11/15/2008Are Credit Swaps Insurance?Are CDS Insurance? Credit Default Swaps (CDS) are used as insurance for risk protection against defaults of bonds and mortages. Although they are like insurance they actually are not based on the same principles as insurance. Hence, they are not allowed to be sold as insurance. A slight diversion, rental car protection is never presented by the rent a car dealer as insurance since it is not regulated by the insurance industry. The same is true with CDS, they are not regulated by the insurance industry and even worse, they are not regulated at all at this time! One stipulation with insurance protection is that you must have an interest in the risk you are insuring. This stipulation is for good reason, would you want someone you did not know take out a life insurance policy on your life? This is quite basic, but believe it or not, CDS coverage can be taken out on securities (bonds and CDO mortgages) which you do not own. It is easily imagined that buyers of CDS will have an interest to have the insured bonds or mortgages fail. As an example, you are not required to own GM bonds, but you still can buy a CDS on GM bonds. And guess what, you would be wanting GM to fail. This is like shorting the stock market but you are shorting the credit market. Insurance (Property and Casualty) is based on actuary research. Actuaries research assumes variables change over time and areas and they work on averages which are predictable over long periods of time and over wide areas of the insured. An example would be the variable of weather, hurricanes risks occur in cycles and in areas. Historic data shows patterns hence allowing actuaries to evaluate risk over a long period of time and over regions. The weather patterns change and hence the variables is re-evaluated and updated. They also assume that the insured houses are not independent variables but rather dependent on each other by the area which they resided and time which losses occur. Hence they model a distribution of risk with dependent variables. The bad modelling of CDS assumed independent variables for each risk, hence not accounting for many defaults in a region or during a period of time. The insurance industry thus sets aside capital to pay claims for periods when hurricanes are prominent, and for areas where hurricanes are prominent. While losing money in an area where hurricanes hit and during hurricane periods when hurricane hit, their capital reserves keep them solvent over the long haul and over a wide insured area. Well that is the game plan! CDS on the other-hand, assume credit defaults are independent variables. CDS are NOT modelled to assume that risk tends to happen in time and area clusters. The math models for most CDSs seem to have assumed that mortgage risks are independent variables, and risk is evenly spread out over time and area. This was not the case! More failures in California and Florida and more failures in 2008. What are Credit Default Swaps A credit default swap (CDS) is a of credit derivative which was intended to behave as an insurance contract, providing the buyer of credit with protection against default risks. The Credit buyers of corporate bond, mortgages buy credit default swaps as insurance to protect against a default by the issuer of the credit. The buyer of the credit default swap is the Protection Buyer, the seller of the credit default swap is the Protection seller. The following illustration depicts the credit default swap transaction between the risk seller, and the risk buyer.
Source:Credit Derivatives and Synthetic Structures, John Wiley &Sons. 2001 CDS Markets: Three - CDS ReferenceTypes: Two - CDS Maturity time: 1 to 10 years The CDS Markets are basicly divided into three markets: corporate, bank credits and emerging market sovereigns. CDS reference entities may be a single credit entity or multiple credit entities. Multi-credit CDS reference entities may reference a portfolio of credits or a CDS index. A CDS maturity range is from one to 10 years. Why CDS? CDS are sold and bought to reduce risk on credit such as Corporate bonds and Mortgages. There are other events that are non-risk events which buyers seek CDS. In addition to hedging event risk, the potential benefits (this has recently turned out not be as beneficial as once thought) of CDS include:
The performance of credit default swaps, like that of corporate bonds, was planned to be related to changes in credit spreads. This sensitivity was to make them an effective hedging tool that can assume exposure to changes in credit spreads as well as default risk. Well this may have been the idea but Libor spreads have increased recently (until the TARP) and these derivatives did nothing to protect bonds or mortgages. Credit default swaps have created opportunities to new arbitrage opportunities, particularly in global markets that do not have the transparency or efficiency. Well, in well establishes markets as in US and Europe, transparency and efficiency must have been lacking also. The International Swaps and Derivatives Association has released letters stating best practices to help increase transparency and efficiency for CDS markets. CDS and Virtual Bonds and Mortgages CDS unlike insurance is based on beting. There are always two sides for a bet. This beting became contagious among investors and investment banks to such an extent that there were not enough mortgages nor bonds to satisfy the demand for CDS! So what did our ingenious banks and investment bankers do? - they created virtual bonds and mortgages!. When a bet-er wanted to bet on the risk of a bond or mortgage, the bet-er would find a bank or investment bank to buy a CDS, this enabled the bank to create another bond (virtual creation) identical in every respect to the original. But there is one big difference, there was no actual homeowner, borrower or corporate issuer. Since the existence of an owner of the credit debt did not exist, then what were the underlining assets of these virtual debts? There were none - just virtual assets! These virtual assets were just bets made by the CDS buyer with the investment banker or banker. These virtual bonds and mortgages were in essence sold with the CDS and the buyers were paying an insurance premium, which was similar to the interest on a mortgage, to the bankers. The fact: there was no real mortgage or bond in existence. And guess what? - those interest payments were not virtual! They were in real hard cash. Seems like the bankers do like virtual payments! The bankers could not find anymore unqualified borrowers to borrow money to buy a house hence they created them out of a virtual finance and they were creating them 100 if not 1000 times over. This may explain why the losses are hundred times greater than the outstanding loans. There are 100 of times more CDS contract capitalization than there are of mortgages! Yes virtual capitalization - how could anyone trust this system? This ability to buy insurance on assets that you have no insurable interest (virtual assets) in, has turned the market into a huge beting game. It is totally unregulated market. Just think of the problem of this system? If someone you do not know is allowed to buy an insurance policy on your home for the risk of fire, how would you sleep at night? It would be to his advantage to have your house torched! Luckily CDS do not insure for homeowner casualties but rather for defaults on mortgages. One can easily interpolate, that forces in the marketplace would encourage bad loans so they could profit. I woulder if government offices which mandate banks to make bad loans had officials buying CDS wishing for a crash in the credit market? There are very wealthy people because of the the credit market crash which makes me wonder if there were pressures creating the fall! Image another situation. I can only hope regulators do not allow CDS to replace life insurance - imagine that someone you do not know is allowed to take out life insurance on your life! This is currently not legal thanks to regulation! Author: Morrell Insurance Staff. Source: Pimco Website, Tag: Insurance News 11/13/2008ISDA, BIS - Credit Swaps Default Volumes - Credit CrisesCredit Default Swap (CDS) Volumes Decreasing Credit Default Swaps act as insurance for mortgages and bond defaults. Reduction in contract volume is considered positive since it should increase transparency. This reduction in contract volume is also known as compression. The Bank of International Settlement reported that the volume of credit-default-swap contracts outstanding fell in the first half of 2008 in their November report "Monetary and Economic Department OTC derivatives market activity in the first half of 2008". The following section is section I.1 from this report: CDS volumes decline (November BIS report Monetary and Economic Department OTC derivatives market activity in the first half of 2008.) CDS volumes decline for the first period ever since publication of the statistics began in December 2004, the notional amounts outstanding of CDS contracts saw a decline of 1% compared with the notional amounts outstanding at the end of 2007 (Graph 1 and Table 4). Despite the decline in outstanding volumes, the gross market value for CDS contracts increased by 58%. Gross market values rose for both single- and multi-name contracts. While single-name CDS contracts grew by 3% to $33.3 trillion, the outstanding volume of multiname CDS contracts, a category that includes CDS indices and CDS index tranches,declined for the first time since publication began in December 2004. The outstanding amount of multi-name CDS contracts decreased by 6.5% to $24.0 trillion in the first half of 2008. 
The decline to a large extent reflects early agreed terminations or netting of outstanding CDS contracts. Multilateral terminations have had a substantial effect on thesize of the CDS market in recent years. This trend continued with increased strength in the first half of 2008, when contracts totalling $17.4 trillion were terminated, mainly in the multi-name segment. This reduced the rate o fincrease in the outstanding amounts by nearly 30 percentage points. Last month, the International Swaps and Derivatives Association (ISDA) also reported that industry initiatives such as "compression," which involves ending existing CDS trades and replacing them with a smaller number of trades that leave a portfolio with the same risk profile, had helped reduce notional outstanding CDS volumes in the first half of the year, to $54.6 trillion from $62.2 trillion.The following section is their October news release: NEW YORK, Friday, October 31, 2008 - The International Swaps and Derivatives Association, Inc. (ISDA) today applauded a number of industry initiatives that have had the beneficial effect of reducing notional amounts outstanding in credit default swaps (CDS), significantly reducing operational, legal and capital costs for industry participants and improving operational efficiency in CDS. In 2008, efforts toreduce notional outstanding amounts have been rewarded by a decrease of over $25 trillion in CDS notionals. This reflects a range of activities, including compression exercises run by Trioptima, Creditex and Markit. In addition, auctions and settlements of the recent series of credit events, including Fannie Mae, Freddie Mac and Lehman Brothers, have proceeded smoothly. This year to date, Trioptima has reduced by $24.5 trillion the amount of CDS notional outstandings through its series of compression cycles (also known as tear-ups), which have included index, tranche and single-name trades.Trioptima’s tri Reduce Credit service has been in effect since2005. Additional efforts implemented by Creditex and Markit that focus on the single name space began as recently as September now account for $550 billion in compressions. "This reduction innotionals is major progress by anyone’s standards, "said ISDA Chairman Eraj Shirvani, Co-Head of Credit Sales and Trading at Credit Suisse." That we have been able to reduce outstanding CDS by more than $25 trillion during this period of immense growth and activity for our products is testament to the will and force behind the industry’s efforts to keep operational issues firmly in check." "Notional outstandings are often misunderstood,” said Robert Pickel, Chief Executive Officer of ISDA. "While they tend to give an exaggerated impression of amount sat risk, reducing notionals helps both front and back offices. Cancelling out economically offsetting transactions reduces the cost and operational workload of managing those transactions." According to ISDA’s semi-annual survey to mid-year 2008, the notional amount outstanding ofcredit default swaps (CDS) decreased by 12 percent in the first six months of the year to $54.6 trillion from $62.2 trillion. For the same period,Trioptima reported $17.4 trillion in completed CDS tear-ups.Subsequent notional reductions would bring CDS notional outstandings to $46.95 trillion before accounting for new trades since July 1,2008. The notional principal, ornotional amount, of a derivative contract is a hypothetical underlying quantity upon which interest rate or other payment obligations are calculated. Notional amounts are an approximate measure of derivatives activity and reflect the size of the field of existing transactions. For CDS this represents the face value of bonds and loans on which participants have written protection. The following sections are for reads those who wish to know more about the International Swap and Derivative Association (ISDA) and the International Settlement Bank (BIS). The about pages from their web sites are provided below. International Swaps and Derivative Association (ISDA) Web Site Information About ISDA ISDA, which represents participants in the privately negotiated derivatives industry, is the largest global financial trade association, by number of member firms. ISDA waschartered in 1985, and today has over 850 member institutions from 57 countries on six continents. These members include most of the world’s major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities. Since its inception, ISDAhas pioneered efforts to identify and reduce the sources of risk in the derivatives and risk management business. Among its most notable accomplishments are: developing the ISDA Master Agreement; publishinga wide range of related documentation materials and instruments covering avariety of transaction types; producing legal opinions on the enforce ability of netting and collateral arrangements (available only to ISDA members); securing recognition of the risk-reducing effects of netting in determining capital requirements; promoting sound risk management practices, and advancing the understanding and treatment of derivatives and risk management from public policy and regulatory capital perspectives. Bank for International Settlements (BIS) - Web Site Information About BIS The Bank for International Settlements (BIS) is an international organisation which fosters international monetary and financial cooperation and serves as a bank for central banks. The BIS fulfils this mandate by acting as: a forum to promote discussion and policy analysis among central banks and within the international financial community a centre for economic and monetary research a prime counterparty for central banks in their financial transactions agent or trustee in connection with international financial operations The head office is in Basel, Switzerland and there are two representative offices: in the Hong Kong Special Administrative Region of the People’s Republic of China and in Mexico City. Established on 17 May 1930, the BIS is the world’s oldest international financial organisation. As its customers are central banks and international organisations, the BIS does not accept deposits from, or provide financial services to, private individuals or corporate entities. The BIS strongly advises caution against fraudulent schemes. The establishmentof the BIS The Bank forInternational Settlements was established in 1930. It is the world’s oldestinternational financial institution and remains the principal centre forinternational central bank cooperation. The BIS was established in the context of the Young Plan (1930), which dealt with the issue of there paration payments imposed on Germany by the Treaty of Versailles following the First World War. The new bank was to take over the functions previously performed by the Agent General for Reparations in Berlin: collection, administration and distribution of the annuities payable as reparations. The Bank’s name is derived from this original role. The BIS was also created to act as a trustee for the Dawes and Young Loans (international loans issued to finance reparations) and to promote central bank cooperation in general. The reparations issue quickly faded, focusing the Bank’s activities entirely on cooperation among central banks and, increasingly, other agencies in pursuit of monetary and financial stability. The changing role of the BIS Since 1930, central bank cooperation at the BIS has taken place through the regular meetings in Basel of central bank Governors and experts from central banks and other agencies.In support of this cooperation, the Bank has developed its own research infinancial and monetary economics and makes an important contribution to the collection, compilation and dissemination of economic and financial statistics. In the monetary policy field, cooperation at the BIS in the immediate aftermath of the Second World War and until the early 1970s focused on implementing and defending the Bretton Woods system. In the 1970s and 1980s, the focus was on managing cross-border capital flows following the oil crises and the international debt crisis. The 1970s crisis also brought the issue of regulatory supervision of internationally active banks to the fore, resulting in the1988 Basel Capital Accord and its "Basel II " revision of 2001-06. More recently, the issue of financial stability in the wake of economic integration and globalisation, as highlighted by the 1997 Asian crisis, has received a lot of attention. Apart from fostering monetary policy cooperation, the BIS has always performed "traditional" banking functions for the central bank community (eg gold and foreign exchange transactions), as well as trustee and agency functions. The BIS wasthe agent for the European Payments Union (EPU, 1950-58), helping the European currencies restore convertibility after the Second World War. Similarly, the BIS has acted as the agent for various European exchange rate arrangements, including the European Monetary System (EMS, 1979-94) which preceded the move to a single currency. Finally, the BIS has also provided or organised emergency financing to support the international monetary system when needed. During the 1931-33 financial crisis, the BIS organised support credits for both the Austrian and German central banks. Inthe 1960s, the BIS arranged special support credits for the French franc(1968), and two so-called Group Arrangements (1966 and 1968) to supportsterling. More recently, the BIS has provided finance in the context -led stabilisation programmes (eg for Mexico in 1982 and Brazil in 1998). Author: Morrell Insurance Staff. Source: ISDA Website, BIS Website, BIS news Release, and WSJ article. Tag: Insurance News 11/7/2008The Morrell Insurance November 2008 NewsletterIntroduction - Welcome!
The Morrell Insurance Newsletter!
This Newsletter is sponsored by Wm. E. Morrell Inc.(Morrell Insurance, founded in 1909) for the purpose of having our subscribers current on insurance news, products, and services. Although in harder times, it is difficult to reflect on blessings received throughout this year, our staff wishes you a very Happy Thanksgiving Day.
Helpful Insurance Information and Tips
Auto Terms, Homeowner Terms, Safety Tips, Money Saving Tips
The National Grange Mutual Insurance Company (NGM) is one of the many insurance companies which Morrell Insurance represents as an Agent. NGM is part of the Main Street America Group. Although we market NGM products mainly for commercial customers, Main Street America does provide helpful information for personel lines products. We have posted on our Blog their article on Auto, Homeower, Safety and general Insurance Tips. The article links to mutliple sites providing vast but easy to read information on topics such as Winter driving tips, Fire prevention, Hurricane preparation, Money saving tips, Emergency Management, Homeowner safety and much more!
See our article on Helpful Insurance Information - Safety Tips at The Lower New York Insurance Blog. NY Regulation: Financial Guaranty Insurance Companies
Financial guaranty insurers (FDI), Governor David Patterson
The Insurance Property and Casualty (P&C) Insurance Carriers have withstood favorably the credit crunch of resent. Much news has been posted on Credit Swaps and the downing of AIG. Credit swaps are financial derivitives used by financial quaranty insurers (FGI) to insure certain types of securities such as bonds and commercial paper. This type of coverage is not based on the same insurance practices as the P&C insurance carriers. In The Lower New York Insurance Blog and in last month’s Newsletter, we had posted several articles on insurance companies solvency. See our articles on Insurance Companies - Insolvencies/ Guaranty Funds , Property and Casualty Insurers and Bailout and Are Insurance Companies Solvent?- AIG as an Example . On September 22, 2008, the New York State Governor David Patterson and Superindentent Eric Dinallo released a letter from the New York State Department of Insurance on Best practices for financial guaranty insurers. From his letter the first two sections are copied and posted in our Blog for your reading. The full document Circular Letter No. 19 (2008) can be found on the New York State Website. See our article on NY Regulation: Financial Guaranty Insurance Companies: at The Lower New York Insurance Blog. Blog Sponsored by Morrell Insurance Tag: Insurance News 10/26/2008The Morrell Insurance October 2008 NewsletterIntroduction - Welcome!
The Morrell Insurance Newsletter!
This newsletter is sponsored by Wm. E. Morrell Inc.(Morrell Insurance, founded in 1909) for the purpose of having our subscribers current on insurance news, products, and services. Our staff hopes you had a Happy Columbus Day. Stay clear of Spooks, Goblins, Ghosts and all other things that go "bump in the night" this Halloween! Insurance Companies Solvency
Financial Collapse - AIG - Insurance Capital
The current Financial Crisis has affected almost all of us in some way, either in our IRA or 401K balances, obtaining loans and prospects of new business Since the AIG turmoil, questions about the solvency of Insurance companies are coming forward. The good news is that Property and Casualty (P&C) subsidiaries of AIG appear to be in good shape unlike the credit-swap businesses of AIG to insure securities. One possible Silver Lining is P&C carriers may not have a big hit in this crises - let’s hope. See our articles on Insurance Companies - Insolvencies/ Guaranty Funds and Property and Casualty Insurers and Bailout and Are Insurance Companies Solvent?- AIG as an Example at The Lower New York Insurance Blog. How to Submit a Claim
Auto, Home Collision or Lose and Claims
Submitting a claim should be straight forward. When a loss occurs, an Independent Trusted Choice Agent will "stand by you until the claim is settled". Having an agent whose staff that helps you today is the same who will serve you for years to come, will give you confidence that your claim will be resolved to your satisfaction. Knowing that the people who sold you the policy are the same people helping you resolve your claim will put you at ease! Although your Independent Agent will stand by you until your claim is settle, there are still some important tips you should know about handling a collision or lose and the associated claim. See our article on How to File an Insurance Claim at The Lower New York Insurance Blog. See our Web version of this Newsletter. Tag: Insurance News Auto Insurance - Competitive Comparison Quotes and Best PracticesWe all like to get the best deal for insurance coverages, and exploiting this need are competitive comparison website providers. These sites provide a service to a user to deliver multiple quotes from several carriers and brokers. These sites are typically providing Car insurance quotes. An UK regulatory body, the FSA has lead a recent investigation on several car insurance comparison providers. They found that some providers are not working to best practices in terms of providing accurate and relevant results. Before presenting this investigation report, it may be helpful to present some facts on the who and what of the FSA.
So, what is the Financial Services Authority (FSA)? I will quote from their website: The Financial Services Authority (FSA) is an independent non-governmental body, given statutory powers by the Financial Services and Markets Act 2000. We are a company limited by guarantee and financed by the financial services industry. The Treasury appoints the FSA Board, which currently consists of a Chairman, a Chief Executive Officer, three Managing Directors, and 9 non-executive directors (including a lead non-executive member, the Deputy Chairman). This Board sets our overall policy, but day-to-day decisions and management of the staff are the responsibility of the Executive. And, what is the FSA mission? I will also quote from their website: We are an independent body that regulates the financial services industry in the UK The FSA investigation found the following four items of good and bad practices:
The full report is available from their website for further reading. Since this is a UK investigation on practices in the UK, it may not apply to the US. Since the UK markets and manner in doing business is very similar to the US it is understandable that such not best of practices may also be present in the US. Many carriers themselves will give competitive quotes from competitive carriers, which has one think are they slanting the results to make their quote more favourable. An Independent Agent represents many carriers hence, presenting to a buyer the best carrier for buyer’s needs without a bias. The reasoning is since they represent the carriers for which they are comparison quoting, they should not have a bias for one carrier or another carrier. Keep looking for competitive pricing but be careful where you obtain your comparison information. Blog Sponsor: Morrell Insurance Tag: Insurance News Author: Morrell Insurance Staff. Source: Financial Services Authority (FSA) Website. |
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- FSA - An UK Independent Regulatory Body.