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Credit Default Swaps

Discussions about the economic and financial ramifications of PEAK OIL

Re: Credit Default Swaps

Unread postby Tanada » Sun 09 Aug 2020, 23:31:44

Much, much longer article at link below the part I quoted.

Credit Default Swaps: Part I Of III - A Brief History Of Mechanics, Product Types, And Standardization

Summary

This prefatory article is the opening of a tripartite series focusing on the most widely used type of credit derivative - credit default swaps.

Part I presents investors with an introduction to these derivatives - namely, the history, mechanics, and product types.

Part II expounds upon credit default swap valuations and provides examples.

Part III culminates in describing some of the indices market participants track these credit default swaps on.

Preface | The Spark of this Series

This series spawns from a recent interview I had with an investment bank for a role in the risk department as a hedge funds analyst. The management asked for an explanation surrounding the mechanics behind credit default swaps and how they are utilized to manage risk for hedge fund clients.

Besides being a great interview question at the time, given the state of our economy, I thought it was an informative topic to delve into in order to sharpen some of the knowledge learned about the credit derivatives space and share with investors who may be interested.

Furthermore, a large swath of our population remains unfamiliar with such instruments that play a vital role in our financial system. Perhaps, this series can provide some information to those who want to read a fair analysis of these products - outside of what they hear from politicians and the financial press.

The following information in this series will not glean insight into certain trading strategies, nor will it reveal any proprietary information belonging to other companies' dealings with credit default swaps. It will only serve the purpose to explain what these derivatives are and how they are used, priced, and where to find them.

A historical backdrop of real-world events and theater will be added to the end of each section to provide the subject matter a dash of flavor - how they have been utilized in a practical sense is just as important and will hopefully keep the material as interesting as possible.

Per the usual disclaimer, this is not investment advice, and I am not being paid for such a post by any institution, except for Seeking Alpha. It is born out of pure interests - writing, history, and financial markets - that I write this series. I hope investors find it to be a good read but, more importantly, find it to be beneficial for their respective endeavors.
Investment Thesis | Alternative Beta

As corporate defaults climbed higher last quarter and credit downgrades hit new records, curious accredited investors may be interested in alternative investments to hedge, speculate, or find arbitrage opportunities during such states of uncertainty.

Prudent measures can be taken in times of duress outside of allocating investments in US treasuries, gold, and other traditional assets. Among the many ways to protect a portfolio is through alternative beta - more precisely, credit default swaps.

The goal - as mentioned in the preface - is for hedge funds, pension plans, and policymakers to benefit from this comprehensive review. Reading about the history, mechanics, and evolution of CDSs will allow institutional investors to consider whether it is a good fit.

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A Brief History | Credit Derivatives & Credit Default Swaps

In order to understand credit default swaps, investors must first understand the term credit derivative. A credit derivative is a bilateral contract that isolates specific aspects of credit risk from an underlying instrument and transfers that risk between two parties. The payoff depends on the creditworthiness of the underlying instrument. Credit derivatives include:

credit default swaps (CDSs)
collateralized debt obligations (CDOs)
total return swaps
credit spread forwards
credit default swap options

In large part, these products were created because banks had little room to maneuver once assuming credit risk and due to the fact that credit had remained a business risk for which no tailored risk-management products existed. Over time, financial innovation and the demand for such products served as a catalyst to bring them to the marketplace.

The acceptance of these credit derivatives filled the gap. Products such as the above-mentioned have allowed these institutions to actively manage their portfolios of credit risk by entering into such credit derivative contracts to hedge their portfolios or speculate for gains. It is a financial innovation that allows for risk to be transferred but not destroyed - such is the nature of risk itself once created.

The largest benefit for institutions may be the fact that credit derivatives allow users to reduce credit exposure without physically removing assets from the balance sheet. Banks find this quite appealing and understandably so.

Therefore, banks have historically been the biggest buyers of credit protection, and insurance companies have been the most prominent sellers. If one would like to do more reading on the different product types and offerings of credit derivatives, this March 2001 Lehman Brothers report provides insight into the instruments that are still used today:

Regarding the recent trends in notional amounts, the growth of credit derivatives came alongside the dot-com bubble in the late 90s. In 2000, the notional principal for outstanding credit derivatives totaled approximately $800 billion. Only 7 years later, that amount spiked to $50 trillion. Later, in 2012, it fell to half of that at around $25 trillion.

Among these credit derivatives is the subject of this series - credit default swaps. Credit default swaps, or CDSs, are the most widely-used credit derivatives.

The first CDSs were created and traded by JPMorgan around 1997. This in-depth interview with Terri Duhon - an ex-JPMorgan swaps trader from 1994-2002 and a pioneer in the CDS space - gives a first-person perspective on the nature and function of these swaps.

Since then, these instruments have been both revered and scorned. The former due to the protection these derivatives provide as a hedge and the latter due primarily to the systemic risks they pose as evidenced in the fallout of AIG in the 2008 Global Financial Crisis, explained later in the epilogue.

As of 2019, credit default swaps were the third-largest OTC derivatives market in the world behind interest rate and foreign exchange derivatives. The latest quarterly report issued on June 26, 2020, from the Office of the Comptroller of the Currency notes that CDSs are the dominant product among credit derivatives - representing approximately $3.5 trillion or 87.5% of all notional amounts. The composition of these derivatives for the 1Q 2020 can be found below:

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It is apparent that the birth of credit derivatives was a watershed development for credit risk management departments within the financial and insurance industry. They continue to fundamentally change the way that banks price, manage, transact, distribute, and account for credit risk.

Hopefully, the following sections regarding these derivatives and, more specifically, CDSs, will give investors a clearer picture and mitigate the cognitive dissonance that surrounds these financial instruments espoused by politicians and the financial press.


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Re: Credit Default Swaps

Unread postby Outcast_Searcher » Tue 11 Aug 2020, 14:53:25

One thing to remember about these, is it's basically insurance. In most years, the people selling these things will make huge profits, as little to nothing bad happens re the overall economy and credit.

Occasionally, a bad economic year or two, often caused by something unexpected (COVID-19, for example), will cause extensive credit events, and the folks selling these things will have HUGE losses.

Generally, there isn't much hype and talk of doom when Berkshire Hathaway, for example, has a bad year re insurance events like floods, earthquakes, etc. And of course, most of the time, they have tremendous profits when not much happens, and all those premiums are net gravy.

As the previous post shows, the risk profile of the swaps (nice pie chart near the end of the piece) is well distributed re both risk and timing. Naturally doomers will point to ANYTHING they can as "doom", but in reality, these CDS's are probably good things in terms of overall, providing a way to reduce risk -- even though SOME sellers of those will lose LOTS of money.
Given the track record of the perma-doomer blogs, I wouldn't bet a fast crash doomer's money on their predictions.
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Re: Credit Default Swaps

Unread postby vtsnowedin » Sun 27 Dec 2020, 14:41:31

Wow an eleven year gap in a thread!!
My problem with CDS is this. You can insure your house for fire or other loss but not your neighbors or that crack house down the street.
They allow you to buy a CDS against bonds you did not write or own.
That made it a casino where betters could place bets on any unsound instrument they thought would default and banks sold hundreds or even thousands of CDOs on the same shaky bond. When that bond defaulted they did not have to pay the value of the bond but that value times the number of CDOs they sold against it.
Goodbye Bear Sterns.
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Re: Credit Default Swaps

Unread postby Outcast_Searcher » Tue 29 Dec 2020, 23:00:34

vtsnowedin wrote:Wow an eleven year gap in a thread!!
My problem with CDS is this. You can insure your house for fire or other loss but not your neighbors or that crack house down the street.
They allow you to buy a CDS against bonds you did not write or own.
That made it a casino where betters could place bets on any unsound instrument they thought would default and banks sold hundreds or even thousands of CDOs on the same shaky bond. When that bond defaulted they did not have to pay the value of the bond but that value times the number of CDOs they sold against it.
Goodbye Bear Sterns.

And owning stock shares in a company you don't work for lets you gain profits, if say, AAPL products do well. And yet that has been FINE for hundreds of years, re common stock.

Do you actually have a point, or do you just enjoy whining? Hint: as technology changes, MANY things that weren't possible before are possible now. For example, stock options only started trading on exchanges in standard contracts, producing significant trading markets in 1974. I make almost all my active stock (or derivative) trading money in options selling weekly or monthly option theta against longer term options (i.e. calendar spreads) -- see option Greeks for a definition of theta re options.

And liberals will say that's "unfair" since I worked my way through calculus in college (supposedly "privelege", even though I earned an academic scholarship and WORKED to earn the room and board), so I actually understand the math I need, behind options. And yet, technology lets MANY things produce results for LOTS of people that were unimaginable before -- see many aspects of electronics, for example.
Given the track record of the perma-doomer blogs, I wouldn't bet a fast crash doomer's money on their predictions.
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Re: Credit Default Swaps

Unread postby vtsnowedin » Thu 31 Dec 2020, 09:13:06

If you buy shares in a company you have skin in the game so of course you are entitled to make a profit. A CDS is for the owner of the bond an insurance policy but for anyone other then the bond holder it is just a bet and that can and has lead to disaster.
Ask the former employees of Bear Sterns.
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Re: Credit Default Swaps

Unread postby Outcast_Searcher » Mon 04 Jan 2021, 21:55:32

vtsnowedin wrote:If you buy shares in a company you have skin in the game so of course you are entitled to make a profit. A CDS is for the owner of the bond an insurance policy but for anyone other then the bond holder it is just a bet and that can and has lead to disaster.
Ask the former employees of Bear Sterns.

Guess what. For most of the options I am in calendar spreads with, I own little or NO underlying stock (unless that is accidentally in the passive mutual funds I own for decades at a time (and don't trade for decades at a time).

Now, show how derivatives are somehow "unfair" or "invalid", given that they're covered by legal contracts, require plenty of margin up front, etc. -- then by all means demonstrate that.

Hint: whining emotionally like Bernie Sanders or Liz Warren is NOT a valid demonstration.

And by the way, when I get hurt on a position for a time (and that happens -- anyone who claims it doesn't is a pure bullshitter), I don't complain that it's not fair, blame the fates, etc.
Given the track record of the perma-doomer blogs, I wouldn't bet a fast crash doomer's money on their predictions.
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Re: Credit Default Swaps

Unread postby vtsnowedin » Tue 05 Jan 2021, 11:13:44

Outcast_Searcher wrote:
vtsnowedin wrote:If you buy shares in a company you have skin in the game so of course you are entitled to make a profit. A CDS is for the owner of the bond an insurance policy but for anyone other then the bond holder it is just a bet and that can and has lead to disaster.
Ask the former employees of Bear Sterns.

Guess what. For most of the options I am in calendar spreads with, I own little or NO underlying stock (unless that is accidentally in the passive mutual funds I own for decades at a time (and don't trade for decades at a time).

Now, show how derivatives are somehow "unfair" or "invalid", given that they're covered by legal contracts, require plenty of margin up front, etc. -- then by all means demonstrate that.

Hint: whining emotionally like Bernie Sanders or Liz Warren is NOT a valid demonstration.

And by the way, when I get hurt on a position for a time (and that happens -- anyone who claims it doesn't is a pure bullshitter), I don't complain that it's not fair, blame the fates, etc.

I am not whining about anything and I care not a bit about your investments in CDSs.
I merely explained why I think they are mathematically unsound when sold to none holders of the insured securities.
I think that is a risk that is unsound and firms would be unwise to sell them even if legal. But of course that is only my layman's opinion and nobody in charge asked me for it.
The casino is open, place your bets gentlemen.!
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