I am just an autodidactic student of financial markets. Me and my father are self-trained technical analysts, and I help do the technical analysis of stock prices for our day-trading. My father is now a good enough analyst to do it on his own, so we decided I’ll learn and specialise in derivatives instead and get onto doing it regularly once I understand it well enough.
I’ll give an explanation of credit default swaps and other things.
Credit Default Swaps
Two companies, A and B. A has corporate bonds of company C with a face value of $100 million. A earns $1 million interest regularly on those bonds, but there is a chance that C might default on those bonds. So A wants protection.
A buys protection from B. A will pay B $500,000 every year. If C ever defaults, B will pay $100 million to A.
B can pay physically or in cash. If B pays physically, B will buy bonds from C for $100 million. If B pays in cash, B will just pay the market value of the difference.
Suppose C defaults, and can pay 30 cents a dollar to creditors. Market value of A’s bonds in C will come down to $30 million. A can sell the bonds to B for a $70 million payoff. Or A can just receive $70 million in cash from B. A third-party can decide market value in case of cash settlement.
(Actually, A might not even have the bonds, but might be in the same industry as C. So maybe default of one company hurts other companies badly as well. So it just might be done for a notional value of $100 million. Then A can buy the bonds for $30 million and sell to B for $100 million. Or just receive $70 million in cash.)
Market Makers
Large financial institutions like Goldman Sachs buy protection from one company, and sell protection to another company. They earn the difference between what they get from one and what they pay to another. This intermediation saves a lot of trouble of personally finding somebody with whom you can do this transaction.
Asset Backed Security
D is a bank. It has issued 10,000 loans. It sells all these loans to E for cash. E will earn interest on those loans. When the principal is paid back, E will get it.
E earns cash flows from its loans. E uses the cash as collateral for issuing bonds.
Everybody else who invested in bonds in D directly can be confident that the credit risk of the bank is reduced, since D already has cash from E.
E might have $100 million worth of loans on accounts receivable. It uses it to issue three categories of bonds. The first category is $75 million of bonds on which 6% interest is paid, the next category is $20 million of bonds on which 10% is paid, and the last category is $5 million of bonds on which 30% is paid. So if defaults start happening, there might be only $99.5 million cash left. The first category is paid back $79.5 million (interest plus principal for the year). The next category is paid back $20 million (only principal). The last category gets nothing.
Since people in the $20 million category are given neither the highest preference, nor the highest rate of return, E can sell those loans to F, who can issue loans out of them, and so on and so on.
E and F are dealers in ABSes, or asset-backed securities.
Collateralized Debt Obligation
A CDO is just an asset backed security, that is done only for corporate bonds or government bonds.
The government of Petrolistan and three oil companies issue bonds. A big buyer of their bonds can sell them to another company, an ABS dealer, which will use the bonds as CDOs to issue more bonds to others. People wouldn’t buy the bonds directly, knowing that an impending invasion of Petrolistan could cause a default in all of them. But the CDO dealer has indirectly issued bonds to them in such a way that some categories of bonds will have least preference in payment. The rest will have a higher rating. So maybe the bonds of these companies and government have a BAA rating. But through the CDO, they can be split into bonds of AAA rating and BBB rating. Fewer and riskier investors can take the latter. So the invasion happens, and at least 75% of the bondholders get all their money back. Otherwise, everybody would have been paid 30 cents a dollar.
What Really Caused Government To Be Concerned - Synthetic Collateralized Debt Obligations
Remember credit default swaps? Instead of corporate bonds, an ABS portfolio of protection sales is created. This is because being the seller of the protection for a notional principal is like holding a bond. Taking company B from the example above, it can sell the default protection to G. So G will receive $500,000 a year, and will pay $100 million when a default happens. G can use the various sums of $500,000 it receives from various default protections and issue loans itself.
So here’s what made people wonder. A credit default swap is made for a purely notional principal. It is sold to somebody else, who is issuing loans, only on the backing of a default swap and not an actual bond.
When I explained this to my father, it sounded to him like making money and credit out of thin air. Some bloggers said that this was a kind of fractional reserve banking that could have dangerous effects. So I guess there might be reason to be concerned.
Many journalists and government folks felt this was either just a kind of fake gambling or shifting invisible money. So they reasoned, fine, let them do it, but put a close watch on it. It is not done through standardized documents or rules or procedures. All the transactions of synthetic CDOs are done through the phone. Either squeeze it or regulate it or armtwist in them into stopping it. Except synthetic CDOs have not caused a single scandal or problem. When real estate developers defaulted in 2007, many investors were protected and got back their money, because of bonds issued through CDOs. We should be happy for that - it reduces risk, not increase it. Some were outraged, since the breakup of a CCC bond into AAA and junk bonds meant that even the AAA holders didn’t get back their money.
Synthetic CDOs have been going on in the US OTC market since the 1990s, and the 1980s in London. People who engage in it know what they are getting into. As for depositors keeping money with funds that engage in such practices and get their money burnt, even depositors should know the lessons of moral hazard.
If some in Mises.Org find this practice to be fraudulent in the same manner as fractional reserve banking, I invite their disagreement.
