In Other News, Larry King is Selling Divorce Insurance
Many months ago, I quoted the brilliant Janet Tavakoli‘s book Credit Derivatives and Synthetic Structures:
The trader then went on to tell me that Commercial Bank of Korea would sell credit default protection on bonds issued by the Commercial Bank of Korea.
“That’s very interesting,” I countered, “but the credit default option is worthless.”
“But people are doing it,” persisted the trader.
“That’s because they don’t know what they’re doing,” I affirmed. “The correlation between Commercial Bank of Korea and itself is 100 percent. I would pay nothing for that credit protection. It is worthless for this purpose.”
The trader mustered his best grammar, chilliest tone, and most authoritative voice: “There are those who would disagree with you.” (p. 85)
Apparently, that anonymous trader—or another money-losing risk-mispricing hedge fund manager—is now running The Big C:
Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis. The firm has drawn up plans for a tradable liquidity index, known as the CLX, on which products could be structured that allow buyers to hedge a spike in funding costs….
“The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don’t worry about interest-rate exposures any more – they just pay a fee to hedge it,” he says.
Because if funding dries up, The Big C will be there to support you!
I thought this was an attempt to make money on a premium, but it isn’t:
Like a swap, the contracts envisaged by Citi would be entered into without an up-front premium, with money changing hands according to the index’s movements around a fair strike value.
So the model is actually that you pay a higher cost of funds during good times, and during bad times, depend on the ability of your counterparty to make you whole.
When banks do it, it’s called “deposit insurance,” and it is valuable because in the worst-case scenario, the U.S. Treasury can print money. Since—the last time I checked—Citigroup cannot do that, the option is as valuable as the ability of the bank to perform in a crisis. How did that work out last time?
I find it very interesting that Ms Tavakoli is the one voice that hasn’t been widely broadcast during the past two years in spite of the fact that she appears to be a font of information regarding the funny money activities of Wall Street. Even up to the present she is publishing damning information, but seeming ly continues to be ignored by the main stream financial press. An example; Details about the Goldman Sachs raid on the Treasury, AIG is just a convenient conduit:
Thanks for the connection Houghton.
Credit insurance is not my field (and certainly not Korean bankruptcy law!), but I’ve seen the notion that in US bankruptcy proceedings, the insurance is senior to just about everybody else — including secured bondholders. Might be smarter than you think! … or a whole lot worse!
Too bad that I never got the chance to play Shoot the Moon with GM — write a huge amount of insurance on the bonds, and use the proceeds to buy the company (for pennies) and retire the debt, and sell the now, debt-free company back to somebody who thinks he knows how to build cars for a profit.
Forgot that part, derivatives go right to the front of the line in bankruptcy as written into the 2005 act.
So the new department of Citi, CitiFP is going into CDS for hedge funds and such a novel idea! Once again premiums will be paid up front the same as was paid to AIGFP and probably pennies on the dollar derived from those premiums placed into a reserve. Its Groundhog Day! These last few sentences in the article wrap it up nicely.
“Chris Rogers, chair of statistical science at Cambridge University, said the only participants able to sell CLX-based products would probably be those who are too big to fail.
“This is basically a kind of insurance product. The main issue is: how good is the party issuing it? If it’s going to be paying out huge numbers in the event of a crisis, will it be able to meet it obligations? Insurers can buy reinsurance for their liabilities, but the buck has to stop somewhere – there’s a limit to how much a private insurer can pay out. Only the government can cover unlimited losses,” he says.”
Guess who will be covering these bets? “Uttering” or the passing of bad bank notes, checks, or forged documents is a crime and in Michigan they kick big butt for that because it is usually the little guy is doing it. For bankers its ok . . . We just came full circle with this. Is Joe Cassano running it? I heard he has experience on scams and is available.
What happened to our comments on Robert’s post on a similar topic.
I thought tha the credit default sawps that were issued by AIG were not technically insurance and that that was a major regulatory hurdle jumped over. If they were insurance then a reserve would have been required by law. Being only some form of financial derivative the only requirements for reserve would have been written into the agreement between the parties to the each deal. Wasn’t the point of developing such toxic waste the getting around the requirement for reserves to cover potential underwriting losses?