Monday, October 06, 2008

Credit default swap

Documentary on CDS :


Anonymous said...

Mr Tan,

With respect to the credit default swap under High Notes 5, I think it should be highlighted that DBS was the swap counterparty. Although I'm not sure of the exact mechanics of the swap, from my brief reading of the pricing statement I think that DBS here could have been the protection buyer (who pays premiums) and its SPV, "Constellation" could have been the protection seller. Constellation is indirectly funded by the proceeds of the high notes. When a credit event occurs, Constellation has to pay to DBS the value of the underlying collateral pool (the 100 or so securities which were purchased using HN5 investors' monies) minus the value of the defaulted obligation, which is what it pays over to the HN5 holders (in this case, Lehman bonds/CDOs which are practically worthless). As you can see, what DBS would effectively get back is the entire collateral at its current value, and investors would get close to zero.

I haven't verified any of the above info with DBS or anyone who specialises in credit default swaps (it is just my opinion from my reading of the pricing statement and I apologise if it is incorrect), but perhaps you or your readers might have the resources to look into this further. I am also not sure if this is correct, especially since DBS has come out to say that it will not profit from HN5.

But the simple fact remains--if the HN5 monies were used to invest in 100 or so securities (not 8 or 1 as some customers may have been led to believe) then there is still definitely a lot of value left somewhere (most of these should still be worth at least 60% or 70% of their face value?). None of the HN5 monies will end up in Lehman's bankruptcy pool. This is a very different situation from the minibond one where the swap counterparty itself (Lehman) defaulted.

ym said...

there you go, the truth is the high-flying, much envied, financial engineers (applied mathematicians and physicists) contributed to the problems with their theorectical models..

one of the best minds in the world said this abt high-flying bankers long before the crisis :
"dont trust them to drive your cars" nassim n. taleb

Anonymous said...

Dear Anonymous,
You said, "This is a very different situation from the minibond one where the swap counterparty itself (Lehman) defaulted."

In the case of Minibonds, Lehman defaulted on interest payment because it has become bankrupt. But the result is still the same as the HN5 because it means the underlying securities have to be liquidated at prevailing market prices which will be much below original value, considering the current market situation. If they are linked to subprime, they are practically valueless.

nhyone said...

10:24 PM, here is my guess.

The prospectus should say the reference entities are not allocated in any proportion, so one out of six failed doesn't mean there's still 5/6 value left.

Also, the clause "first-to-default" and "may lose the entire capital" seems to imply that the issuer uses almost the entire sum to buy the CDS for *each* reference entity.

They can do this, why not? If the issuer has $1.2mil, instead of "pledging" $200k per reference entity, it can pledge the whole $1.2mil and get better premiums. When one entity failed, it has to pay the entire $1.2mil, not just $200k.

(If two failed at the same time? Perhaps the issuer has taken out some CDS on it. :))

I don't know if it really works this way.

Unknown said...

Could the following extract taken from

be true?

"...Instead of just putting together a package of say, 1,000 mortgages and selling them to an investment group for the interest that they paid, Wall Street included complicated, overly sophisticated, opaque derivatives within the package.


Well, the short answer is that a lot more money could be made by Wall Street.

And Wall Street does what's best for Wall Street. That you can count on.

The first instance of credit derivatives being used on Wall Street was 1981 when Salomon Brothers arranged for IBM and the World Bank to swap debt payments in Swiss Francs and German Marks for dollar obligations.

The practice spread like wildfire in a dry forest during the decade of the 1990's and beyond.

It is important to understand that Wall Street firms deliberately structured these packages to be opaque and confusing. That way, the investors weren't really sure what they were getting.

Let's take a look at a simple example to expose the truth. Suppose 500 people each owe me $10.00. That makes $5,000 the total amount owed to me. These people are paying me seventy cents per year in interest (7%).

Suppose that I package those 500 loans together and sell them to you. You would then be able to collect the interest as well as the principal when it is paid back. We will label this a five thousand dollar package.

I might sell this package of loans to you for $4,925 to allow for approximately 1.5% of the loans not getting repaid.

If there was a broker involved, the broker might get a commission of between 1 and 2%.

Now, what if that five thousand dollar package didn't contain 500 loans of ten dollars each? What if it only contained something like 200 or 300 loans for ten dollars each, and of those, more than half were subprime and of questionable ability to repay, while the remainder of the "five thousand dollar package" was used lottery tickets?

Would you still want to pay $4,925 for that package of loans? Of course not! You would only be owed about half of what you paid, and you probably will not receive even half, because so much is owed by borrowers with poor credit ratings who have difficulty making payments on time. There is no way that "package" would be worth $5,000.

What if the the package only contained 50 loans of $10 each, and the remainder was used lottery tickets? Would that package be worth $5,000.00? At this point, you're probably thinking that this author is out of his mind.

Let me tell you that I'm not.

Wall Street put packages exactly like that together. How else could they get 50% commissions? Yes, that's right, commissions of 50% or more! Please see the article Derivatives Abuse by Wall Street for a detailed example of how Wall Street took over half the "value" as a commission. The article links right to a recent new story reported by Bloomberg news.

When the general public finds out what has happened, there are going to be mobs of angry people.

Over, and over, and over again Wall Street put together packages very similar to the over-simplified example just provide. Take 50 loans of $10 each, mix in some very confusing speculative derivatives, label it a $5,000 package, and receive half the proceeds of the sale as a commission.

Wall Street didn't do this for thousands of dollars, Wall Street did this for billions, and billions, and billions, and billions, and billions of dollars. And took half the money!

Folks, I couldn't make something this crazy up. Truth sometimes is stranger than fiction.

And now here we are in 2008, and those packages aren't worth the $5,000 that they are supposed to be worth. They are not even worth half of what they are supposed to be worth.

It's no wonder that the entire financial system of the world is teetering on the brink of collapse. They system has been abused to such an extent that it is technically insolvent.

You see, derivatives are nothing more than speculative bets, thus the example above of used lottery tickets."

(1) Can MAS establish whether the underlying securities were really AA securities or mixed with junk securities as described above? If the latter, then it was clearly a fraudulent scheme.

(2) The fact even now we do not know what the underlying securities are means that there is a lack of transparency. Does MAS support the sale of products in such an opaque manner? If not, then what relief should be granted to the investor for the loss suffered?

(3) How much did the distributor earn? If they earn more than the 5% or 6% offered to investors, then something is clearly wrong since the investors are the ones taking the risks.

Anonymous said...


That's a very interesting article. Thanks for the post. I absolutely support your questions to MAS. I feel that DBS is not transparent in revealing HN5 details.

Anonymous said...

Derivatives Week

N.Y. AG Probes Brokers On CDS

New York Attorney General Andrew Cuomo has subpoenaed eight interdealer brokers to produce data and other communication regarding their activities in credit default swap trading. People familiar with the situation say Cuomo, as well as the Securities and Exchange Commission in a separate inquiry, are looking to identify dealers who during August and September may have spread false information to manipulate CDS prices. Two of the exchanges uncovered were emails between Marcos Brodsky, a partner at Phoenix Partners, and Roman Shukhman, a credit derivatives trader at JPMorgan. According to documents, the first email from Brodsky suggested Goldman Sachs was looking to sell a CDS index position, while the second one, from Shukhman asked about seeking notification for when a Deutsche Bank had entered the market.

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