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Mandated selling because of downgrades will provide "panic mode" data points (i.e. lots of sellers and few buyers), which will feed on themselves in a vicious circle. The unwinding can only be painful, precisely because of these trigger mechanisms, which force transactions to take place and 'shine light' on the whole sorry mess, whose sudden visibility in turn makes the crisis real and feeds it.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 11:11:26 AM EST
[ Parent ]
Can any of you Bears of Financial Brain tell me what the key differences are between a CDS and a Guarantee?

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Jul 4th, 2007 at 11:28:14 AM EST
[ Parent ]
It's pretty similar, from the point of view of the purpose it serves for "hedging" customers. It's an insurance against default by the borrower, which repays you of the nominal remaining at the time of default (forgoing expected trailing interests, but you can reinvest the premium at the rates available at the time).

And the cost is regular payments, so it really works a lot like those "unpaid lease" insurances that individuals can get for property they let.

But it is different from an asset-backing, in that it is hassle free: you get cash, full stop. No legal action to take to seize the backing asset, no doubt about its future value and liquidity at the time of default, no delays...

The two can coexist: there are CDS on asset-backed loans. But you can't have your cake and eat too. In such cases, the CDS contract says that all you initial entitlements as lenders are transfered to the CDS issuer (that is, they try to recoup the loss they made on a default, by snatching the assets and getting whatever recovery they can - in short, with the CDS, you transfer the hassle to a bank)

Pierre

by Pierre on Wed Jul 4th, 2007 at 11:41:25 AM EST
[ Parent ]
But if, as Pierre suggests, the banks are beginning to get worrying signals from their models even without the credit ratings being downgraded, they will try to quietly reduce their exposure by selling any high-risk debt instruments they do hold. In addition, if they start writing things off, this is bound to show up in their quarterly financial statements. Which will provide more data points.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 11:40:50 AM EST
[ Parent ]
Exactly. The only way they could conceal this much longer, is if the SEC is complicit and also validates "updates to the in-house models" to shift the baseline as the crash goes.

Note that this will not be easy: I read last week that some (smart shark) hedge funds have shorted the bank stocks, purchased CDS from them without the underlyings (nothing prevents you from doing that, effectively betting on ACME going belly up), and sometimes even shorted the MBS when markets allowed. These hedge funds have officially demanded that the SEC applies regulation swifly and strictly to the big street names (in short: they will not let their preys escape). So there is big money pushing for a crash too, and lobbying power on both sides.

Pierre

by Pierre on Wed Jul 4th, 2007 at 11:48:05 AM EST
[ Parent ]
I read last week that some (smart shark) hedge funds have shorted the bank stocks, purchased CDS from them without the underlyings (nothing prevents you from doing that, effectively betting on ACME going belly up), and sometimes even shorted the MBS when markets allowed.

In other words, fredoiul cannot profit from this any longer, as people with deeper pockets than him and earlier access to information already have ;-)

Can the last politician to go out the revolving door please turn the lights off?

by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 11:50:12 AM EST
[ Parent ]
Fredouille can still give it a try, I just gave the recipe. But it is risky: as always, timing is critical, as if you short too early and wait you pay a lot for margin calls, and some stocks could benefit from (heresy !) ... a bailout !!

Pierre
by Pierre on Wed Jul 4th, 2007 at 11:59:23 AM EST
[ Parent ]

FSA sounds alarm on subprime lending (4 July)

The Financial Services Authority has started disciplinary action against five mortgage brokers for weak "responsible lending" practices in the subprime mortgage market.

The UK financial regulator on Wednesday issued a damning report on the sector, which lends to borrowers with spotty credit histories. Arrears among subprime borrowers are currently running at 20 times those of mainstream mortgage holders, sparking concerns firms have taken on excessive risk in ramping up their lending in this area.


SEC examines subprime market (27 June)

The Securities and Exchange Commission yesterday said it had initiated a broad-based investigation into the troubled subprime mortgage market.

Christopher Cox, chairman of the SEC, told a congressional panel that the regulator was investigating a dozen subprime mortgage issues, including collaterallised debt obligations (CDOs), which are repackaged pools of debt sold to investors.

The SEC is also looking into the secondary market for these instruments.

Asked what had prompted the scrutiny, Mr Cox said "the climate and the environment". He added: "The attention that is being paid generally to problems in this area causes us to be alert to the potential for violations of the laws and regulations that we enforce."



In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Jul 4th, 2007 at 12:24:48 PM EST
[ Parent ]
Funny.  CCox naming the problem "the climate and the environment" and then admitting the SEC is way behind the industry he is in charge of regulating.

Our knowledge has surpassed our wisdom. -Charu Saxena.
by metavision on Fri Jul 6th, 2007 at 07:24:53 PM EST
[ Parent ]
By the way, why would anyone want to enter a marked-to-model swap with the institution that maintains the (proprietary) model? That's naïve in the extreme.

Can the last politician to go out the revolving door please turn the lights off?
by Migeru (migeru at eurotrib dot com) on Wed Jul 4th, 2007 at 11:53:08 AM EST
[ Parent ]
you mean a credit default swap or a regular swap ? I assume it's a CDS you are talking about.

Actually, it is not relevant to the "subscriber of the insurance": most of the time, he wants a hedge. If the rate of payments for the hedge doesn't chew up a too big proportion of the coupons, he'll be happy. He only wants a big name to sell the protection (you don't want your insurance to go belly up, do you ?)

The model is only pertinent to the book value of the contingent claim in the bank's account. Pretty much like the valuation of a portfolio of drivers at an insurer. The problem is that driver insurers have models based on big old historical records where Gauss works very well.

The banks do have a problem: they sold lots of protections for too cheap fees, valuing them a derisory price coming from a fancy model (ACME will default in a credit crunch ? nononon, that can't be). And they thought they were faster than Insurance companies, because models enabled them to roll out new products faster and without waiting for the accumulation of long historical records, etc...

Now the models will either be tweaked or they will make it apparent that lots of cash will be due shortly, and that the hedges of the banks are grossly inadequate. Note that it is only because the swing in the inputs is terrible (from bubble to crunch) that the model can do nothing but confirm the disaster (that common sense could have predicted). We do not know for real how these models would perform in a non-bubble, non-crunch period, because they have never been back tested on such a period.

I take it they are rather poor in that they did not incorporate more indicators that would have raised alarms as early as two years ago in the real estate market.

Also, I think the theoricians will soon discover such realities as "friction" and "inefficiency" in the market. There's plenty of this in an illiquid real estate market (legal costs, janitor costs, realtor fees...)

Pierre

by Pierre on Wed Jul 4th, 2007 at 12:22:06 PM EST
[ Parent ]

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