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Regulations for Credit Default Swaps (CDS)

Gladiator

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What regulations should be proposed for Credit Default Swaps? Other mortgage derivatives?

What disclosure should be required?

CDS as source of hte problem?


"The Fed could not let Bear Stearns enter bankruptcy because - and only because - the trillions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they’ve been carrying at higher values because they could say that they were insured for those losses."


Credit default swaps: The Real Reason for the Global Financial Crisis...the Story No One's Talking About. | Twine



"What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn’t have.

In short, what happened in one small AIG corporate subsidiary blew apart the largest insurance company in the world.

But there’s more - a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. Knowing what all this means for hedge funds, the credit markets and the stock market is the key to understanding where this might end and how. "




Credit default swaps: The Real Reason for the Global Financial Crisis...the Story No One's Talking About.


"Recent Releases

ISDA Master Agreements and Bridges

ISDA Credit Support Documentation, User's Guides and Guidelines

ISDA Master Give-Up Agreement and Compensation Agreement

ISDA Commodity Definitions, Exhibits Annexes and Confirmations (including Bullion)

ISDA Credit Derivatives Definitions, Supplements and Commentaries

ISDA Equity Derivatives Definitions and Confirmations

FX and Currency Option Definitions, Annex, Supplements and User's Guide

ISDA Government Bond Option Definitions and Confirmation

ISDA Convertible Asset Swap and Convertible Asset Option

ISDA Inflation Derivatives Definitions

ISDA Interest Rate and Currency Derivative Definitions, Confirmations and Supplements

Property Index Derivatives Definitions

Covered Bond Transactions – Riders to Schedule to the ISDA Master Agreement

Total Return Swap Documentation

ISDA Operations Materials, Novation Agreement and User's Guide

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ISDA - International Swaps and Derivatives Association, Inc.



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Gladiator

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New York to start regulating CDS in January:

"New state regulations will take effect on Jan. 1, but the governor said New York had jurisdiction to regulate only about a fifth of the sprawling market, and he called on the federal government to take steps of its own to oversee credit-default swaps, which have gone unregulated.

Credit-default swaps essentially function like insurance contracts to protect bond buyers from the risk that companies will default, but over the years they have become a favorite tool of speculators who use them to bet that a certain company will fail.

Exposure to the roughly $62 trillion market was one of the main reasons that the American International Group, the insurance giant, required a federal bailout, and contributed to the crises that led to the collapses of Bear Stearns and Lehman Brothers.

The governor’s move reverses previous state policy, which did not consider any credit-default swaps to be insurance products."




http://www.nytimes.com/2008/09/23/business/23swap.html

"October 3, 2008

The market for credit default swaps (“CDS”) has been under intense scrutiny and criticism. CDS have been viewed as a contributing cause of recent financial dislocations, second perhaps only to subprime lending. Concerns about AIG’s CDS exposure (or, more accurately, counterparties’ exposure to AIG) were an important factor in AIG’s government rescue. Lehman’s bankruptcy has raised the heat. Calls for regulation of and changes to the CDS market are loud and persistent.

A step back may be helpful here. CDS are privately negotiated bilateral derivatives transactions in which one party buys and the other sells credit protection against default by a reference entity. The CDS market is not heavily regulated in the United States; some would say it is unregulated but that is not entirely accurate. The Commodity Futures Modernization Act of 2000 created a category of derivatives called a “security-based swap” and CDS are viewed as coming within that category. Security-based swaps are subject to the anti-fraud provisions of the U.S. securities laws, but are not subject to most other aspects of those laws. They are also not within the jurisdiction of the CFTC. "




New York State Insurance Department to Regulate Credit Default Swaps

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Solidus

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Gladiator said:
"What regulations should be proposed for Credit Default Swaps? Other mortgage derivatives?"

Two ideas.

1) Collateral requirements should not be dependent on agency rating. ISDA CDS contracts had collateral requirements, but companies with AAA rating (ie. AIG) had much lower ratios. If the ratios were constant (or perhaps merely lower slope), than AIGs ratings downgrade would not result in implosion since collateral was already present.

I'm not well informed enough to extrapolate other consequences of this 'fixed' collateral requirement. Anyone have input on the virtues of variable collateral requirements tied to rating?

2) Federal Government has the responsibility for monitoring systemic risk, they currently don't effectively perform this task. Private actors have their best interests in mind, government should have "the system"s best interest in mind. To this end something like the following: Companies A, B, and C all have the same "exit strategy" (ie. method of hedging, all in CDS or all trying to short the same inter-related group of stocks / bonds), these companies make up X% of market which is above some threshold Y. Government directs companies A, B, and C to figure out amongst themselves how to re-arrange their "exit strategy" until the X% taking the same bet is below the threshold Y. Government should refrain from doing the choosing, but a "you have 2 months to agree to changes and implement them, or we will decide for you" ultimatum may be required. Maybe Companies B and C pay a premium to A to have it unwind it's hedge thus pushing X below Y. Other possibilities?

I have no idea what values of X and Y are reasonable or plausible, nor how to properly scope "inter-related group". I'm sure there's a better incentive method for getting companies to change their "exit strategy" than government ultimatum as well, ideas?

Gladiator said:
"What disclosure should be required?"

To the other party in the contract? As much as they require to close the deal. ISDA does have a standard "boiler plate" for a basis.

To the government? Size of position and collateral holdings. I believe those are already available to the government.

Gladiator said:
"CDS as source of hte problem?"

Not really (see the "Deregulation Meme" thread). If the CDS were only against "traditional" 30-yr mortgages there wouldn't be an issue (risk is better defined). If CDO / CDS buyers and sellers properly valued modern mortgage risk, there wouldn't be an issue. Scope of CDS market did create systemic risk, everyone was using CDS to hedge against mortgage risk. When a crowded theater is on fire and everyone runs for the same exit, people get burned.

J
 

donsutherland1

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IMO, derivative instruments should be subject to regulation. Some things I would like to see would include:

1. A derivatives clearinghouse to reduce counterparty risk. The Fed should oversee it.

2. Limits on the underwriting of CDSs based on an organization's capital, liquidity, etc.

3. Full on-balance sheet reporting of derivatives positions.

4. Disclosure of various risk scenarios (including that of a severe recession/depression) in the notes to the financial statements estimating the financial impact of those situations.
 
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Gladiator

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If an individual or institutional investors cosider investing in a bank, a thrift or an insurance company, how can the investor determin how much of the value of the stock is dependent upon mortgage deriviatives, and with what leverage?

If an inverstor loses money on a stock purchase, where full disclosure of leveraged mortgage derivatives was not made, what should be the remedies available to the such stock purchasers?

Suspension of assault laws, and publications of the private info of all officers of the obfuscating stock purveyor?


Credit Default Swaps can be tricky to enforce:

OverHedged: A Little Noted Case Regarding Credit Default Swaps Could Portend Major Problems for Financial Institutions

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