Annihilate the Perverse Effect of CDS

A stable and sustainable economic and financial system should have few positive feedback loops, or as some call pro-cyclic factors. Unfortunately, finance by nature tends to be pro-cyclic, thus the saying about bankers lending out umbrella when it's not raining. So one must be especially watchful of positive feedback mechanism in finance.

One unintended consequence of CDS is exactly the disastrous positive feedback. Bond holders with CDS protection would rather push the company into bankruptcy, as demonstrated by Lehman and Chrysler.

The bankruptcy code, whether by conscious design or not, disincentivize stakeholders from forcing bankruptcy except as the last resort. It achieves this effect by prolonging the process of stakeholder recovery and increasing the cost. This encourages creditors and owners to try to work it out, even through Chapter 11. After all, even though bankruptcy is no moral evil, it's still better to avoid it.

However, CDS changed the game dynamics (to be exact, the change is a compound effect of bankruptcy code change of 2005, which is disastrous in retrospect, and CDS). If you own bond and buy corresponding amount of CDS with physical delivery, you'd want the company to go bankrupt as soon as it shows the first sign of trouble and the bond devalues. You get 100% back on CDS settlement. It's much sooner than the end of Chapter 11, and you get back not only much more than at the end of Chapter 11 but even much more than if you unload the bond right now.

Before you cry "head off CDS", however, please realize it's not necessary to dump the baby with the bath water. As I said many times here before, CDS is just a tool. If it's caused bad effects, blame the people who use the tool or how its use is regulated, not the tool itself.

Here's how to save the baby while dumping the bath water.

If a bond holder also owns CDS, then her economic interest in the debtor is reduced by the protected amount. In bankruptcy court, her say should be reduced accordingly. The hedged interest is transferred to the CDS seller, who could/should replace the hedged bond holder in bankruptcy court.

Simple as that. I'd also argue that a shareholder with option protection should be pro-rated in a similar fashion on shareholder meetings.

There're always complications. For example, a shareholder with CDS protection could be incentivized to drive down the company. Bankruptcy code reform alone will not be sufficient to cover all bases, nor should it be the only tool. But at least it's a good start.

USD Can and Will Drop

Recently there's been a wave of blogosphere opinion that USD is a win-win bet. It goes like this: if the world economy gets worse or stays in the dumps, then USD will remain strong, as demonstrated by its performance since Sept 08; if the world economy rebounds, then USD will of course be strong.

It is the "of course" part that I have a problem with. There're two scenarios under which USD will drop, and only one under which USD will remain strong in the intermediate term (a year or two). But even under the last scenario, USD is likely to drop in the longer term.

1. The world economy stabilizes. Make no mistake, we're not there yet. It won't happen until at least the clouds of CEE debt/currency crisis, US/European banking and credit crisis, housing price, unemployment, and consumer demand start to dissipate. But when that happens, the world will be shifting away from USD assets. Furthermore, it is very unlikely that the Fed has enough political will to siphon the massive amount of USD cash it will have printed off the system early enough and fast enough to pre-empt the surge of inflation once the economy stablizes and credit starts to flow again.

2. The world economy stays sickly for years. Under this scenario, the Fed would likely continue printing massive amount of moneyfor awhile. This would put other countries at a disadvantage since nobody else has this kind of monetary leverage. Therefore, they would be increasingly determined to seek alternative reserve currencies. True, right now there is no alternative. But I don't think it's wise to misunderestimate the world's determination and creativity when defending their own economic and strategic interests. When such alternatives emerge, a big part of the world would not feel sorry to abandon USD, a once safe asset abused and discredited by the Fed and US government.

3. As I mentioned above, there're still numerous cloud overhangs. We are quite likely yet to encounter a few more trigger events. Under this scenario, USD would strengthen. But there's a limit to how long the perception of USD being the safe harbor can last. If the crisis mode continues for another year or two, the world would increasingly re-examine the assumption and seek alternatives.

In particular, I find the assumption that China will remain contend sitting in the USD trap laughably arrogant, short-sighted, and lacking imagination. It may happen in the end. But don't take it for granted.It'd take a fundamental shift in US' China policy for China to stop trying getting out of the trap. So far they've talked about SDR, arranged a sleuth of bilateral currency swaps, and piled up on gold. None of the approaches is the end solution. But it'd be foolish not to take their effort seriously.

I've been long USD (against EUR and JPY), gold and TIPS since the beginning of the year. I remain comfortable with all three right now. I trade the intermediate time horizon, from weeks to months. But I'll be ready to flip USD in short order going forward. Against what I don't know yet. We'll find out. But with the wave of opinion of USD win-win bet, I suspect we'll find out soon.

The Legal Scam of FASB Statement 159

1. Set up Company, go IPO.

2. Sell $1B bond.

3. Spread rumor of Company's demise. Or better yet, actually run Company almost into ground. Quickly.

4. Buy Company's bond at $40 on $100 par.

5. Book $600M profit, and pocket the $600M extra cash from bond issuance.

6. Retire as a rich hero.

BTW, you don't even need to actually buy the bond in order to book the profit, thanks to the infinite wisdom of FASB (aka FASB Statement 159). Yes, the $600M profit will disappear into thin air by bond maturity, if Company survives, that is. But who cares about next quarter, not to mention 10 quarters later. In any case, the extra cash is real if you manage to drive Company almost into ground faster than spending the bond issuance proceeds.

And if you can recycle these paper as cash through the Fed, you don't even have to worry about financing. Spend the bond proceeds, buy back paper, give it to Fed as collateral for cash, buy back more paper. Zero cost, zero risk, much reward.

This applies to loans just as well, as long as it's securitized and traded on secondary market.

In reality, it takes good research to locate current bond holders and may take some persuasion to buy it from them. But if the gloom looks real enough and you're crafty enough (e.g., gradually over a period of time, through a third-party broker), it can be done without raising too much suspicion.

It gets better. Once you have bought back almost all of your bond, you can set up a phony market price whereever you want.

Companies have actually bought back their bonds on the secondary market. I'm not saying any of them did it intentionally, as outlined above. But this doesn't change the fact that such scams are legal and plausible.

Unless the bond is callable, the issuer should be forbidden to purchase it on the secondary market, be it at discount or premium, and such accounting games cannot be played.In terms of interest rate risk, buying one's own bond from the secondary market is equivalent to having an embedded call option, which otherwise would result in a higher coupon. In terms of credit risk, it is equivalent to selling one's own CDS or life insurance (not considering differences in financing), it doesn't make sense, nor should it be legal, except in the wonderland of modern financial accounting and regulation.

Too-Freemarket Has Become Anti-Free-Market

I mean, our financial industry has so overgrown that it has taken over iconic manufacturers such as GM, GE, and Boeing and become their main profit center for years, even decades. It has hired so many traders who don't even understand their own trades, risk managers who blindly throw VAR at everything like snakeoil (or Gaussian distribution, or mean reversion, or my personal favorite, 40% recovery assumption), executives who don't know or even care about what their companies have been doing, programmers who don't understand anything about programming beyond the syntax, and a vast army of middle-management whose only job it is to foward emails and track status. It has hijacked world governments and public policy to such an extend thatthe society has no choice but to bail it out, because it is too big to fail.

But here's the rub: we're making it even more too-big-to-fail.

There is no stronger an advocate of free market and presumed righteousness of market pricing than Wall Street. But when Wall Street's puppet government, across two supposedly ideological opposites no less, insists on using public money to create an artifical market, you know it has gone too far.It has gone straight around the circle of Yinyang and become its own moral enemy, its own Judas.

Free market has committed suicide.

But it gets worse. The Unholy Ghost of Anti-Freemarket is still walking the Earth, preaching the same words to the Great Unwashed Public, who nod and chant in unison: Yeah! Thou shalt not nationalize! Amen! WTF?!

No, that last part was me.

Free market is inherently unstable due to built-in positive feedback, which is in turn due to human greed and fear among other behavioral patterns. This is the source for fat tail or Black Swan. We may never be able to eliminate the instability short of killing free market altogether.But pretending we're still a Freemarket while using public money to create an artificial market is sheer lunacy.

I'm still against government regulation. And what we have now is regulation to the extreme. Instead, we should let banks fail as they may, re-enact Glass-Steagall, and let free market return to Wall Street in the form of private partnership investment banks.

Derivatives is not the problem. The problem is people playing derivatives with other people's money.

Bonus is not the problem. The problem is maturity mismatch between bonus and risk, or letting incompetent managers allocate bonus based not on merit but on personal politics.

Even bubble is not the problem. It's inevitable (instability, positive feedback). The problem is denying the possibility of bubble in the name of omnipotent Freemarket.

Kill Freemarket. Long live the free market.

The Beginning of End for USD The Reserve Currency

I still can't believe it happened just like that. It's so unceremonial, it's a huge anticlimax.

I'm talking about the Fed announcement of the plan to purchase up to $1.5T debt. That's the last bullet in their clip. Lowering the rates further would be like firing from an empty gun, mathematically sound but a bit tricky technically. So the dollar tanked (makes sense), gold shot up (makes sense), treasuries shot up (what?), and stock market shot up (WHAT? Oh, ok, shot-term).

I suspect that, looking back 10 years from now, we'll realize this is the beginning of the end of USD's reserve currency status. Yes, people have been talking about the demise of the dollar for years. But so far everything else -- budget deficit, total debt, trade deficit -- has been gradual, and reversible at least in theory. This is the ominous turn of events that pushes it beyond the point of no return. Even if Fed miraculously manages to shrink its balance sheet back down in the future, which would require just too much political will and independence short of a Second Coming of Volcker++, the cherry is already popped. The confidence in US monetary restraint is gone. So much of what defines US and the world order hinges on the dollar's reserve currency status, I don't even want to speculate what'd happen when it changes.

But the announcement shouldn't be a surprise, though. The downside I mentioned above is long-term. Humans, indeed most animals, are evolutionarily conditioned to consistently overweigh short-term risk and underweigh long-term risk. Yes, the short-term risk is grave. But the short-term risk the government sees is not the real risk, but rather the pain it'd take to fix the real problem. So they did exactly the things they lectured, with condescension and moral superiority, Japan and IMF rescuees on not doing.

Ever seen a kid kicking and screaming, refusing to go to the doctor and go under the needle? That's what the government has been doing throughout the crisis.

But even for the short-term, I doubt the benefit will last. EUR and GBP are up, along with most other currencies. But hey, naughty girls need inflation, too. Chances are that Fed has more than just popped their own monetary cherry, they've started a new lifestyle of monetary promiscuity with abandon. Everybody goes monetizing their own debt, lending from the right hand to the left hand and, whoala, currency stops going up and wonderful, wonderful inflation everywhere.

But is this the real solution, I mean, even in the sense of superficial, short-term fix of symptoms? It is most certainly not. It's inflation for inflation's sake, which achieves nothing except stealing from the future generations. It's a race to the cliff.

I still can't believe it happened just like that.

It's time to buy gold and TIPS, maybe commodities, too.

Bailouts Forcing Surge in Systemic Risk

Imagine you're a bank. What do you at this juncture, wind down and go conservative or ramp up and take as much counterparty risk as you could get your hands on?

If you chose the former, you may be doing the responsible thing. But it would also the stupid thing. Here're the smart things you can do to ensure your prosperity, or survival at the very worst, in this wonderfully morally hazardous world:

1. Get your tentacles reached as far as possible, and as deeply as possible, into other banks, preferrably the biggest ones. Encourage your counterparties to do the same, but not directly. Rather, make long-winded chains so as to get around netting. Counterparty risk is your best insurance. The more counterparty risk others take on you, the safer you are.

2. With the counterparty web in place, take as big bets as you can get away with. If you win, you get rich, look smart, and get hailed as hero. If you lose, no worries. Government will bail you out.

This is exactly what many banks have done since the first AIG bailout. The world before Lehman bankruptcy may have been pretty screwed up in retrospect, but it was decidedly more sane than today in one aspect: risk carried at least theorectical downside. Back then, everybody would've stopped trading with AIG, C, and BAC if they had been in situations they're in today. Who in their right mind would trade with somebody who has a stock price of $0.35, with a market cap of less than $1B, and lost $60B in one quarter?

But that was stupid, of course; look what happened to Bear and Lehman. Now people have learned the lesson; let's continue trading. If you can't post collateral, no problem. Government will give you more cash or at least swap your ABCDO Squared Mezzanine into treasuries. Even if they don't, they'll give me more cash or at least swap my ABCDO Squared Equity into Fanny paper, which is about the same thing but worth a lot more.

Can you blame the banks?

Of course not. They're merely acting on their self-interest, which is exactly what they're supposed to do. It's the government's implicit guarantee of all companies that are mysteriously deemed too big to fail. All big banks have already been nationalized, except taxpayers pay all the price and get no control.

I know this question is vein but still, I can't help asking: why is AIG still allowed to trade, and by the same people? Just shut down everything except their insurance business, pay everyone $1M and ask them to please stay away from the office, go to Caribbeans or go fishing, just go. Taxpayers would've saved a LOT of money. And it would've been much more fair, sensible, and with much lessmoral hazard than what the government has done.

The Biggest Source for Risk: Government

The perpetual bailouts are wrong on many levels. Today I'll focus on just one. The government has become the single biggest risk in financial markets.

What will the next bailout do? Is it going to wipe out common equity? Preferreds? If so, will it be the C-series? S-series? Or will they screw the junior debt? Senior? Or are they going to let it fail? Or maybe they'll just keep on pumping money in?

With the perpetual, arbitrary, ever-shifting bailouts and interference in the market, the government has paralyzed the already-disfunctional financial market machinery. Regulatory and policy risks are scaring a lot of players to the sidelines, and at the same time creating huge arbitrage opportunities that could turn out to be equally lethal traps.

Take Citi for example. One possible explanation for C's precipitous fall last week is the perceived arbitrage between preferred and common shares, which called for longing preferreds and shorting common. But is it an arbitrage or a trap? The answer depends on how each series of the preferreds will be converted, which was very unclear when the bailout was first announced. It's an arbitrage if you assume all preferreds get the same treatment; otherwise it depends on the conversion formula, which preferred you bought and at what price (you can only buy the publically traded preferreds, not those held by Uncle Sam, Prince Talal, or Sanford Weill), and at what price you shorted the common stock. The latest report, last updated on 3/3, was that the discrimination against publically traded preferreds would not be "so bad". But still, the language is vague and non-commital.

Such confusion is much more common, and deeper, in fixed income and other areas of capital market. Which JPM bond is backed by the government? How strongly? But really? I mean, are you sure? Will Uncle Sam really tear through the veil of secrecy of Swiss banking or is it just a show? Who gets paid through the conduit called Assured Income from Government? What will happen when AIG loses another $100B next quarter? Will GS still get it or will the conduit be shut down finally? Will somebody high in Washington say/do something that pushes the Chinese over the edge and pricks the treasuries bubble? Who will take how much loss in forced mortgage mod? Or could it be a windfall in disguise in the fantacy land of modern accounting? Will they help European banks when the Eastern Europe Crisis of 2009 hits, or will there be another round of global meltdown?

It's uncertain enough without the government messing around. But if they have to mess around, can't they at least make up their mind and show some consistency?

You Can Give Me Money, But You Can't Make Me Lend It

I understand it's hard to argue for bank's case on anything nowadays. But I believe the old motto of "easy things are not worth trying" so I'll take a shot here.

(Speaking in evil bank's voice) Uncle Sam, do you want me to be a for-profit entity or a social service? Make up your schizophrenic mind quick because every hour in self-debate will put both of us, along with the society as collateral, in further limbo.

Even though I'm fundamentally a libertarian, I'm far from a fundamentalist libertarian. I readily concur some social services are necessary. I think forcing banks and investors to make mortgage mods is morally wrong nor will it work but I'll not argue it here. Let's assume for the moment we will make homeownership our social goal and banks will be the conduit. Fine. Then take over banks like Fannie and Freddie.

But if you don't have the stomach for it, then let banks be banks. Give banks a chance to do the right (economic) thing for a change. If they decide a credit is worth the risk, they will take it. If they refuse, generally speaking there's a good reason for it.They don't like anyone or hate anyone. They're for profit, remember?

If you force banks to lend to risky credit in this dismal climate, then you're forcing them to repeat the same mistakes that got us into this mess. Only this time you can't blame the banks. And you'd better be ready to keep pumping money into the system. Lots of it. For a long time.

And if you don't want to keep pumping in money, that's fine, too. Let'em fail. There'll be capable and hard-working people starting from scratch in no time. The market and the society will be much healthier and sustainable after rising from the ash.

Pick your poison.

Anything but what the government has been doing so far, which is absolutely the most convenient, irresponsible, morally bankrupt (there! I said bankrupt!), schizophrenic approach.

Re-privatization, Not Nationalization

No, it's a bit more than rhetorics.

Those who're opposed to government intervention in the banking industry, or anything beyond no-string-attached handouts anyway, wisely choose the word "nationalization" to describe it. The neutrals go along. But I don't understand why those who are for it fall for such an obvious rhetorical trap.

As far as I can tell, no self-respecting mouthpiece is calling for nationalization of any banks. Notionalization is not the goal, but rather a temporary measure, a transient point leading to a better, healthier, and more sustainable form of private banking. The Whitehouse declaration today about how they've been supporting a private banking sector "for quite some time" would be comical if it weren't so sad. Really, only for "quite some time", as opposed to since day 0? Does that imply state-owned banking was on their mind some time ago? Now that's worrisome.

No, I don't seriously believe Team Obama has ever entertained the idea of making banks nationalized as an end-point. I bring it up here only to highlight the sad rhetorical mess we've gotten ourselves in on this critical issue. Messages in the public arena as well as from the government have been drowning in mind-boggling confusion. Real issues such as corporate governance, entitlement society, structural corruption of government regulators, chronical decline of savings and manufacturing are pushed aside by relatively trivial, shallow soundbytes such as office furniture and corporate jet. Congress would've appeared only clueless, no worse than the two executive teams so far, if they hadn't put up pathetic political show after pathetic political show bellowing down shallow, tedious indignation on bank CEOs.

Can we at least get one tiny technicality clarified so as to avoid another sad day like Friday? Namely, are we talking about nationalization or re-privatization?

That's a rhetorical question, as I made clear at the beginning of this post. Of course we're talking about re-privatization, aren't we?

I can't speak for others but here's what I mean by re-privatization.

1. Let insolvent banks fail. Throwing money into insolvent banks in a bad, global, likely prolonged recession/depression will not work. Reasons for why this will not work and examples of how this has not worked have been cited ad nauseum in media and blogosphere so I'll not repeat them here. But some people get a mental blackout right here. But if we could peek beyond the mental block just for sport, perhaps the Great Beyond is not so scary after all.

2. Government immediately puts failed bank(s) into conservatorship. Here's the scary N word but hang on with me for a moment. Guarantee deposits as usual. Restructure outstanding debt. Let CDS settle and common/preferred equity do whatever the market fancies to do. Hang on.

3. Segregate the deposits and traditional commercial banking part, re-IPO it, and regulate them as good'ol commercial banks. Re-enact Glass-Steagall and make it a requirement for any foreign banks wanting to do business here. Push for an international standard along the same line later.

4. Set up an RTC as custodian for "bad assets", classified by a one-time sweep. Minimal administrative cost, no trading. The government has incentive to minimize potentially good assets in this pool so as to faciliate the IPO and sale (see below) process and maximize return.

5. Sell the remaining investment banking and capital markets part to private investors ASAP. Make a law forbidding them to go IPO. As I argued before, private partnership is probably the only sustainable governance model for investment banking and capital markets, and public ownership is most certainly not. Extend the safetyguard to all foreign banks doing business here.

Of course, there're a lot of details that need to be worked out. A critical factor is the international aspect. If Uncle Sam unilaterally takes over a multi-national bank, guarantees deposit accounts in US branches but without regard to those in other countries, it could get very ugly very fast. International coordination and cooperation is pivotal. But if there's ever a time for true American leadership, or true American bullying if you prefer, this is it. Get Cheney to chair the G20 meeting with his loose shotgun on the table if necessary. I'm not saying we could force US interest on everyone. But let's face it, it requires power politics, in addition to masterful diplomacy, to get the global villagers to agree on anything without getting hopelessly boggled down on each one's petty issues and historical grudges.

True leadership, both domestically and internationally. Do we have it?

When Will the USD Carry Trade Finish Unwinding?

Back in Oct 08, I speculated that USD had become a major carry-trade currency, along with JPY. Bad news for US economy made USD stronger, much like what had been happening to JPY for the past few years. That was a dramatic reversal against the usual carry-trade target currencies such as AUD and CHF (Swiss Franc), and to a somewhat lesser degree EUR and GBP, since early 06. FX rates are one of the most complex dynamics in the complex dynamics of financial world. But when bad news is good news for a currency, it's a sure sign of it being a pivotal carry-trade currency.

Recently, and especially today, we're seeing another proof of USD and JPY being the carry-trade currencies. It's implausible to argue the recent USD strength has anything to do with safety or even risk aversion, the latter being the usual explanation for carry-trade currency strength. It's more like forced, maybe even panicking, unwind of existing carry trades.

Hence lies the surprise to me as a casual observer of the FX market: what, there's still a massive amount of carry trades open, a year and half after the crisis blew up in the US and half a year after the crisis became an exported, global one?

But the more interesting question is this: when will this unwinding finish and bad news for US economy becomes bad news for USD? That would mark the next turning point in the dynamics for USD and JPY.

I would appreciate readers' enlightenment as to how to find data, or even if just a guesstimate, on the scope of carry trades.

Can We Go Back To The Old Wall Street?

Michael Lewis hit it on the head when he called the IPO of Salomon Brothers the "beginning of the end of Wall St". Goldman CEO Blankfein almost suggested we go back to the old Wall Street of private partnership in an FT article yesterday.

Let's face it. We screwed up by dismantling Glass-Steagall, a lesson learned the hard way during the Great Depression but thrown away when complacency and greed got the better of us. Basel II is a joke. The European model of combined commercial and investment banks creates way too much systemic risk. Heck, people on the two sides don't even like each other. Commercial banks serve too much social function (taking deposits and making loans) to be aggressive profit seekers. They must be closely and prudently managed and regulated. Investment banks (including capital markets), on the other hand, must be aggressive profit seekers and risk takers in order to serve their social function, which is to keep the capital markets somewhat efficient and fair. But institutions playing such a pivotal social role cannot be public.

Why? Because public ownership is a farce. The concept of "ownership" is a mirage for most modern companies big enough to pass the IPO threshold. But it's like a CDO Squared backed by mirages when it comes to investment banks. I've written specifically about this before so I'll not repeat it here.

But I'd like to stress another point here: regulation alone cannot possibly be adequate for a beast like investment banking. Two reasons:

1. Regulation by definition is rigid and static, while investment banking by nature must be nimble, innovative, and flexible. The result is you end up with either too little regulation, too much, or the wrong kind. Most likely you end up with D) All of the above.
2. Regulators cannot possibly understand the going-ons at investment banks even if they are honest, earnest, and have the authority. There's just too much going on, too fast, that is too complex. There's no way the regulatory bodies can compete with investment banks for high-quality talent without severely corrupting the process, thus defeating its purpose.

While some regulation on investment banking is necessary, it takes the watchful eyes of private partners to keep the beast from hurting itself and taking the society with it. Only private partners have the power, the incentive, and the capability to do so.

So separate commercial banks from investment banks, nationalize the latter, set up RTC for the latter, and then auction off investment banks to private partners. Out of the ashes of the Wall Street everyone loves to hate today, we'll have a lean and nimble Old Wall Street back in no time.

Without costing nearly as much taxpayer money.

Furthermore, not only should we re-enact Glass-Steagall, we should insist on making it an international standard to level the playing field and avoid future contagion. If someone refuses to adopt the standard, they would not be allowed to compete in the member markets.

Whatcha Gonna Do When 1+1 No Longer Equals 2?

Several widely respected experts have recently said the same thing: all US/European banks are insolvent if they mark everything to market.

How could this be, after so much write-downs and bailouts? I have no evidence to support or refute them. So my only logical choice is to join them.

My guess is, forget about CDS/CDOs. They're past problems, known problems. The hidden toxic dump remaining, the next bomb that keeps blowing up, may be the highly customized, highly complex structured deals they've been accumulating over the years. There's no wholesale market for any of them. Decomposing them carries substantial risk of mismatching due to the various disparities in the market today. Hedging? If Merrill got into a $15B trap doing the simplest CDS/bond basis trade, how can you have any confidence of any hedge/arbitrage/trade working as expected?

Here lies the biggest surprise to the financial world so far throughout this crisis. 1+1 no longer equals to 2.

If the industry is still struggling to explain the CDS/bond basis and determine whether and how to trade it, then good luck with the structured deals. I've seen some of them. It could easily take a highly specialized expert days to digest it, break it down to pieces, figure out how it'd behave under different scenarios, and calculate risk based on existing standard models. Except, of course, the assumptions made by many standard models have been proven way off-base by the market over the past year. Now, on top of this, take away 1+1=2.

Portfolio decomposition is THE foundation for synthetics and much of structured finance. If you take this away, you take away a big part of the foundation of financial pricing. But the world should not be surprised. It happened before for Long Term Capital. Calling the market stupid is as productive as calling reality stupid, even though you could very well be correct. The market is just pricing in some factors omitted by standard models. I have a model that can explain and quantify these factors but it's beyond this article and beside my point.

My point is,
1. it's futile to expect anybody to price/hedge lots of the structured trades meaningfully, even with the best/purest intentions, and
2. even if there is a liquid market, the pricing mechanism is so different now that many tried-and-true, fundamental assumptions in finance are no longer valid.

It's a wild new world. It may be rational still, we have to assume it so. But it's so fundamentally different that it'd take some time (at least months, quite possibly years) for the industry to make sense of it. If you think I'm exaggerating, think about the impact of abandoning Libor and the US treasury curve having a credit spread of 50 bps embedded.

What we're going through is wholesale, across-the-board, fundamental repricing of every financial instrument in existence.

So why are we still debating about which banks are good and which are bad, what their valuation should be, whether to take away bad asset and how to value them, etc etc?

Forget about valuation and risk management! It's not possible! It's a new world that we don't understand!

There, feels better already. Now we can calm down and think rationally.

Now that we admit we don't know how to price them and cannot possibly know for a long time, the solution becomes apparent: don't price them.

1. Ask banks to do a one-time categorization of assets they deem "hard to price". This hard-to-price pool cannot change in the future.
2. Sweep these hard-to-price assets aside. Get rid of all hedging and stop all trading of this pool. It will be held to maturity except, for perpetuals (e.g., real estate), the bank can decide when to sell (but never buy back into the pool) subject to some hard deadline (e.g. 30 years).
3. Provide a total cost, not including operational/financing costs/hedging costs so far since initial trade, future collateral/margin costs, and any realized P&L due to position changes so far since initial trade.
4. The total cost becomes a nominal addition to the bank's Tier-2 capital base for regulatory and accounting purposes.
5. As assets in the frozen pool mature, the realized P&L with respect to the reported cost is accounted for in Tier-2 capital.
6. The frozen asset can be used as collateral, at reported cost, at the Fed window prior to maturity.
7. Everything else will be marked to market.

The final settlement at maturity is the only sure answer to the perennial question of "what's its worth".

Currently banks do have some flexibility in which assets to mark to cost. But there're too many restrictions in some regards while too much flexibility in others. By doing it across the board (regardless of whether the asset is owned by the mortgage division, a trading desk, or the financing department) and at the same time, one time only, we eliminate the regulatory arbitrage and uncertainty.

Under this system, banks will have to prove some illiquidity threshold for assets they put in the pool. Such threshold will be determined by expert panels set up by the government. Other than the illiquidity criterion, banks are free to choose which ones to keep frozen. If they choose assets already marked down, they'd get a one-time boost, which they must disclose in the quarterly report.

The merit of this approach is to provide capital relief to the banks without government subsidy, government guarantee, or some other artificial price intervention. Banks would not be forced to sell assets and/or raise capital in the worst moment. It's the ultimate bailout without spending a penny.

The hope is that, when held to maturity, the macro-economy will recover and most assets will pay off. Nobody is seriously predicting Armageddon after all. In fact, China used essentially the same approach circa 1998 and it worked out beautifully.

This is not the best solution, of course. The best solution is to let all banks fail, use a small fraction of the trillions of bailout money to support deposits and the massive ensuing unemployment, let the good and capable to restart from scratch. We'd have a lean and healthy private partnership Wall Street in no time, in which risk and reward are matched in magnitude and duration, owners actually have control, and stupidity/mediocrity has nowhere to hide.

But that's no going to happen, is it?

Careful Playing with Black Swan

Now that everybody and their stock broker have bought Taleb's book, everyone knows about black swan. A good number of people may have played with it, I fear.

If you bought deep-out-of-money long-term puts any time after last September, good luck, you probably won't get back to the waterline even if the market goes down 20% from here. Aside from time-decay, the implied vol (VIX) was so hysterically high last October that you have a good chance to lose money even if the market goes your direction.

As usual throughout our evolutionary history, most people follow and lose. Only a select few have what it takes to do the Black Swan Trade.

I'm not talking about the math behind options. Black and Scholes Themselves may not have what it takes to do the Black Swan Trade. I'll use a little anecdote to make my point.

A friend of mine bought some deep-out-of-money LEAPS puts on SPY back in April, 08, when market started rallying on Bear Stearns' bailout. He said "shit is gonna blow up again in September". Pretty succinct, don't you think? But market kept going up, VIX kept going down, as a result he was bleeding a little every day. But early September brought rumors about Lehman. He was almost back above the water! Here's what happened as he told me later (I'm paraphrasing):

There's a good chance that the government will bailout Lehman in the end. So I'll close this one and roll it forward. Then, after I sold the puts, I thought "VIX just shot up and, if the gov bails Lehman out this weekend, I'd be killed by the double whammy of market going up and VIX going down -- look what happened after Bear...just too much risk opening a position now. I'll sit the weekend out."


The rest, of course, is history. With hindsight, he could've opened another Black Swan trade right after the Lehman weekend anyway and made some money. But the risk of doing that back then was also high. Regardless, the point is that the satisfaction was gone. The glory was tarnished. Once you get that close to a ten-bagger, a two-bagger is hardly enticing.

Here's a guy who understands the math, the pitfalls, all the greeks. He saw it coming while the herd was cheering. He just left his would-be-perfect Black Swan Trade open for one weekend.

The Black Swan Trade requires extraordinary courage, persistence, and patience. The herd says you're wrong. The market proves you're wrong day after day for months or even years. Wife complains. Peers jab at you at the bar. Yet if you slack for one day, you may miss the single day you've been suffering months/years for.

It's a miserable way to make money.

No wonder Taleb quit his fund. No wonder he has such a strong urge to brag and show he's right. Now that he's totally famous and proven right, I'm still not sure he's satisfied or that he can ever be. (I'm not trying to psychoanalyze him per se. This is just a generalized observation.)

Maybe it's time to take another look at the Black Swan Trade you did.

Crisis? What Crisis?

The near-term crisis is over.

Libor is coming down. Mortgage rates are coming down. Bond market of all maturities and for all stripes of borrowers has thawed. Prime consumer credit is moving. CDS spreads have come down from hysterical/historical levels, although it's likely never to come back to pre-crisis levels -- before it disappears. There're still a few anomalies remaining in the market, most notably the spread between nominal and inflation-indexed treasuries. But these anomalies are generally understandable and temporary.

This is not to say all problems are over. Employment and housing will lag at least a few months. The on-going earnings season will be ugly. The tsunami may very well reverberate around the globe back and forth another round, or two. But, barring human stupidity (which can never be barred), these are problems, not crisis.

Oh, another powerful socio-psychological support: the society so much wants Obama to succeed that Citi, BofA, and JP Morgan all decided to move their bad earnings up to Friday, before the inauguration. Wow, that's powerful, meticulous command and control from Obama's still-shadow government, as well as incredible cooperation from our good corporate citizens. Can we assume the remaining bank earnings (Goldman, Wells Fargo) will be good?

On the other hand, the long-term crisis remains healthy and strong, completely unharmed. In fact, I'd say it's been strengthened tremendously by all the scrambling trying to avert the short-term one.

1. Corporate governance.
Lack of shareholder visibility and control, loss of board independence, de-coupling of risk-taker and reward-taker, maturity mismatch between (shareholders and debt-holders) risk and (decision-makers) reward, grossly inadequate risk management systems and techniques, massive built-in systemic chain reaction mechanism...do you see any improvement? Me, neither.

2. Government debt.
Yes, somebody has to pay. That somebody is most likely our later selves and our children and grandchildren, in the form of massively diminished purchasing power and high inflation.

3. Inflation.
Yes, right now it's deflation. And expanded M0 money base alone doesn't cause inflation; more important factors in modern economy include leverage and velocity of money. But greed will drive us to leverage up and churn money as soon as the economy seems to show the first sign of life. And this inflation will be particularly punishing to the poor and polarizing to the society because it will be first and foremost driven by commodities. Will the Fed have enough foresight and political will to jack up interest rates soon enough and fast enough? No chance. In fact, inflation is the path of least resistance to eliminate the massive internal debt. In order to do this, the real interest rate needs to remain negative for a long time. It needs to be an integral part of fiscal policy. I'm not saying it's the right thing to do. It's just the thing people will do.

4. Devaluing dollar.
Yes, right now the dollar is strong for lack of alternatives and unwinding of USD carry trades. But this is bad for US economy and the unsustainable global imbalance. Service economy is a mirage. It's simply impossible to sustain an economy the size of US with lawyers, management consultants, middlemen, and McDonalds and Walmarts. We have to make some stuff, from iPhones to good cars to, yes, steel and toys. To do that we need a significantly devalued dollar to kick start it. Furthermore, there's no easier way to eliminate the massive external debt than devaluing dollar. Yes, it's a scam and everybody knows it but what can they do about it hehehehe...

5. Savings deficit.
No, we refuse to learn to save. It's unamerican. If the government let the crisis blow up, allowed the market to work through its wrongs, and gave people the chance to learn from pain, maybe we would've learned to save. But no, we the people will not allow the government to give us that chance. We are a democracy damnit. The society at large will continue to borrow until the government bails them out, again and again. And the government will continue to bailout the irresponsible until nobody is willing to lend us anymore. And Asia will stop lending, some day.

6. Democracy.
Our democracy failed. It failed when it allowed Bush to invade Iraq and erect Patriotic Act. It failed epically when it re-elected Bush after the disastrous first term. If Bush had just given up in face of pathetic ratings and done nothing about the crisis, instead just followed his inborn, legendary apathy and ignorance, he would've done one virtuous service to the country by giving the capitalist system a chance to work its way through. But hell no, he had to mess up our long-term prospect one last time with the massive, rapid-fire, headless-chicken bailouts. And our elected Congress laid down, spread their collective legs, and let Paulson have his way, any which way he wished. And we had a collective orgasm watching it on TV. Ultimate political porn.

But mostly I'm upset that all the government interventions screwed up the system and made it even more irrational in the long-term. Capitalism requires a minimum degree of rationalism. Arbitrariness increases risk. Arbitrariness from world governments is the ultimate systemic risk. Excessive regulation increases societal cost of doing business. Without all the political headless chickens mucking around, it would've been very painful in the short-term for sure, but the long-term future would've been much clearer and more stable.

I'll Sell You All the CDS on Citi, Suckers

CDS spread has gotten an undeserved attention as some sort of prophetic leading indicator during this crisis. Is there something special about CDS buyers and sellers that make CDS spreads more insightful than anything else? NO, of course not.

If you think the 40 bps CDS premium on US is ridiculous (for up to 5 years anyway), then I have a surprise for you. Citi CDS was going for 470 bps last Friday. This is close to imminent default range. It's much worse than the usual junk credit.

All the bad news and gloomy speculations about Citi notwithstanding, the simple fact is that

1. Citi deposits will not be endangered. This is hugely political. Governments around the world cannot afford to let it happen, or else they'd be stoned to death by the revolution.

2. Citi bonds will not default. Although Paulson maintains that he didn't think the decision to let Lehman go down was a mistake, everybody knows (Paulson included) it was a critical mistake in transforming a financial crisis into a full-blown global, economic crisis. I think we've learned the lesson by now. The world cannot deal with another CDS settlement of a big company. Not Citi, not GM.

Beyond the above two points, everything else is in play, including wiping out equity.

But, before you get too excited about the parallel between Citi and Bear/Lehamn/AIG, think about the following:

1. Unlike the situation weeks before Bear/Lehman, even for weeks for Morgan Stanley, no bank is stopping trading with Citi. Remember, some banks stopped trading with each of them WEEKS before the trouble became public. It's a very easy decision for them to make, with negligible downside compared to the risk IF they seriously think there's a real risk. But no, nobody stopped trading with Citi, as of the past Friday.

2. Unlike Bear/Lehman/MS, Citi is a real bank with real deposit base. I don't know about the off-balance sheet toxic asset in Citi that everybody suddenly seems to know. But the crucial difference is that Citi is not an investment bank. As long as you believe humanity is not quite stupid enough to march off the cliff, Citi will survive - with pain, maybe, but they will survive.

I think it's quite clear by now that the emerging market crisis of last month is mostly aritificial and technical. They are vulnerable for sure. But there's no structural deficiency in BRIC world in the same order of magnitude as in the developed world. China will be hurt by decrease in demand in goods. India will be hurt by decreasing demand in offshoring. Russia will be hurt by slumping oil price. Brazil will be hurt by slumping oil price (ethenol) and FDI. But none of them is nearly as severe as the chronical, structural deficiencies of future-mortgaging and over-consumption in the developed world. As demonstrated by the 4 trillion Yuan plan announced by Beijing, they are at a point where they CAN create enough demand domestically to get through a temporary glut.

What does this have to do with Citi? My point is the world, not just the US government, will not allow Citi to go down. The US government may not have enough credibility, with Paulson changing his mind every week. But the world ganged up together is a credible threat to the shorts.

And, dare I say, with its truly global franchise, Citi is in a better position to benifit from emerging markets while most other banks, much more concentrated in US and Europe, are exposed to the long struggle ahead of us in the develped world.

If you want to say Citi is too big to manage, that's fine. But it still does not negate the fact that Citi is truly too big to fail -- not just to US, but to the world.

I don't know what will happen to Citi stock. But if you want to buy Citi CDS, I can sell you as much as you want.

USD Carry Trades?

Yen is the carry trade currency. You know, you borrow Yen, pay next-to-nothing interest, swap it for Australian dollar, get high interest return on AUD. You own the license to print money, unless and until Yen goes up in value. Then you may need/want to unwind -- sell AUD, buy JPY, which drives up JPY, which makes more people need/want to unwind. It's a positive feedback which, despite of the word "positive", means it's destabilizing. Bad. Dangerous. Crash. Crisis. Bad bad bad.

Another possibility you may need/want to unwind the carry trade is increase of risk aversion -- people want to hoard cash. Again, destabilizing positive feedback.

Our financial system is full of positive feedbacks. It's so full of inherent instability it's a wonder it hasn't blown up completely ten years ago. Until we redesign it to eliminate such instabilities, it will blow up again. I believe it's possible to eliminate such instabilities; the key is to eliminate windfalls (spread it out), encourage long-term behavior and discourage short-term speculative behavior. But human society will not have enough political will to make such drastic corrections, not until we suffer greatly. The current crisis does not inflict enough pain.

Let's get back to carry trades.

Why is JPY the currency of choice for carry trades? First, the interest rate is low and the Japanese government wants to keep it low so that cost of financing to the industry is low. It's a saver society. You can have 0 interest rate and inflation and the Japanese society would still save. Secondly, the government wants to keep the currency cheap so as to encourage export. The Japanese domestic market may be big enough to support a decent economy, but not the second biggest economy in the world. JPY-based carry trades help them achieving this goal. In return, they subject themselves to the whims of international speculators, with added misery in a worldwide recession scenario.

This is exactly what we saw last Friday. Bad economic news from Japan. Yen surged, causing more pain for exporters. No surprise there.

But we also saw something else last Friday. USD is about the only other currency that strengthened across the board. Why is that? People think US economy will bounce back fast? USD is once again gold? Or even though USD is not gold but everything else stinks even more? If you believe any of that, I have some wonder organic matter that cures cancer.

This is another round of unwinding and deleveraging. The panic about emerging markets hit. People want to get out, unwind and deleverage. How? Unwind their USD carry trades.

Around end of last year and early this year, when Fed aggressively cut the rate, I asked an FX trader friend of mine whether he'd seen any sign of USD-based carry trades. It made sense. The real interest rate in USD is negative (lower than real inflation) so it doesn't make sense to hold cash in USD. The government wants to devalue USD and keep it low for awhile; it's the easiest way out of the massive external as well as internal debt. So you borrow USD, swap it into Latin American currencies, Euro, Canadian dollar, whatever.

He didn't see any concrete signs of such trend.

Last Friday I asked him the same question again. He said yes.

Emerging markets are fine if it weren't for their currencies being destroyed. Their vast needs for infrastructure improvement and fundamental transformation of entire populations can generate enough demand for sustaining at least another twenty years of worldwide, healthy growth. But what we have instead is the currencies of the two biggest economies being used to pump up their economy beyond hot, suck the lifeblood out of them, then leave them withering in rubles.

I don't think Sarkozy's Statism is the answer. But I at least agree with him that the current international financial regime is fundamentally broken.A system of traders and speculators but no investors is destined to be traded into oblivion.

CDS Exchange = Assured Systemic Shock

Friday I submitted a Proposal on Transforming CDS. I encourage you to read it if you hold just a passing interest in the current financial crisis. But the talk of moving CDS to exchanges has been gaining momentum, touted as the cure by SEC Chairman Chrisopher Cox.

If the man who advocated for deregulation of all things financial, and who was appointed to head SEC for the purpose of making it irrelevant, touts The Cure for the crisis that his agency helped create, we need to be automatically suspicious.

But let's go beyond philosophy, go into details and make a concrete case.

Exchanges reduce counterparty risk by being the sole counterparty; in turn, they protect themselves by imposing margin requirements on their client accounts. So far, in almost everything exchange-traded, this mechanism has succeeded. But this does not make it a fit for CDS due to its inherent high leverage on the seller side.

Say I sell on the exchange $1B CDS on XYZ, which is a decent credit and premium is $10M per year (100 bps). The exchange finds you as the buyer. Since you're liable for the $10M annual premium payment, it requires you to put up collateral of $10M. No problem.

But how much collateral does the exchange require me to post? Obviously the amount should be tied to the notional, NOT PREMIUM, since my liability is tied to the notional -- a fraction of it, but the fraction could range from 0.1% to 91%, as illustrated by recent Fannie and Lehman CDS auctions. 100% of notional? There's no way any seller could afford to sell under such collateral requirements, not at a price buyers would buy. Remember, my collateral would be 100 times of my annual proceeds from this transaction. Even 10 times premium would be too high for the seller. Even at 2 times sellers would cry for pain.

But 2 times premium is 2% of notional, and assuming recovery of 40% (another laughable character of CDS standard models), 1/30 of the seller's liability in case of default.

There may be some remedial measures, such as increasing collateral ratio as the credit deteriorates. But, unlike naked equity options, the payout for CDS is by nature sudden-death, a jump event. The day before Lehman bankruptcy, Lehman CDS was trading at 20% upfront. The next day, you're looking at 80% payout.

Convergence between collateral and potential liability on CDS sellers is not possible. Recovery rate upon default is an unsolved problem. Putting CDS on exchange forces the exchange to take the recovery risk.

Who fills the hole? The Exchange. What happens if The Exchange fails? Complete, certain failure of CDS market. In contrast, the fallout from Lehman bankruptcy we've seen so far is less than 100% in both probability and scale.

If we let the old players and the old guards design the new system, the exchange would be guaranteed by the government, with the exchange taking the profit in good times and the government taking unknown, undetermined risk of recovery rate for no return when disaster strikes. And the collateral requirement of sellers would be pathetically inadequate. Future systemic failure is assured.

Will the society allow this travesty to repeat itself?

Proposal on Transforming CDS: Credit Insurance Trust

The latest round of eruption of year-long financial volcano has thrust CDS into almost bar-conversation vocabulary. The common sentiment seems to be total hatred or disgust. Eulogies for CDS have already been published. Others are calling for change in how CDS is traded and/or treated in accounting. Common proposals include

1. Regulate CDS as what it is, insurance.
2. Trade CDS on exchanges so as to minimize counterparty (seller) risk.
3. Move CDS on balance sheet.

But the cost to the seller -- capital reserve in 1 and 3, margin collateral in 2 -- would be prohibitively high if the capital/collateral cushion is to be enough to meaningfully reduce counterparty risk. Such high cost to the seller translates to high premium for the buyer. Result: dramatically reduced market size. In other words, CDS is still dead.

Few people would shed a basis point of a tear on such news today, I suspect. But let's not forget CDS can serve a legitimate and important function: hedge. Yes, there are real, meaningful hedges using CDS. If you hold a bond or otherwise are exposed to credit risk of somebody, there's nothing like CDS that can provide direct, fast, efficient, and clean hedge in time of need.

Credit derivatives are NOT financial weapons of mass destruction. They merely have the capacity of being such powerful tools. But whether it serves good or evil depends on people. Blaming financial products strikes me as profoundly misguided and ignorant, even dishonest.

No, credit derivatives didn't cause this crisis. WE -- the government, some market players, some mortgage lenders, and some home buyers -- caused this crisis. We didn't use the powerful tool of credit derivatives properly.

And while we're on it, let's make one point very clear. The reason why we failed to use it properly is not due to lack of understanding of the risks; rather, it's because the system -- regulators, laws, and corporate governance -- has incentivized decision makers at all levels to ignore the risks and focus on short-term gain. Calling regulators and Wall Street executives stupid or incompetent might feel good. But it wouldn't be correct at the overall level.

It's the system that's skewed and flawed. The magnitude and duration of decision makers' risk and reward are misaligned; sometimes even the sign is wrong. If we only focus on a few individuals' misjudgment or unethical/criminal behavior, we run the risk of missing the deeper, greater cause -- the systemic flaws. In doing so, we only set ourselves up for a repeat in the future.

So I'd like to focus on addressing the systemic flaws here, and only on CDS. Let's first take a look at what makes CDS unique -- forget about the standard pricing model or how it's been treated so far, focus on the economic idea behind it.

1. CDS by nature is an insurance.

2. However, there is one important distinction between CDS and traditional insurance products. The latter can be "hedged" via diversification. It's very difficult to hedge CDS this way because, by definition, it deals with low-probability, high-weight events among a small population. This is the most fundamental flaw of CDS as we know it today. It goes right into the well-known fact that statistical applications (not the theory) loses relevance as you migrate towards the distribution tails. No company is big enough to provide meaningful insurance of such risks on a meaningful scale, especially since the company is a credit risk itself. As to governments playing any role, I hope the governments' involvement in this crisis has thoroughly disgusted everyone so let's not even go there.

3. CDS differs from most of other derivatives in that it is inherently highly leveraged. This makes CDS the key ingredient of the chain reaction.

If you understand the above three fundamental characters of credit default protection, you'd realize regulation or accounting gimmicks could not possibly address the real cause of the problem, short of killing the market altogether. The real solution must address all of the three fundamental characters while avoiding throwing the baby out with bathwater.

In addition, just as nobody should, in the legal sense, moral sense, or from societal considerations, reap a windfall from tragedies, as is the case for all traditional insurance, nobody should reap a windfall from default through CDS. The social utility of insurance is to lessen the impact of tragedies as opposed to encourage speculative or reckless behavior. You may be tempted to ban naked CDS based on this consideration. But naked CDS has its legitimate use, since all exposed to a credit risk do not hold the bond.

More importantly, since CDS settlement is by definition a zero-sum game, there is absolutely no reason the society as a whole should be greatly damaged by it aside from the fact that the reference entity has just defaulted. If we cannot find a way out of this PURELY artificial problem without sacrificing its beneficial functions (or going into state capitalism as we are), then I don't know how we deserve the top spot on the food chain.

My proposal is to set up a private, non-profit Credit Insurance Trust (CIT). To begin with, let's call it what it is, Credit Insurance (CI).

1. Those who want to sell CI must contribute capital, the amount of which is tied to the total amount of notional they can sell. The relationship between contribution and allowable notional is determined by auction, e.g., $1 contribution gives you a permanent, revocable, transferable license to sell up to $1000 notional CI (hold you protest on such outrageous leverage -- read on). Licensees are subject to trustee approval. Licensees are seller agents for CIT, which is the legal seller of all CI. Licensees can buy additional licensed amount at prevailing auction price, subject to the total cap set by the Board of Trustees.

2. Board of Trustees is elected annually by CI buyers. The vote is weighted by notional outstanding bought.

3. CIT invests the fund in long-dated treasuries (or other "riskless" securities the BOT deems appropriate).

4. CI premium goes to the Trust. Licensees take a haircut, ranging from 0 to 5 bps. The better the credit, the bigger the haircut. This discourages speculative selling on poor credits. The returned premium goes into a separate fund -- let's call it CITIF -- which also invests in "riskless" securities, but with maturity no longer than one year. Furthermore, CI on a credit cannot be sold once the credit quality deteriorates beyond certain level. This prevents agents from selling garbage while making fees via private arrangements. Existing CI contracts can always be transferred, however, with registration to CIT.

5. Returns on CIT and CITIF investment pay for the administrative cost first. Excess goes into CITIF; deficit comes from CITIF. It's to the BOT's interest not to let CITIF run dry.

6. CI buyers must invest all of the settlement windfall into CIT, which is done automatically as part of the settlement process. In return, they become holders of CIT's interest-only, non-compounding, annual coupon, 10Y bond. In other words, each settlement is automatically a CIT bond issuance. Coupon payments of such bonds come from the accumulated funds in CITIF, set in arrears and capped at 20%, after administrative expenses. CIT bonds can be auctioned at issuance (buyer cash out) or traded on secondary market.

This may seem a bit complicated, and will get more so when put in the international context. Price of CI depends on the valuation of CIT bonds, the pricing of which would be quite interesting. But it has numerous advantages:

1. While credit default risk may have proven too high-weight for any particular company to bear, by definition such risks can be handled, and statistically "hedged" in the same sense of traditional insurance, at the macroeconomic level. This setup solves the fundamental flaw pointed above.

2. There's no economic incentive for speculative selling by the agents. Speculative selling of CDS is the biggest systemic flaw currently. This setup cuts off the chain reaction mechanism from the root.

3. Contrary to the destabilizing effect of CDS, this setup serves to stabilize the system and benefits everyone involved, therefore by extension the society in general. It will also lower the systemic correlation, which is extremely beneficial to many other credit derivatives, e.g., certain types of CDO.

4. Speculative buying is also greatly discouraged. As a credit worsens, the haircut by seller-agents decreases, discouraging them to sell protection on the credit. Also, buyers' payout is directly tied to the future health of CIT; it's to their interest to keep it well.

5. It aligns risk and reward perfectly. In essence, the insurance is backed by the pool of premiums, not by the promise of any single entity. Licensees make the fee for their service and providing the initial funding to the Trust.

6. CIT's fund is guaranteed to be perpetual. The only way it goes bankrupt is for its "riskless" investment to go sour. In such worst-case scenario, the government would have defaulted. The biggest risks cannot be hedged, period (one example is Earth being demolished by Vogons).

7. Buyers can remain anonymous until settlement. This is important to protecting their interest. But anonymity in this framework will not have the side effect of its current form because the net position on each credit can be easily calculated on the seller side, which is completely public.

8. Last but not the least, this setup is in fact extremely simple. It heavily relies on the market, minimizing reliance on government intervention or artificial, arbitrarily set rules and prices.

Let's run some numbers. Say CIT total fund is $1B. Based on auction price of license amounts, $1T notional can be sold. Average premium is 100 bps (1%), or $10B, per year going into CITIF. Average haircut by licensees is 2 bps, or $200M per year. In an EXTREMELY bad year, 10% of covered credits (by notional sold) default. That's $100B. Buyers still get 10% coupon for the first year. Since in such dreadful times people would want to buy more protection, and premium would have increased, future coupon on CIT bonds will likely increase. (I've omitted investment income and expense for simplicity.)

Everybody wins.

Can I Buy My Own Bond? CDS?

I wonder if it's legal for companies to buy their own debt on the secondary market or CDS on themselves from another party. If it is, I have some fantastic business models to sell to VCs.

1. You sell $1B bond, then proceed to wreck havoc of the company, for example by taking ridiculous amount of bad risk. Rumors start flying around. Stock plummets. CDS spread shoots up. Your bond plummets. You use $700M of the $1B proceeds of prior bond issurance to buy back all your debt from the secondary market, even though it's not callable. You keep the $300M cash.

2. You buy naked CDS on yourself from somebody, with notional say twice as much as all your outstanding debt. If you ever go down, you'll get such a windfall that you'll snap right back out of Chapter 11 looking prettier than before you went in. In other words, you cannot fail. Technically, you could still fail after the CDS sellers fail to pay you. But we all know now that big CDS sellers are not allowed to fail; our government would call their CEOs into a room and hold guns to their heads and ask them to accept huge sums of money for peanuts in return and the CEOs, after reading the fine print in big bold fonts, would try their personal best to fein indiginity while signing and to hold their laughter long enough to get back into their limos. Therefore you cannot fail, no matter how badly you screw up.

So let's do circle time. I buy CDS on me from you, you buy CDS on you from her, she buys CDS on her from me. As Borat would say, NIIIIICE!

But these are brutes. There're more subtle varieties.

1. You buy CDS on yourself, then casually give out some hints of pending trouble -- insider selling, unintended leak to a reporter while drinking, etc. CDS spread shoots up. You sell or unwind your existing CDS for a 100% profit. Insiders buy low. Company turns out fine. CDS spread goes back down. Repeat as necessary.

2. You're a holding company. One of your subsidiaries is in trouble. Or maybe you decide it's in a dead-end market but can't find a good price to sell. You buy CDS on the sub. You force it down. You get paid, wealth transfer from bankrupt sub to parent.

When Senior Bond Is Very Junior

Many people are baffled by how Lehman senior debt has been trading after they filed for Chapter 11 protection, as I illustrated in a previous article. Turns out Robert Waldmann at AngryBear has an excellent analysis on the same topic, only earlier.

But, after some more research, I realized it's more general than Lehman selling CDS protection on itself, although the irony makes it more interesting. Generally speaking, in bankruptcy code, derivatives counterparty claim can go right through Chapter 11 protection and force liquidation. Chicago Fed in fact had a research paper in 2004 (thanks to SeekingAlpha reader emrald@aol.com) analyzing the original rationale behind and the unintended consequences -- cliche of the month? -- of this exceptional treatment of derivatives.

So, what does it mean? If you buy senior debt from a company with significant activity in the derivatives business, your senior bond is in fact subordinate to all such counterparty claims. In case of Lehman, it's not hard to imagine how counterparty claims could easily eat up all that's left. I'm just surprised the market thinks there would still be around 10 cents on the dollar left when all counterparty claims are settled.

If you think only financials are involved in significant derivatives trading, you'd be wrong. Virtually all big companies today are neck deep in this business.

This is arguably one of the biggest stealth dilutions (to bond/eqquity holders) in today's capital markets. The other one would be off-balance-sheet but that belongs to another day.

Market CDS spreads often imply significantly higher default probability than historical data suggest. There're a plural of potential justifications for this apparent "discrepancy". But I tend to think a big part of it is not that market is implying higher default probability. It's lower recovery that market has been trying to say all along.

So, how did such bonds ever get the "senior" label? Did the rating agencies take this into account when rating them?

These are $700B questions, in court. (Not that I'm trying to be dramatic, it's just that anything less than $700B doesn't carry any weight nowadays...)