“Thirty-year, fixed-rate mortgages averaged 4.96 percent last week, according to McLean, Virginia-based mortgage finance company Freddie Mac, or 2.64 percentage points more than 10-year Treasuries. Before the credit markets began to seize up in the second half of 2007, the difference averaged about 1.78 percentage points since the start of the decade.”
Treasury Yields Flattened as Fed Fights to Cut Mortgage Rates [Bloomberg]
That TED Sure Is A Funny Fellow (And Worth Keeping An Eye On) [SocketSite]

51 thoughts on “JustQuotes: While Treasury Rates Drop, Risk Premiums Rose”
  1. I will admit I was wrong on this one.
    2 years ago (and even 1 year ago) I posted that we’d likely not see 5% 30 year fixed rate mortgages for many years if not decades.
    later, I did amend once I realized how foolish (IMO) the govt would get. and that’s why I changed my tune about 4-6 months ago that nobody can predict anything anymore since the markets are now all based on events in Washington, DC, the new financial capital of the world.
    who knows how low they’ll try to push it?
    of note:
    many like me would argue that today’s risk premiums are NORMAL, and that the premiums seen from 2000-2007 were the abnormal risk premiums. (people took a lot of risk, and did not demand much for it).
    the govts are trying to push risk premiums back to abnormally low to spur the economy. there are of course risks to this (currency crisis, new bubble formation, etc).

  2. Banks would be fooolish to lend massively into a declining market. Do not add insult to the injury. They might have nicely priced mortgage products, but I am sure they are mucho mas selective and asking you to fund next year’s decline (20% down?).

  3. Banks would be fooolish to lend massively into a declining market.
    That’s why you need government-sponsored Phonie and Fraudie. There is literally no limit to how foolish the taxpayer is.
    BTW, look at the banks today. The whole sector is on its deathbed. The next 10 years are going to be a whole new world for people who think that credit and leverage are a way of life. Nothing the government can do will stop this (but their silly atempts will make it all a lot worse).

  4. Here’s what I don’t understand when people throw around the phrase “risk premium” when talking about the spread between the interest rate on 10-year T-bills and the interest rate on a 30-year fixed rate mortgage. Perhaps one of you can enlighten me, I’ll say straight away that this may show me to be not quite as sophisticated as all you folks here.
    What exactly is the risk that the mortgage originator is trying to account for with this higher rate?
    One possibility is that the couple taking out the mortgage might default. The reason that I don’t understand this is that the couple, once they get the loan and the house, is going to be paying for mortgage insurance and in the case of a default, presumably the loan insurer (who has their own actuary tables describing how likely the couple is to default) is going to pay off the loan or at least that part of the loan not recovered in the foreclosure (I admit I don’t know anything about how the mortgage gets paid off when it’s still covered by mortgage insurance). So in this case, it seems like the increased rate on the 30-year fixed is the originator trying to compensate for their risk that when the couple defaults, the originator will be stuck with a house that worth substantially less than 80 percent of the mortgage loan value. Put another way, the originator is telling the couple, “well, we are charging you this higher rate, because we think going in that it’s more likely than not we’ll lose more than 20% of the loan value on this deal when you default.”
    Home buying couple: What?
    The other possibility I can think of is that the loan originator thinks they won’t be able to get the loan off of their books fast enough, when all they really want to do is slice it, dice it, and sell it off as a julienned part of a group of mortgage backed securities. Horror of horrors, they might actually have to hold the loan in their own portfolio! Can’t have that, there’s not enough profit in it for the CEO to pull down his million-dollar-a-year bonus! Put another way, the originator is essentially telling the couple, “well, we are charging you this higher rate because that’s to compensate us for the amount of time and effort we spend turning your loan into something we can sell to someone else, like teacher’s retirement funds in foreign countries, or worst case scenario, Freddie or Fannie, or the risk that we won’t be able to sell it and have to hold it on our own books.”
    Home buying couple: Then why are we paying you all of these origination fees if you’re charging the higher rate as compensation?

  5. once they get the loan and the house, is going to be paying for mortgage insurance and in the case of a default,
    only if they get mortgage insurance. they don’t need PMI if they put down 20% or if they do an 80/20 or 80/15/5 type of mortgage as example.
    also; the risk premium is partly there due to prepayment risk. Long story short, the investor may lose money depending on if the loan is prepaid (like in a refinance).
    quick example: you write a mortgage at 6.25%. you expect to get 6.25% for 30 years. 3 years later the people refinance at 5%. they will prepay your note to get that. You were expecting 6.25% for 30 years, but when they refi you aren’t getting that any more. presumably even if you get a new buyer they will pay less than 6.25% (which allowed the refinance in the first place).
    “well, we are charging you this higher rate, because we think going in that it’s more likely than not we’ll lose more than 20% of the loan value on this deal when you default.”
    that is exactly what they are saying.
    also, remember that the banks are so insolvent that most of them are a stone’s throw from going under.
    thus, some of this has nothing to do with current borrowers.
    it is the banks using the WONDERFUL gift from teh Federal Reserve to get cheap money at near 0%, and then loan it out at higher rates. they make money off the spread. It’s a way to “recapitalize” the banks.
    you don’t think that Ben Bernanke lowered rates to near 0% for you, did you! hahhahahah. it’s for the banks!
    in fact, if you look closely, you will quickly realize that almost EVERYTHING being done thus far is for the banks.
    Home buying couple: Then why are we paying you all of these origination fees if you’re charging the higher rate as compensation?
    why do you hate America? this is the “system” that we have to “save”.
    even worse:
    why are we giving nearly-free taxpayer money to the banks with little to no strings attached (yet), so that the banks can take that money and lend it to consumers and skim fees off the top? why not just bypass the banks and use the taxpayer money to directly help the consumer?
    again, they want to save “the system”.

  6. what I don’t understand is why the govt is trying to save these huge banks. There are plenty of small banks that have not been as stupid as the big ones. Give the smaller banks the chance to compete based on their handling of money as opposed to the mismanagment of it from the big banks.

  7. “what I don’t understand is why the govt is trying to save these huge banks.”
    To quote George Carlin as best as I can remember, “There’s a big club in the world, and you’re not in it.”

  8. That’s a very good insight, viewlover. As you might have noticed, we now have survival of the weakest. People have noted that while banking is important to the US system, existing banks aren’t.
    The reason the existing institutions/system is being perpetuated is because the people who run the banks and the Fed (they are the same people) also run the politicians. Don’t overthink this!

  9. I disagree with LMRIM
    one of the (I’d say THE biggest) reasons that the big banks are being propped up is due to the CDS market.
    the Feds learned (and learned quickly) after Lehman that you cannot let a big bank fail due to the CDS market. There is no transparency whatsoever with the CDS market, and a bank failure could trigger cascading cross defaults.
    NOBODY predicted that Lehman failing would trigger AIG to fail, nor that Lehman failing would trigger the largest money market fund to break the bank, causing a run on money market funds. That almost collapsed our economy.
    The “big” banks are MUCH larger than Lehman> the CDS contracts are just as opaque (even moreso). nobody knows how to ringfence the problem.
    this is the problem with unregulated free markets. They are… uh, unregulated.
    I’ve said this before. The 100,000 ton elephant in the room are the CDS contracts on the various banks. the trades do NOT “net”. we found that out with Lehman.
    No bank can be allowed to fail. IF a bank falls apart, it must do so in a way that doesn’t trigger a CDS “credit event”. so far nobody has figured out how to do that.
    LMRiM disagrees with me on this issue. but he is wrong. I rarely say things like that. but LMRiM is wrong.
    The CDS problem is thus far unmanageable. People are working frantically to try to figure it out. until it’s figured out, NO big bank will be allowed to fail.
    it is the most terrifying thing I’ve ever analyzed.

  10. ex SF-er,
    Every CDS contract contains a force majeur clause. (They are written on standard ISDA forms.) The USG could just declare them over and done with, and let the bankrupt players fight the USG in court (good luck…). In the meantime, they could seed finance 10 new banks with half the money they’ve thrown at this so far. Radical times call for radical solutions! Will it work? Who knows for sure. Would there be unintended consequences? Yes, of course. But what they are doing is not working either. And when it all finally blows, all the money we threw away on propping up the system will be long gone….
    this is the problem with unregulated free markets.
    There is nothing even approaching “free” or “unregulated” when you have a monopoly supplier of currency. Why can’t anybody manufacture currency (like bread, for instance). Sounds crazy, but think about it….
    Please, ex SF-er, don’t fall for the hype that this is a “crisis” of failure to regulate. The regulated will always become the regulators in a system like ours, and without a sound currency to rein everyone in and keep them honest, we will have “crisis” after “crisis” (first, inflation, then deflation, etc. etc.)

  11. LMRiM:
    you can wiggle all you like, but the CDS contracts are completely unregulated. there is nothing regulated about them. they are completely opaque. there is no way to make the CDS problem “government’s fault” unless you fault the fact that they didn’t regulate the CDS market.
    The CDS problem is the nirvana of free market capitalism. it’s Free market capitalism taken to the extreme. Oh… and it failed miserably. unfettered free market capitalism works as well as pure communism. (it doesn’t).
    The USG could just declare them over and done with, and let the bankrupt players fight the USG in court (good luck…).
    Really? I’m surprised to hear a law school grad say this. nullifying contracts would be a huge leap. our entire economy has been based upon 200 years of govt enforcing contracts and contract law precedent. govt breaking contracts would be pretty socialist and quite the departure. (I’m not saying they shouldn’t do it… just that it would be pretty anti-free market)
    nonetheless, they could nullify IF they knew who held what contracts. what if nullifying the CDS contracts makes CalPers explode? or PIMCO? or the state of California? we have no idea.
    I am not saying the govt is doing the RIGHT thing by the way. I’m saying I understand WHY they are doing it.
    I’ve said countless times we should nationalize all the banking simultaneously a la the Swedish model. we’ll see a CDS party like never before. We will likely enter immediate depression. can we survive? I dunno. it’s possibly our only hope. god knows what we’re doing is SURE to fail.
    perhaps nationalize all banking while also nullifying all CDS contracts. It’s been discussed by others smarter than me.
    but I agree with you. the govt is WASTING all the taxpayer money pouring it into insolvent banks.
    the only part we disagree on is the size/scope of the CDS problem.
    Oh, and we disagree that the CDS is free market. But you have yet to tell me how a contract between 2 parties that has no govt oversight and no govt involvement is anything BUT free market.
    where was the govt involvement in the CDS debacle again?
    There is nothing even approaching “free” or “unregulated” when you have a monopoly supplier of currency
    the fact that Uncle Sam prints the currency has nothing to do with CDS contracts. CDS contracts can be (and are) written in every currency on the planet, and could also be written based on Gold if the parties so chose.
    without a sound currency to rein everyone in and keep them honest, we will have “crisis” after “crisis”
    I agree with you. but let’s just be honest. there was “crisis” after “crisis” on the gold standard as well.
    (May I remind you that The Great depression happened ON the Gold standard.) not to mention the panic of 1873, the tulip bubble, the South Seas bubble and so forth.
    the issue is fractional reserve lending, not fiat. (although they are intertwined).

  12. Well, ex SF-er, at least we are agree that it’s all going to fail 🙂 Perhaps under Obama the collapse will be speeded up, now that the public sector unions will go as hog wild as the banks with our money (not that the unions haven’t gone hog wild already…) 🙂

  13. Way in over my head on the turn this thread has taken, but I can inject a few points.
    Executory contracts certainly can be nullified or “rejected” in bankruptcy. Don’t even need a reason — just say “I’m out” (it is subject to court approval to avoid abuse). It is a central feature of the bankruptcy code. We can argue about whether that is the best way to go about dealing with the CDS problems, but it is an option.
    From what I have gleaned, the CDS issue does seem to be the big elephant in the room when we are talking about some magic bullet. I like the idea LMRiM posed a few weeks ago — stick the dozen-odd major players in the CDS space in a room and tell them to work it out, and any intransigent party gets slammed into non-existence (i.e. no more bailout).

  14. Trip,
    OT, but I worked on the standard form ISDA document back when I was a summer associate (and now you can probably guess which firm my all too brief legal career touched) almost 20 years ago. There are a number of ways out, including force majeur, regulatory change, etc., and of course netting across trades was presupposed (or at least it was like that – I haven’t seen the full form in 15 years, although I did trade swaps on occasion in the mid 90s and had to check the ISDA term supplements on the individual executions). I don’t make this stuff up. (well, not totally :))

  15. I’ve read Trump is trying to invoke a force majeure clause to get out of some loan guarantees on his boondoggle condo skyscraper in Chicago. I’m all for using the outs provided in the ISDA contract (and hiring lawyers to do it). Well, I can narrow the list of your possible employers to two . . . I’d trade profits-per-partner with either of them, but on the other hand, you couldn’t pay me enough to work at either.
    I only posted the above to respond to ex SF-er’s point about the sanctity of contract. It is one of the foundations of our business system, but we also abolished debtors’ prisons (bad move, in retrospect?) and contracts don’t mean much once you throw yourselves at the mercy of the bankruptcy system to stiff your creditors.

  16. I don’t know what CDS are, but these apparently exist in the private domain and need to be resolved there via courts or bankruptcies or whatever. Ironic that the banks lobbied for anti-bankruptcy laws for consumers but bankruptcy does not apply to them. KARMA!
    Why should the gov’t keep infusing money it is borrowing in order to keep these banks afloat when there are other banks that with time can pick up the slack.
    Simplistically, the financial system has failed and that needs to be recognized. There is a an incredibly large paradigm shift, being a giant is not good. All of this happened in the private sector. Business and boards of directors and shareholders should have acted on the coming disaster. They did not and they lost.
    I for one have lost much of my retirement, the 20% down on one property and hopefully still holding on to the other $280k I put on my current residence, if I sold today!
    My losses have been pretty high and nobody is helping me at all. I have to start from scratch, again! But thats America.
    Deposits are protected up to 100 grand, so let these things burn down. All of the multi-billionaires never really existed and that’s what our leaders really want to protect. But no matter how much the govt tries, it can’t. It was all smoke and mirrors, and the emporor is not wearing any clothes.
    As far as California or PERS imploding, a projected 70 billion deficit puts us there already. Good luck with that.
    Let the jumping off buildings start just like the depression. I would never kill myself over money, I’ll just keep working, no freaking choice.

  17. Executory contracts certainly can be nullified or “rejected” in bankruptcy. Don’t even need a reason — just say “I’m out” (it is subject to court approval to avoid abuse). It is a central feature of the bankruptcy code. We can argue about whether that is the best way to go about dealing with the CDS problems, but it is an option.
    can executory contracts be used when the bankrupted party is NOT part of the contracted parties?
    example: BofA goes bankrupt.
    But the CDS contract is between CALPERS and Cerebrus.
    BofA’s bankruptcy nullify’s CALPERS’ contract with Cerebrus?
    I’m NOT arguing that the govt can’t declare force majeure or similar. Just saying it would be dicey.
    we’re talking untold of amounts of contracts here
    it’s not just as simple as getting “10-12” people in a room for the CDS boondoggle. LMRiM made that up. there is no data anywhere that supports or refutes the claim that there are 10-12 major parties involved in the CDS boondoggle. (and I have huge suspicions that there are only 10-12 players. I would guess there are more like 20-50 MAJOR players, many of them international… almost every major US bank, all the “old” investment banks, most major european and japanese bank and also the large sovereign wealth funds just to name a few).
    This was tried by the way with Lehman PRIOR to lehman blowing up. they had a test-clearing mechanism to see the damage. It failed miserably. it involved the top suspsected CDS parties in Lehman. After Lehman Failed, people found out much later where the CDS contracts really were.

  18. Ex SF-er, you are right that this would not be nearly as simple as having a few key players file for bankruptcy and reject the ugly CDS liabilities. A bankruptcy court cannot (to my knowledge) reject (or nullify) any contract except an executory one between the bankrupt party (the debtor) and another party. So the buck would just get passed on to someone else. By the way, only “executory” contracts can be rejected, meaning there is some material obligation under the contract owing by both parties. This gets very complex with deals such as a CDS.

  19. gosh… sorry for the horrific spelling and wording from my last post. I’m an idiot today.
    the reason they don’t want to let the CDS contracts blowup is that it would take too long for firms to find out if they are solvent or not.
    Think how long it took to do an audit of Fannie/Freddie’s books.
    Now multiply that by 100’s of firms and make it much more complicated. (lawsuits, accounting rules, creative accounting, off balance entities, etc)
    if a major bank goes down, it is very possible (odds impossible to know, given the opacity of the CDS market) that almost every major bank would be instantly insolvent (or not know if it were solvent) due to cascading cross defaults in the CDS space. it could possibly take YEARS to figure out which banks were “whole” and which were not
    thus, working and commerce would be difficult. where would your employer keep its money to pay your salary? where would you cash your checks? hard to work if there is no way to get a check cashed…
    thus, if you let the CDS explode, there must be another functional entity so that commerce can continue.
    my thoughts on what “should” be done:
    -we should force ALL CDS contracts into a central clearing house. all CDS contracts held outside of a central clearing house would be immediately nullified.
    -we should then amass a huge amount of taxpayer money (or federal debt) to help with the “survivors”. we will need Trillions of dollars
    -we should then let a big bank fail. (like Citi or BofA)
    -The CDS market will implode but in a TRANSPARENT way.
    -Almost all the banks will be immediately insolvent or incapable of knowing if they are solvent.
    -There will be a few banks left standing around the country.
    -Use the Trillions of dollars to backstop OR nationalize the still-standing banks (whoever they may be) so that our economy has a chance of survival.
    -Use the remainder of the Trillions of dollars to fund the FDIC insured deposits as much as possible.
    Instant depression. But I think it would be best.
    but what politician is ready to take “the blame” for instant depression?
    hahahahahahahah that’s right. none of ’em.
    better to let it drag out for eternity, this way nobody has the blame.

  20. Back to viewlover’s original question:
    Correct me if I am wrong, but isn’t the Federal Reserve a private bank (with some public oversight) whose shareholders are all the banks that are being bailed out? If so, why does it surprise anyone that the Fed is bailing out its owners at the expense of non-owners (taxpayers)? Seems to me like a pretty obvious solution to the banks’ problems. Why the government and taxpayers would tolerate such an arrangement is another matter. Hopefully someone can point out where I am wrong but that is how I understand our current financial chicanery.

  21. This is the type of thread that we’ve been missing for awhile. Some disagreeing viewpoints from some extremely intelligent people – without petty bickering. Good stuff – and one of the major reasons that I check Socketsite each day.
    Thanks guys.

  22. Some perspective. I had a front row seat for the implosion of Enron. I ran a large book of energy derivatives, primarily OTC physically settled forwards, many ISDA swaps, a few futures and many one off structured deals.
    There were 700-800 contracts in my book and Enron’s name was on about 20% of them. I had holes all over my book as did many other prop and house books. It took a couple days to replace the Enron trades, but it wasn’t the most difficult situation one could have faced. Traders in OTC markets (like CDS’s) know who to call and how to get their business done when necessary. The bid / ask may be gnarly, the PNL hits can be significant, but unless you’re the guy underpricing volatility and loading up the boat, you will likely be okay. AIG was not okay because they were those guys. Most of their counterparties knew what they were doing and are fine.
    LMRiM is materially correct in saying that 10 to 12 guys run the CDS market and those guys can sort it out, in a couple days. ISDA language varies from place to place but not much. AIG was probably the largest net exporter of CDS contracts (i.e. short as hell Lehman default risk, for starters). Taking them out left many guys with big holes in their books. It’s also safe to assume GS, MS, JP and DB were long a lot AIG’s paper and have been receiving payments of Federal largesse through AIG to settle these contracts. They aren’t whole and probably won’t be made whole, but relatively speaking, they are fine.
    As for all the fear mongering about how massive and unregulated the CDS market is, well, 90% of the participants in the market hold a small fraction of the risk and just don’t matter much. Aside from the banks and a few hedge funds, CDs’s aren’t highly concentrated. Those 10-12 guys can net out their risk, a couple will be sacrificed and deserve to be but that’s expected in a tail event. The CDS problem isn’t as big as feared.

  23. It’s been over 20 years since I studied banking and have stayed away from finance for almost that long. However, I remember thinking that the fed and treasury were somehow linked but they could only effect liquity and interest rates. And the only time they were supposed to mess with them was to keep inflation and deflation under control. The free markets were supposed to do the rest.
    The deregulation of Glass-Steagell was the last straw. I used to read articles about the Casino Society back in the 80’s when volume would be 100 million and program trading became popular. Since then it seems the basics, debt should be used only for investing, took a wierd turn somewhere. Now investing is betting on making a right decision, but not on an investment, but on someone elses hand so to speak and how it compares to your own cards. Nothing is produced, jobs are actually cut and the money multiplier decreases and real wealth is lost, but the gambling keeps going at higher stakes, everyone must know that there is no value but it’s a matter of who ends up with the hot potato. The financial system has gone way out on a tangent and it needs to get back to basics.
    Asset valuation is not even basics anymore. Look at what happened to oil prices. It’s not like that didn’t have an impact on the economy, probably what broke the camels back. And we never really knew the energy policies Cheney discussed with the oil companies. NOt being a conspiracist, but believe the underlying premise of those meetings were to maximize profits for themselves. This was the whole mantra across all industries and sectors of the economy. Big banks included. Lobbiest sold our government to business and who knows what fine print is in the legislation enacted over the last 8 years ane before, other than the lawyers from the companies that sponsored the lobbying. At the same time pull the reins in on the consumer, make them a slave to our banking system, secure the debts and this way their assets are worth more, more to leverage and so on.
    It is amazing that Bernake and Paulson did not see this coming. Paulson thought the problem could be fixed with a 3 page memo. These bankers had convidence that they always had a safety net, the government. Bernake, Paulson, all the ex-wall streeters know they run the government. But they are stupid businessen in the real sense of the word. Now that they’ve also broken the gov’ts bank, take more from the little guys. These guys are just a bunch of smart-asses and part of the lucky sperm club. I’m not impressed with any of them. Alan Greenspan is a smart man, however, he is from a different time and I don’t think he really understood the modern thinking. Old dogs really can’t learn new tricks, even the smartest at his time is no competition for the modern thinker.

  24. Re: CDS
    My understanding of the core problem with CDS (which I post so that the experts can correct me) is that these contracts were used by entities that have a statuatory requirement to invest only in AAA rated debt. These entities would buy debt (AA and below) and then buy a CDS contract which allows the debt to inherit the credit rating of CDS issuer.
    When subprime bonds lost value the losses to the CDS issuer where large enough to warrant a reduction in the CDS issuers credit rating. The moment a CDS issuer gets downgraded from AAA to AA all of the debt that’s covered by their CDS gets downgraded as well. The people holding the debt covered by their CDS are forced to sell. Forced sales cause the value of the bonds to plummet. This causes losses that force other CDS issuers to be downgraded. Those bonds have to be sold as well. In short order all of the non-AAA bonds that are covered by CDS have to be fire-saled into the market and it crashes the bond market and makes large swaths of the financial system insolvent.

  25. Diemos:
    the problem you discuss is one of the problems with the CDS market.
    A bigger problem is the size of the market. it rapidly grew from under 1T in 1997 to over 62T last year. The CDS Dwarfs the size of teh Treasury market, AND the entire stock market (combined)
    Another big problem is that the CDS market is CONCENTRATED in bad comopanies. who buys CDS on a strong company? only people interested in using it as INSURANCE to cover their investment in that company. who buys it on a failing company? lots of speculators who are betting.
    The amount of CDS out there is often 10x or more the size of the underlying company, especially for companies IN DISTRESS (so the risk is concentrated in the worst companies)
    so for example there are an estimated $1 Trillion worth of CDS written against GM, a $15 billion company (so the CDS monster is 66x larger than the actual worth of the entire company!). to compare: who writes CDS on McDonalds? Few people.
    the other problem with the CDS market is that it is (or at least WAS) very liquid. Thus, it is not uncommon that the counterparties DONT EVEN KNOW WHO THEY ARE.
    COmpany A may write a CDS with Company B. then A may trade it to C, who trades it to D.
    However, since there is no transparent mechanism, company B MIGHT NOT KNOW that it is actually now on the other side of a deal with Company D (it might think it’s still in cahoots with Company A).
    For instance 13% of the trades in these contracts were UNCONFIRMED 3 months AFTER the credit crisis in August> This means that of the trades done, 13% of the time at least one of the trading partners was unidentified. Makes tracking down “who owes you” a little difficult.

  26. ====
    as for the “big players”…. I say this with respect, but unless you can put up some figures to back your claims, you are wrong.
    You are the only two people making these claims. Everybody who knows anything about the market (like me) acknowledges that we don’t know.
    It is possible that there are 10-12 major players, but unlikely given the data we have from ISDA and the Comptroller for the Currency.
    The last data I actually went through (from data from 2007, it has changed substantially since then):
    -The CDS market at the time was estimated at $45-50T (it grew substantially after that)
    -JP Morgan Chase held about $8T
    -Citi held about $3T
    -BofA held about $1.5T
    (that’s only 12.5T of the total)
    -the largest US 25 banks COMBINED held around $15T. this means that after bank #3, the next 22 banks only had 2.5T combined of CDS)
    So it’s true, most is concentrated in 3 US banks… but that only made up 12.5 of the 45T total.
    the top 25 US banks only makes up 15 of 45T.
    The other players are
    -International Banks (so they don’t report to our govt)
    -Insurance Companies (who only need to report to the STATES not to the US Govt… and CDS are unregulated so they chose NOT to report to the states or US govt)
    -Sovereign National Funds
    -Pension Funds (this data is likely out there, but not aggregated anywhere I know)
    -others I’ve just not thougt of now
    **To put things in perspective, my understanding is that AIG ONLY had written $500B in CDS. So they would probably be a “minor” player.
    Geez… they didn’t seem very minor to me.
    there are some “big boys” that is true… but they’re not dominant enough to drive change. and certainly not big enough to be able to sit in a room and “figure it out”
    I would be HAPPY to see DATA that backs up your claim of “10-12” players.
    until then, you MADE IT UP in my opinion.
    (my data from above comes from Gretchcen Morgensen, NYT, February 2007)
    here’s an excerpt in the San Diego Union Tribune
    You guys can tell me how to get the data on the major HEDGE FUNDS involved in the CDS market, the major Sovereign wealth funds, and the Foreign banks… since you seem to know so much about the COMPLETELY opaque and unregulated CDS market.
    I personally don’t know how to get the rest of the data, except by digging firm to firm to off balance sheet entity to off balance sheet entity (how do I do that?) to calling the Emirate of Dubai and read the documents of Societe General and CALPERS

  27. “so for example there are an estimated $1 Trillion worth of CDS written against GM, a $15 billion company”
    Now this is an issue that puzzles me. Aren’t these contracts written such that the purchaser has to surrender the bond in order to get his payout? Doesn’t that mean that anyone who purchased a CDS without owning an actual bond is SOL?

  28. Red Pill,
    I suspected from one of your earlier posts that you had worked in this area. I didn’t run a book of swaps, but as a prop buy side trader/manager often used swaps to effect OTC derivative positions (synthetic index exposure, swaps that replicated KIKO and range payouts, interest rate swaps in currency markets where the forwards were NDF, etc.).
    All this was in the 1990s, as early as 94. This is not a new market, but the explosion in betting on – or insuring against – credit quality of issuers is a more modern iteration. Swaps in general were expressly encouraged and fomented by the NYFed and Greenspan in the late 1980s/early 1990s. As I wrote above, I briefly worked for the corporate counsel (before I went to the buy side as a trader) for ISDA on the structuring of the early model forms, so I was privy to just how much “regulatory” input there was.
    I haven’t been involved in trading the modern variant of CDS, however, although I can almost guarantee they work the same way all the currency, derivative and synthetic underlying swaps worked back in the 90s. In this system (Red Pill can confirm here), the “buy side” of the swap – that is, the side of the swap that is held by a non-AAA captive sub of one of the ISDA members – is marked to market continously, and entities like hedge funds, mutual funds, even private individuals*, have to post margin to cover fluctuations. The big guys don’t do this – perhaps they post with each other (I couldn’t say) – but as regards the little guys, they do not post collateral with them if the trade goes against the big guys’ favor. I know this first hand, and the risks were driven home when I had to liquidate a synthetic short position on the Russian Ruble with CSFB (at great loss to my marked-to-market p/l) in 1998, because we feared CSFB insolvency and our fund wanted to tell investors that we reduced exposure to shaky counterparties. You can imagine what the bid-ask spread was on a customized swap that had gone against CSFB, yet was of a type that CSFB knew all hedge funds were squaring up.
    (*Individuals sometimes entered into customized swaps. A favorite was synthetic shorts in dot com companies by executives there. This allowed some big guys in Silicon Valley to flatten their exposure to their dotbombs, while the peasants toiled away waiting for their “options to vest” or for the “lockup to expire”. LOL, why do people thnk that Citi or JPMorgan had equity derivative desks in SF late 90s/early 00s?)
    I have no doubt that much of the netted “exposure” in the CDS market today lies with these ISDA members, who have not posted any collateral with the counterparties in the money. Exposure from the hedge fund side is already covered by collateral – I can guarantee that. As ex SF-er writes, no one really knows the result of removing the “insurance” from the CDS-wrapped turds that have been turned to gold and are now held by pension funds, insurance cos, etc. But I’d rather force all this out in the open now, and force the liquidation (if necessary) of all this bad debt that is wrapped in the CDS seal of approval. I have no faith in the ability of the same people who got us into this to get us out (and yes, they are all the very same people – there has been no change, none). It’s time to pay the piper.
    Last, why do people think the CDS market exploded upwards suddenly in the 2000s? The regulators require pension funds to hold AAA assets. The rating agencies – BY LAW – have a monopoly on the blessing of turds and turning them into gold. The Fed and the USG were desperate to push debt after the 1990-91 recession (that’s what kick started securitization, which was in its infancy, and the burgeoning swap market) and especially after the 2001 recession. Just as they are now, by the way. The Fed and the USG (which goes along with it) causes a lot of damage when they continuously and repeatedly drive interest rates below their “natural” level, and they’re just getting started again. “Free market”, lol.

  29. LRMiM wrote:
    > I worked on the standard form ISDA document back
    > when I was a summer associate (and now you can
    > probably guess which firm my all too brief legal career
    > touched) almost 20 years ago.
    I had a brief full time career in the world of investment banking after business school before I left to work in the family real estate business. Since almost all my close friends continue to work in banking, VC, PE or hedge funds I’m often contacted (and occasionally get paid) to give my input on real estate in a deal. On every credit rated deal I have been involved with (CTL, CDO, CMBS) we had to deal with the firm of Cadwalader, Wickersham & Taft who seemed to have some kind of racket where you had to use them (and pay a ton of money) or your deal would not get the rating you needed…
    > Last, why do people think the CDS market exploded upwards
    > suddenly in the 2000s? The regulators require pension funds
    > to hold AAA assets. The rating agencies – BY LAW – have a
    > monopoly on the blessing of turds and turning them into gold.
    I know some of the “quant jocks” that play with numbers for big banks and hedge funds and one of the things that they all have in common is that they have never actually owned and operated any kind of business or really been out in the real world. By comparison the silver spoon kids who hung out at Bain and McKinsey for a couple years before going to B School were business experts. I have actually met smart guys who looked me in the eye and told me that “there is no higher default risk in a zero down loan vs. a 20% cash down loan” and “if you pool a portfolio of loans from people who bought homes they can’t afford you will have a traunch that is AAA”…

  30. Great discussion and insight here from all of the commenters. LMRiM’s last post seems to explain it all to me – as does the last paragraph above from FormerAptBroker.

  31. LMRiM,
    Large trading houses will usually have master netting agreements in place with each other. Exposures across equity, debt, currency and commodity desks will be recalc’ed daily, a new net exposure to each counterparty will be generated, some risk / VaR cop will tap the CFO on the shoulder if a number gets too big, etc.
    Generally, whoever is not in the money on a CDS contract will post margin, subject to any master netting agreement. It was a common complaint for us to max out a trading line with some counterparty and for a netting agreement to be slapped in place to bring the exposure down. It’s possible the lack of netting capabilities of second tier CDS traders has alot to do with the large aggregate $ exposures being trumpeted about the size of the CDS market.
    Credit downgrades can (did) hit a company like AIG hard. Margin exposures are a function of who is writing the paper (their rating) and how in / out of the money the contract is. ISDA language is consistent on this. If AIG sells alot of Lehman paper to the usual suspects and Lehman tips over (call this a 4 sigma event), then AIG not only has to pay out, but also scare up new liquidity to keep the ratings police at bay. AIG was not taken seriously in most markets and I suspect the credit desks of most investment banks viewed AIG as the golden goose because they mispriced things and had a AAA rating, i.e. they could afford to misprice things for a long time.
    A CDS is a stand alone contract and doesn’t require you to own a bond or some sort of linked instrument. The contracts were frequently paired with lower rated debt so a trader could hold it up to his boss and say, yeah, it yields 14%, and the company is a uranium miner in Nigeria, but I own 3 for 1 CDS protection so we are safe.
    You could probably persuade a hedge fund to sell you a CDS if you pre paid for it. They’ll call a bank, get a quote, charge you accordingly, and require you to stay very current on the premiums, but it can be done. Us energy guys, when we saw how utterly Gray Davis was in it with PG&E did buy CDS’s on the Cal utilities and later quietly sold them. But this was small change compared to the break taking volatility in the California electricity market.
    Ex SF-er, I don’t have hard numbers to back up what I’m saying about the CDS market. But I have deep experience and know exactly how large financials approach tail events and systemic issues in unregulated OTC markets. For example, tens of thousands of people make their living extracting, transporting, buying and selling fuel oil. But if you want to hedge multiple years of price exposure to fuel oil anywhere in the world, you will end up dealing with one of two people, a GS guy (in NY) or a MS guy (in London). I operated in a similar market, unregulated, run by a few guys. What you quickly learned was that a trader’s first priority was actually not to make a PNL, it was to protect the firm. AIG collected nickels in front of the steam roller until their pockets were too full to move. Picking up nickels is fine and all good market makers do it, but a competent trader just wouldn’t have a majority of his longs or shorts with just one counterparty, no matter what their rating.
    Unregulated markets are nothing to be feared if you are competent and properly capitalized.

  32. Red Pill, interesting stuff about how the Enron collapse was handled to avoid an AIG/Lehman-type ripple effect. The 2000-2001 energy mess was where I got most of my (very limited) knowledge in this area. I am still litigating a number of massive lawsuits from that breakdown. Conventional wisdom blames manipulation by traders for all of it. Those of us who have dealt with all the forensics know better.

  33. AIG was not taken seriously in most markets and I suspect the credit desks of most investment banks viewed AIG as the golden goose because they mispriced things and had a AAA rating, i.e. they could afford to misprice things for a long time.
    ROFL. Yes, AIG is so dumb, not like the geniuses at the trading desks who have priced risk soooooo well. ROFL. Everybody, including JP Morgan Chase and Societe General and Barclays and HSBC and Credit Suisse and UBS and Goldman and Merrill ALL mispriced risk.
    and looks like that fleecing didn’t go too well either, since all the idiot firms (like Goldman) who “fleeced” AIG found out about counterparty risk pretty quickly, didn’t they? (lucky for them grandma govt came to let them suck on her teat)
    Spare me the Investment Banker intellectual superiority. I’m over it.
    Unregulated markets are nothing to be feared if you are competent and properly capitalized.
    correct. too bad none of the big boys were competent OR properly capitalized.
    spare me the “well AIG wasn’t taken seriously and they mispriced risk” argument.
    WTF? AIG is THE biggest insurer out there. Who else can price risk if not the biggest insurer on the planet? Certainly they’re no worse at it than Goldman Sucks. They just imploded faster and didn’t get the govt bailout as fast as some other firms.
    I don’t fear unregulated markets. I just know that they don’t work. They never have. Because it’s only a matter of time until some suck-job screws it up for everybody.
    Try deregulating the energy markets? BZZZZZ. wrong answer, you get Enron.
    Try deregulating the financial markets? BZZZZZ. Shadow banking system runs amok.
    we will NEVER get “free” markets because as soon as we try we get a big boondoggle like the mess we’re currently in.
    Ex SF-er, I don’t have hard numbers to back up what I’m saying about the CDS market.
    I know. Because nobody does. Your acumen may look impressive, but I’m sorry, I know more about this specific issue than either of you do.
    you both keep missing the forest through the trees.
    AIG wasn’t alone. They are joined by almost all of the great companies! almost every financial firm mispriced risk the last 10 years! haven’t you figured that out yet?
    EVERYBODY thought they were “hedged” because everybody had different trading strategies based on very important looking models. know what? the models all had huge flaws and so don’t work. Thus BAM, they’re not hedged.
    I admire your trust in the intelligence of the financial elite. Keep that trust as they continue to cause our economy to spiral into oblivian.
    but I’ll continue with my own DATA driven analysis over your hunches.

  34. But if you want to hedge multiple years of price exposure to fuel oil anywhere in the world, you will end up dealing with one of two people, a GS guy (in NY) or a MS guy (in London)
    c’mon, you’re not honestly going to compare the derivatives market in oil to the global CDS market?
    why not compare the CDS market to the Treasury Market or Forex? has about as much in common.
    it does clarify to me where your error is however. You are viewing the CDS market as though it is like some of the other OTC derivatives markets. Do some research, you’ll see that there are vast differences.
    yes, the OTC derivatives market in OIL and other commodities clearly have a few dominant players, who can be singled out, who are often at the nexus of most trades.
    unfortunately that has not proven to be the case with the CDS market. (it could be, we don’t know… and you can’t extrapolate the OTC oil deriv market either since they’re not the same type of market whatsoever)
    some of that data has shown that 13-14% of CDS trades are CONSISTENTLY unconfirmed. even after MONTHS the resale trades remained unconfirmed, with at least one party being UNIDENTIFIED
    So you’re trying to tell me
    -the masters of the universe are so smart
    -there are “probably” only 10-12 major ones
    -those that failed just “mispriced” risk a little, but the rest surely priced risk well, despite all the evidence to the contrary
    -the masters of the universe have really figured out how to price risk and know how to evaluate their counterparties, despite the fact that we still can’t even IDENTIFY 13-14% of the counterparties? and despite the fact that one of their counterparties (AIG) almost collapsed the system and started wave after wave of financial firm terror?
    stretching credulity. something’s wrong with that math. I know what it is
    -the masters of the universe ALL mispriced risk
    -they all used faulty models
    -they all thought they were hedged but did not understand counterparty risk
    -they traded whatever they could whenever they could so that they could reap SHORT TERM gain (since bonuses and compensation is all based on short term gain…) regardless of long term fundamentals.
    -they are thus all at risk for cascading cross defaults
    -there are numerous players all of whom are important due to the sheer size of the market
    FWIW: yes I understand that “notional” amount is not important. but I also understand that a “minor” player (by your estimation, not mine) nearly collapsed the entire financial system. thus, not sure we can just ignore the minor players as you so want to do.
    The traders aren’t as smart as you think they are. They were bouyed by a worldwide credit bubble so that all their trades won… with time they thought that the CDS were truly liquid, and due to the lack of losses they made financial models that were faulty. in the end they didn’t care because it was all OTHER PEOPLE’S MONEY anyway. if they win, they get big bonuses. if they lose, no big deal just start again with other people’s money again.
    traders were no smarter than the house flippers who bought houses slapped some paint on a house and sold it a week later for $100k. sure, looks like a genius. until it don’t work no more.
    CDS don’t work no more.

  35. The traders aren’t as smart as you think they are. They were bouyed by a worldwide credit bubble so that all their trades won…. if they lose, no big deal just start again with other people’s money again (emphasis added)
    Sounds pretty smart to me! The money they put in their pockets is now gone. Poof. And the taxpayer is going to pick up the pieces. $20 BILLION of bonuses were paid out on wall street for 2008, lol. (down from the record, though, of $33 BILLION last year).
    It became clear that this would happen when the Fed godfather intervened and twisted arms to save LTCM in 1998, and Mr. Magoo cut rates like mad (at least it seemed mad back then in those innocent times) in Fall 98, when every data point and aggregate said “do nothing”. That’s one of the reasons I always identify LTCM as possibly the last chance to avoid the credit collapse, which was most assuredly put in motion by the early 1990s. These things take time to play out, and the traders on Wall Street knew they had a “friend” in high places. Still do 🙂

  36. LMRiM. we are in complete agreement on that.
    I’m just disputing The Red Pill’s characterization of Wall Street traders being this haven of knowledge and risk-pricing ability.
    I understand your “bailout” meme and I agree fully with it. that said, be honest: how many traders/financial types do you know who TRULY saw this coming?
    I, like you, have hordes of friends/family in the financial industry. and very very few of them saw this coming. in general, they confused the idea of spreading risk with elimination of risk.
    they drank the koolaid just like everybody else. I really see them like the house flippers of 2005.
    those who really saw the problem were usually
    -bloggers (like CR/nakedcapitalism)
    -certain financial reporters (especially Meredith Whitney and others like some from the Economist)
    -EX-financial types. (like yourself, CR, Yves again).
    -geeks (like me)
    -others (like David Walker, ex comptroller of the currency, or Warren Buffet who steered clear)
    -short sellers (who tend to not follow the crowd… like Jim Paulson)
    but the financial types were mostly like Chuck Prince and Stan O’neal… dancing through it all. oh and lying sacks of dung.
    Even Goldman Sachs figured out only PART of the problem. they knew it was going to implode… but didn’t realize counterparty risk. in the end, that’s what makes this crisis “different” than most of them since the Great Depression.
    simply put: the firms and the financial products are too complex for human thought at this time. it only works through CONFIDENCE and trust. Too bad, wall streeters can’t be honest. because now the only thing left of confidence is the big CON.
    almost firm lies and cheats and manipulates their data. financial tricks and off balance sheets and questionable transactions. it is IMPOSSIBLE to properly evaluate your counterparty due to all of this. thus, things like AIG and Madoff can happen. no way to stop it.

  37. Good points, ex SF-er.
    About who saw it coming, I know a number of smart people – current and former financial industry types – who knew absolutely that “something” was coming, and a few who got the timing right.
    It’s sort of not the right question, though, IMHO. The real string pullers knew a crisis would come, in the same way that a degenerate but successful gambler “knows” he can’t beat the odds forever. After all, Mises told us it would 🙂
    They also knew that the deck was always stacked in their favor (heads I win, tails you lose), in that the system had become too big to fail.
    The Fed is in on the same game as well. If it’s true that these guys don’t understand the very simple concept that a country that produces 2-3% real growth per year (max) cannot service or repay debt that is 360% the size of the economy, then we have larger problems. I find it more comforting to believe that these guys are crooks, but not stupid 🙂 Any fool recognizes that we have been running a ponzi scheme with our fiat currency, even government-pay-scale fools.
    “Regulation” is a nice palliative – a warm and fuzzy sounding idea and it has a nice ring to it. Reality is that the regulated have become the regulators. Quis custodiet ipsos custodes? Asked thousands of yars ago, and just as relevant today as ever. Answer: it certainly isn’t the population. (That last reference is for diemos :)).

  38. thanks for the compliment dub dub, but I promise I’m not Nassim. I have read his stuff, and agree with much of what he says.
    I’m a regular old doctor from SF who now lives in the midwest who happens to have a bizarre interest in world financial markets, financial crises, and in particular a fascination with the CDS market. I’m a nobody.
    some people watch “Survivor”. I analyze things financial.
    I would be considered at best “an ivory tower academic”, more often “an armchair economist”, and I don’t want to think about the worst! mainly because I do not have (or desire) professional trading experience.
    that said, I have a front row seat for some of this due to some connections that I’m not willing to disclose. those connections have allowed me to be 100% sure that my analysis (of “unknowability”) is correct when it comes to the CDS market. If my connections don’t know, then nobody knows. Sometimes it is important to know what you do not know.
    although I often disagree with other posters, I feel like I very rarely call someone out as totally wrong (although perhaps I do it more than I think). however, this is one of those times.
    I know enough to know what isn’t known. in this case LMRiM and Red Pill don’t know what they don’t know, so I will correct them on this.
    in other things trading-related (not to mention other topics as well), I am an imbecile compared to them.
    “True knowledge exists in knowing that you know nothing.” -Socrates

  39. LMRiM:
    I agree with you that regulation is not a panacea, and also that it usually ends up subverted. That does not mean that regulation is bad, it means that we must ENFORCE sensible regulation.
    I am not of the “regulate everything” variety. I am of the “we must make sensible regulations and then enforce them to the max” variety. I also understand that the pendulum will swing to overregulation. but can you blame us? look at what has happened in the deregulated space!
    some regulations (especially many made after the Great Depression) made a lot of sense, like Glass Steagal. And our situation would be 1000x improved had it still existed
    everything is good in moderation. thus, like I’ve said pure commonism doesn’t work, and completely “free” markets don’t work either. both are too extreme.
    some philosophical questions that may resonate with LMRiM’s points:
    (keep in mind as I ask these that I disagree almost 100% with most of the actions/bailouts done over the last year)
    -at the beginning of this crisis, we had a very free-market oriented Hank Paulson as a Treasury Secretary. As the leader of Goldman Sachs, could he be anything but? our President was also pretty pro-deregulation and free-market minded at least from an economic standpoint. what made them change? was it only because they wanted handouts to their friends?
    -did the governmental response change at all after Lehman failed? why or why not.
    -do you think that Hank Paulson and Ben B and staff HAVEN’T gotten the biggest CDS players in one room to try to sort things out? if so, what makes you think that? What were the meetings of October 2008 about when Henry Paulson met with the CEO’s of all the largest banks in PRIVATE. what do you think was said? afterwards, what happened? What have the other private telephone and in-person meetings been about? is it just to figure out how to best fleece the taxpayer?
    -why do you think well-capitalized banks accepted huge amounts of TARP money? Specifically, why did Wells Fargo (who was and is currently in a “strong” position, at least theoretically) accept the money? what happened immediately before they accepted. can you remember was it temporally related to any secret meetings with govt officials? did they only do it to enrich themselves? or because the govt is stupid but powerful so forced them to do it?
    -why do you think that the govt gives gobs of money to entities with NO transparency… against taxpayer wishes, in a relatively bipartison manner? specifically AIG, Citi, BofA to name a few. is it only due to cronyism and govt incompetence? could there be other reasons? did this money come without analyzing these company’s books? or did it come after analyzing the books?
    -why do you think it was an accident or oversight when the government changed laws specifically so that Wells Fargo could take over Wachovia even though Citibank already had a contract for Wachovia in place? why would they do that?
    -do you think that a central clearing mechanism would be a good idea for the CDS problem as I do? if so, why hasn’t the govt looked into that much? are you sure they haven’t? what would the govt do (or say) if they did such a thing and got answers they didn’t feel were acceptable? announce that they did it and failed? why hasn’t the CME group put the CDS on its exchanges (especially if CDS are so similar to OTC contracts on oil derivatives)
    **you can google “Peterffy Says CME Group Credit Swap Plan Puts Billions at Risk”
    is this whole thing as LMRiM states? is it all an easily solveable problem if we just let unfettered free markets work? is the only problem that we have this pesky government in the way that ruins everything?
    is the only problem the fact that there are central banks and fiat currency and fractional reserve lending, and this never would have happened without those? regulation is at fault because regulation FORCES people to go to unregulated spaces and do foolish things? if regulation forces people to do this, why do they go to the unregulated space to do it? why not just do it in regulated space?

  40. “Quis custodiet ipsos custodes?”
    “That last reference is for diemos :)”
    I assume that you haven’t gotten around to reading “Systems of Survival” yet. Jacobs has some interesting points on just that topic.

    Eternal vigilance is the price of liberty.
    The only thing necessary for the triumph of evil is for good men to do nothing.

  41. diemos,
    I definitely read it (that’s why I called out that reference to the “guardian syndrome”)! Interesting, lots of fun ideas. Much more a descriptive survey than any attempt at normative rigor. Some of it is a little contrived (focus on art in “taker” societies because they appreciated the ecological soundness of leisure?). I’m going to read her other works as well. She doesn’t have any answer, really, to the question. Vigilance is fine, especially when the guardian class is largely limited to political questions. But once the guardian class gets more than 50% of the economy and succeeds in fostering utter dependence, the idea of effective vigilance becomes implausible.
    Thanks for the recommendation, though, I really liked it. As you know, I’m an ex trader and my brother is a cop, so we’ve got both the syndromes covered 🙂

  42. Yup. I don’t think that there is “an answer”. I think it’s an inherently unstable system that manifests itself as an endless cycle of governing systems becoming corrupt, bleeding the commercial class dry, falling, and being refounded.
    For your next book I would recommend “The death and life of great american cities”, a classic on what creates dynamic, livable urban neighborhoods. Just about every time the city puts forth an urban planning initiative I get the urge to take my copy down to the planning department and beat them black and blue with it.

  43. We’re talking Jane Jacobs now? That’s actually a topic that I can possibly add something to the conversation 😉
    I’ve even got my copy of “Death and Life” signed by Jacobs. A nice little surprise during a visit to Toronto in ’03.

  44. I’m curious why ex SF-er’s extensive comments have been allowed to stand. No rebuttals from the usual suspects?

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