Credit Default Swaps

What is a Credit Default Swap (CDS)? Basically, it is bond insurance, usually. Due to the Clinton and Bush administrations not wanting to regulate the CDS market (codified in the Commodity Futures Modernization Act of 2000) it also became a way to gamble on financials.

Here is how a CDS is supposed to work: Person A owns $1 billion par value worth of a 10 year ACME Company (ACME) bonds that pays 8%; so Person A gets payments of $80 million each year from ACME for the next ten years. Person A really only needs $40 million a year to be happy, so Person A is looking to lock in a 4% return. Enter Person B; Person B thinks that there is only a 2% chance a year that ACME will default on the bond; so, Person B, knowing a little about probabilities, and such, knows that Person B needs $18,292,719.31 a year to cover the expected value of default on ACME’s bond. Or, to put it another way: Person B is willing to sell insurance on the bond for at least 1.829271931% of the par value of the bond peryear. So, since Person A is willing to pay more for the insurance than Person B is willing to charge, a deal will eventually happen; to continue this example, lets assume both are happy with 3% of the par value of the bond. So, Person A is getting $80 million a year from ACME, paying Person B $30 million a year to insure the cash flows (including the repayment of $1 billion at the end of year 10), thus netting Person A $50 million a year of ‘riskless’ income.

Well, let’s make this example a bit more complicated: suppose that Person B is happy with $15 million a year in income, and Person C thinks there is only a 1% chance that ACME will default, so, Person C, also knowing a bit about probabilities, is willing to cover ACME’s bond at $9,561,792.50 a year. Or, Person C is willing to insure the bond at 0.956179250% of par value of the bond. So, as with Person A and Person B; Person B and Person C’s bid-ask spread is positive, so a deal will take place. Let’s say they agree on 1.25% of par value of the bond. So, Person B receives $30 million a year from Person A, and pays person C $12.5 million a year to insure the bond. This can happen again and again, as long as someone thinks the payments they receive are greater than the expected value of payout on a default.

There are a couple of issues that CDS’s bring up: 1) counterparty risk, 2) lack of transparency, and 3) speculation. One of the biggest drivers of the bailout is counterparty risk. In the my example Person B and Person C are just people, or they could be hedge funds, private equity firms, banks, businesses, pension funds, etc; what they are not are insurance firms. The lack of regulation allowed these entities to take on these risks without having the necessary assets to cover the losses incase of defaults. Lets consider what happens if ACME defaults after 5 years: Person A ask person B for $1 billion, and Person B asks person C for $1 billion. Person C has received $12.5 million for 5 years which it has used to buy T-Bonds a 4%, so Person C (a retirement fund) only has $67.7 million for this asset. So, Person C goes bankrupt and has Person B (a hedge fund) seize the $67.7 million plus the $100 million Person C had in assets for the retirement fund. Person B (the hedge fund) has the $167.7 million, plus the $15 million for 5 years, which it invested at 4%, or $81.2 million; or, $248.9 million in assets from the CDS’s. But, being a hedge fund they had $150 million in assets under management, so Person A seizes all $398.9 million of Person B’s assets. So, Person A, with their $50 million a year at 4%, expected to have $1.6 billion in total value at the end of year 10, but only will have $814.9 million, or 51% of expected value. This is 18.5% less than the original $1 billion Person A paid for the bond. Also, Person B and Person C are wiped out in this situation.

In the current situation, lots of banks, hedge funds, insurance companies, and other institutions entered in to lots of these transactions. A lot of companies bought and sold these kind of CDS. So, as illustrated above, once a link in the chain is broken, the system soon collapses; this is called counter party risk. More broadly, counter party risk is the risk associated that the other party in the transaction will not be able to cover their position. (Person B and Person C did not have enough assets to pay Person A $1 billion)

The second big issue is a lack of transparency. Both the Clinton and the Bush (the second) administrations declined to regulate this market. Because this market wasn’t regulated a couple of problems occurred. The first was mentioned above, the insuring firms did not have to have enough assets on their books to cover the losses. The second issue is that because each transaction was private, every entity buying insurance did not know who the originator of the insurance was “re-insuring” the obligation to. They might transact with an entity who resided in a jurisdiction where legal recourse couldn’t be taken. (Imagine that Person C couldn’t be sued) This lack of transparency led the potential for something bad to happen grow in both probability and scope.

The third big issue that CDS’s created is gambling on financials. In the end, people didn’t have to own the bonds to buy insurance. Imagine that Person A believed ACME might fail 10% of the time over the next 10 years, so they agreed to the contact in the above example with out actually owning the bond. They would still get the $398.9 million with only having the out lay of $30 million a year. Firms were allowed to make bets on defaults without actually having to own the bonds.

Perhaps that is the ‘casino like atmosphere’ that John McCain is talking about. Anywho, that is what a CDS is, in its most simplest form.


Later,

B

Economics Tuesday: The Economic Crisis

Well, folks, its been a while since I updated my blog, and even longer since an economic Tuesday Blog. Why has it been so long? Meh, I'm lazy and I've been busy. Down to the topic: Why is the economy in the toilet?

Well, I am going to attempt to explain that to the best of my understanding and ability. So, a while ago, at the end of the Clinton years and the beginning of W's years, the economy started to slow down (the internet bubble was bursting). As a result, G.W. gave just about every U.S. citizen a $300 check and the Paragon of Central Banking, Alan Greenspan, lowered the Fed Funds Rate. These two measures were taken to jump-start the economy; and the were moderately successful. While the $300 check's effect is debatable, the consequences of the rate cut, both intended and otherwise, are quite apparent. As money loosened through the middle of 2001 the economy started to strengthen, as banks were willing to take more risk because their Cost of Capital was cheaper. The Federal Reserve (The Fed) was aggressive in their rate cuts to deal with the imploding Internet bubble; and then some whack jobs flew planes into the World Trade Center Towers. The 9/11 attacks sent a barely recovering economy into a full-on crash (no pun intended); and then the Fed got to cutting the Fed Funds Rate in earnest. An initial problem with this is that the Business Community got used to the low Fed Funds Rates; any time the rates were raised the Market punished stocks. So there was a lot of pressure on the Fed to keep rates low, and the pressure came from all side.

Here is how this plays into the current crisis: when the Fed lowers the Fed Funds Rate, the lower rate is eventually reflected in home loans. This made it quite cheaper to borrow money to buy a home. This started to put price pressure on homes to the upside: think about it this way, a perspective home owner would have to pay $1,153 a month for a $150,000 home at 8.5%, the same buyer could afford a $203,000 home for $1,152 a month at 5.5%. So, this increase in people’s ability to get money allowed them to start to pay a little bit more for the same house (it is hard to think someone would pay $203k for a $150k house; however, it isn’t unthinkable for them to pay, say $161k for the house if they really wanted it; a 7.3% premium).

The cheapness of money was on key factor to the credit crunch / housing collapse. Another key factor is the easing of eligibility of credit; the banks made it easier for people with lower credit scores to get good rates. When housing prices started to rise, banks started to make more money on their loans, and once the bulk of the credit worthy borrowers had refinanced and/or bought new homes, the banks had to find new people to lend to keep the money coming in. Banks decided to make it easier for less credit worthy people to get decent rates; and thus lower the eligibility to qualify for, and lowered the rate charged to the dreaded SUBPRIME borrowers. The banks were not being completely reckless with this idea, before the wild lending days of the mid-2000’s, the Federal Government forced lenders to lend to low-income individuals in traditionally disadvantaged groups through special programs. The analysis of this debt showed that these lenders were not much worse on default than traditional borrowers and the Federal Government provided a backstop. So the banks started giving subprime borrowers cheaper money. Guess what this did: it cause housing prices to go up.

This positive pricing pressure caused home prices to go berserk in hot markets. Notably, housing price went through the roof in Las Vegas, southeast Florida, and southern California. And this created the issue that proved fatal: high risk loans to suspect borrowers. Like any good addict, the housing industry kept doing more and more to catch the same buzz. Cheap money to legit borrowers, gone. Cheap money to subprime borrowers, gone. And now, housing prices were so high that legit, and subprime borrowers couldn’t afford the houses at normal rates….. Enter ARMs/Option ARMs; Adjustable Rate Mortagaes, that’s the ticket.

The beauty of the ARMs are what make them so dangerous, and what sent a hot housing market in to fully overheated mode. An ARM operates likes this, one can borrow a huge amount of money at an excessively cheap rate for an introductory period, usually two years (which is soooooo evil, in itself), and then mortgage adjusts to the Prime Rate plus some percentage. Using the old example, let say our guy can borrow for a introductory rate of 2%, so for his $1,153 he can afford a $312,000 home for two years, and if his rate adjusts to 9.5%, he has to pay $2.326 a month. The reason 2 years is evil is this: if you own your primary residence for two or more years, and sell it for a gain, you don’t owe capital gains taxes. The ARM loan was developed to encourage people to buy houses with the intention of selling them for a gain in two years, and if they didn’t; they’d be crushed by the new rate.

A very important part of the puzzle, and perhaps the hardest to understand, is the securitization of the home loans. Freddie Mac and Fannie Mae are companies that would buy up home loans, convert their payments into bonds, and sell the bond to investors. Here is the how and why. The how is like this, if you are giving me a payment of $100 in a year, and I need $90 now, I can sell your $100 obligation to me to an investor for, let’s say, $95. I have $5 more than I need, and the investor get an extra $5 in a year. Now, the math for determining the amount someone is going to pay for the obligations of a home loan is complicated, but essentially it is just selling a future obligation today. The why is this; a bank has to get the principle back on a loan as quick as possible so it can lend it out again, so a way to speed up this process is selling a receivable. So, if Local Bank give me a mortgage at 5.5%, and sells it to Fannie or Freddie at 3.5%, Local bank makes 2% on the loan. Fannie and Freddie take all of those obligations, bundle them together, and sell them as bonds. Think of it as them reselling it again at 3.25% to other investors. (Making only 0.25% doesn’t sound like much, but when they do this with trillions, yes, trillions, of dollars of mortgages, 0.25% ends up being a lot of cash)

The problem started when people refused to keeping paying more for the same houses. Builders kept building, house flippers kept trying to flip houses, and brokers kept trying to sell Adjustable Rate Mortgages; but people kept demanding less. Like any good, when less housing is demanded, the price of housing falls. The only problem is that those damn ARM loans started to adjust up after two years. The US Post Office carrier that was living in a $400,000 home he wanted to flip couldn’t afford it anymore; so the bank took it back. So Freddie and/or Fannie couldn’t make the payment on the bond they issued with the house as collateral. When the bond became less valuable, the banks that made big bets on these bonds saw their returns go from largely positive to largely negative. These banks became less credit worthy because they had too few assets to cover their debts because their assets became largely worthless. Other banks became scared of doing business with these banks because they are less credit worthy. Then there it was, these banks that were century old going concerns became cash poor in short order because other banks were scared of doing business with them; and when a bank is cash poor it is a dead bank.

Everyone is point to the executives at Wall Street as the culprits, but as far as I can see, there are a lot of people out there that share some of the blame: the Fed for cheap money, banks for loosening credit standards, brokers for lending money to speculators, borrowers for speculating and/or trying to get into a house they can’t afford, Freddie and Fannie for buying too much junkie subprime mortgages, investment professionals for putting too much trust in subprime backed bonds, and some other elements. Yeah, greed and the need to make the next quarter’s earning did drive some of this; but it is a bit simplistic to heap all of the blame on them.

Later,

B

Very happ!

So I got to have a great week with my brother. I got to hang with him, cut up with him, see the Dark Knight with him, etc. I am glad that he is enjoying his time Korea; but I sure do hope he comes home in April. Man, I hope he comes home.

Today is a good day

Like the poet Ice Cube says, "I have to say, it is a good day."

Today is the day that my little brother, Luke, comes home from Korea. I haven't seen him since April of 2007, so its been a while. I can't wait to hang out with him, shoot the breeze, play video games, etc. It is a good day.

Peace out,

B

Windfall Profit Tax and Dummies

I have a lot of hippie-liberal friends. They’re okay, but they’re a bit dogmatic. That would be fine; but, they’re a bit stupid about it. The thing that as been driving me crazy is the liberals going around clamoring for a ‘windfall profit tax.’ Whenever I hear someone talking about this panacea of American economic woes, all I hear is ‘I’m stupid.’

Why am I so down on the Windfall Profit Tax? Am I just a Right-Wing Nut Job? Am I a shill for Big Oil? Do I like to see the little man get crushed? (Okay, okay, okay, I do like to see the little man get crushed, but the others are false) No, it is just that I see through this deceptive tripe.

The argument for the Windfall Profit Tax on Big Oil is flawed. It presumes that the level of profit the Big Oil companies are making is excessive. The argument goes like this: Exxon-Mobil made $43.6 billion in profit over the last four quarters. On the face of it, this seems like a huge amount… hell, that is more than the GDP of most of the countries on earth. I argue that, that amount of profit is not a ‘windfall’; but, rather, the right amount of profit for Exxon-Mobil to be making. I took the time to look up the Revenue and the Net Income of Exxon-Mobile and 27 other name companies. Exxon-Mobile had $473.9B in revenue and $43.6B in net income, for a profit margin of 9.2%. For all 28 companies, the total revenue was $2.523 trillion with net income of $247.7 billion, for a profit margin of 9.8%. I argue that Exxon-Mobile isn’t any more profitable than these successful, name companies; it is just that the cost of their raw materials (namely, oil) has gone up tremendously over the past few years and they have raised prices to keep their profit margins inline.

Now, there will be some idiots out there that will have the counter argument of: why don’t they lower their profit margins so gas is cheaper and the common man would be hurt as much by the rising cost of oil? This argument has all of the trappings of Leftist quackery: it almost sounds logical, it is populist, and it is, in the end, suicidal. If a company lowered its profit margin, the company’s investors would pull their capital out of the company. It would be similar if you or I made 9% on a Government Bond we bought for $10,000; but when we bought $100,000,000 worth of bonds, the Government came back and said something like this: Well, you were happy with your $900 before, and we don’t want to pay you $9,000,000; so we are going to tax your interest on your $100,000,000 until you just have $900 left. How would you feel about the Government turning you 9% investment into a 0 .001% investment?

So, the next time you hear a liberal talking about a ‘Windfall Profit Tax’, point at them and call them stupid. It only takes a little bit of time and effort to see through the silliness.

Below are the companies I looked up, their revenue numbers, and their profit margin. All data was attained by looking at their Income Statements on Yahoo Financial. Profit Margin is defined as Net Income / Gross Revenue. I used the last four available quarters to come up with the annual numbers. (Click on 'photo' to enlarge and see the data)

The Pounding, the Screeching, the Scraping

So, I work in a building that is more of a converted warehouse, than an office building. It is not some cool, old, dare I say, stylish warehouse; but some generic, suburban sprawl warehouse. This isn’t a bad thing, on most days. It is new, very clean, open, and nice. The front half of the building was converted to office space so that a couple of business units could have offices away from our sister company. Also, the platform (bigger than a business unit, still too small to be our own division) has its HQ here.

Here is where the problem, the building is so nice, and the old, beat up building our sister company has is so, well, not nice, that all of the Platform level employees want an office here; and the business units that share the space want more space. So, what to do, right? Well, the warehouse part of it is used to story inventory (it’s a warehouse, after all) and do electrical component integration. So, we took part of the space where the component integration is done, and are making more warehouse space.

So, here is where it becomes a problem. My office is RIGHT next to where the remodeling is going on. I see various construction guys walking past my office all day. Some speaking English, a lot speaking Spanish, especially the drywall crew. The framing of the walls was okay, most putting anchor bolts down, and putting the metal studs up, some noise, but not too bad. Monday sucked, a lot, because they drywall crew was putting drywall screw after drywall screw into the metal studs. Reetch! Reetch! Reeetch! All the goddamn day long. It was horrible. Yesterday was an extension of Tuesday: Reetch! Today started off with me watching some guy on stilts mud and old doorway that was closed. As I allergic to dust, I am not looking forward, at all, to when they sand the drywall.

All through out the day, I hear various noises associated with building office space: cutting, screwing, hammering, et al. I gave me a headache Monday, and if there is too much dust in the air, it will give me one today. I’m glad that I scheduled my self to visit the US HQ for US business unit.

Later,

B

Gold Medals, and the like

I have to admit, I really don't care about the Summer Olympics.

The big story is if Michael Phelps can get eight gold medals; and people are saying if he does that may be the biggest achievement in sports ever. First, swimming is not a sport, it is an athletic event. The difference is that if one can make the other actively lose, it’s a sport; otherwise, it’s an athletic event. Second, it isn’t even the greatest Olympic accomplishment ever, the Dream Team was more dominant than Phelps, Aleksandr Karelin’s dominance in Greco-roman wrestling was greater, boxing is replete with wars that were/are much more engaging than this.

I also could care less about the Redeem Team. I think it is neat that some NBA players decided that they could be just unselfish enough to represent the Red, White, and Blue; and that they’ll kick ass. However; I just can’t get into the world’s best pound on the masses. If they win, yeah, the expectations are met, but that’s all…. no great victory, just met expectations.

I care not for gymnastics. Again, great athletes, but not a sport. Plus it’s participants look like emaciated pre-pubescent girls, and overly muscular effete guys. Track and field is much the same, but the female participants look like butch badasses. And, no matter how fast those 100M guys go, I can beat them with my truck.

I have particular distaste for rowing. An exercise should not be an Olympic event, even if it is the sport of the Ivy Leagues. Ditto for weightlifting, if I wanted to see a strongman competition, I could watch ESPN2 late night.

I think I were to watch the Olympics I would watch judo, wrestling, and boxing because, well, I like violence. I would watch women’s beach volleyball, because they prance around in bikinis that appear to be a size too small. I might BMX cycling on the odd chance that one of those dumb bastards might wreck, real bad like.

Until the Olympics is over, I suppose I’ll be regulated to renting movies and watching re-run of Law and Order on TNT.

In 2010 I’ll watch the winter Olympics as there is nothing better than Olympic Hockey. Well College football is, but it happens every fall.

Peace out,

B