This is a nice example of the mispricing of risk and the related fallacy of netting in the derivatives markets which I discussed the other day, Critical Mass: The Mispricing of Desrivatives Risk and How the Financial World Ends.
It makes the assumption about risk in Black-Scholes look like a firecracker.
Not everyone has a Tavakoli-class analyst watching their back. I suspect that there are a lot of unintended bagholders blissfully walking around out there. They are one flick of a button away from financial evisceration. They just don't know it. The implosion of MF Global was just a taste.
And that is what keeps the Fed and the ECB awake at night.
"One well-known, well-respected, American investment bank asked me to consider protection from one of their “transformer” vehicles. They asked if the bank I worked for would intermediate a credit default swap transaction. Requests for intermediation are common. Many banks need an OECD bank counterparty for regulatory capital purposes. If the structure is right, the intermediation fee can allow the intermediary bank to earn a reasonable return on the minimal capital required, and all parties are satisfied.
The investment bank sent over their documentation. It was a paltry two-page document, whereas monolines will send a small booklet and make their lawyers available to discuss language details. When I looked at the document, I realized that the transaction was unsuitable. The following diagram shows the gist of the proposal, without embarrassing those who should be.
The investment bank assured me they would give me proper credit default swap documentation incorporating whatever language I wanted. If a credit event occurred, the bank would look to the SPE to make payment under the terms of the credit default swap, and I could design the terms.
I declined.
The investment bank invited me to a meeting at their offices. Four tailored Armani suits or better appeared at the meeting. If life were a fashion war, the investment bankers would be winning. They were confident and took victory postures. They attempted to persuade me to do the transaction. I continued to decline. I could sense their building frustration. They couldn’t understand why they weren’t getting my agreement. After all, they were taller, they were louder, and they were in the majority.
So what was the problem?
I picked up a cookie – the meeting didn’t have to be a total loss - and explained. I didn’t want to play their shell game. The problem was that my counterparty for the credit default swap protection would have been the SPE, a shell corporation. The only asset of the SPE was an insurance contract. The SPE would only receive a credit default payment after the insurance company determined its actual recovery after taking the matter through bankruptcy proceedings. The SPE had no way of assuring timely payment under the terms of the credit default swap confirmation.
The transformer wasn’t even worth the price of the child’s toy of the same name for the purpose they were suggesting. Sure, the SPE would have ultimately got paid and the bank would ultimately have received payment, but that wasn’t the point.
The point was that the SPE did not have the resources to perform under the terms of its transaction with the bank. It could not pay on a timely basis, no matter how cleverly crafted the credit default swap confirmation. If a credit event occurred, the bank would have to fund the credit default payment to the ultimate protection buyer until the SPE finally received its payment from the insurance company. The investment bank only offered the usual credit default swap intermediation fee, but the bank had additional risk beyond the credit default swap agreement.
It’s possible that the well-dressed guys weren’t aware of this until I pointed it out. The implications of that are ugly enough. But if they were aware, the implications are even uglier."
I hear that the bankers in question were annoyed because they were just doing God's work.
Coyle: I want to tell you my secret now. I see dead people.
Malcolm: Dead people like, in graves? In coffins?
Coyle: Walking around like regular people. They don't see each other. They only see what they want to see. They don't know they're dead.
