"Credit-recovery swaps are trading on the debt of about 70 companies"

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?

"If you hear lawmakers and pundits repeating these like mantras, you can be sure that the financial regulation facelift is off to a bad start. "

A hugely important post on Bloomberg by Susan Antilla if you believe, as I do, that fraud, negligence, and fiduciary mismanagement are more important issues than CDS's, CDO's, complexity, ignorance of risk, etc.:

"Listen carefully for these words and phrases as politicians get to work on an overhaul of U.S. financial regulation in the months ahead: ``duplicative,'' ``balkanized,'' and the twin ``quilts'' -- ``patchwork quilt'' and ``crazy quilt.''

If you hear lawmakers and pundits repeating these like mantras, you can be sure that the financial regulation facelift is off to a bad start.

Those are the adjectives often used to describe the role of state securities regulators, the 50 local cops on the securities beat whose presence has long been a thorn in the deregulatory side of the financial industry.

Although the role of state regulators has been derided as wasteful (they regulate something that's supposedly already being regulated), expensive (it costs big bucks to pay lawyers to comply, and even bigger bucks to pay lawyers if you don't comply and get caught) and petty (they're just trying to steal the thunder from the real regulators in Washington), those who support the states see it differently.

``If you take away the states' power, there is only one game in town -- the Securities and Exchange Commission,'' says Renee Jones, associate professor of law at Boston College. ``That's a risk to investors.''

Yet there's a significant prospect that, amid plans to streamline financial regulation in ways that address the current financial crisis, state regulators might lose some of their power."

Understand this, they look into the treatment of average investors, and please remember the recent performance of the SEC.

``Given this opportunity to change the law, I think they will pounce on this,'' Jones says, referring to members of our sterling financial industry, their lobbyists and various politicians who are always keen to get government at any level to stop badgering business with rules.

It's far more desirable to be regulated by the SEC -- four recent reports by the agency's inspector general will help you understand why -- than by, say, Texas, where Securities Commissioner Denise Crawford says her underpaid and overworked civil servants find it rewarding ``to see the results when bad guys get put in jail.''

``The folks in my office are not looking to go to work for Wall Street,'' says Crawford, drawing a comparison to the well- worn career path that propels smart but underpaid SEC staffers into lucrative jobs defending financial firms.

To get an idea of what she's talking about, go to your favorite Web search engine and plug in ``former Securities and Exchange Commission.'' The results are thick with gushing press releases that announce the hiring of regulators by industry."

Good Lord, actual sense. The power of the financial lobby is immense. Exhibit A: TARP.

"The North American Securities Administrators Association, an investor-protection organization made up of 67 state, provincial, and territorial administrators in the U.S., Canada, and Mexico, tallied 2,276 enforcement actions and returned $616 million to investors in 2007, racking up 1,062 years of jail time for offenders who ended up being prosecuted. And that's only a partial tally that excludes 32 members that haven't gotten around to sending NASAA their data.

By comparison, the SEC in its most recent annual reporting period brought 671 enforcement cases and returned more than $1 billion to investors.

It was Kansas that started all this trouble back in 1911, adopting laws to address crooked promoters who fleeced investors in the state. Jones says that every state except for Nevada had enacted similar law -- known as ``blue sky'' -- by the early 1930S.

State regulators in their earliest days didn't have what it took to ward off the Great Depression, though, and Congress passed the Securities Act of 1933, which a year later led to the creation of the SEC as a federal regulator. Thus, there would be two layers of supervision to handle problems in the financial markets, Jones says."

We need a blue sky right now to deal with all these dreadful weather words we've been hearing.

"Business interests have successfully slashed the authority of the states during several rounds of political fighting over the years. Most notably, in 1996 the National Securities Markets Improvement Act, or NSMIA, took away the states' authority to oversee registration and review of public companies whose securities were sold to investors in their jurisdictions.

Even though their powers were reduced, the states roared back. Former New York State Attorney General Eliot Spitzer exposed and punished Wall Street firms for conflicts of interest between investment-banking departments, which underwrote securities sales by public companies, and research departments, which touted the stocks of those clients.

This year, regulators from Massachusetts and 11 other states brought cases against major banks and securities firms that had marketed auction-rate securities to investors as ``safe,'' only to see that market collapse. The states negotiated agreements that got customers' money back."

Can't have financial advisers taken to task for lying, exaggerating, etc. It's the system, the complexity, the models, etc. We can't blame human beings for these problems. It gums the system up, and our models include gullible clients.

"The SEC hopped on those auction-rate cases after the tough work already had been done by those crazy-quilt regulation duplicators in the states. Massachusetts, for example, sued UBS AG on June 26 and settled with the firm jointly with other NASAA members and the SEC on Aug. 8.

You would hardly know that, though, to read an Oct. 6 statement by the President's Working Group on Financial Markets at the U.S. Treasury Department, whose research is often cited as a starting point for regulatory overhaul.

``In the past few months, the SEC, with others in law enforcement, have restored liquidity to Auction-Rate Security investors in the largest securities buyback in the nation's history with tens of billions of dollars of liquidity being restored to tens of thousands of investors,'' the group gushed.

It isn't a far stretch to divine that Treasury is looking to downplay the role of the unnamed ``others in law enforcement'' who actually did the work.

SEC spokesman John Nester said the agency was involved with the auction-rate case ``from the get-go.'' William Galvin, secretary of state of Massachusetts, remembers it differently. ``We certainly consulted with the SEC,'' he said. ``But the idea that they were leading the charge is absurd.''

And so is the idea of cutting back on what the states are allowed to do in the financial arena. Memo to Congress: if you're looking for talent to run the new regulatory world, skip the SEC. The phone numbers you need are a click away in the records of your state payroll back home."

Looks to me like these state fellows get it, and are doing the heavy lifting. Please understand this: Regulations are one thing, fraud, negligence, and fiduciary mismanagement are another.

"it is ready to begin clearing CDS contracts as soon as it receives regulatory approval"

From Bloomberg, Fed to control clearinghouse for CDS market:

"Nov. 11 (Bloomberg) -- The Federal Reserve is working on a plan that would give it authority to regulate the clearing of trades for the $33 trillion credit-default swap market, according to people with knowledge of the proposal.

The Fed, the U.S. Securities and Exchange Commission, the Treasury Department and the Commodity Futures Trading Commission are discussing a memorandum of understanding that lays out oversight of clearinghouses that would become the central counterparty to credit-default swap trades, said the people who asked not to be named because the discussions are private.

The SEC and CFTC would also share trading information under the plan, the people said.

``The main concern is systemic risk and that's much more in the Fed's wheelhouse than the SEC or CFTC,'' said Craig Pirrong, a finance professor at the University of Houston who studies futures markets. ``The Fed is the natural place for it to go.''

The Fed has been pushing the industry to form a clearinghouse that would absorb losses should a market maker fail. Regulators stepped up their efforts after the failure of Lehman Brothers Holdings Inc. in September and the near-collapse of American International Group Inc. The New York Fed has been meeting with groups including CME Group Inc., Intercontinental Exchange Inc. and NYSE Euronext to press them to accelerate their progress."

The two items that interest me are:

1) The concentration on systemic risk ( Yes )

2) Industry absorb losses ( Yes, if I understand this )

"We just need better regulation."

Kevin Sullivan and Neil Irwin in the Washington Post with a good post on hedge funds:

"Regulators at the Federal Reserve, Securities and Exchange Commission and beyond have increasingly concluded that they need more power to gather information about what kinds of risks hedge funds are taking and what risks they pose to the financial system as a whole.

Using its existing legal authority, the SEC attempted to require hedge funds to register as investment advisers, but a court ruled against that decision in 2006. In congressional testimony Thursday, SEC Chairman Christopher Cox said the agency wants lawmakers to grant it that authority explicitly. He also said he would favor folding the Commodity Futures Trading Commission, an independent agency that regulates futures markets, into the SEC to better coordinate regulation."

Here's my comment:

DonthelibertarianDemocrat wrote:

"Leaders of the Federal Reserve, meanwhile, are broadly re-examining their views on financial regulation in light of the crisis. Among their concerns is that light regulation could be worse than none at all, as it could give hedge funds the implicit protection of government oversight even if officials lack the tools to actually guard against risks to the system."

This is a real problem, which is why regulation to aimed at basic concepts like transparency and collateralization, things that the industry itself recognizes.

"Those gathered in London had mixed views on greater regulation. Roman, the executive at GLG Partners, said greater regulation of hedge funds was "long overdue." He said "someone can graduate from college on a Friday and start a hedge fund on Monday."

But Borges said the current political clamor for more regulation could backfire and hurt the economy. "We are not saying that we need zero regulation," he said. "We just need better regulation."

Again, the regulations should simply focus on making the trade clear and solvent.

Let's be honest: We also need better investors.

10/25/2008 11:14:54 AM