Third Time, Someone Will Believe: Manage Risk or It Manages You
As the late Allison Snow-Jones noted, economics depends on working mathematics. Mathematics, in turn, depend on the conditions being described correctly. If I build a model in which two things are independent, they have to be independent for my model to work. Or, to quote a quoting:
Many months ago, I quoted the brilliant Janet Tavakoli‘s book Credit Derivatives and Synthetic Structures:
The trader then went on to tell me that Commercial Bank of Korea would sell credit default protection on bonds issued by the Commercial Bank of Korea.
“That’s very interesting,” I countered, “but the credit default option is worthless.”
“But people are doing it,” persisted the trader.
“That’s because they don’t know what they’re doing,” I affirmed. “The correlation between Commercial Bank of Korea and itself is 100 percent. I would pay nothing for that credit protection. It is worthless for this purpose.”
The trader mustered his best grammar, chilliest tone, and most authoritative voice: “There are those who would disagree with you.” (p. 85)
That apparently includes the Spanish government:
The Frob capital injection comes in the form of convertible preference shares from the Frob, or Spain’s Fund for Orderly Bank Restructuring. As a reminder, the Frob itself has lending capacity of €15bn and can leverage itself to €99bn by issuing bonds — guaranteed by the Kingdom of Spain — to private investors.
And the equity it lends to banks really resembles more of a subordinated loan than actual loss-absorbing capital. What’s more, it pays a coupon and is excluded from core Tier 1 calculations under incoming Basel III rules for this very reason.
Did we mention the Frob is also backed by Spain?
I realise all the attention is on Egypt right now—and it should be&mdaash;but the rest of the world is going to be there on Monday, too. And traditional “sovereign risk management” still has a ways to go.
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If I build a model in which two things are independent, they have to be independent for my model to work.
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And LTCM might add that some ‘independent’ variables may eventually exhibit dependencies.
In the second case (Frob), since the issue are “convertible preference shares” or preferred stock, the guarantee from Spain definitely has value as this makes the shares equal to Spain Senior Debt.
Can’t speak to the first example, but it is possible the Commercial Bank of Korea CDS is collatoralized, or possibly guaranteed by the Korean Government, above that of their normal bonds. That would be one of the only things that would make sense.
In the second case (Frob), since the issue are “convertible preference shares” or preferred stock, the guarantee from Spain definitely has value as this makes the shares equal to Spain Senior Debt.
Can’t speak to the first example, but it is possible the Commercial Bank of Korea CDS is collatoralized, or possibly guaranteed by the Korean Government, above that of their normal bonds. This makes sense if ROK wants to lower CBK’s borrowing costs.
I believe that the The CDS written by the Commerical Bank of Korea on bonds issued by the Commercial Bank of Korea is not worthless. Janet Tavakoli assumes that the only possible resolution ratio in case of default is zero. Even Lehman didn’t manage to get the secondary market value of its senior unsecured debt below 12 cents on the dollar.
I’d say that, at the time of that 12 cent quotation, the value of a Lehman written CDS on Lehman unsecured debt should be 10.56 cents per dollar of notional value or hmm carry the one … a whole damn lot.
It’s like arguming that health insurance with a deductible is worthless. The correlation with having health care expenses and paying the deductible is one, therefoer the alleged instrument “health insurance with a deductible” is completely worthless. I believe I have been completely fair to Tavakoli.
When I last argued this, commenters suggested that self CDS might be disallowed by bankruptcy court as a dilution scheme. That might be relevant in Korea, but it isn’t relevant in the USA, where, following the dread bankruptcy reform, financial counterparties can reach right through chapter 11 protection and bankruptcy courts can’t stop them (it’s not your father’s bankruptcy code).
That’s why the Austrian School of Economics tends to argue that there tend to be no suitable mathmatical models to decribe real economies. There are too many variable to plug in and decribe…
Japan just got degraded a notch last week. I wonder if next week will bring more pressures on the PIIGS countries… Ireland might choose a new government in March. The Irish tax payers might say we won’t bail out the bad bad private bond investors whom invested in risk taking Banks… They might just see what Iceland did, screw the bankers, and save the tax payers… I don’t see any reason this EU dilemma dying anytime soon…
The crisis happening in egypt has a big effect on the global economy and that is something that we need to focus on rather than personal interest.
I really thought that not only Egypt have a corrupt government and economic downfall. If people would start to realize the main reasons of these all and start hepling each other rather than baming others.
Yes, i would definitely agree on your opinion.Egypt is one of the countries that are vast in resources and political crisis is ruining it’s economy and we are being affected by their conflict.