gipa69
collegio dei patafisici
Received a fascinating e-mail from a former hedge-fund colleague that I want to share with all of you (with his permission of course!). Before I get to it, some introductory words:
Morgenson's article in the NYT earlier this week kicked up a bit of controversy in the blogosphere. She puts the size of the CDS market at $45 trillion, but Felix Salmon responded at Portfolio.com that her numbers are a bit misleading.
That may be so, but there's still tons of risk built into this market. Salmon doesn't address fears that someone must be sitting on billions of unrealized losses. That's a big problem in the markets for RMBS, CMBS, leveraged loans, junk debt, CDOs, CDPOs, CDS, etc. No one knows who's sitting on the losses. Is it the big Wall Street banks? Which ones? Is it hedge funds? Probably all of the above and more. Hell, even NON-financial companies like pharma giant Bristol Myers have taken losses.....
Everyone knows there are huge losses sitting on SOMEONE'S books. But while lenders wait to find out who, they're exercising an overabundance of caution: refusing to lend to ANYONE. Another reason they may be hoarding capital is that lenders themselves may be sitting on losses and will need capital to cover them when the day of reckoning arrives. [The dynamic above, market panic created by uncertainty, is a big reason you may read that regulators are encouraging banks to disclose as much as possible about the losses hidden on their balance sheets. Markets fail to function during periods of great uncertainty. If we just knew where the losses were hidden, credit markets might start to function again.]
So that's my way of introducing his e-mail:
We spent some time a couple weeks ago learning more about these CDS instruments. I was wrongly under the impression that you closed out a position by simply taking the other side of it, thus creating a zero-sum market but also exposing you to downside risk until the contract expires. The way the market really works, though, is you’re able to settle your position for cash simply by calling a broker and agreeing on a price, which is based on current spreads and the forecast for future spreads coupled with the remaining duration of your contract. The broker then either takes your position and pays you cash from its own BS or finds someone who will and pays you the cash proceeds from that transaction.
I’m not sure if you’ve seen the numbers, but most of the Tiger Cubs [a group of hedge funds with seed capital from Tiger Mgmt guru Julian Robertson] were up 40%+ last year and nearly all of their performance came from CDS positions. They were buying in at 10 to 20 bps spreads on companies like Countrywide and homebuilders like Lennar whose spreads have since widened to 300 to 600+ bps. That’s a pretty solid return. Smart guys for making that trade.
My question, though, was whether they could actually realize these returns like you could with a stock – i.e., by simply selling them for cash. As I mentioned above, it turns out you can.
That catch, of course, is that someone needs to PAY you that cash price at settlement for your gain to be realized.
GREAT point. There's a huge difference between PAPER gains and REAL gains. If I buy a stock that doubles in price, I have a PAPER gain of 100%. I don't have a REAL gain until I close the position, until I sell the stock for actual cash. That can complicate matters. If my position is very large, for instance, then the act of selling the whole position may drive the price down. It's important not to forget this necessary step--the actual conversion of paper gains to cash.
While the particulars differ, the point is the same with Credit Default Swaps. To turn a gain into cash, you have to sell your position. John Paulson reportedly generated billions in gains in 2007 using CDS to bet against subprime mortgage-backed securities. But to close out his CDS positions, he had to settle them for cash. Someone had to pay him billions of dollars for the derivative contracts he sold. Where did those billions of dollars come from? For every dollar made, somewhere a dollar is lost.
.......I wonder how well the banks, insurance companies, and others that are on the other side of these transactions can actually afford to cash out the CDS holders. To date, most of those contracts have reflected unrealized losses, but if there’s a run on the banks to cash out the realized losses could mount very quickly.
We have yet to see a major CDS blowup from someone who is was writing these contracts for banks to hedge their credit portfolios and/or hedge funds to speculate on credit spreads widening. That seems inevitable at some point. We talked to a fairly large buy-side institution a few weeks ago that’s been dealing in CDS for some time (mostly going long spread widening). Even they are unsure who is on the other side of their transactions, and these are sophisticated guys. They tend to settle their positions with their brokers and don’t know if that cash at settlement is coming from the broker or someone buying in to take over their position. Either way, there have been some nice fortunes made from the spread widening (Paulson, Hayman, Blue Ridge, Lone Pine, etc.) but I have yet to see where the fortunes are being lost on the other side of those trades. I guess you don’t have to blow up until you have to cash in those positions for massive losses. I think, though, that if we follow the cash on these transactions we’ll see that something ugly will happen at some point as more book losses convert to realized losses.
Time will tell but, as I said above, I think another blow up or two might be inevitable. Within six months it’s possible the term “counter-party risk” will have become almost as colloquial as “subprime” has.
Morgenson's article in the NYT earlier this week kicked up a bit of controversy in the blogosphere. She puts the size of the CDS market at $45 trillion, but Felix Salmon responded at Portfolio.com that her numbers are a bit misleading.
That may be so, but there's still tons of risk built into this market. Salmon doesn't address fears that someone must be sitting on billions of unrealized losses. That's a big problem in the markets for RMBS, CMBS, leveraged loans, junk debt, CDOs, CDPOs, CDS, etc. No one knows who's sitting on the losses. Is it the big Wall Street banks? Which ones? Is it hedge funds? Probably all of the above and more. Hell, even NON-financial companies like pharma giant Bristol Myers have taken losses.....
Everyone knows there are huge losses sitting on SOMEONE'S books. But while lenders wait to find out who, they're exercising an overabundance of caution: refusing to lend to ANYONE. Another reason they may be hoarding capital is that lenders themselves may be sitting on losses and will need capital to cover them when the day of reckoning arrives. [The dynamic above, market panic created by uncertainty, is a big reason you may read that regulators are encouraging banks to disclose as much as possible about the losses hidden on their balance sheets. Markets fail to function during periods of great uncertainty. If we just knew where the losses were hidden, credit markets might start to function again.]
So that's my way of introducing his e-mail:
We spent some time a couple weeks ago learning more about these CDS instruments. I was wrongly under the impression that you closed out a position by simply taking the other side of it, thus creating a zero-sum market but also exposing you to downside risk until the contract expires. The way the market really works, though, is you’re able to settle your position for cash simply by calling a broker and agreeing on a price, which is based on current spreads and the forecast for future spreads coupled with the remaining duration of your contract. The broker then either takes your position and pays you cash from its own BS or finds someone who will and pays you the cash proceeds from that transaction.
I’m not sure if you’ve seen the numbers, but most of the Tiger Cubs [a group of hedge funds with seed capital from Tiger Mgmt guru Julian Robertson] were up 40%+ last year and nearly all of their performance came from CDS positions. They were buying in at 10 to 20 bps spreads on companies like Countrywide and homebuilders like Lennar whose spreads have since widened to 300 to 600+ bps. That’s a pretty solid return. Smart guys for making that trade.
My question, though, was whether they could actually realize these returns like you could with a stock – i.e., by simply selling them for cash. As I mentioned above, it turns out you can.
That catch, of course, is that someone needs to PAY you that cash price at settlement for your gain to be realized.
GREAT point. There's a huge difference between PAPER gains and REAL gains. If I buy a stock that doubles in price, I have a PAPER gain of 100%. I don't have a REAL gain until I close the position, until I sell the stock for actual cash. That can complicate matters. If my position is very large, for instance, then the act of selling the whole position may drive the price down. It's important not to forget this necessary step--the actual conversion of paper gains to cash.
While the particulars differ, the point is the same with Credit Default Swaps. To turn a gain into cash, you have to sell your position. John Paulson reportedly generated billions in gains in 2007 using CDS to bet against subprime mortgage-backed securities. But to close out his CDS positions, he had to settle them for cash. Someone had to pay him billions of dollars for the derivative contracts he sold. Where did those billions of dollars come from? For every dollar made, somewhere a dollar is lost.
.......I wonder how well the banks, insurance companies, and others that are on the other side of these transactions can actually afford to cash out the CDS holders. To date, most of those contracts have reflected unrealized losses, but if there’s a run on the banks to cash out the realized losses could mount very quickly.
We have yet to see a major CDS blowup from someone who is was writing these contracts for banks to hedge their credit portfolios and/or hedge funds to speculate on credit spreads widening. That seems inevitable at some point. We talked to a fairly large buy-side institution a few weeks ago that’s been dealing in CDS for some time (mostly going long spread widening). Even they are unsure who is on the other side of their transactions, and these are sophisticated guys. They tend to settle their positions with their brokers and don’t know if that cash at settlement is coming from the broker or someone buying in to take over their position. Either way, there have been some nice fortunes made from the spread widening (Paulson, Hayman, Blue Ridge, Lone Pine, etc.) but I have yet to see where the fortunes are being lost on the other side of those trades. I guess you don’t have to blow up until you have to cash in those positions for massive losses. I think, though, that if we follow the cash on these transactions we’ll see that something ugly will happen at some point as more book losses convert to realized losses.
Time will tell but, as I said above, I think another blow up or two might be inevitable. Within six months it’s possible the term “counter-party risk” will have become almost as colloquial as “subprime” has.
