Bo Peng

Five Ways This Bubble May End

Ricard, I think I've answered your question of "bank fails then what" question before. I see that you're not convinced. ;>

Bank fails. Deposit is saved. Commercial banking part remains public if possible. Investment banking part is taken over by gov and then sold to private partners ASAP. We go back to the old Wall Street model that had worked quite well for about two centuries. Counterparty risk chain reaction is unlikely as demonstrated by the non-event of Lehman CDS settlement.

My point is, too big to fail means it's too big, therefore needs to be broken down. Instead, the gov (not just US gov) is making them even bigger.

Be Careful Playing with the Black Swan

Yes, Ricard, time horizon is one of the most important factors in options. Many people forget that. For the rest who remember, it doesn't make it any easier still. The temptation of making a short-term bet is always strong. John Paulsons are like cockroaches -- for every one you see, there're 100 others you don't. The one you see is the one who lucked out -- among a subset that's small among the whole population but still quite large in number.

Be Careful Playing with the Black Swan

ok, akapital9, let's get a little philosophical.

"Outside the bound of experience". But that bound is only due to Aristotle's ignorance, isn't it? Even if you expand it to the "whole society", that's still our ignorance. If you base the the definition on subjective cognition, then there's no basis for commonality. Black swan to you, same'ol shit to me. Your trash, my treasure. Why are we talking about it?

Totally individual-based value system is total farce. Look where modern arts has led itself into.

Be Careful Playing with the Black Swan

kelm, I suppose you take a narrow definition of Black Swan, that it has to be "unpredictable". Would an asteroid impact be unpredictable? No matter how unlikely it is, I'm sure we can find somebody had been predicting it if we survive to dig through the records. On the other hand, for all the people claiming to have predicted the crisis years ago, did they really predict it? I mean, the chain reaction from subprime to CDO to CDS to bond insurers to credit agencies to ARNs to Fanny to CB to investment banks to Europe to EM to oil to dollar? Really?

Therefore my view is that neither "predictability" nor "predictedness" belongs to the definition of Black Swan. Including them would only cause unnecessary confusion. Instead, we could simply say "an n-sigma event is a Black Swan".

All these are actually more than semantics. But they're beside the point, which is the human factor in Black Swan trades.

Lehman Bankruptcy: Crisis Management Via Crisis Export?

Yes, mrfreddo, Lehman bankruptcy "paid out" for the US in many ways. But it'd give too much credit to our elected and politically appointed officials if we say they saw all these and then did it. Heavens no! Otherwise we would've had the housing bubble starting at least moderating in 04. I think they were just reacting like headless chickens, as they've always done.

From the global perspective and the European perspective in particular, however, it's a sad mistake that nobody was willing to chip in a joint effort until the pain undeniably spread everywhere. Everybody was enjoying the slowly unfolding US demise. So "screw'em" is ironic, sad, yet poetic justice for all.

Work, reward, pain -- all must be shared.

Lehman Bankruptcy: Crisis Management Via Crisis Export?

I should add one more point:

For a full year before Lehman bankruptcy, US had been struggling while "Old Europe" had been standing on the sideline enjoying the pathetic show. I believe Europe made a strategic mistake in not helping US more proactively and earlier. They took this as an opportunity to establish Europe as one pole in the new multi-polar world, but failed to see how fragile their own footing was -- perhaps the most vivid evidence of this attitude is ECB's decision to raise rate as late as July 08.

Without active European corporation, Lehman bailout would probably have been very damaging to USD and treasuries. Why should we (US) bear all the brunt saving their ass while they enjoy the benefits as the best opportunity in a lifetime?

IMO, it was a strategic decision in the framework of international politics to let Lehman fail. US had little choice in face of Europe's persistent, misguided judgment of the situation.

This Recession Will Be Anything but Deep

Today's market has been somewhat puzzling. No reports of damage from Lehman settlement, which may mean the daily hedge and collateral adjustment may have worked better than many (me included) had expected or feared. Or it could mean just a delay -- the public won't see it until the next quarterly report.

The Fed's decision yesterday to inject $630B into money market funds was also puzzling, after reports showing a sizable inflow into them. Why did they decide it was necessary, ineptitude of the Fed or factors unseen by the public?

Synthetic CDOs are definitely affected by this settlement. But I don't understand why the big fuzz all of a sudden as if it's a huge surprise. Synthetic CDOs based on ABS certainly have taken their losses a long time (months) ago. Those involving Lehman may have their equity or mezzanine tranches wiped out or severely damaged. But these tranches are very narrow. And CDO issuers (big banks) usually hedge them, though may not perfectly. The ultimate losers in synthetic CDOs are the CDO investors in equity and mezzanine tranches, of which there aren't that many.

Regardless, I think we can say by now that the government bailouts have worked. Chain reaction has been stopped, at least for now. I expect Libor to continue dropping and the money pipes to continue opening up.

A Proposal on Transforming CDSs: Credit Insurance Trust

VERY insightful, Waiting out. Your comment alone is worth my labor.

It's the same idea economically. The only difference is that Lloyds of London was desgined by the names, for the names, and of the names. My CIT makes CI buyers the controller of CIT. Nobody gets a windfall from others' misery (default) except by happenstance, never by design.

A Proposal on Transforming CDSs: Credit Insurance Trust

nitadmin, CDS is fundamentally different from equity options in two important ways:

1. CDS' built-in leverage is often much higher than equity options.
2. CDS payout (default) is a jump process whereas equity prices are almost continuous.

Because of these, the exchange treatment on equity options will not work on CDS. It'd either be under-collateralized so as to provide inadequate protection against counterparty risk, or drive the price so high as to render the product economically meaningless and kill the market.

A Proposal on Transforming CDSs: Credit Insurance Trust

The comments above helped illustrate the inadequacy of moving CDS to exhanges. It would either continue the illusion without reducing counterparty risk in any meaningful way, or raise the seller's cost so high that it would kill the market.

Margin requirement on exchange clients must depend on the client's position. For CDS buyers, it should be tied to premium. This is fine. For sellers, it should be tied to the notional. Now this is a bit of problem. How much of the notional? 2% 5%? Effectively this is what CDS counterparties have been asking. When shit happens the exchange is left with a 95% hole. It's still a systemic risk, only bigger -- failure of the exchange would be a certain, complete systemic failure, not the "likely" failure caused by Lehman.

100% collateral on the notional? There's no way sellers could make a profit on the price buyers are willing to pay. Even 50% would be unimaginable.

I can't believe the talk of exchange traded CDS is gaining momentum. I see where this is going -- under-collateralized seller accounts, thus greater systemic risk. This is beyond sad.

My proposal of Credit Insurance addresses the fundamental flaws:

1. Insurance claims are backed by the pool of premiums. Seller can make deceiving, scandalous promises.

2. Claim payout from the Seller is spread over ten years, not an instant. Claimant can still opt to cash out by selling the CIT bond, but from the bond buyer on the secondary market, not CIT. This prevents chain reaction.

This Recession Will Be Anything but Deep

Pretzel Logic, I agree with most of what you said. But I also say the destruction of credit is close to an end -- some hedge funds, perhaps even another regional bank or two.

In addition, it's hard to argue what the gov has done to Fannie and Freddie, no matter how flawed, is not helping the housing market. And there'll be more and more such "help homeowner" legislation and policies going forward. Politicians will feel obliged to dish out handouts until the deflation is over. So housing market will be help by two sides: easy credit and homeowner support.

As to the psychological aversion to "easy credit", I don' think it'll last. We may have learned a lesson now. But we also forget. Instant gratification and greed triumphs over long-term discipline every time.

This Recession Will Be Anything but Deep

Talin, what we're witnessing is nothing less than the tragic failure of private capitalism AND democracy. This is a sad chapter in human history.

This Recession Will Be Anything but Deep

Deflation in the short term is expected, as banks and hedge funds deleverage and/or unwind. I was talking about inflation in the longer term, starting from at least a few months out, when money flows down the pipe and reaches Main St and takes effect in consumer credit, hiring, etc.

Is the End of the Crisis Near?

I sent this to SeekingAlpha on Saturday. They seem to have decided not to publish it. I'll just post it here for my own record: The DTCC press release today on Lehman CDS net settlement being only $6B doesn't change my view.
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10/21: The Bottom

If anybody has anything to do with financial stocks but hasn't paid attention to an "obscure" thing called CDS, while such investor should not exist in theory, now is the time for such non-existent, hypothetical investors to take notice.

Let's cut to the chase. On Oct 21, somebody A will have to pay somebody B $C in cash to settle CDS on Lehman. Estimates on C range from 100 billion to 400 billion. Group A will almost certainly include AIG, the biggest net seller of CDS, and many hedge funds, who have been using CDS selling as their cheap (HA!) financing source for the past few years. Besides single-name CDS specifically on Lehman, other credit derivatives such as CMCDS, CDS options, or Nth to Defaults, CDX indices and bespoke CDOs with Lehman in it will also settle, partially or in full.

This will be arguably the biggest cash-exchange day in human history to date. I don't care how much tax-payer's money the government will use to bail them out, somebody will fail.

Group B includes two types. One has Lehman bonds. They will be made whole by the settlement although Lehman bonds changed hands at 8.625 cents on the dollar at today's auction. The other doesn't have Lehman bonds. They bought naked CDS on Lehman. They will have a HUGE windfall -- for every dollar notional, they'll get over 91 cents. If they could collect, that is.
Back to the more immediate concern. Who is A?

You could pore over the CreditFixings' auction info and guess. I think a lot of people did just that today. They pounced on MS, GS, CS, and DB, who happen to be the biggest Physical Settlement Sellers (meaning they sold CDS on Lehman). JPM shot up the whole day, which happens to be the biggest buyer.

But I don't know how productive this guessing game is. The dealers could be placing orders and requests for their hedge fund clients. Short of serious insider info, there's no way of knowing how much of those requests are for themselves vs clients. More importantly, physical settlement will almost certainly be just a small portion of the overall settlement size. Today's auction had $5.7B sell orders. Cash settlement will most likely be at least 10, maybe 100 times bigger than that. People learned the lesson from Delphi. Furthermore, it'd be very unusual for banks to have a huge net position on CDS, with the possible exception being their proprietary desks and funds. Again, most likely suspects are AIG and hedge funds.

Now you know what the government bailout of AIG is for, the initial $85B and then the additional $37.8B (suspiciously precise isn't it?). Don't be surprised if the number goes up again before 10/21. Will tax-payers get the money back after 10/21? Fat chance. Is the money really for saving AIG or making sure others who bought CDS on Lehman will get their windfall? Take your pick.

On to hedge funds. They knew how much they would need to pay since Lehman bankruptcy. Reportedly JPM, GS, and MS have issued massive margin calls to their hedge fund clients, which is consistent with their sell requests (except JPM who, being the clearing bank for Lehman, may have bought protection) at the ISDA auction and my suspicion that a big part of their requests are on behalf of their clients. Some hedge funds are forced to cash out. And since Thursday some apparently went shorting in desperation, trying to make a quick buck before the doomsday. The 900 point surge Friday 3PM in half an hour showed how nervous and desperate they are.

In the meantime, of course, hedge fund investors must be withdrawing as fast as they possibly could, adding to their misery. Bankruptcy law will be the golden profession for many years to come.

WaMu CDS settles on Nov 7. Its impact is expected to be much smaller, although nobody can be sure, as for all CDS. We may get some rough idea on its auction date, 10/23. If there're high-profile bankruptcies on 10/21 (banks, AIG), then market would be spooked and all eyes would turn to WaMu; otherwise it'd likely be a non-event in comparison.

If there were bankruptcies of anything other than hedge funds on 10/21 (or 11/7, though less likely), then we could be in a serious chain reaction. But governments all over the world would band together to stop it. Governments may be stupid and inept, but they're not suicidal. Fed window will stay open late on 10/21. For banks (or AIG) who cannot post enough collateral, Paulson will be ready to buy stocks in a heartbeat. If the initial $250B runs out that day, they can let foreign sovereign funds to buy perferred stocks. It's a wonderful world.

Moreover, I suspect the pending doomsday is a big reason why banks have shied away from lending to each other over the past few weeks. Nobody knows how much anybody else owes on that day. Coming 10/22, assuming no banks fail, it'd be a huge cloud gone. Back to business as usual, or as usual as it gets nowadays.

Hedge funds' fire-sale exit may be creating a very rare buying opportunity in many financial markets (stocks, bonds, commodities, maybe even dreaded CDOs and mortgages). Two days ago I wondered if the bottom is near. Now I'm convinced the bottom will be around 10/21, if not earlier. The way back up may be painfully fast or painfully slow. But the crisis is essentially over unless we let the chain reaction take place.

Then we'll only have to deal with the massive debt, recession, and inflation. Piece of cake.

Is the End of the Crisis Near?

The short squeeze at 3pm was spectacular. Hedge funds are desperate. But they have to know the end of game is near.