13 May 2009

"CDO contracts insured by CDS are in effect non-regulated banks" ~ So "Credulity is caught in a stress test" Lui

Excellent analysis from an insider who knows the ropes....

While margin payments do flow periodically between counterparties to rebalance changing risk exposures, the special conduits that hold CDO contracts insured by CDS are in effect non-regulated banks, much like hedge funds, with no requirements to hold reserves against a "Black Swan" event or a Minsky Moment that might cause a chain reaction.

A Black Swan event is a large-impact, hard-to-predict and rare occurrence that deviates beyond what is normally expected of a situation. This term was coined by Nassim Nicholas Taleb and summarized in his 2007 book, The Black Swan.

A Minsky Moment, named after economist Hyman Minsky (1919-1996), is the point in a credit cycle when investors develop cash flow problems due to spiraling debt they had been structurally compelled by systemic logic to incur in order to finance irresistible speculative investments offered by imbalance between the penalty and reward of risk caused by mis-pricing of risk, usually caused by excessively low cost of borrowing.

At the point of a Minsky Moment, a major sell-off would begin due to the inability to find counterparty to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market-clearing asset prices and a sudden, sharp drop in liquidity. The term Minsky Moment was coined by Paul McCulley of PIMCO (Pacific Investment Management Co) in 1998 to describe the Russian default that led to the collapse of hedge fund Long-Term Capital Management, as worked out by the late Hyman Minsky decades earlier.

According to the Bank for International Settlements, total outstanding CDS at year-end 2007 was $43 trillion, more than half the size of the entire asset base of the global banking system. Total derivatives amounted to over $500 trillion in notional value, spread out in the balance sheets of special investment vehicles (SIVs), CDOs and other conduits comprising the highly leveraged shadow banking system. July 2007 was the month the credit market imploded.


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