Monday, November 24, 2008

Another Day, Another Theory

Felix blog has another entry with even more conjecture regarding the mysterious Berkshire credit default swaps.  The assumption that can't die is this: 

 The quoted price on Berkshire credit defaults last week is meaningful.  Exactly how many swaps were sold and at what prices?  We don't know, because the market is an unregulated, over the counter market that seems to be used for speculation more then hedging.  How else can you account for the $50 trillion in notional swaps -- which is a staggering figure?  Much higher then the value of the referenced debt.  

There has been a lot of discussion lately about how this market may be involved in manipulation of stock prices.  See my previous posts for references to the WSJ article about the investigation regarding manipulation of Morgan Stanley's market price using a combination of swaps and shorting. 

The quoted cds prices are meaningless without volume data.  

Anyway, today's version is that the counter party itself is trying to hedge its exposure, after the fact, since the swaps are now more valuable.  

Let's say you're the investor who bought the equity puts from Berkshire -- and let's say that although Goldman might have brokered the deal, your contract is with Berkshire directly. As a large institutional investor, you mark your positions to market daily. The puts are part of your portfolio, and whatever value you put on them, that value has surely been rising substantially in recent months.

As the value of those puts rises, so your counterparty risk with Berkshire Hathaway rises as well.... [and] your counterparty risk is much higher than it was. After all, there's no point in paying billions of dollars for puts, if the counterparty you buy the puts from isn't going to be around to pay out on them at maturity.
Let's examine the assumptions.  A large institutional investor bought the puts.  The mark to market daily, and even though they weren't worried about collateral when they bought the puts, they are now.

First, the puts were bought for $4 billion.  A large sum of money.  But the firm(s) didn't see the need for hedging its $4 billion exposure.  However, now that the puts are worth maybe $8 billion, it is a huge issue for them.  $8 billion is bigger then $4 billion, but if you didn't ask for collateral at $4, why is is crucial at $8?

You just paid $4 billion for "insurance" from a AAA insurer.  You are now going to pay another 4% per year to insure your insurer?  And this is going to be bought from whom?  Goldman?  Citi?  A hedge fund?

$400,000 for $10,000,000 is another $460,000,000 per year for the next 5 years.  That's a lot of money for a remote risk.  And that's only buying cds's on the additional $4 billion.  

How about a single entity bought a single contract for $400,000 or $500,000 after shorting Berkshire stock?  

As far as the purchaser, they would be marking to market daily?????  There is no market -- this is a level 3 asset.  But they would remark these daily?  Maybe, but why?  Why did they buy them in the first place?  So they could worry about them?  

Which brings me to the only really interesting thing to me..... who bought them and why?  Here is a hypothesis.  Maybe a large insurer is selling variable annuities or some other product that is tied to equity indices.  And maybe the product guarantees that, at a minimum, the the payout won't be less then the initial investment.  That is a straight up hedge.

Another possibility is an entity (say a pension fund) that can't buy (more) equities for regulatory reasons but can buy securities that offer protection against loss of principal.  In other words, they should be buying bonds, but with the puts, stocks qualify.  Kind of crazy, but there are a lot of legacy regulations out there.

But here is the interesting part.  In a mark to market world, if the buyer owns the indices.  $39 billion of them, then the "delta" on that asset is 1.0.  For every dollar the index goes down -- the market value is one dollar less.  Thats mark to market, no?

If they bought American options, they would be hedged.  They could exercise the option at any time and have $0 losses.

With the European options, they wouldn't be hedged.  The delta on the European options is less then 25%.  They would still have to book $0.75 for every dollar their long position lost.  Something to think about.  

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