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.

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.

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.

Is the End of the Crisis Near?

Interesting. The same persistent, guided down pressure is in place again. What are they trying to do? If someone has to sell but retains composure so well, she would give it a rest, let it rebound, and sell into the strength.

It's as if someone wants to make a statement and rub it in, over and over again. Doesn't make sense. But this is too big to be random.

It'd be interesting to see if they can bring Dow down to <9000 today.

Is the End of the Crisis Near?

Wayne T, the financial system will not melt down. It's so easy technically to prevent the melt-down. The perceived difficulty lies in greed and will. As I said, when it REALLY hurts, people will put aside the petty calculations, temporarily, and fix it. I think we're close to that point now.

If we're so self-centered as to let the financial system melt down this time, then I'd have to seriously reevaluate my cynicism on humanity. For now, I still classify it as cynicism.

The Bailout Pork Effect: Short Term Rally, Long Term Disaster

Zooey, I think I made it abundantly clear in the first paragraph that the debate about the rescue plan cuts across traditional party lines. It's not even about fiscal policy. It's about the insatiable greed of the establishment vs self-interest and independence of the people.

YR Dog, today's market showed that it's smarter than I gave it credit for. It actually appears to be thinking longer term. The short term outlook is further complicated by the mess in Europe, where banks are in even deeper trouble than here. But the report of Europe's disappearance is greatly exaggerated, just as when Bernanke told Schumer et al "if we wait until Monday, there won't be an economy for us to save" (I'm paraphrasing from memory) two Fridays ago. US, Europe, BRIC, we're all in this together. Financial crisis can often hurt economy, but for a financial crisis to become an economic CRISIS, it takes extraordinary ignorance and neglect. I never believed the world would allow the current financial crisis to become a real economic one, even before Paulson started talking about his plan.

Maybe we will have a recession. Maybe we already have if you use the real inflation to adjust GDP. But, in this particular case, it hardly matters to the question of inflation. The surge of capital created by this Bailout Pork Package will drive up inflation even in a recession.

I'm sticking with commodities for at least a few more months.

How Much Can Investors Recover from CDOs?

No worries, the Fed is holding all of them now. Tax-payer funded, 0 financing cost, no pay back necessary.

Welcome to the risk-free world.

Market Sentiment: Eye-Poppingly Bearish

Sorry, I don't get the part about repo market. If there's a mad dash to safety and record failure of delivering treasury as collateral, then everybody would hold on to cash and repo rate should be much higher. Conversely, if repo rate is very low, it just means there's not so much demand for cash/financing. And if the overnight repo rate is much lower than the overnight fed fund rate, that says to me that there's plenty of supply of financing in the market, re-asserting the notion of the fed being the lender of last resort.

What am I missing? Any enlightenment would be appreciated!