Tom Jacobs

Writing Naked CDS: When Murder (and Betting on It) Is Legal

There are plenty of agents with no commodity exposure who either agree to deliver or accept delivery of commodities in futures contracts and they perform the role of enabling those with said exposure to hedge and no one wants to take them out to the woodshed. Tangentially, a number of academic studies showed that those tech stocks that could not be shorted due to technical and other factors experienced the largest degree of "bubble" in their shares during the late nineties boom in tech stocks. Thus, I would conclude that the idea that one has to demonstrate an economic exposure to hedge in order to short credit or that shorting both credit and equity is somehow evil is misguided, at best.

I also liked this line from the Barron's piece: "If the total cost of buying a bond and insuring it to par is less than par, it creates an arbitrage that ultimately destroys capital." How does this destroy capital? The arbitrage is to buy the bond and buy protection on the CDS which will drive up the bond price and the cost of insurance until par is reached and the arbitrage is gone.

Tom

A Positive Step for the CDS Market

Thanks for a great post, Jim. You laid out the obvious argument I never see anywhere else, how can you only permit owners to hedge their position without speculators to take the other side? As far as AIG and risk management go, don't guns always fire themselves and shouldn't we outlaw them to prevent their use? Kudos for going out on a limb in this environment and carefully (cautiously?) stating what no one wants to hear.

Why AIG Was in the CDS Business

I would like to add that this exchange, like most I have read, seems to imply there is a big difference between buying a bond or writing protection on it via a CDS - there is not. Fundamentally, If I am a reasonably high rated counterparty and borrow money to buy the bond, the difference in spread will be very close to the rate I would receive by writing protection on the bond. If I own the bond and it defaults I am left with the recovery in bankruptcy. If I write protection and the bond defaults I have to buy the bond from the protection buyer at par and I am left with the recovery in bankruptcy. The big place one might see spread differences with this strategy is for those buying protection on a bond since the alternative is to short the bond which is often very difficult so there is no approximate arbitrage trade to tie the two together. Now I have left out some details on the borrowing side for buying the bond, particularly if the purchaser is not of high quality or the tenor of the default swap is very different from the tenor of the bond but the basic argument is sound.

The problem here, as mentioned by another poster, is that AIG did not plan for the collateral calls of marking to market on something widely viewed as AAA+ (the super senior tranches of these CDOs). Why they did not is simply politics. When a business unit at one of these organizations is making money no one has the power to question them. Not internal risk managers and certainly not regulators. They may sing and dance about their independent reporting lines for risk management to the CEO but the reality is no one will get anywhere saying "you need to reserve againt AAA+ tranches going down, rating agencies don't know what they are doing, etc." With all the overlapping branches of regulation the one to try and call the company on the carpet BEFORE the problem occurs is always immediately attacked as extreme by the other regulators. I am not making this up - I have seen it myself. The other simple fact is that no one has cracked the code on default correlation or even default - recovery correlation on corporate names, let alone individual mortgage borrowers.

AIG Gets the Scarlet Letter

Sure Warren Buffet's a great guy:

www.dealbreaker.com/20...

He is so sincere when he makes all these statements about increasing taxes for everyone else (keep the death tax, raise property taxes in California, etc.)

Am I the only one disgusted by all the hypocrisy between his behavior and his public statements?