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Berkshire Bond Yields vs. CDS Rates

Hate to point out to you dlaw, but my sample arbitrage requires nothing to happen and is a risk free arbitrage. Try reading it again. Yours requires a downgrade and increase in BRK yields which has not happened yet and is thus a guess. Mine is a true arbitrage, yours is a bet and thus not arbitrage. Someone making your bet would be much better off simply shorting the bonds, because CDS are so expensive.

btw - let's explore CDS is a "larger market". Let's imagine for a moment, that if I bought a derivative of a bond from you. We'll call it a derivative since it won't be the actual bond itself, even though it will function 100% the same as the underlying bond itself. Now, I have a notional exposure of the total position and so do you. Bonds are worth $1 million, notional exposure is $2 million, since we both have a position. Then I trade it to someone else, perhaps even you at a different rate to adjust for yield changes. Notional exposure is now $4 million over the $1 million bond equivalent and now we just have a small spread yield payment in between us. On it goes every time it's traded including anyone else who comes into the trades. It's still just a $1 milion bond. The notional exposure means more about trading activity than it does about real exposure. How big do you think the bond market or stock market would be for that matter if notional exposure multiplied by two every time it was traded and was simply added to all other "notional" value of every trade made? Bigger than GDP? So much bigger than GDP it would be ridiculous to think it has any meaning to derive from the number?

04:25 PM dlaw wrote:

> "Real, economical, pure free money." - incredible. Something about
> Warren Buffett causes people to live in a complete fantasy world.
>
>
> But the author does show exactly why the CDS are so expensive: CDS
> are not only a default aritrage, they are also a spread arbitrage.
> While there are credit spread swaps (which would be the more-precise
> way to play a spread arbitrage) apparently CDS are the larger market.
>
>
> If BRK bonds are trading at a premium to the AAA market, then CDS
> are a perfect way to play the arbitrage between BRK bonds and the
> AAA market. Since the derivatives losses seem a no-brainer to at
> least move BRK bonds down 133 bp - as the author notes - there is
> a nice, built-in cushion to the downgrade/default play.
>
> So thanks to the author. Sometimes you can learn what's right by
> reading what's wrong.

Is Buffett Buying American Express for Berkshire Hathaway?

Get an explanation to how those calculations are being made before you believe them. Those numbers are Economic Capital as defined by IRA in association with what they think about derivative exposures, which basically means, IMO, that if you make a market in derivatives, Economic Capital "as calculated" by IRA is completely deficient because of what they assume about is required because of notional exposure. Notional exposure can increase through time through what is essentially trading and offsetting risks, not really the addition of new positions (ie: if you sell a position to another party, your net exposure went to 0, but your notional exposure doubled). If you want transparency as to what real risk for banks are considering the economic capital needed to underlie the risks on the portfolio, then they need to disclose how exactly they come up with the numbers and I've never seen that. If they have, that's great and it should be more obvious. It seems to me that the numbers they come up with are materially different than from a regulators POV and since JPM has been one of the strongest banks through the crisis and according to IRA faces the largest risk, then either the market doesn't see the risk that IRA supposes they face, or the market disagrees with the analysis.

Charlie Munger's Lollapalooza Effect and This Credit Fiasco

I so wholeheartedly agree with much of what you've said in this post. This problem has so much to do with incentives and disclosures. Theoretically, since the securities buyers are the ones who are owning the risk, they maybe should have started to be a little more careful when they saw real estate prices going crazy. But even there, they didn't, even though they were the ones who were going to lose money. But they're often running OPM, getting a cut on the profits they make, which give an incentive to search for yield. Options programs can distort executive incentives towards gaining short term stock price appreciation. Hedge funds are evaluated on sharpe ratios, which encourage carry trades, which work with exceptionally small amounts of volatility until they don't. Wall Street investors themselves are so concerned about whether or not a company beats the street, they get the exact type of short-term management behavior that they ask for, which eventually blows up for thinking so myopically. Ratings agencies may think that a fat tail event looks increasingly possible, but has no data, therefore can conveniently look away from a problem that a single person who just has a lick of common sense can predict better what is going to happen than people enormously more sophisticated can. This problem has nothing to do with the securities or financial engineering at all, IMO. It is the incentives that surrounds them.

An irony is that many of these companies do have incentive structures in place to theoretically limit such mistakes. Mortgage companies often get portions of their own securities as payment for the origination, especially the dicier ones. They can get the pants sued off them if they do anything illegal and be forced to buy back the mortgages. Ratings agencies are threatening their business model if they make ridiculous assumptions that people in the future are going to laugh at. Hedge fund managers will lose all their business if they lose other people's money. But none of it worked. Somehow it seems to me that human nature is short sighted and our incentive structures for the most part, don't properly handle this. We're always looking for shortcuts.