Friday, October 24, 2008

CDS - Weapons of financial mass destruction....

The banks' move to compensate vulnerable investors first after they were urged by MAS to "do the right thing" has a few strings attached. Vulnerable investors will be asked to sign a statement to say that they will not participate in any lawsuits against the banks for mis-selling. The existence of vulnerable investors is the best evidence that widespread mis-selling has occurred. Divide and conquer. The best way not to pay everyone fully is to pay some people first - the vulnerable investors are called "deserving investors" in various press release. So what does that make the rest of the investors? Drag the compensation process, case by case, by then the protests would have died down - with the old aunties compensated, the sympathy of the public would wane and the govt will try to move on. Like I said in my earlier posting, our victims are lucky that the same product was sold in Hong Kong. There will be some pressure to apply resolution is arrived at in Hong Kong - if they compensate everyone there, hopefully everyone here is compensated. The Hong Kong govt has taken a hardball approach against the banks with investigations, threats of sanctions etc they have pledge to do everything they can to bring justice to the victims. I've heard no such pledge from Lim Hng Kiang - just this denial of responsibility:

'So MAS has never said that these are risk-free products or low-risk products or safe products"- Minister Lim Hng Kiang
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Buffett once said that CDS (Credit Default Swap) were weapons of mass destruction. By now everyone who has been monitoring this crisis would know what a CDS is. A CDS is an insurance that one can buy in case a company defaults on its debt. You lend $1M to company A by buying its bonds but you are afraid that company A might collapse. So you go to an insurer, Company B, to buy a CDS that pays you in full if company A collapses. The problem with CDS is that you don't have to own the bonds to buy the insurance. What happened is that many hedge funds and individuals who want to bet that company A might collapse can go to Company B to buy insurance. Company A might have issued $100M of bonds but because the CDS market is unregulated, Company B might end up selling insurance for $1B worth of company A's debt i.e. through CDS, debt that does not exist is insured. Now if company A collapses, company B has to pay $1B to the purchasers of CDS. Right now CDS have been sold to insure $62T (yes trillions) worth of debt - that is more debt than the sum total of the corporate bonds and US govt debt. Company B itself might have debt that is insured by company C. If company A collapses, it might cause B to collapse because it sold so much CDS ...and if B collapses, C might collapse. ...then we have CONTAGION.
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There are other effects of CDS and some of it is linked to the falls in the stock market:
  • Short sellers short the bonds and stocks of a company.
  • They then buy CDS - pushing up the price of the CDS for the company.
  • CDS price is used by banks and investors as an indicator of credit worthiness so when the CDS (insurance premium) goes up, the company is perceived as risky. They will sell the bonds & stocks of the company to trim their exposure. This causes the stocks price to drop. Falling stock price can cause rating agencies to downgrade the company causing further drops.
  • The short seller can then cover for a profit.
The most scary effects of CDS might come later as the economy weakens and companies default on their debt in large numbers. This will cause an endless wave of bankruptcies that will bring down the entire financial system. That is why Bernanke is pushing for a stimulus package to soft land the economy. This package has to be large enough to delay or spread out company bankruptcies...so that the CDS can expire. They have to step in to regulate the amount of CDS issued or prevent the issuance of new CDS.
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You will know by now that the purchasers of minibonds and high notes unknowingly became sellers of CDS i.e. insurance sellers. But the damage is not limited to minibond, high notes, Pinnacle notes....many investors who purchased structured products are not even aware that there are problems with the products they own. Take the example of GE's Grandlink Choice Notes, although the number of credit events required to make these notes worthless has not occurred the price of these notes have fallen substantially because the probability of hitting that number of credit events by the time the notes mature is very high i.e. probability of becoming worthless is not low.
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GreatLink Choice (Aug 2013) 0.244
GreatLink Choice (Dec 2013) 0.210
GreatLink Choice (OCT 2012) 0.280
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I think investors have to be wary of any solution in the minibond & high notes fiasco that involving having them hold those notes to maturity. It seems like a good idea on the surface because right now the underlying securities of the minibonds fetch a very low price - we will know what they are worth when the Hong Kong banks are done with the valuation in a matter of days. The logic is investors may stand a better chance if they are held to maturity. Please be careful with that because they valuations may be worse if held to maturity just like those GreatLink Choice notes - I can buy them now for $0.24 when they once sold for $1 - but you think they will be worth more upon maturity? I think investors should not stop pursuing their rightful compensation due to mis-selling even when a new swap counter party is found for the Lehman Minibonds. I know Tan Kin Lian is has referred a few possible the new swap counter parties to MAS. Please think about it carefully - banks who are guilty of mis-selling are still guilty of mis-selling - those risky products are still remain risky with new counter parties. I think while everyone is trying to help, they have to be careful with the solutions. The situation is likely to become worse with the recession, holding a risky product to maturity MAY result in a worse outcome than making banks buy back at the current market price. I believe the Hong Kong govt is trying to get the market value first, then use evidence of mis-selling to force the banks to compensate fully. It is very easily to slip up and let the banks get away once the counter-party is found. I hope everyone involved in helping these investors be very careful.....otherwise the investors will lose out and the banks will go unpunished.

4 comments:

AlphavilleSG said...

Good Morning Everyone!

STI looks like it is heading to towards history! Asian financial Crisis redux! SBO helmets on!

LuckySingaporean said...

alphava]illesg,

This is the point when people are either too afraid to buy or want to buy but are out of money.

Many smaller caps don't even trade so those who want to raise cash sell bluechips like I said in my previous post....I believe we are at a near term bottom.

I remember the day the market bottomed in the asian crisis very well.....volume was thin and there was dumping of bluechips...the last of the funds desperately wanting to get out at any price. today looks no different

Anonymous said...

Hi Lucky Tan,

before you start rambling on your blog about CDS bullshit, get your facts right about these products.

Take the Greatlink choice notes, you cant buy they are non-tradable. There is (obviously) no secondary market for ILPs.

Plus no matter what the price is at the end, the policy holder gets everything back if the losses is still within the loss cushion level.

However, i must comment that the way some notes were structured, were just too complex for the gen public to understand, let alone invest in. I also did not like the fact that the financial institutions had passed on the risk of financial institutions failing to investors by using nice packaging and the illusion of high returns without ensuring their product distributors had explained the risks involved to clients.

Anonymous said...

I look at all the confusing discussions regarding complex structured products.

I wondered, why don't simply buy shares of SBS Transit and SMRT given that their dividend yields is comparable to returns from these structured products also.