks write for their counterparties. This makes the contract opaque and the markets become illiquid quickly at the sign of trouble. It also makes the risk taking game, a game of poker, where the egos of senior managers becomes the driver of the business. "We're the best player at credit defaults swaps!". This type of mentality leads to banks taking risk where they shouldn't. Most of the current issues could have been avoided if the regulators enforced exchanges for standard contracts sooner. Frankly speaking, it seems quite beyond belief that such huge markets could exist without a clearinghouse. Once again, it is hard to see how responsible regulators could allow this to happen. In truth, the absurd gigantism of the derivatives markets in relation to their actual underlying commodities or securities is of no conceivable economic value. What we need are hedgers, and speculators willing to provide the hedge for a fee. The rest ought to be eliminated. There are plenty of casinos, racetracks and bookies; no need to threaten the real economy with your gambling.
CDO gambling