CDS - CDO and others financial weapons of mass destruction

I just renamed that thread in order to follow up the discussion we started here regarding CDS and CDO - Sauros



Société Générale is set to report €1.3bn ($1.8bn) in losses from credit default swaps when it reports second-quarter results next month, muting its return to profitability.
The French bank said it expected to register on August 5 only "slightly" positive net income in the quarter, in spite of strong results from its corporate and investment banking arm. It forecast a "significant negative impact" from CDSs and from mark-to-market losses on its debt.
SocGen said the trade value of its CDSs, which the bank took out as insurance against default on various corporate loans, had fallen as credit spreads tightened amid reduced risk aversion since the end of March.
The cost of insuring European investment-grade corporate debt has fallen significantly since March 31, with the iTraxx Europe index tightening 53 basis points to 119bp.
In a statement, SocGen said it expected the cost of risk to reach a level comparable to the that in the first quarter, and that it would continue to reduce its exposures.
The group’s tier one ratio is forecast to remain stable, at about 9.2 per cent.
In May the lender surprised the market with a first-quarter net loss of €278m, confounding expectations for a €350m profit, as a result of worse-than-expected writedowns.
Olivia Frieser, senior credit analyst at BNP Paribas, said: "The market has tightened significantly and in that sense, the CDS losses are not surprising. SocGen will not be the only bank to suffer from this, and from the mark-to-market losses on its own debt.
"As far as hedging the loan book is concerned, the bank has been rather conservative in the recession, and now as the market has improved, it has been hurt by the tightening of credit spreads."
The amount, at €1.3bn, was "pretty big" but seemed to be a "one-off", Ms Frieser said.
"SocGen are saying their operational performance is solid and the cost of risk will remain similar, so I’m not too concerned."
SocGen released the update at an extraordinary meeting on Monday, in which shareholders voted by a majority of 80 per cent for Frederic Oudea, chief executive, to become chairman as well.

Credit Default Swaps can be the next big hit, making the subprime crisis appear as a drop. To follow up closely
I'll say more later

please explain how CDS's are used and the nature of the market and how its structured for us Non-bankers!!!

Thanks!

-snapman

Good question Young Man, the Credit Default Swap are just the latest generation of Financial weapon of mass destruction...

It's not easy to define briefly how a CDS works but roughly : a CDS works like an insurance contract on an underlying credit (a corporate name for instance) where a counterpart, the purchaser of protection, pays quarterly a premium the other counterpart, the seller of protection, on a given notional amount. The premium paid, called the Spread, corresponds to the risk premium for the underlying credit (as viewed by the market at the moment of the trade..)
In the case the underlying credit defaults (Bankruptcy, Failure to Pay, Restructuring of the debt), the purchaser of protection is compensated for the loss made on the credit (basically receive the notional amount - the recovery value of the referenced debt).I guess you can find good definitions of CDS on the web... One i found decent and pretty clear is the one George Soros (himself...) gave in his latest book on the crisis.

Now, more practically, CDS are a way to take an exposure on the underlying credit and might be considered as the "Futures contracts" of the credit markets. When you purchase the protection through a CDS you actually "short" the underlying name like you can do with an equity or a future.

For instance, Alcoa 5Y CDS trades today at 4.50% p.a, if you short it and buy protection today, you will pay every year 4.5% of the notional amount of the CDS to be "protected" against its default. Now tomorrow, if there are "bad" news on Alcoa, it would be considered more risky and the premium to pay would increase (we say the spread widens). Let's assume it goes to 5%. Your Mark-to-market profit as a shorter is 0.50% times a factor, called the "risky sensitivity", close to the remaining maturity of the CDS (or to the duration for people familiar with bonds)

Now a few points why I argue that's a financial weapon of massive destruction, the list is not exhaustive, I may give more points and detail further those ones in a later post :

- Actually CDS constitute synthetic bonds where a high leverage (1/1.5%) is granted : it means technically a credit exposure much greater than the actual debt of a corporate can be traded

- As a CDS allows to transfer credit risk, a participant can pile up massive amounts of exposure transferring his/her current credit risk to others market counterparts (replacing his/credit risk by counterparty risk)

- At the end, Insurances are provided by risk takers for which insurance is not the job, typically Hedge Funds (now this being said, the insurers like AIG did the HF's job ie speculate...)

- The CDS is the base element of more complex Synthetic Corporate CDOs, those ones unlike their Subprime CDO cousin have not really burst yet...

Ah thank you very much for making CDS much clear for me! I like the explanation Alcoa, it helps a lot!

CIT Group, hitting the news headlines with its potential bailout and bankruptcy, is one of the most used names in the European synthetic CDOs, along with VW and in the main US CDS index
To be followed very closely.

Myself and Group ANLZ were pretty bear on citi to begin with, just an ugly chart overall and poor management. They are way to big and falling apart from within, but then again Id probably want to back this up with some equity fundamental analysis :p

The impact of a bankruptcy ? systemic risk ?
As seen on CIT's website http://cit.com/about-cit/vital-role/index.htm

"It may not be a household name, but CIT has a million business customers that rely on the company"

"We are talking about business that make up the backbone of the economy"

"CIT plays a vital lending role to over 1,000,000 small and mid cap businesses"

The Vital Role of CIT

Over 1,000,000 business customers depend on CIT to provide the financing they need to run their businesses. And for more than 100 years, CIT has remained committed to the lending needs of the small and middle market – providing needed capital to markets that other larger and smaller financial institutions often don’t.
The current financial challenges in the market haven’t wavered our commitment to the businesses that count on us. To get a sense of the vital role CIT plays to small and middle-market businesses throughout the US, let’s look at the role it plays in two important sectors at thecenter of the current credit crisis.

The importance of CIT to the retail industry

CIT is the leading factoring company in the US. Factoring is a crucial part of ensuring the retail industry can fill their shelves with the products they sell. If, for example, a small dress manufacturer delivers a shipment of dresses to a retailer, CIT “factors” their invoice, taking on the responsibility of procuring payment from the retailer – providing them with the capital they need to continue their business. Without CIT as a factoring partner, manufacturers would find it more difficult to maintain the capital they need to produce the products that US retailers need.

The importance of CIT to small businesses

According to the SBA, small businesses make up more than 99.7% of all employers and create 75% of net new US jobs. And for nine straight years, CIT has been the #1 SBA 7(a) lender in the US – and the top lender to women, minorities, and veteran entrepreneurs for the last six. CIT provides the vital capital that mid-size and small businesses – from private schools to restaurants to veterinary hospitals – depend on to keep their company’s dreams alive – including commercial real
estate financing, construction loans, franchise financing and more.

Snapman wrote:

bear on citi to begin with, just an ugly chart overall and poor management.

on CITI ??? Interesting : Typo or lapsus ???
Unless you have an inside information we don't know, just pm me

http://www.hedgeweek.com/articles/detail.jsp?content_id=342730

The majority of credit default
swaps products, which are blamed for adding significant systemic risk
to the global financial markets, will never be centrally cleared in the
US and Europe, according to research by Tabb Group.
'Central clearing is undergoing considerable change brought on by
the domino-like impact of the sub-prime mortgage crisis, the loss of
major firms, the seizing of credit markets and the bailout of major
banks - challenges exerting pressure on industry participants and
regulators to develop a better clearing model,' the report states.
The continuing credit crisis puts the bank community, already
disadvantaged by CDS clearing issues, in a vulnerable position with
diminished negotiating power to ward off regulators seeking to lower
banks' risk profiles and reduce their balance sheets.
Recent exposure to risk in the derivatives markets has fueled the
call for the financial industry to mandate central clearing of
derivative products, CDS in particular.
However, the authors say that while clearing securities is fairly
straightforward, CDS clearing is not, because CDS agreements can be
outstanding for years and need to be risk-managed daily.
'CDS clearing is more about managing risk, margin and workflow than
transferring securities title and facilitating payment,' says Larry
Tabb, founder, chief executive and co-author (pictured). 'The clearing
of CDS is not all homogenous and has different complexity levels.
Index-based CDS clearing is much more straightforward than clearing
single-name CDS or CDS tranche products. We believe the most
significant CDS clearing challenges come from five major issues:
product complexity, valuation, liquidity, interoperability and
counterparty-risk.'
One of the challenges with CDS clearing is simply the global nature of CDS.
'Most clearinghouses are local, as members, products and regulators
typically are regulated nationally. For clearing of over-the-counter
products to succeed, all of the participants must adopt standard
contract language, structure, trade matching, affirmation and
communication timeframes. But one of the primary challenges for
effective global OTC trade clearance is the lack of consistent access
to clearing corporations by potential participants, because scale and
critical mass maximize the value of clearing.'
CDS clearinghouses generally provide five major services -
comparison, trade guarantee, novation, margin management and
netting/compression - and strive to reduce risk, increase operational
efficiency and honor members' obligations when counterparties fail.
When markets are running smoothly, most members focus on the
operational benefits of clearinghouses from streamlined workflows,
reduced credit vetting and increased credit lines.
'But this is only part of the value,' says Robert Iati, partner,
global head of consulting and co-author. 'The real benefits are
realized when things go wrong - really wrong. Without central
counterparties, the insolvency of a single organization could impact
the entire financial system with one organization's problems having a
deleterious impact on their trading partners, creating a domino effect
across the market.'
TABB Group believes there will be CDS CCPs in the US and Europe for
CDS agreements. Dollar-denominated products will most likely be cleared
in a US-based and regulated entity and Euro-based products will be
cleared in a European platform.
'The larger question, though, revolves around what happens to the
Euro-platform,' says Tabb. 'Will there be one platform for Eurozone
only and another for European non-Eurozone members? Will the platform
be London-based, offered through players such as NYSE Euronext bClear
or ICE Clear Europe or will flow consolidate to a more continental
platform such as Eurex?'
The need for competition in the CDS clearing space is being driven
by six factors: opportunity, jurisdictional squabbles, cost, multiple
CDS products, risk mitigation and dealers do not want to put all of
their eggs in one basket - at least at this time.
'CCP competition is possible, yet competition in the CDS clearing
space is fraught with complexity, due to the heterogeneity of national,
fiscal, legal and regulatory structures of the individual markets and
the varied economic interests of market participants.'