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Just because you have a CDS swap supposedly covering your investment doesn't mean that your counter-party will be able to pay if it is triggered.

Granted, but if you buy CDS protection it's because you expect to be paid in case it is triggered, right?

Right?

Um...

the whole point of CDS swaps was to enable you to treat risky junk as though they were AAA investments and relieve you of the obnoxious reserve requirements

Okay, let's parse this.

The following table applies for its risk-weighting:

Claims on sovereigns and their central banks will be risk weighted as follows:
Credit AssessmentAAA to AA-A+ to A-BBB+ to BBB-BB+ to B-Below B-Unrated
Risk Weight0%20%50%100%150%100%
A triple-A bank has a risk weighting of 20%.

Capital is 8% of risk-weighted assets.

So... take a Greek bond.

Before the crisis started, Greece was in the category where its bonds had a risk weighting of zero. So, holding a Greek bond costed no capital.

Now, Greece is rated below B, so its risk weighting is 150%, so the capital charge is 8% times 150% or 12% of notional.

You can buy a CDS at a 16% annual premium. The capital charge for the AAA CDS is 8% times 20% or 2%.

So, does it pay to free up 10% of notional from the capital charge, at the expense of 16% annually in CDS premia? I don't think so.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Wed Jun 15th, 2011 at 05:07:21 PM EST
[ Parent ]
The example I had in mind was Goldman and AIG. AIG had lost effective internal controls when the former CEO departed and insured below reasonable cost. I do not know if buying a CDO makes sense to free up capital if the CDO is properly priced. I will bet that lots of CDO issuers on Greek debt would be happy to give back  premium they have received and then some to be off the hook on those CDOs. And even good rocket scientists make rockets that explode.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Jun 16th, 2011 at 12:41:13 AM EST
[ Parent ]
Not CDO (Collaterallised Debt Obligation - a kind of Asset-Backed-Security) but CDS  (Credit Default Swap).

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Thu Jun 16th, 2011 at 01:56:27 AM EST
[ Parent ]
Yes, I realized that, but yesterday was a day from Hell! I will make a post in the OT.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Jun 17th, 2011 at 02:24:46 PM EST
[ Parent ]

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