Q&A 12/13 and Credit Default Swaps

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Thomas Chancellor
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Q&A 12/13 and Credit Default Swaps

Post by Thomas Chancellor »

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Although the following e-mail correspondence about credit-default swaps was sparked by our December 2011 meeting, the information they contain is relevant to Q&A-12 and Q&A-13 of the Short Quiz for the January 2012 meeting.

---------------------------- Original Message ----------------------------
Subject: Re: Credit Default Swaps
From: Thomas Chancellor
Date: Thu, December 29, 2011 3:52 am
To: John Karls
--------------------------------------------------------------------------

Dear John,

At our last meeting, we had a brief discussion re credit default swaps. I expressed the view that, during the recent financial crisis, credit default swaps were used to bet on defaults of mortgage debt obligations in which neither party to the credit default swap contract had an interest (insurable or otherwise) in the mortgage obligation. You disputed this. I call your attention to the Wikipedia discussion of credit default swaps. The situation I described is there called a "naked" credit default swap.

Thomas


---------------------------- Original Message ----------------------------
Subject: Re: Re: Credit Default Swaps
From: John Karls
Date: Thu, December 29, 2011 9:37 pm
To: Thomas Chancellor
--------------------------------------------------------------------------

Dear Thomas,

Thank you very much for your e-mail.

It is not clear to me what your point is.

If your point is that the insurance contracts that were called credit-default swaps did not legally require the purchaser of the insurance to have an insurable interest, I agree.

That, of course, was the purpose of AIG Financial Products in inventing such insurance to concoct a name for the insurance that would fool the New York State Insurance Commissioner into not regulating these insurance contracts, especially not in requiring AIG and other mortgage-pool insurers to maintain adequate reserves to cover future losses.

And a by-product of the failure of the New York State Insurance Commissioner to regulate mortgage-pool insurance was that a purchaser of such a policy was not required to have an insurable interest.

However, if your point is that a significant percentage of purchasers of such insurance policies did not in fact have insurable interests, that is where we part company.

Several comments are in order.

Investors in mortgage-backed securities, beginning with Goldman Sachs, recognized that the return on mortgage-backed securities exceeded the market rate of return for limited- or no-risk investments by an amount that exceeded the insurance premiums that AIG Financial Products was charging for insuring the value of the mortgage-backed securities.

However, even though the New York State Insurance Commissioner did not recognize the mortgage-pool insurance as insurance, the investors led by Goldman Sachs did.

Investors led by Goldman Sachs recognized that AIG Financial Products, the proverbial "teat on the whale," did not have the net worth to provide the de facto reserves that would be required to assure that the insurance contracts would be honored.

Accordingly, investors led by Goldman Sachs required the parent AIG Company to guarantee the mortgage-pool insurance contracts known as credit-default swaps that were being issued by AIG Financial Products.

AIG had three huge successful businesses in addition to the "teat on the whale" = AIG Financial Products.

It was because of these guarantees of the mortgage-pool insurance contracts being written by AIG Financial Products that the AIG parent company became bankrupt, rather than just the insignificant (in terms of net worth) AIG Financial Products subsidiary. [Technically, the AIG parent company, though bankrupt, did not have to file a bankruptcy lawsuit because it was bailed out at the last moment by the Federal Reserve.]

The reason why I challenged you at our meeting was because the other participants seemed to be interpreting your comments as meaning that the credit-default swaps were not insurance contracts and that they were, by and large, purchased by speculators.

My challenge was (1) the credit-default swaps were in fact insurance contracts even though the insurance-regulators failed to recognize that fact, and (2) the overwhelming majority of such insurance that was written by AIG and others was in fact issued to purchasers who did in fact have an insurable interest, even though an insurable interest was not legally required due to the failure of the regulators.

I'm not aware of whether there are any reliable statistics regarding the percentage of credit-default swaps sold to purchasers that did NOT have an insurable interest.

However, although I was not involved personally with credit-default swaps, I knew all the players, including the head of AIG Financial Products and the attorneys for the AIG parent corporation who prepared the parent-company guarantees that were required by the purchasers of the swaps (as well as key personnel with other issuers of such swaps).

And the common wisdom seemed to be that the swaps were issued almost solely to mortgage-pool investors who DID have insurable interests.

Accordingly, I would have a heart attack to learn that there exist any reliable statistics that would show that anywhere close to 10% of the swaps were issued to purchasers who did NOT have insurable interests.

Any comments or questions would be welcome. Though I think I have already said everything I know about the subject.

I hope you and Denise have been having a very-enjoyable holiday season!!!


Your friend,

John K.


---------------------------- Original Message ----------------------------
Subject: Re: Credit Default Swaps
From: Thomas Chancellor
Date: Sat, December 31, 2011 2:38 pm
To: John Karls
-------------------------------------------------------------------------------

Dear John,

My point in the email is the one I made at reading liberally: Naked credit default swaps were used (and marketed by brokerage firms) as a way to bet against the subprime and other toxic loans that were packaged and sold by brokers to investors (made marketable by the AAA rating of the rating agencies) during the housing bubble. This makes as much sense as allowing me to buy fire insurance coverage on your house.

Of course, some of the credit default swaps were purchased by people who held the bonds (covered credit default swaps) and were protecting themselves. I don't know the percentages in 2006-2008; I don't think anyone does since the amounts of the contracts, their terms etc were non public. Apparently even the Fed didn't know. Some clever people who saw what was going on with these toxic debts jumped on the chance to purchase naked credit default swaps as a way to bet against these obligations; and they made a lot of money because AIG and others were willing to sell such contracts in exchange for very low monthly or quarterly payments. Apparently they believed the rating agencies as to the credit risk.

This was my point. I understood at the meeting that you disputed this. That's why I referenced Wikipedia.

Happy new year,

Thomas


---------------------------- Original Message ----------------------------
Subject: Re: Re: Credit Default Swaps
From: John Karls
Date: Sat, December 31, 2011 5:52 pm
To: Thomas Chancellor
-------------------------------------------------------------------------------

Dear Thomas,

It appears we are (and always were) in complete agreement = (1) speculators were able to buy mortgage-pool insurance contracts even though they did not have insurable interests because of the failure of the insurance regulators to regulate these insurance contracts, and (2) neither of us is aware of any credible statistics regarding the percentage of such insurance contracts sold to speculators (vs. investors who had insurable interests).

Happy New Year!!!

Your friend,

John K.

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