Entries Tagged 'finance' ↓

Definition of Credit Default Swap - CDS are a financial instrument for swaping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond

• The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted.
• The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.

Example of Credit Default Swap

Example, suppose that Lloyds TSB has lent money to riskymortgage.co.uk in the form of a £1,000 bond.

Another party (e.g. hedge fund) may buy a credit default swap in this bond. Over time, the hedge fund will pay say a £1,050 (5% premium) to Lloyds TSB. If the riskymortgage.co.uk payback the loan, Lloyds TSB make a profit. However, if riskymortgage.co.uk default on the loan, then Lloyds TSB have to pay the remaining amount of the bond to the hedge fund.

Why Would People Buy Credit Default Swaps?

1. Hedge against risk. Suppose an investment fund owned mortgage bonds from riskymortgage.co.uk. It might be worried about losing all its investment. Therefore, to hedge against the risk of default, they could purchase a credit default swap from Lloyds TSB. If riskymortgage.co.uk defaulted, they will lose their investment, but receive a payoff from Lloyds to compensate. If they don’t default, they have paid a premium to Lloyds but have had security

2. Speculation e.g. risk is underpriced.

Suppose a hedge fund felt riskymortgage was very likely to default because of a rise in home repossessions. They would buy a credit default swap. If the debt was defaulted, then they would make profit from Lloyds TSB. Note you don’t have to actually own debt to take a credit default swap.

Clearly the more risky a bond is the higher premium will be required from a buyer of a credit default swap. It is argued that credit default swaps provide an important role in indicating the riskiness / credit worthiness of a firm.

3. Arbitrage

If a company’s financial position improves, the credit rating should also improve and therefore, the CDS spread should fall to reflect improved rating. This makes CDS more attractive to sell CDS protection. If the company position deteriorated, CDS protection would be more attractive to buy. Arbitrage could occur when dealers exploit any slowness of the market  to respond to signals.
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Given concerns over the financial system, many British savers may be anxious about the future of British banks.

Yesterday, shares in HBOS fell 18% (at one point in the day it had fallen 35%.) Shares in Barclays and Royal Bank of Scotland also posted double digit falls.

British banks are not directly exposed to the same subprime mortgages as in America. However, they are indirectly exposed to the problems stemming from America. The problem is that banks no longer just rely on deposits to make loans and mortgages. They rely on lending a mortgage and then being able to rebundle the debt onto other finanical instutions. With Lehman brothers going under, this business plan only becomes more difficult.

The reason that Northern Rock got into difficulties, last year was that it had the highest ratio of mortgages financed by reselling rather than deposits.

British banks will also be increasingly vulnerable from the state of the housing market. WIth house prices falling, the number in negative equity is increasing. A recession and rising unemployment could create a real problem of bad debts in the UK.

What Should I do With My Savings?

I think the Banking system will be able to weather the storm, althought the government dithered over Northern Rock, at the end of the day they realised they couldn’t let it go under.

However, these are not normal times, there is a lot to be said for diversifying your life savings. Don’t put all your wealth into one finanical institution. Consider Northern Rock or National savings, both of which are guaranteed by the government.

“There is a saying: stock markets have predicted 10 out of the last 3 recessions.”

Readers Question: That does not make sense - how can you predict 10 out of 3? Did you mean 3 out of 10?

The rationale behind the statement “stock markets have predicted 10 out of the last 3 recessions.” is that stock market volatility does not necessarily reflect economic conditions.
Sometimes stock market investors panic; they think share prices are overvalued or some bad piece of economic news makes them fearful about future economic conditions. These small signals can, in some circumstances, can cause a rapid fall in share prices. The fall can then precipitate panic selling and share prices suddenly lose a large % of their value. However, later, it is realised that the stock market has overreacted to a piece of bad news and actually conditions are not as dire as they feel.

Example, Continue reading →

Yesterday, the bank of England  offered a scheme to bailout the banking sector by offering to exchange ‘unpopular’ mortgage debt for government backed securities.

The money markets have struggled since last summer and the American subprime crisis. This has led to a shortage of funds for mortgages and increased cost of mortgages.

I wrote an in depth analysis here: - Bank of England Bailout for Mortgage companies.

It is not certain how successful it is going to be. Abbey announced this morning that they will increase their mortgage rates anyway.

Readers Question: In early American banking history, banks would issue banknotes to patrons that were supposed to be backed by gold and silver. My questions is, what did the patrons give the banks to get the bank notes, and why were many banks unable to make payment on demand when the patrons tried to exchange their notes?

Banknotes have evolved over time. Initially bank notes were issues in lieu of precious metals and were essentially I O U’s. A more technical term is that bank notes were ‘promissory’ - Rather than give gold to customers, banks gave a credit note saying they promised to exchange this credit note for an equivalent sum of gold or silver.

Over time, gold and silver were no longer used in the monetary system, thus bank notes became effective credit notes.

It was the  banks who were most keen to use promissory notes rather than deal in precious metals. Bank notes had the advantage that is was easier to transport, lower costs and, most importantly, enabled the banks to make better use of their assets. Continue reading →

Readers Question: with econonomic scare, do you advise to invest? how do you predict inflation and interest rates will affect business?

I answered this question at my economic essay blog: Investing in a recession 

As I said in the post, I doubt a penniless Economist is the best person to ask for investment tips; but economists are, if nothing else, never short of giving advice

One thing worth bearing in mind is that some investments can give a good return during a recession. Even stock markets have been known to rise during a recession because analysts have already priced the downturn into share price.

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Readers Question: What do you think would happen if all depositors of a bank requested their deposits?

The Banking would probably collapse, unless it could secure unlimited funding from a Central Bank or other banks.

If a bank has deposits of £10billion. The bank will keep perhaps 1% in liquid assets (i.e. cash that can quickly be given to customers who demand it. Therefore, out of £10 billion, the bank will have cash reserves of say £100million. We say it has a liquidity ratio of 1%. Therefore, if customers asked for £100 million to be withdrawn the bank could do it. However, once customers require more cash, it faces a problem - The bank doesn’t have the deposits in a liquid form.

What banks do is they lend out deposits to other people. This is how they make a profit.  They pay you 2% a year to save money, then lend to someone else and charge 7%. They can do this because usually people don’t want to suddenly withdraw all their money and it is more profitable than simply keeping money behind the counter. Continue reading →

The banking system in the UK is highly concentrated with the top 10 banks having over 90% of market share.

In recent years, the advent of internet banking has provided a new source of income, but, at the moment the banking system is still dominated by these top 10 banks.

Note: Recent merger of HBOS and Lloyds TSB

This is a rough guide to the biggest 10 British banks.

Some interesting facts about British banks.

• They employ 0.5million people Continue reading →

In a way stock markets are an example of perfect competition. There are hundreds of buyers and sellers, with equal access to regularly updated information. We can assume most stock market traders are rational people who seek to maximise their profits. There are few barriers to entry and exit; anybody can buy shares if they have enough money. Shares in one company are homogenous.

But despite this, stock markets tend to behave erratically with large swings in share prices. This suggests that the market is not perfectly competitive.

For example, if investors have perfect information how do we explain stock market crashes?

1. Herding behaviour. ‘Wisdom of the Crowds’

It is often assumed that if markets are rising there must be a good reason for the rise in prices. If professional investors are buying dot com shares why should we not? Therefore, it is often the case that people get caught up in the prevailing mood of the market.  When prices rise this encourages other people to buy. When prices fall the opposite occurs and investors seek to sell before prices fall anymore.

2. Information is poor.

The other assumption is that investors have accurate information. Firstly, it is difficult to be completely aware of the current profits of a company. But the key for share prices are forecasts for the future. People buy shares on expectations of future profits. However, there are many factors that can make it difficult to accurately predict profit growth. Often profit forecasts are extrapolated by looking at past profit trends. However, just because a company has had profit growth of 20% for the past 5 years, there is no guarantee it will continue to have similar profit growth.

• Effects of a falling stock market 

I wrote a brief explanation to the current credit crunch, breaking it down into 10 stages - including why It occured and who does it  affect.

Some Common questions on Credit Crisis

Why Do US Mortgage Defaults Affect the UK?

The US mortgage companies funded their mortgage lending by selling their loans onto other financial companies. This is known as rebundling debt; ironically, it was aimed at making the debt appear safer because the risk was shared amongst other financial institutions. (This is one reason why US subprime loans got a triple AAA credit rating). Therefore, when US mortgage defaults occured, it wasn’t just US mortgage firms who were in trouble. Many big banks who had bought the mortgage bundles lost money. Also because of the crisis it has become more difficult and expensive to borrow money, financers don’t want to get burnt with buying any more bad subprime debt.

What is actually meant by Subprime?

Subprime was primarily used in the US, but, has quickly slipped into British English use. Subprime essentially means lending to people without perfect credit histories. For example, if you miss a payment or go overdrawn without authority, you get a negative credit rating. This means you will be classed as subprime. In practice subprime can refer to any type of risky lending. This could be people with bad credit histories, or people with irregular income.

• In the UK subprime is sometimes referred to as ‘bad credit’ payments.
• There can be different levels of subprime. For example, one missed payment could cause a credit rating of subprime. But, if your home was repossessed this is clearly a more serious form of subprime.

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