Bo Peng

Annihilate the Perverse Effect of CDS on Bondholders

George, I don't think the orderly unwinding of LTCM is the source of the problem. The problem is that Wall St learned from that lesson and lobbied hard for the bankruptcy code reform of 2005. They got their wishes, and became the wolves that devoured Bear, Lehman, and Merrill, and then went on life support themselves. You could almost call it poetic justice if the consequences weren't so dire and widespread.

Annihilate the Perverse Effect of CDS on Bondholders

viewfromnyc, you're right that the US corporate law emphasizes more on shareholder than, say, the German system that gives bondholders more weight. I'm not advocating any change at the philosophical level. There's no duty for the bondholder to "help" the company. If only to respect your effort of writing such long comments, I'd like to avoid diverging into other directions.

What I am advocating is the simplest, most common-sensical remedy of the disassociation of the normal economic interest created by modern hedging techniques. No need to bring in naked CDS buying. It's a separate topic by itself. Let's reiterate:

Set-up: You hold $1M bond. Company is in trouble.

Scenario A: You're unhedged. You have $1M worth of say in re-org/restructuring/b... negotiations. No problem there.

Scenario B: You're fully hedged with CDS -- how much premium you pay for it is irrelevant. Now you have 0 exposure. In fact, given the fact that the company is in trouble, it's better for you if the company defaults right away than going through some other remedies. But you still have $1M say in the negotiations. Of course you'll push for speedy default. This is a problem. While bondholder is not expected to help the company, she's not expected to push the company off the cliff, either, not in a system that's rational on the macroscopic level. The old system was mostly rational. With CDS and the bankruptcy code reform of 2005, the last inhibition is taken out.

Compare LTCM and Lehman. Back when LTCM was in trouble, all Wall St banks had their skin in the game. They pitched in and helped orderly unwind. In the end, everybody won in the sense that the economic loss turned out to be much less than a brute force shutdown, and the shock to the financial system was much smaller. When Lehman was in deep water, however, bankruptcy reform of 2005 had been in place. Derivatives counterparties got to cash out even through Chapter 11 protection. Furthermore, most big Lehman bond holders are well protected with CDS. As a direct result of this new dymanics, no big institutions had the incentive to help Lehman avoid bankruptcy. The end reuslt is a disastrous shock to the system, and a lot of retail bondholders got wiped out of their life savings.

If there were no 2005 reform, the other Wall St banks would've been incentized to at least help Lehman unwind orderly, much like LTCM. If the bondholder netotiation power had been allocated by the real economic interest after accounting for hedging, which would shut out many of the institutional bondholders and bring in net Lehman CDS sellers, at least everybody's interests would've been much better aligned.

Annihilate the Perverse Effect of CDS on Bondholders

viewfromnyc, I think you misunderstood what I was saying. I was not saying CDS seller should share the bond recovery. That would change the nature of the product. I was saying CDS seller takes on credit risk of the issuer while the buyer transfers out of the credit risk, therefore in bankruptcy court the bondholder's representation should reflect her real credit risk exposure after accounting for the hedge.

In normal times, bondholders of course would like to get coupon payments. In distressed situation, however, yield goes to 30% and bondholder is faced with the choice of taking the capital loss by selling on the secondary market or taking the significant default risk by holding on to the paper. In good'ol times, these are the only two choices. So she's very incentivized to help saving the company. Now she just buys CDS and, all of a sudden, bankruptcy becomes at worst a non-event, roughly equivalent to if the company spring back to health and bond goes back to par or if the company drags on in despair.

DIP financing used to be an important life saver for companies in Chapter 11. Shareholders used to aligned with the company. Now with hedging, people can have zero exposure, yet still retain their voting rights. This is absurd. Hedging is perfectly fine. It's the bankruptcy court and shareholder meetings that have fallen behind times and produced the absurdity.

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.

Can We Go Back to the Old Wall Street?

Ricard,
There's very little cost if we
1. separate commercial banks from investment banks
2. let investment banks fail -- and fail they will
3. nationalize investment banks
4. set up RTC for investment banks
5. auction off investment banks to private partners more or less right away
6. auction off RTC assets in a few years (hold some to maturity)

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.

Long-Term Crisis Remains Strong

tdilliian, I try to keep an open mind on Obama. I'll see what he can/will do.

Actually I voted for him. So why did I say the above? Because the problems are so deep and wide, and expectation so high, chances of him disappointing are excellent. Bickering between many democrats in Congress and his team, before he even starts, shows how shallow the phenomenal "support and goodwill" actually is in some segments of the society.

If he fails, a most likely direct cause is democrats in Congress. He needs to start a grassroots movement to replace them. After all, by and large they cooperated with Bush for all eight years didn't they?

He ran against the democratic party establishment, not unlike McCain ran against the republican party establishment. Now let's see how long he can remain his own man before the democratic establishment assimilates him. Based on his cabinet choices, it doesn't look too good.

But still, the world so much wants him to succeed that he still has a chance to make some meaningful changes, at least in theory. So I'm keeping my, uh, hope for change damn that's so lame...

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.