I don't know why this strikes me as funny, except that the ingenuity of investors astonishes someone like me who has no such skills. From Bloomberg:
"Nov. 25 (Bloomberg) --
Goldman Sachs Group Inc.,
Citigroup Inc. and
JPMorgan Chase & Co., which helped turn bets on company defaults into a $47 trillion market, are among banks offering wagers on the amount investors may recover from bonds after borrowers go bankrupt. "
First of all, notice the use of the word "wager". Yep, Derivative Dribble isn't going to like that. It sounds a bit like me. Anyway, we now have, are you ready, DRSs, i.e., Default-Recovery Swaps.
Now, given the wonderful explanations on Derivative Dribble, and so knowing that anything on earth that can go up or down and be measured can become a Derivative, I should have expected this.
So, we now have a Derivative on CDSs. Hello.
"Credit-recovery swaps are trading on the debt of about 70 companies, including automaker
General Motors Corp. and bond- insurer MBIA Inc. That’s up from 40 during the summer, according to
Mikhail Foux, a strategist at Citigroup in New York.
The contracts, barely traded in 2006, are now worth about $10 billion as more companies fail to repay debts, Foux said. Also known as recovery locks, the agreements are bought as insurance by sellers of credit-default swaps, such as banks, hedge funds and insurers."
So, DRSs=Recovery Locks. They are an insurance policy on CDSs, which are an insurance policy on mortgage defaults. So, I assume, if your CDS doesn't pay, or defaults, then you get paid. I'm getting dizzy.
How long will it take to have insurance on DRSs?
“The market definitely has potential to grow,” Foux said. “As we see more defaults -- and there’s no doubt we’re going to see more defaults -- you’re going to see more recovery swaps trading.”
Try and control your glee, for God's sake. Hey, how can they figure odds on defaults of CDSs, when no one else can? Wouldn't they need to know that to write insurance on them? And how can they trade? That means they're priced. How can you price them without some idea of how many CDSs are going to default?
"Goldman Sachs and JPMorgan officials declined to discuss their role in the market. '
Yeh, some people earlier lost money on these derivatives you're writing derivatives on. It's in the news. Give it a read. And, no, we don't want to be seen profiting on this distress. Can you say "Bad publicity"?
"Securities and Exchange Commission Chairman
Christopher Cox blames speculation in credit-default swaps for contributing to almost $1 trillion in global financial losses. Some sellers of the contracts buy recovery locks to protect what they may get back on bonds when companies default. "
How do they know what they might get back?
"Holders of recovery swaps agree to exchange a preset fixed rate for the actual amount received by bondholders after a default. The investor getting the fixed amount will benefit if the payment they get is lower than the rate agreed. "
How are they figuring these things?
"The Oct. 10 derivative industry auction on bankrupt
Lehman Brothers Holdings Inc.’s credit-default swaps set a value of 8.625 cents on the dollar for the New York investment bank’s debt, according to
Creditfixings.com. '
Okay. You got nine cents on the dollar. Yikes.
"A credit-default derivative seller could have bought a recovery lock to ensure a 20 percent recovery rate on Lehman debt three days before the firm’s Sept. 15 bankruptcy, Foux said. The seller would thus have received 11.375 cents on the dollar from the recovery contract."
That sounds like a better deal, less the premiums and fees. Yep, an extra 11 cents. Good work, if you did that.
"MBIA, of Armonk, New York, trades at a recovery value of about 26.5 cents on the dollar, down from 40 cents at the beginning of the year, Foux said. Detroit-based GM, the largest U.S. automaker, is valued for a recovery of about 15 cents, about half what it was on Jan. 1. "
I'm shocked that they had these things at the beginning of the year. And they were betting on getting back only 40%? At the beginning of this year? And it's only declined 15 cents?
"Many credit-default contracts written early this year assumed a 40 percent recovery rate in pricing deals, Foux said.
MBIA spokesman Jim McCarthy and GM spokeswoman Julie Gibson each declined comment."
No ever comments on these things from the company being "wagered on". I guess if you figure something's going to default, you're not going to bet on getting a lot back.
"Recovery locks for Tribune, the newspaper publisher and broadcaster taken private by billionaire
Sam Zell, are trading at about 7 cents on the dollar, down from about 14 cents in September, Foux said. Contracts for MGM Mirage, the biggest casino operator in Las Vegas, are trading at about 27 cents, compared with about 37 cents in September. "
No TARP money, maybe, explains this drop. Or just the general downturn? Can we write Derivatives on government bailouts? Calling Derivative Dribble.
"Tribune spokesman
Gary Weitman declined to comment. MGM Mirage spokesman
Alan Feldman didn’t immediately return a call seeking comment. "
Do any of these people ever answer their phones?
"Seventy U.S. companies have defaulted through Nov. 11, more than four times as many as in all of last year, according to a Nov. 17 Standard & Poor’s report. "
No Frank Sinatra songs for this year.
“One would expect much lower recovery rates as default rates soar,”
Diane Vazza, head of S&P’s global fixed income research group, said in an e-mail. '
Hey, somebody answered an e-mail. I guess the likelihood of default helps determine the recovery rate. Less money to go around when these things settle.
"S&P cited an “inverse correlation” between defaults and investor recoveries in a February 2007 report. "
That's interesting.
"When default rates are less than 2 percent, more than half of defaulted debt recovers more than 70 percent of face value, according to the rating company.
When defaults are greater than 8 percent, more than half such debt recovers less than 40 percent, S&P estimated."
I can only figure that the pool of money to settle is smaller if there are more defaults. Any other explanation?
"Investors use credit-default swaps to protect themselves or speculate on the value of company debt. The market grew 100-fold to more than $62 trillion between 2001 and the end of 2007."
In other words, CDSs can be:
1) Actual insurance
2) A bet on the likelihood of default
It's 2 that troubles the average person. It certainly can be used to determine risk, since that's what 2 is based upon, but most people, I'll wager, see it as a side bet.
"In case of a default, swap sellers must pay buyers the difference between the amount being protected and the value of the defaulted bond, as determined by an industry auction."
In that sense, it's like insurance.
"Specifics about recovery-lock contracts aren’t generally available because they are made privately and don’t trade on an exchange. The contracts date back to 2005, when a Fitch Ratings report said investors were starting to use them to lock in returns after defaults. "
So, this all was beginning in 2005. I wonder if they'll have to be on an exchange going forward?
"The International Swaps and Derivatives Association established standard documents for deals in 2006. The New York- based trade group doesn’t keep records on the size of the market.
“There has not yet been member demand for us to track recovery swaps,” said spokeswoman Cesaltine Gregorio.
“Nobody thought about hedging the recovery rate” when default rates were low and recoveries stable, said Philip Gisdakis, a Munich-based credit strategist at UniCredit SpA."
Wouldn't the demand be to see how they're doing, so that I could invest in them? No average investors need apply. How about just doing it because it interests me?
“Typically, investors thought recovery rates for financial companies should be in the range of 80 to 85 percent,” Gisdakis said. “With Lehman below 10 percent and with other financials at very low recovery rates, that’s something that is completely new.”
Well, yeh, which is why I thought those 40% rates at the beginning of the year were scary.
"Recovery swaps aren’t traded heavily because bid-offer spreads “remain wide,”
Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California said in an e-mail. That means it’s hard to find a price that satisfies traders on both sides of a deal. "
I'm surprised that they can be priced at all, with so little information to go on, unless you can correlate these things with other, more definable, numbers.
“It is definitely more of a buy-and-hold security than a traded security in this environment,” Backshall said. "
In other words, it's more insurance than speculation.
"The bid-ask spread for MBIA and GM debt is about 6 percentage points, according to Foux. By comparison, the companies’ credit-default swap bid-ask spreads are about 2 percentage points, according to CMA Datavision prices. "
Now, that interests me. You have an idea about one number, which you base the second on, but the second is iffier. It makes sense, but the spread seems too wide. Oh well.
Have I convinced anyone to buy DRSs?
Posts
“So, for anyone who owns the underlying bond, a CDS will allow them to protect the principal on that bond in exchange for sacrificing some of the yield on that bond.”
This just looks like insurance.
A. If AIG defaults, B has to go out and buy $100 million par value of AIG bonds.
B. B has to pay out $500,000 per month for the life of the agreement and receives nothing.
Why couldn’t this transaction be tied to anything? Wheat, currency, anything that I’d have to buy if it’s devalued? In other words, if you don’t own it, peg it to anything. Is there some reason to peg it to bonds or mortgages, as opposed to anything else?
If my question doesn’t make sense, don’t answer it. If you don’t want it on the blog but can answer me, please email me. Thanks, Don
And here's his answer, which is very clear and interesting:
"Hi Don,
Great name! Yes, it does look like insurance. At at a bilateral level, it is. However, insurance regulations don’t work in swap markets. Here’s why:
http://derivativedribble.wordpress.com/2008/10/21/the-regulatory-gong-show-new-york-struts-and-frets-its-hour-upon-the-stage/
Derivative contracts can indeed be linked to any objectively observable and measurable event, e.g., the occurrence of a hurricane. These types of things exist. They’re called “weather bonds.”
I’m writing a piece on “synthetic instruments” which will discuss things like this so keep an eye out for it!"
I'm going to, and you should as well.