about 6 months ago i was talking to a stockbroker in the
locker room and i asked him if he could explain hedge
funds and derivatives. i had heard about them and couldn't
find a decent explanation.
he said he "leaves it to the experts".
so i wrote one of the experts, John Mauldin, who manages
one of those funds where you need to have about $2 million
before they will manage your money.
he published a few articles that did a good job explaining
it. this one explains how mortgage backed securities
ties into things like currency valuations and how banks
do banking.
it's long.
http://www.investorsinsight.co...int.aspx?EditionID=619
"Credit Default Swaps: A Brief Introduction
Just a decade ago, the corporate credit market was comparatively simple. Companies seeking to fund their operations and expansion plans tapped commercial banks for loans and financial markets for bonds. Commercial banks carried these senior secured loans directly on their balance sheet. Subordinated lenders - primarily banks, mutual funds, and pension funds - evaluated the credit worthiness of the issuer and determined an appropriate compensation for the risk that the issuer might fail to meet its obligations. When the borrower offered sufficient compensation and legal protection, the company received financing. Since many bondholders owned assets to defray long-term liabilities, the corporate bond markets had relatively low turnover. Investment banks served primarily as intermediaries between corporations and capital providers to place new issues and refinance paper.
While these arrangements served most participants upon initial offer, bank loans did not exchange hands in secondary markets, and hedge fund shied away from shorting credit because of expensive borrowing costs.[iii] More cynically and perhaps more accurately, the absence of loan trading and "bond loan" departments left holes in the investment banks' playbook that they could fill with a more fluid trading vehicle. In order to meet these needs, in the mid-1990s Wall Street gave birth to the credit default swap ("CDS"), the basic contract from which all credit derivatives emanated.
The CDS was an innovative financial technology that revolutionized the way credit changes hands. A CDS is a financial agreement between two parties to exchange the credit risk of a reference entity or issuer. The buyer of CDS pays a periodic premium for which it purchases credit protection on a specified, notional amount of exposure. In the event the reference entity faces a credit event - typically a bankruptcy, failure to pay, or restructuring - the owner of credit protection receives a windfall profit. In terms of exposure, a buyer of CDS is short the credit risk of the reference issuer. Conversely, the seller of protection assumes a risk comparable to owning the reference bond; the seller receives a premium for taking risk but suffers large losses in an event of default. Thus, the CDS market is a zero sum game between the buyers and sellers of protection.
While new to the credit markets a decade ago, CDS has roots in generations of related financial contracts. A CDS closely resembles an insurance contract in which the seller receives a premium and suffers losses of up to the notional amount in the event a low probability default occurs within the term of the agreement. If the market properly handicaps the probability of default, the premium on CDS should equal the yield spread of a corporate issue over Treasuries after taking into account funding costs.
CDS also share characteristics with put options. Buyers of put options pay a small premium and have the opportunity to make a large sum should the underlying stock fall precipitously. However, unlike options that trade on organized exchanges, CDS transact only between two counterparties, carrying an additional counterparty risk absent in listed options markets."
"An Insurance Market with No Loss Reserves
One way of thinking about the CDS market is that of a huge, new insurance industry whose providers reserve nothing for future losses. Imagine what would happen if $45 trillion worth of insurance policies experienced an actuarial average of 5% losses and no one had $2.25 trillion sitting around to foot the bill![vii]
This woefully undercapitalized market may be a frightening reality. Sellers of credit protection post margin for marked-to-market moves, but CDS contracts are generally uncollateralized. Further, investment banks that hold one side of each CDS transaction claim to be hedged, but their financial statements show neither loss reserves nor bad debt reserves for potential counterparty failure. The absence of collateral and significance of counterparty risk have important implications discussed below.
For a number of years, credit spreads have tightened to historical lows. During this time, CDS took over cash bonds as the primary form of trading in credit markets. Is it too much of a stretch to consider that spreads have been abnormally tight in part because sellers failed to price in a reserve for future losses and thus systematically underpriced risk?
The Second Domino: "High"-Yield Bonds"
- - -
John Mauldin in general has been bullish about the markets.
so it's interesting to here him use terms like "An Insurance
Market with No Loss Reserves"
"Imagine what would happen if $45 trillion worth of insurance policies experienced an actuarial average of 5% losses and no one had $2.25 trillion sitting around to foot the bill"
i think what this means is that the $80 billion fund Citi
and other banks created in the last few months to
buy mortgage backed securities (the FDIC has $50
billion in reserves) is about $2.17 Trillion short of
covering a reasonable estimate of bank and brokerage
exposure to losses in the product categories of mortgage-
backed security and related Wall Street products.
{ one other tidbit that showed up is that the top
20 or 30 hedge fund managers averaged approx.
$500 million annual income last year. Bonfire of
the Vanities, Part 2 ? }
the Federal Reserve is injecting similar amounts of
money into the banking system, $30 billion here and
$30 the week before that.
- - -
what is equilibrium for the system, in terms of the
valuation of the dollar relative to other currencies ?
if the dollar devalued about 50%, it would stop the
losses from mortgage backed securities.
to overseas investors, who are holding many $US
Trillions, i can imagine them saying in whatever
language they speak,
"hey Martha, we can buy a condo near the beach
in San Diego for $250K". For people holding Euro's
or Yuan ( which the US government has repeatedly
asked China not to raise the value of, relative to
the dollar ) or Canadian dollars, $250K is affordable,
a deal.
i'm not saying that the dollar will devalue 50%. it
has devalued about 40% since 2002. There is some
huge number of credit derivatives outstanding,
$45 Trillion.
i wonder what the financial risk is compared to the
Savings & Loan so-called crisis in the '80's.
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