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Relevant Matt Levine: "Why Would Anyone Buy Credit Default Swaps on the U.S.?" https://archive.is/r0lI2 https://archive.is/r0lI2

by ucha 3y ago

H8crilA 3y ago
To be honest there were countries that defaulted on their sovereign bonds in their home fully controlled currency. Russia did this in the late 90s and took down LTCM, which was collecting premiums for insuring something that they thought is too illogical to ever occur. Well, it did occur. The reason why this is illogical is that there is very little distinction between "the dollar" and US sovereign debt. It applies to all countries in a similar situation, for example "the Yen" and Japanese Government Bonds. It doesn't quite apply to odd cases like, IDK, Spanish sovereign debt in EUR and "the Euro" since the Spanish government does not control all forms of the issuance of the currency of the bond.
- btilly 3y ago
  I don't believe that LTCM was insuring anything. What they were doing is identifying pairs of securities whose values had diverged and they believed would eventually converge. They would short the more expensive one and buy the cheap one. When they converged they would sell the no longer cheap one, use the money to close out the no longer expensive one, and collect a profit. However usually the reason why one was more expensive is that it had a more liquid market. So people could safely invest in it with money that they might need back quickly. This shouldn't matter if you planned to buy and hold though..at least in theory. But in the wake of the Russian default, liquidity became more valued. So people sought to get rid of illiquid securities and buy liquid ones. This meant that LTCM had shorted things that were rising in value, and bought things that were falling in value. So they had a loss. And as the shorts got higher, they wound up having to sell assets at a loss to cover their shorts. And now the temporary losses became very real ones, and drove them bankrupt. However, infamously, their investments made money in the end. They just weren't able to last long enough to benefit from it.
  - Scoundreller 3y ago
    > I don't believe that LTCM was insuring anything. While most of their strategy was convergence arbitrage, if I recall from the book, they thought of selling short equity options as a form of selling insurance. People buy these options to insure against some event and they expected more buyers than sellers, so LTCM figured they would profitably be the provider of it. Well-structured insurance is always a loss to the buyer (they take in more than they pay out).
    - edmundsauto 3y ago
      Been a while since I read the book as well, but wasn’t part of the narrative that their backstop as insurance enabled traders to take bigger and bigger bets, because they were hedged with LTCM?
      - djsavvy 3y ago
        Which book are your referring to?
        400thecat 3y ago
        When genius failed. there is no other book
      - seanhunter 3y ago
        I don't think any trader at a broker/dealer would think that, but it's possible people on the buyside thought that. There are plenty of funds who have a strat of just allocating say 95% of their holdings to the Russell or something and then putting the remaining 5% into some high-vol bets (like putting them into LTCM or whatever). They don't see it as a hedge exactly, but it means that they hardly need to work at all and when these pay off they say "look this is alpha" and when they don't they say "look, your error vs the Russell is less than 5%". Some funds (eg big pensions) have enough AUM that this risky piece is a very significant amount of money. I was working in the city shortly after LTCM failed and one of the interesting things I heard is that several large European institutions were using LTCM for overnight treasury. So at cob in Europe they would sweep funds into LTCM and then move them out the next morning for trading. If that was actually the case it would have caused massive fluctuations in their assets during the day which would be extremely hard to manage.
- Scoundreller 3y ago
  > It doesn't quite apply to odd cases like, IDK, Spanish sovereign debt in EUR and "the Euro" since the Spanish government does not control all forms of the issuance of the currency of the bond. While that's true, Spain could go the tax route and say "gimme more euros this year" or sell off assets it owns. I guess a printer is faster (if they feel like it) but medium-term, developed countries have lots of tools to pay down debts (if they feel like it). For some reason, people are more comfortable with inflation as a tax than taxes.
  - htss2013 3y ago
    >For some reason, people are more comfortable with inflation as a tax than taxes. Because everything doesn't inflate at the same rate at the same time. That means the average person has some theoretical room to reconfigure their spending to minimize the impact of inflation. Ordinary people have no legal options to minimize the impact of higher taxes. That requires expensive CPAs and lawyers.
  - singleshot_ 3y ago
    Well, I would assume apropos of my one economics class that the reason the average person doesn't care too much about inflation is that he has more debt than assets. If you ask me whether I want to pay a lot of taxes on my income or whether I want a big slice of my house to be free in inflation-adjusted dollars, here we would be, assuming I had no assets and most of my income went to my home loan. (Right? What did I miss by not taking Econ 102?)
    - Scoundreller 3y ago
      > the average person doesn't care too much about inflation is that he has more debt than assets What the average person forgets is that some people (and businesses) have wayyyyyy more debt, so when it gets diluted, they're a net loser on average. Kinda like getting a $1000 stimmy cheque while large capital owners gets their equity saved by government bailout money. Everybody wins something, but winning last place isn't a win when no real wealth was created.
- whitemary 3y ago
  > To be honest Thanks for coming clean.
khuey 3y ago
This is an extremely relevant Matt Levine piece. He gives an example of long-dated treasuries trading at 83 cents on the dollar. Today long-dated treasuries issued during COVID are trading well into the 50ies.
- H8crilA 3y ago
  That's not because of their credit risk but because they pay little to no coupon and get discounted through the interest rates. In particular imagine a treasury bond that will pay $100 in 10 years, you wouldn't pay $100 for that, would you? You'd instead put that $100 in a savings account (t-bills). The true credit risk on US Treasuries is indeed an abstract and mysterious creature. Nobody knows what would such a "default" mean in practice, what paper would get paid up and what paper would not get paid. Would commercial bank deposits at the Fed get paid? And if not, then what does it even mean to "pay in dollars"? Like how do you achieve "paying someone X dollars", do you deliver printed currency?
  - khuey 3y ago
    Yes, they're trading well under par because they're very long duration bonds and interest rates have moved against them, not because of credit risk. What Levine points out in the linked piece is that per the terms of these CDSes if the US technically defaults you can use the CDS to accelerate repayment of these very long duration bonds and get par back immediately rather than having to wait 30 years to collect. There's little to do with credit risk per se and everything to do with the interaction of the CDS contract and the current low valuation of certain debt instruments.
    - H8crilA 3y ago
      OMG, you made me read his article, and only then realized how ludicrous the "cheapest-to-deliver option" is. I had no idea you can send the CDS issuer any bond! Of course this is just an option for the scenario of "the congress got into a massive fist-fight and couldn't press the `yes` button on their voting machines for three weeks straight". What a hilarious piece of financial engineering.
heisenbit 3y ago
The way I understand the article: Insurance not likely to pay in case of small short cured default and in a major default the counterparty is at risk. So buying it as insurance makes no sense. But.. .. there are special rules which trigger even in a short default allowing a fair bit of money to be made turning the CDS into a sensible bet on a short duration US default.

Relevant Matt Levine: "Why Would Anyone Buy Credit Default Swaps on the U.S.?" https://archive.is/r0lI2 https://archive.is/r0lI2

by ucha 3y ago

Relevant Matt Levine: "Why Would Anyone Buy Credit Default Swaps on the U.S.?" https://archive.is/r0lI2 https://archive.is/r0lI2

H8crilA 3y ago

To be honest there were countries that defaulted on their sovereign bonds in their home fully controlled currency. Russia did this in the late 90s and took down LTCM, which was collecting premiums for insuring something that they thought is too illogical to ever occur. Well, it did occur. The reason why this is illogical is that there is very little distinction between "the dollar" and US sovereign debt. It applies to all countries in a similar situation, for example "the Yen" and Japanese Government Bonds. It doesn't quite apply to odd cases like, IDK, Spanish sovereign debt in EUR and "the Euro" since the Spanish government does not control all forms of the issuance of the currency of the bond.

btilly 3y ago
I don't believe that LTCM was insuring anything. What they were doing is identifying pairs of securities whose values had diverged and they believed would eventually converge. They would short the more expensive one and buy the cheap one. When they converged they would sell the no longer cheap one, use the money to close out the no longer expensive one, and collect a profit. However usually the reason why one was more expensive is that it had a more liquid market. So people could safely invest in it with money that they might need back quickly. This shouldn't matter if you planned to buy and hold though..at least in theory. But in the wake of the Russian default, liquidity became more valued. So people sought to get rid of illiquid securities and buy liquid ones. This meant that LTCM had shorted things that were rising in value, and bought things that were falling in value. So they had a loss. And as the shorts got higher, they wound up having to sell assets at a loss to cover their shorts. And now the temporary losses became very real ones, and drove them bankrupt. However, infamously, their investments made money in the end. They just weren't able to last long enough to benefit from it.
- Scoundreller 3y ago
  > I don't believe that LTCM was insuring anything. While most of their strategy was convergence arbitrage, if I recall from the book, they thought of selling short equity options as a form of selling insurance. People buy these options to insure against some event and they expected more buyers than sellers, so LTCM figured they would profitably be the provider of it. Well-structured insurance is always a loss to the buyer (they take in more than they pay out).
  - edmundsauto 3y ago
    Been a while since I read the book as well, but wasn’t part of the narrative that their backstop as insurance enabled traders to take bigger and bigger bets, because they were hedged with LTCM?
    - djsavvy 3y ago
      Which book are your referring to?
      - 400thecat 3y ago
        When genius failed. there is no other book
    - seanhunter 3y ago
      I don't think any trader at a broker/dealer would think that, but it's possible people on the buyside thought that. There are plenty of funds who have a strat of just allocating say 95% of their holdings to the Russell or something and then putting the remaining 5% into some high-vol bets (like putting them into LTCM or whatever). They don't see it as a hedge exactly, but it means that they hardly need to work at all and when these pay off they say "look this is alpha" and when they don't they say "look, your error vs the Russell is less than 5%". Some funds (eg big pensions) have enough AUM that this risky piece is a very significant amount of money. I was working in the city shortly after LTCM failed and one of the interesting things I heard is that several large European institutions were using LTCM for overnight treasury. So at cob in Europe they would sweep funds into LTCM and then move them out the next morning for trading. If that was actually the case it would have caused massive fluctuations in their assets during the day which would be extremely hard to manage.
Scoundreller 3y ago
> It doesn't quite apply to odd cases like, IDK, Spanish sovereign debt in EUR and "the Euro" since the Spanish government does not control all forms of the issuance of the currency of the bond. While that's true, Spain could go the tax route and say "gimme more euros this year" or sell off assets it owns. I guess a printer is faster (if they feel like it) but medium-term, developed countries have lots of tools to pay down debts (if they feel like it). For some reason, people are more comfortable with inflation as a tax than taxes.
- htss2013 3y ago
  >For some reason, people are more comfortable with inflation as a tax than taxes. Because everything doesn't inflate at the same rate at the same time. That means the average person has some theoretical room to reconfigure their spending to minimize the impact of inflation. Ordinary people have no legal options to minimize the impact of higher taxes. That requires expensive CPAs and lawyers.
- singleshot_ 3y ago
  Well, I would assume apropos of my one economics class that the reason the average person doesn't care too much about inflation is that he has more debt than assets. If you ask me whether I want to pay a lot of taxes on my income or whether I want a big slice of my house to be free in inflation-adjusted dollars, here we would be, assuming I had no assets and most of my income went to my home loan. (Right? What did I miss by not taking Econ 102?)
  - Scoundreller 3y ago
    > the average person doesn't care too much about inflation is that he has more debt than assets What the average person forgets is that some people (and businesses) have wayyyyyy more debt, so when it gets diluted, they're a net loser on average. Kinda like getting a $1000 stimmy cheque while large capital owners gets their equity saved by government bailout money. Everybody wins something, but winning last place isn't a win when no real wealth was created.
whitemary 3y ago
> To be honest Thanks for coming clean.

khuey 3y ago

This is an extremely relevant Matt Levine piece. He gives an example of long-dated treasuries trading at 83 cents on the dollar. Today long-dated treasuries issued during COVID are trading well into the 50ies.

H8crilA 3y ago
That's not because of their credit risk but because they pay little to no coupon and get discounted through the interest rates. In particular imagine a treasury bond that will pay $100 in 10 years, you wouldn't pay $100 for that, would you? You'd instead put that $100 in a savings account (t-bills). The true credit risk on US Treasuries is indeed an abstract and mysterious creature. Nobody knows what would such a "default" mean in practice, what paper would get paid up and what paper would not get paid. Would commercial bank deposits at the Fed get paid? And if not, then what does it even mean to "pay in dollars"? Like how do you achieve "paying someone X dollars", do you deliver printed currency?
- khuey 3y ago
  Yes, they're trading well under par because they're very long duration bonds and interest rates have moved against them, not because of credit risk. What Levine points out in the linked piece is that per the terms of these CDSes if the US technically defaults you can use the CDS to accelerate repayment of these very long duration bonds and get par back immediately rather than having to wait 30 years to collect. There's little to do with credit risk per se and everything to do with the interaction of the CDS contract and the current low valuation of certain debt instruments.
  - H8crilA 3y ago
    OMG, you made me read his article, and only then realized how ludicrous the "cheapest-to-deliver option" is. I had no idea you can send the CDS issuer any bond! Of course this is just an option for the scenario of "the congress got into a massive fist-fight and couldn't press the `yes` button on their voting machines for three weeks straight". What a hilarious piece of financial engineering.

heisenbit 3y ago

The way I understand the article: Insurance not likely to pay in case of small short cured default and in a major default the counterparty is at risk. So buying it as insurance makes no sense. But.. .. there are special rules which trigger even in a short default allowing a fair bit of money to be made turning the CDS into a sensible bet on a short duration US default.