Wednesday, March 24, 2010

Wolf!!

The discussion about Credit Default Swaps is replete with allusions, examples and (over-)simplifications.  The most frequently used is that CDS is akin to buying fire insurance on a neighbor's house and thus having every incentive to see it burn down.  

But this misses a crucial point: derivatives traders rarely, if ever, want to "take delivery", or execute the futures contract, option, swap, etc.  Instead, they want to make a quick killing on the going market price, i.e. by  trading fire insurance as much as possible instead of seeing the house burn down and collecting on it.  If you want another allusion from Sudden Debt's misty past, they want to trade the "sardine", instead of eating it. 


To wit, it is a fact that the vast majority of futures and many other derivatives contracts are closed out before delivery date, and that most options expire worthless.  Likewise, the vast majority of CDS traders/speculators/hedgers have next to zero desire to deliver (or take delivery of ) the underlying bonds, but , instead, to profit from the market's swings during the time they hold the contract.  

Furthermore, I can tell you from long and relevant experience that the line separating a hedger from a speculator is so thin as to be practically invisible in most cases.  For example, an investor holding a portfolio of bonds comes to the conclusion that credit conditions are worsening and hedges by buying CDS.  Her portfolio now consists of two "legs": bonds and the CDS hedge.  Naturally, the cost of buying and holding a credit hedge reduces her current return close to a risk-free equivalent (say, a U.S. Treasury).  However, this is as near to anathema for active portfolio managers as it gets and that's when trouble starts.  (Why would you pay a manager anything from 0.2% to 2% p.a. just to hold a risk-free asset?)  So, before long, she gets itchy to lift one of the legs, i.e. go net long or net short, no matter what she may preach about prudence and hedging.  It's human nature - and that's what makes markets swing.


Anyway, back to the main story.  The relevant parable for CDS is The Boy Who Cried Wolf (But Didn't Himself Own Any Sheep).  The boy in question is bent upon terrorizing other shepherds because he has shorted mutton meat at the town market and wants to see the shepherds unload their sheep as fast as possible before the "wolf" gets 'em, thus driving down the price.  He has been known to occasionally don a fresh wolf-skin over his body on certain nights and howl to the moon...


20 comments:

Greenie said...

What nonsense. There are real wolves around, but some people are pissed that speculators are eating the meat and leaving empty bones for the wolves themselves.

Lord Blagger said...

However, if two people have a bet on a football match, does that affect the result?

Same with CDS. It's only those shorting who are to blame, not those who bet the other way.

The real reason its screwed up, is the governments pissing money all over the place, funded by debt

Thai said...

Hell, why is this different than the commodities futures market?

And, FYI, it appears that Brits too live in interesting times.

Hellasious said...

"funded by debt|

As opposed to funded by what?

Remember, we are talking fiat currency regime here.

After a point, the whole too-much-debt discussion becomes theological, as in how many angels can dance on the head of a pin?

Anonymous said...

Heyyyy!! Mrs C!!

(this is a test of fonz, this is a test of fonz)

jp said...

I'm 36 and I'm funded by debt!

And at the moment, as a disabilty attorney, the way that I get paid is through the contiuned issuance of federal debt. From a cash flow perspective, I collect way more in federal money than I pay in federal taxes.

I can also switch back to being a patent attorney, in which case, I can encourage people to fund the federal government through the patent application process.

So, I, from a purely economic perspective, I can function both as a tax farmer/debt "issuer" and a tax collector depending on my mood.

Debra said...

Hey Thai, I checked out Karlsson's blog.
He looks AMAZINGLY conservative... (I'm not a name caller, but most conservatives I know have tons of prejudices. Come to think of it, most "liberals", too...)
On his little piece on how well Sweden was doing in terms of debt by reducing unemployment compensation and kicking people's butt to get work, he DIDN'T say whether people were managing to eat enough to survive on the salaries that that work paid...
An annoying detail ??
Mea culpa. I'm not adequately informed on Sweden't "utopia". But Sweden's "socialism" makes France look like a free market country, that's for sure...in terms of telling people what to do, I mean.

jp said...

Thai,

Crisis eras/K-cycle winters are always "intersting times".

Because they are crisis eras/k-cycle winters.

Here's a guy, Xenakis, who's actully thinking/talking about it at least:

www.generationaldynamics.com

Debra said...

Hey, jp, I checked out that site.
It's about on a parr with Wiki, and other Wiki type stuff... (like Google's translations, by the way)
I looked at the Basics page.
It only goes back to WW2 ?
It predicts ? (Even loosely, admittedly)
The text is incredibly simplistic. The level of a sixth grader.
I suggest you check out Philip Slater's 1970's book, "The Pursuit of Loneliness" for some high class challenging sociological analysis. I read it a while ago, and picked it up again. It is still a VERY good read. And short too, by the way. For us lazies.
Slater does NOT predict.
Only.. PROPHETS predict. And if they're good, they limit their predictions to the strict minimum.
Because of that... butterfly effect.
Now, speaking of prophets, where is Yoyo ?
I miss him.

jp said...

Debra:

Xenakis is the only one blogging daily on the subject. He's got great entertainment value. I'm certain his writing style comes from his computer/technical background.

If you want to really amuse yourself, get into his postings on the coming intelligent robots after the coming clash of civilizations world war.

He bases his stuff off of Strauss and Howe's work for the most part, and couples it with the technological singularity. :)

www.fourthturning.com

I will eventually remember how to create links on blogger.

Mike Alexander, with whom Xenakis has had some amusing exchanges over the years, has lots of his postings up at:

www.safehaven.com/archive-7.htm

He's much more data-centered. In some of Mike's articles, he goes all the way back to the Champagne Fairs in the 1250s or so.

He also has articles on the war cycle within recent Modern Europe.

Mike eventually got tired of writing and now spends most of his time posting on the fourth turning chat board under the name "MikeBert", since he's a chemical engineer for a megacorp pharma company.

Debra said...

ah jp... you are going to get me revving to run back to my Dune cycle and nurse it through all six books again...
It doesn't sound like these guys can hold a candle to Herbert for sheer sophistication and encyclopedic knowledge.

OkieLawyer said...

jp:

So you are a lawyer, eh? I am so sorry.

Anyway, re: cycles.

Don't forget author/blogger Charles Hugh Smith and his Of Two Minds blog.

He has also written a book that discusses the intersection of several "long wave" cycles:

Weblogs & New Media: Marketing in Crisis

jp said...

Okie:

Well, being an attorney beats being a chemical engineer inside a chemical plant. That's part of the reason I went to law school in the first place. I toured chemical plants. I'm only doing contingency fee work these days, so no billable hour for me.

Yeah, CHS talks about the long wave with respect to the inflation cycle. I think he calls it the Price Revolution or something like that. I haven't really looked into that particualr cycle much.

I'm more interested in the fact that we are in a major secular bear market with respect to investing. Knowing that has allowed me to make money all through this financial mess

I read Of Two Minds often. He's got some intersting points from time to time.

You can always read Spengler in Decline of the West if you like your cycles large, with civilizations lasting about 1000 years or so.

According to Spengler, we are now reaching the Civilization period of the West, in which the power of money will be overwhelmed by the era of the Ceasers so to speak.

For the next 200 years, we can expect:

"2. Formation of Caesarism. Victory of force-politics over money. Increasing primitiveness of political forms. Inward decline of the nations into a formless population, and constitution thereof as an Imperium of gradually-increasing crudity of despotism"

en.wikipedia.org/wiki/Spengler%27s_civilization_model

OkieLawyer said...

Here is an article that I think readers here would be interested in:

Basically, It's Over: A parable about how one nation came to financial ruin.
By Charles Munger

OkieLawyer said...

Oh, and here is a quote from the above-referenced article:

But even a country as cautious, sound, and generous as Basicland could come to ruin if it failed to address the dangers that can be caused by the ordinary accidents of life. These dangers were significant by 2012, when the extreme prosperity of Basicland had created a peculiar outcome: As their affluence and leisure time grew, Basicland's citizens more and more whiled away their time in the excitement of casino gambling. Most casino revenue now came from bets on security prices under a system used in the 1920s in the United States and called "the bucket shop system."

The winnings of the casinos eventually amounted to 25 percent of Basicland's GDP, while 22 percent of all employee earnings in Basicland were paid to persons employed by the casinos (many of whom were engineers needed elsewhere). So much time was spent at casinos that it amounted to an average of five hours per day for every citizen of Basicland, including newborn babies and the comatose elderly. Many of the gamblers were highly talented engineers attracted partly by casino poker but mostly by bets available in the bucket shop systems, with the bets now called "financial derivatives."

Thai said...

I'm sorry but I had to pass this little bit of humor on ;-)


@JP, thanks. I have read Xenakis a few times in the past and I do enjoy him... In fact, as I'm sure you're aware, he used to post on this blog for a while. But I have not he seen him in at least a year. I do hope he comes back some time for a chat.

However- and Mr. Xenakis, I mean no disrespect if you read this as it is all in good humor- you do need to compare Xenakis's ADHD... look at the diagrams on his book!!

With that favorite talking head Glenn Beck... I am quite sure Xenakis (and Beck) sees fractals as well. ;-)

Edwardo said...

LOL! I am so glad I tuned in to read Thai's bit of humor. Absolutely fantastic.

Thai said...

Oh and I thought I might pass on a little detail I am sure most of you know about

Hellasious said...

There's more laughs at the Thai link than you can shake a stick at!!

;)

Debra said...

Thanks Thai.
Ever the life of the party. ;-)
Oops, I had to REREAD your link because I missed IT the first time.
I'm slow to pick up on that kind of stuff. Little ole naïve me...
I tend to hang out in the Porter's scene in "Macbeth"...