Amicus

Establishing Hypotheses to Test My Economic Predictions

Bill, I think we now know that to be false.

See here:
seekingalpha.com/artic...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

More (read it and weep?):

Hedge Funds: The Credit Market’s New Paradigm, June, 2007 (last year)
www.rgemonitor.com/blo...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

Updating:

From the DTC's note, it appears that their contract registry covers all the major dealers. It doesn't appear to cover any hedge-fund to hedge-fund trading, if there is much volume to that.

Also, from what I could tell, most of the major banks (and by extension, their clients) are covered under the CLS settlement protocol. I did not see AIG on the list .... They are suggesting that "all major institutional players" will be 'on the list' by end of 2009, which, of course, is an ocean of time, with today's worried markets.

www.cls-group.com/Abou...

Here's the Financial Markets Stabilization Act We Should Have Seen

Feedback, for your amusement:

1. Keep people in their homes - good for the economy, good for a slow home-price adjustment process. Government offers terms to the existing lenders and 50% participation in home price declines. Government offers reasonably close-to-market terms for those with ridiculous sub-prime or alt-a loans.

The worst-case scenario for the mortgage pools behind a CDO, under this plan, is that it is converted into a government-backed, yield-enhanced bond at maybe 16%-22% off of original face value (based on home price declines of 30-40% and 90-95% of LTV assumptions) and with maybe a 4% default rate (those homeowners who cannot meet even the government's reduced terms).

This is a Brady plan for sub-prime and alt-A mortgage debt, focused on those near or at default, that doesn't promise no defaults, keeps people in their homes as long and as much as possible, and shares the burden between lender and borrower, circa 50% in the "workout".

2. No "loan modification". The lender chooses to accept the governments (generous terms) or the risk of a costly, lengthy foreclosure process, as well as the associated home price risk. You can bet that, until house prices stabilize, most of them - well, their servicing agents - will go for the government terms.

4. yes and no. A limited amount of direct assistance, but it is better to get people jobs and to target stimulus to other things, than to start subsidizing lending.

5. absolutely not. For a time, the economy can run with ... less capital.

6. yes, but have no faith that "smart regulation" is ever anything that would make it to a final Congressional Bill.

7. We've done what needs to be done to supervised mortgage lending, but doubling the watch, so to speak, on all these other kinds of abuses, including a look at bankruptcy "relief", is probably a GREAT idea.

Establishing Hypotheses to Test My Economic Predictions

now, let's do the matrix game from the other side.

THE DEATH SPIRAL

Events move faster than policy makers can keep up, as a series of further blows to confidence eludes the efforts of a semi-competent Treasury Secretary. Luckily, we have a Fed Charmian who seem really attuned to this, so far (I put up as an exhibit how quickly California's financing needs got off the front page of the papers).

You can make up the list(s) yourselves, because I don't like the game of death spiral.

They include further, dramatic bankruptcies and any kind of unexpected, financial services "dislocation".

Key funding events that fail for mergers that really, really make sense to everyone.

Also, geopolitical events, especially those that spike the price of oil.

Establishing Hypotheses to Test My Economic Predictions

I'll bite.

Where you could be wrong.

The sub-prime meltdown is no longer a financial stocks issue. This problem was just about fully reserved a long while back. At worst, it is a headwind, now, not an anchor. If not, we will vote money for the FDIC and keep putting money into the banks, because neither politician party will be able to change course, politically.

The current bank lock-up is not related to a "crunch" at all, but to uncertainty about derivatives exposures and the anticipated need(s) to deal with that. As such, it will dissipate instantly, once those problems are resolved.

The real credit crunch is occurring at GM and GE, who are losing the grip on their financing arms, for different reasons, both profound both with non-trivial affects to the real economy.

S&P earnings are already down, but a slowdown is already priced into the equity markets, at S&P 1,000.

Obama will win what is left of what we call U.S. democracy.

Oil is a wildcard, still. Unemployment will be fine, if oil keeps coming down, perhaps topping out at 6.5%, especially if a targeted stimulus actually invests in some infrastructure (i.e. one industry that is shedding workers ...).

Consumers will tap on the brakes for Christmastime spending, but by next spring, they will have had enough of belt-tightening. By then, the low interest rates will have just started to work their magic on those banks who are so amazingly profitable at 2.5% funding rates. The Obama "middle class", ill-advised tax cuts will give them ... splendorous optimism.

Housing will take a long time to bottom. Various schemes to prevent an overshoot of housing prices will be tried.

No one will be found responsible and certainly no one will go to jail.

As time goes by, new energy solutions and maybe some public spending on energy efficiency upgrades will mute the impact of a rebound in energy costs, as the recovery turns from remote to likely.

Long yields will... do nothing and everyone will continue to invest in the U.S. The Chinese and India and Brazil will continue to build their position on the Global board-game of RISK.

The wrong regulations will be enacted, in a flurry of inarticulate activity on the Hill, setting the stage for the next crisis, years down the road.

Lehman CDS Net Settlement Only $6B: What Does It Mean?

With luck, A was hedged, ...
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It does seem that some are speculating that "A", in this example, might collectively be "lotsa hedge funds", who may not have had sufficient hedges, and consequently, not have the money ...

I'd speculate - not even guess, speculate - that the clearing firms would be on the hook to complete the settlement(s) if their clients fail.

That could be just totally wrong.

Whatever the case, it is unlikely that there will be another auction, since those are geared toward setting a settlement price, not who owes what...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

you are right, so let me revise and extend my remarks.

I'm not a settlements expert, but you may have calculated the "net" wrong in your example (not just the math).

If A owes B $600 billion and B owes C $540 billion, then the net settlement, I'd *guess* is $600 billion, with $60 paid from A to B and $540 paid from A to C.

There isn't too much evidence to suggest that there was a player out there who wrote up to $600 billion in unhedged CDS, on any one name. So far, it seems only AIG had large, unhedged positions (why else would they suddenly need $85 billion dollars).

The DTC calcualtion *suggests* that, after all the back-and-forth, the net settlement will be a lot smaller than our illustration.

For instance:
C is "flat" as follows:
C owes $8 biliion to B and C is owed $8 billion from A
A is a net payor
A owes $120b to B and B owes $115b to A (net 5 A to B); and
D, a customer, has protection from C
C owes D $1 billion

I'd *guess* that the net settlement, here is $6 billion, with $5 from A-to-B and $1 from C to D.

With luck, A was hedged, so they don't have to come up with $5 billion, but some lesser amount, because of the performance of their hedge.

I wish I had more confidence, but I think that is the right interpretation of the DTC's figure. They list a phone number on their press release. We should call them...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

Derivatives counterparties can go thought bankruptcy protection and force liquidation.
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It's not clear (to me) how many will.

see here:
www.isda.org/press/pre...

Lehman CDS Net Settlement Only $6B: What Does It Mean?

2 dealers, 3 dealers, it matters, but not the way you may think. They use a multi-lateral netting process.

The settlement system, via the CLS Bank that is used, is very much developed. It is used for the settlement of F/X, where the notional values soar as high as any in the history of the world ...

I found this primer to share:

www.bis.org/publ/qtrpd...

Lehman's Loss: More Than $200 Billion

the teaser from the ISDA press release (they traded everything, it appears):

"The special trading session is taking place on Sunday September 14 for OTC derivatives. The purpose of the session is to permit parties to reduce their market risk associated with a potential Lehman Brothers Holding Inc. bankruptcy filing, by entering into transactions with other participants that would fully or partially offset OTC derivatives positions that they have with Lehman. Product classes involved are credit, equity, rates, FX and commodity derivatives."

Lehman's Loss: More Than $200 Billion

Lehman had about $613 billion in liabilities, the majority of which was secured and should have minimal losses, ...
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At what price are Lehman's (defaulted) senior bonds trading? Last week's CDS auction suggested that the recovery rate on Lehman "bonds" was not nearly as high as suggested here. That discrepancy could be explainable.

Separately:

"Losses" in your terminology perhaps should be refined. Here's what I have in mind.

True or false: the net economic losses from any defaulted set of bonds is limited to the par-value of the bonds, at the time of default.

Derivatives, such as CDS, are essentially risk-transfers. As such, they net to zero. Put another way, my loss is always someone else's gain.

If Lehman was running a perfectly hedged book of CDS, at the time of bankruptcy, then a netting of the "long" claims against Lehman with the "short" claims, coupled with any cash positions used for hedging or collateral, ought to net zero residual claim.

As you may recall, ISDA held and extra-ordinary derivatives trading session on the Sunday before Lehman went under.

The net results of that, in terms of plucking an incompletely hedged book out of the chain of dominoes, ... is not public, so far as I know.

www.isda.org/press/pre...

Moody's Is Acting on Private Mortgage Insurers

LOL.

80% probability that these stocks will triple in the next 18 months, I'd guess.

Lehman CDS Net Settlement Only $6B: What Does It Mean?

Bo, luckily the settlement for these things is net. Even a "fail" is a net fail, I believe.

In your simple two-dealer example, no one delivers $600 billion. All that is deliverable is $6 billion, in cash, from A to B.

The most that could "fail' is the net amount(s).

Six billion is still a lot of cash, but it's not ... fantastically large.

Skeletons in the Closet: Credit Default Swaps and Housing

They've been pushing home prices up from the bottom, paying more for starter homes,...
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I believe that the figures for sub-prime lending will not bear that conclusion out. On the whole, it did not expand home ownership. Something like 1% of new home buyers were subprime borrowers.

In most markets, it is supply and demand of real-estate that drives the prices, not financing ...