Betting the House
October 22, 2008 7:39 AM Subscribe
Any Investment Bankers out there? I have a question about Credit Default Swaps.
Much that I’ve heard indicates that speculation in CDS’s is a major factor in the current economic mess, and that tens of trillions of dollars were “bet” (for lack of a better term) on them. I understand how a holder of a bond would want to buy CDS’s as hedges. What I don’t understand is the pure speculative aspects of them. Was defaulting on bonds fairly common? If not, it doesn’t seem like it would be a good market for speculative CDS purchasers – it would be akin to buying long-shot lottery tickets. If there were a lot of bond defaults, you would think that the price of a CDS’s would be high enough to reflect that.
Along the same lines, since both the buyers and sellers were sophisticated, you would thing that the pricing would be close to dead-on – barring catastrophic events – except for maybe a slight premium the seller would get for providing a hedging opportunity. So there does not seem to be any advantage in speculating on these things, regulated or not. What am I missing?
Much that I’ve heard indicates that speculation in CDS’s is a major factor in the current economic mess, and that tens of trillions of dollars were “bet” (for lack of a better term) on them. I understand how a holder of a bond would want to buy CDS’s as hedges. What I don’t understand is the pure speculative aspects of them. Was defaulting on bonds fairly common? If not, it doesn’t seem like it would be a good market for speculative CDS purchasers – it would be akin to buying long-shot lottery tickets. If there were a lot of bond defaults, you would think that the price of a CDS’s would be high enough to reflect that.
Along the same lines, since both the buyers and sellers were sophisticated, you would thing that the pricing would be close to dead-on – barring catastrophic events – except for maybe a slight premium the seller would get for providing a hedging opportunity. So there does not seem to be any advantage in speculating on these things, regulated or not. What am I missing?
Let's say you think a company is about to announce bad news. You buy CDS protection of $1M for $100, even though you don't own any bonds from that company. They do, in fact, subsequently announce bad news. Now you can sell CDS protection of $1M for $200 to someone else. The problem is that selling does not clear your books. In case of default, you're just relying on the guy who originally sold you CDS protection to give you the $1M so you can in turn give it to the guy you sold CDS protection to. Repeat that a bunch of times, and also have a company like, say, Lehman originate it all, and you've got a problem.
posted by Durin's Bane at 8:11 AM on October 22, 2008
posted by Durin's Bane at 8:11 AM on October 22, 2008
The Planet Money podcast (http://www.npr.org/blogs/money/) is pretty good at explaining things that are going on. One of the first couple of episodes outlines the whole CDS mess.
posted by thewalledcity at 8:21 AM on October 22, 2008
posted by thewalledcity at 8:21 AM on October 22, 2008
Oh, I used unrealistically low numbers for the cost of CDS protection to show that even though the risk of default is miniscule, you could still make money off trades.
posted by Durin's Bane at 8:22 AM on October 22, 2008
posted by Durin's Bane at 8:22 AM on October 22, 2008
Response by poster: Apologies if I get a bit vague here, but I am a bit out of my depth. You guys are saying that they are are a lot like futures or forwards, except unregulated. But aren't they different in that they expire and have no underlying asset? (vagueness begins here). If I buy a CDS on a five-year bond, it covers, lets say, 2008 through 2013. When I try to sell it in 2011, it is only good for two more years, and its value should be diminished -- unless, of course, the bond-issuer looks much worse. On the day before its expiration date it would be worth essentially nothing. Seems like a relatively crappy investment.
posted by UncleJoe at 8:33 AM on October 22, 2008
posted by UncleJoe at 8:33 AM on October 22, 2008
If you were a speculative CDS trader, you wouldn't want to normally buy one on a five-year bond and hang onto it for three years. To make money on CDS speculative trading, you would need to be highly leveraged, and you'd be buying and selling on a shorter timetable.
posted by BobbyVan at 9:18 AM on October 22, 2008
posted by BobbyVan at 9:18 AM on October 22, 2008
Seems like a relatively crappy investment.
If you buy CDS for the purpose of speculating on the reference bond and you hold it through maturity but it never defaults, then it was a pretty crappy investment. But that's not really a flaw in the structure--it's a flaw in investment decision making.
But aren't they different in that they expire and have no underlying asset?
Since CDS act like insurance (and are used that way by holders of the actual reference obligations), it makes sense that there's no physical delivery of assets at maturity. When you insure your car, the auto policy doesn't result in delivery of your car to the insurer once the policy expires.
posted by mullacc at 9:19 AM on October 22, 2008
If you buy CDS for the purpose of speculating on the reference bond and you hold it through maturity but it never defaults, then it was a pretty crappy investment. But that's not really a flaw in the structure--it's a flaw in investment decision making.
But aren't they different in that they expire and have no underlying asset?
Since CDS act like insurance (and are used that way by holders of the actual reference obligations), it makes sense that there's no physical delivery of assets at maturity. When you insure your car, the auto policy doesn't result in delivery of your car to the insurer once the policy expires.
posted by mullacc at 9:19 AM on October 22, 2008
This thread is closed to new comments.
CDS attract speculative players because you can trade them--when the market's expectation of default increases, the price of the CDS increases. Here are some charts showing the price of protection on MS, LEH and MER CDS (kinda old though). If you bought protection against MS bonds at the start of the credit crisis in mid-2007 and then sold that protection in March '08. you'd have made a lot of money even though there was no default event.
posted by mullacc at 8:09 AM on October 22, 2008