Market crash nobodies fault

[my_wan]

Most of us has heard about how shocked Greenspan was at the market crash. This sent me on a paper trail of the theory behind mortgage derivatives. It starts with an equation invented by economics Nobelists Robert Merton and Myron Scholes. I'll try to explain what's behind this equation.

The problem is how to evaluate risk of a stock option (http://en.wikipedia.org/wiki/Option_(finance)), a classic problem in economics. What this equation does is to avoid the problem of risk premium value of an option by a very simple mechanism. Suppose you own stock S. You can essentially remove your risk of owning this stock by writing two options for this stock. In essence betting that the stock will both rise and fall. By doing this the market value should be such that the return is zero, or more specifically equal to that periods risk free treasury bill return. It didn't remove the risk it just recognized the risk was already accounted for in the pricing of the stock. It is actually quiet a beautiful method and worked quiet well in the risk assessment of stock. So why did it break and make Greenspan look like a bumbling fool?

The market qualifies for what is called a self referential system. Self referential system are at the crux of many modern day paradoxes. It's even behind an ingenious interpretation of Quantum Mechanics. Consider an absurd example of someone finding a full proof method determining what a stock will do 24 hours in advance. You get ultra rich and world famous for your method. However, now everybody knows how this method works and the no risk means that investors will change market dynamics such that there is no return on the method because it is risk free. Market feedback does not allow risk free money. So what changed when these derivatives based on this equation went on the market?

Notice that the central assumption of the equation was that the stock valuations set the zero-sum point of the game. Perfectly true and valid assumption at this point. However, these same stock are now packaged into derivatives and these derivatives now determine stock valuations, not the stock themselves on which the assumption of the equation depended. Without the underlying stock setting the derivative valuations the equation begins using the value of itself to try to determine the value of itself. It becomes totally insensitive to any actual value of the packaged stock. The risk free zero-sum approach to determining risk valuation then creates a humongous over-capitalization of the mortgage market exacerbating the situation. It couldn't do anything but stretch until it broke no matter how much care was given.

Of course you can still blame Nobelists Robert Merton and Myron Scholes. They have been un-repentantly sloppy in so many economic issues, especially with regard to feedback mechanisms. They attempted to use the market feedback mechanism against itself and lost. The sad thing is now governments are questioning the legitimacy of the free market itself.

[Francesca R]

Sorry, not at all sure what you're trying to say :)

[my_wan]

Sorry, not at all sure what you're trying to say :)

Hmm... I'll try to articulate. Fundamentally the Black–Scholes formula (http://en.wikipedia.org/wiki/Black-Scholes) was the formula used to value the derivatives behind the mortgage crisis. It was the inability of this formula to do what it claimed that caused the crash. You can look at the many parts that seemed responsible, like subprime lending, regulation, etc., but this is the formula that was fundamentally being depended on to manage these risk, with or without regulators. Essentially my claim is that it did not manage the risk it just made the risk invisible. The market therefore took on more and more risk with the illusion that it was well managed. In fact there was a Nobel Prize supporting the notion that these risk were well managed.

All the arguments about corrupt banks, etc., doesn't hold all that well in the big picture. So what I'm looking at here is what went wrong with that formula that made it ok to take on such huge risk.

The Black–Scholes formula (http://en.wikipedia.org/wiki/Black-Scholes) is based on the idea that you can remove risk of owning a stock by betting that the price will both rise and fall at the same time, selling two options one "short selling (http://en.wikipedia.org/wiki/Short_selling)" and one "going long (http://en.wikipedia.org/wiki/Going_long)" at the same time. In fact this does remove or significantly reduce your risk of owning that stock but at a zero or greatly reduced profit or loss. If a profit is anything other than zero (actually equal to a treasury bill return) then that is considered market inefficiency and should be priced out of existence because it is risk free profit. In essence a derivative we hear so much about is a group of stock which has been grouped and priced in such a manner that you are betting that the individual stock that it's made from will both rise and fall. A derivative is then considered a risk free or greatly reduced risk investment. That's why you seen bankers in senate hearings in 2005 claiming there is no risk.

In fact this hedging of bets scheme works on a small scale when the market trades the underlying stocks, i.e., components of the derivatives. In fact it will continue to work when derivatives are traded as long as the derivatives market remains a small part of the market for the underlying stocks. This is because the derivatives can adjust their value on the day to day variations of the traded value of the underlying stock. Once the derivatives market exceeds the market for the individual stock then the derivatives market is setting the market price of individual stock rather than the other way around as the formula intended. The derivatives are then setting the market value of themselves. Even worse is the illusion of being risk free with all changes in actual risk being totally hidden by the lack of a market for the underlying stock. The last term in the equation assumes a stochastic process so without adjustments to actual risk from underlying stock the equation becomes a purely random walk into oblivion.

If you think you have some idea but have questions it would make it a lot easier to respond. If it is still incomprehensible at least try to mirror what you don't get so I can better guess what points to articulate. Perhaps I can model this effect using a thermodynamic model and write a computer program to simulate it. Of course you can just say I don't get it if it fits.

[Just thinking]

The walk into oblivion ... that I understand.

[Scottch]

The promulgation of your descriptive thought is enticing. However, I further depict your argument as a broke illustration of a bursting consideration by using immense vocabulary to impel your suggestion. My inclination is that you would bring into play supplementary customary expressions to explicate what you are chatting about. I am anxious that, for the reason that you deem you are intelligent by using physically powerful words, you are in point of fact marginalizing yourself from the wide-ranging communal and being elitist and pompous. I anticipate your comments (not you) should go to meet your maker in a conflagration of internal combustion parts of organic matter.

Scottch

[mhaze]

Hmm... I'll try to articulate. Fundamentally the Black–Scholes formula (http://en.wikipedia.org/wiki/Black-Scholes) was the formula used to value the derivatives behind the mortgage crisis. It was the inability of this formula to do what it claimed that caused the crash.....

Black Sholes was behind the 1987 crash.

The very theory underlying all insurance against financial panic falls apart in the face of an actual panic. (http://www.portfolio.com/news-markets/national-news/portfolio/2008/02/19/Black-Scholes-Pricing-Model?print=true)

Nobody learned.

[dudalb]

The OP needs to get a copy of Strunk and White's "The Elements Of Style", fast.

[my_wan]

The promulgation of your descriptive thought is enticing. However, I further depict your argument as a broke illustration of a bursting consideration by using immense vocabulary to impel your suggestion. My inclination is that you would bring into play supplementary customary expressions to explicate what you are chatting about. I am anxious that, for the reason that you deem you are intelligent by using physically powerful words, you are in point of fact marginalizing yourself from the wide-ranging communal and being elitist and pompous. I anticipate you go to meet your maker in a conflagration of internal combustion parts of organic matter.

Scottch
Ok ok I get it.. LOL

Let's try this analogy. I flip a coin and bet Jack $5 bucks it's going the be heads and bet Bob $5 bucks it's going to be tails. Zero-sum game since I'll come out losing as much as I win. If I don't it's because I made different bet with Jack $6 and Bob $4 thinking the odds was better for heads but wasn't willing to "risk" the whole $5 bucks on the bet. Stock prices don't really have 50/50 odds of moving up or down. Market coins are biased to one side and change the bias some from day to day. If the stock market values heads the sames as tails then the market is giving odds of 50/50. If it values heads at 60% and tails at 40% then the market odds are 60/40 in favor of heads. If market odds are 65% and 40% (65/40) then it's possible to make instant risk free money which the market will adjust out of the price real quick from people taking advantage of it.

So let's make a derivative out of our mortgage coin tosses. Our odds on our coin can change from day to day. Going market prices say it's got a 60/40 chance of going up. We have our bookie (Wall Street, investment bankers, etc.) package together 100 coin tosses to a group (a derivative). Now we can control exactly how much risk we want to take because we are averaging over so many coin tosses. The next day the individual coin toss market adjust the odds 59/41. We adjust our derivative prices accordingly. So far so good. Now we see it works so well that we package all coin tosses into derivatives. Problem is that now there is no way to track the market value of the individual coin toss because the individual coin toss market doesn't even exist anymore. Only nobody notices because everybody is assuming that the derivative value/100 is the market value of the individual tosses. Even if a few coins started coming out two headed the derivative wouldn't notice because it's so tiny in comparison and the derivative is pricing itself without any help from the non-existent individual coin toss market. Nobody is even looking at individual coin tosses anymore to see what the real value is. The demand for these nearly risk free derivatives then drives the prices for derivatives that (inappropriately) determine the supposed value of individual coin tosses. The formula was designed to price derivatives from coin tosses, not price coin tosses from derivatives. When the value of the individual coin toss starts disagreeing with the value of the derivative bad enough, like when the forclosure rate is zooming up without any indicators from the derivatives, everybody wants out, it crashes, Greenspan goes: 'Duh.. I don't get it', and the rest is history.

If the derivatives had actually been able to track the real risk then mortgage money provided by investor would have been far more limited so that capital wouldn't have been available for such massive subprime loans. It was only the fact that the Black–Scholes formula (http://en.wikipedia.org/wiki/Black-Scholes) promised nearly perfect risk management, when in reality was blind as a bat to any risk, that the money kept pouring into subprime loans.

[my_wan]

Black Sholes was behind the 1987 crash.

The very theory underlying all insurance against financial panic falls apart in the face of an actual panic. (http://www.portfolio.com/news-markets/national-news/portfolio/2008/02/19/Black-Scholes-Pricing-Model?print=true)

Nobody learned.

This is interesting. I haven't had time for a careful read yet but I definately intend to track the paper by Taleb mentioned here.

[Gazpacho]

It was only the fact that the Black–Scholes formula (http://en.wikipedia.org/wiki/Black-Scholes) promised nearly perfect risk management
The Black-Scholes formula never promised this. It only provides a relationship between statistics. You remind me of Proudhon going on about logarithms and how they're a tool of ruination

The problem is not the Black-Scholes formula. It is the persistent belief in a perfect investment, the ignorance of the difference between what is expected and what will happen. Basically the belief that any model is reality, rather than a tool for understanding reality that, like any tool, has to be inspected from time to time.

[mhaze]

Ok ok I get it.. LOL

Let's try this analogy. ....For those who do not have the light of understanding on this, here is an analogous sham.

Assume prices never change. A convenience store builds an extra room, and fills shelves with envelopes, more than the number of items the store has. Each envelope contains a promise to provide several of the store's items at a future date. Trading at the store, cash flow and profit skyrocket, because people buying like the envelopes.

The obvious problem is the store can sell more than it owns.

Now presume not only that prices change locally due to demand, but that the envelopes contain a mix of promises to provide product if certain conditions on product current value are met. Demand and price are coupled, and envelopes come to drive demand.

The death spiral.

Oops, they say. We never thought of that - give us a bailout.

[my_wan]

Black Sholes was behind the 1987 crash.

The very theory underlying all insurance against financial panic falls apart in the face of an actual panic. (http://www.portfolio.com/news-markets/national-news/portfolio/2008/02/19/Black-Scholes-Pricing-Model?print=true)

Nobody learned.

This is quiet a bit different from the claim I made here but this guy makes a powerful case. I still haven't got his main mathematical paper but I read a lot of what his critics had to say. I'll find his paper soon.

Taleb's argument is a far more general than mine. It deals with volatility, rare events (Black Swans), and the non-linear sensitivity of the entire system to those events. He then considers that is is not just risk that must be considered but risk times consequences. I think his argument could be cleaned up but I'm having trouble cleaning my argument up. His powerpoint presentation seemed to endlessly drum out the obvious basics. The analogy that occurred to me wrt Taleb's argument is to compare Black–Scholes formula (http://en.wikipedia.org/wiki/Black-Scholes) to the linear wave model (http://en.wikipedia.org/wiki/Linear_wave_theory). Based on this linear wave model rogue waves (http://en.wikipedia.org/wiki/Rogue_wave) commonly report by mariners were thought to be myth until the Draupner wave (http://en.wikipedia.org/wiki/Draupner_wave) in 1995.

My claim is limited to the notion that when derivatives supplants the underlying stock as the commodity that set the price of those underlying commodities it breaks the individual stock pricing mechanism on which the formula depends. It is in principle possible to fix this by tracking enough information about the individual underlying stock and making it transparent to the investor. However, that breaks the utility of the derivative to a large extent. It would make some derivatives more valuable than others even though they contain the same type of underlying stock, especially with respect to mortgages. In the way it's done now the underlying stock is considered a representative random sampling, whether true or not.

[my_wan]

The Black-Scholes formula never promised this. It only provides a relationship between statistics. You remind me of Proudhon going on about logarithms and how they're a tool of ruination

The problem is not the Black-Scholes formula. It is the persistent belief in a perfect investment, the ignorance of the difference between what is expected and what will happen. Basically the belief that any model is reality, rather than a tool for understanding reality that, like any tool, has to be inspected from time to time.

Don't know about Proudhon. I don't read on anarchist though I presume it had something to do with his dislike of compound interest or usury as a political position. That alone makes it a strawman in my view. I'm talking about a market mechanism and "the difference between what is expected and what will happen" and I'm inspecting this tool. Within the confines of my claim I'm not even saying the tool is not valid. I'm saying the validity of the tool breaks down in the limit. The limit being the when the stock is exclusively marketed and/or priced by the derivatives. The breakdown starts slowly enough and gains speed as the limit is approached.

The Black-Scholes formula does in fact promise to finely tune the control of risk. "Promised nearly perfect risk management" does not mean risk free or "perfect investment". It means that people can set the level of risk they are willing to take for the potential profit. Greater risk higher profits and losses. Derivatives were theoretically supposed the represent the lowest possible risk and return levels. It's basically meant to be a different version of diversification. I think the notion that people have a "persistent belief in a perfect investment" is a mythology you created in your theory about people. I'm sure you can find plenty anecdotal cases Vegas and even some on Wall Street but they certainly don't drive the market. I stand by my claim that there are endemic problems with the Black-Scholes formula. The value problem of derivatives is a classic economics problem.

[mhaze]

This is quiet a bit different from the claim I made here but this guy makes a powerful case. I still haven't got his main mathematical paper but I read a lot of what his critics had to say. I'll find his paper soon.

Taleb's argument is a far more general than mine. It deals with volatility, rare events (Black Swans), and the non-linear sensitivity of the entire system to those events. He then considers that is is not just risk that must be considered but risk times consequences. I think his argument could be cleaned up but I'm having trouble cleaning my argument up. His powerpoint presentation seemed to endlessly drum out the obvious basics. The analogy that occurred to me wrt Taleb's argument is to compare Black–Scholes formula (http://en.wikipedia.org/wiki/Black-Scholes) to the linear wave model (http://en.wikipedia.org/wiki/Linear_wave_theory). Based on this linear wave model rogue waves (http://en.wikipedia.org/wiki/Rogue_wave) commonly report by mariners were thought to be myth until the Draupner wave (http://en.wikipedia.org/wiki/Draupner_wave) in 1995.

My claim is limited to the notion that when derivatives supplants the underlying stock as the commodity that set the price of those underlying commodities it breaks the individual stock pricing mechanism on which the formula depends. It is in principle possible to fix this by tracking enough information about the individual underlying stock and making it transparent to the investor. However, that breaks the utility of the derivative to a large extent. It would make some derivatives more valuable than others even though they contain the same type of underlying stock, especially with respect to mortgages. In the way it's done now the underlying stock is considered a representative random sampling, whether true or not.Interesting, I was also considering wave action similarities. By the way, my little convenience store case is of course a generalized example.

Possibly another good example would be kids playing with overpowered 4 wheel drive trucks in mudholes. Will they never get stuck? That's what the truck salesman told them. Will that little winch pull them out?Anything to attach it to ?

As long as the freak wave action doesn't approach those of Lituya Bay (http://www.drgeorgepc.com/Tsunami1958LituyaB.html)we are doing - fine...

[my_wan]

For those who do not have the light of understanding on this, here is an analogous sham.

Assume prices never change. A convenience store builds an extra room, and fills shelves with envelopes, more than the number of items the store has. Each envelope contains a promise to provide several of the store's items at a future date. Trading at the store, cash flow and profit skyrocket, because people buying like the envelopes.

The obvious problem is the store can sell more than it owns.

Now presume not only that prices change locally due to demand, but that the envelopes contain a mix of promises to provide product if certain conditions on product current value are met. Demand and price are coupled, and envelopes come to drive demand.

The death spiral.

Oops, they say. We never thought of that - give us a bailout.

It sounds to me like what you are talking about is "naked shorting (http://en.wikipedia.org/wiki/Naked_short_selling)". This did in fact occur a lot but as of September 2008 it is prohibited. It does in fact exacerbate the situation, and depresses stock prices in general, but by no means caused the crash. Rather than driving demand it reduces demand and prices because it makes it appear that more stock is on the market than what actually exist.
http://www.forbes.com/2007/02/02/naked-short-suit-overstock-biz-cx_lm_0202naked.html
Otherwise I'm not sure what particular market mechanism your anology refers to.

[my_wan]

I was reading comments on Taleb's work, http://www.fooledbyrandomness.com/ayache2.pdf, and this quote exactly mirrors the main issue I have taken with derivatives.

You need a certain context to dynamically replicate and price a certain derivative (for instance, you need a stochastic volatility model, consistent with the vanilla smile, to dynamically replicate and price a barrier option), and the pricing/trading of that derivative soon forces you to overstep the context (as soon as it trades, the market forces drive the barrier option away from the value of its replicating strategy).<snip (bolding mine)>

In fact my claim is that once the derivative defines the market value this way the "stochastic volatility model", dominates the price variation rather than market risk/value adjustments. This means that the apparent reduction in volatility is an illusion. Any adjustments from actually market risk/conditions can come but months or even years after the fact. Even then only when the assumed risk and real market risk diverge to the degree it can no longer be ignored, like when people start defaulting in mass as in the mortgage case. That's why so many seen the markets warnings even before 2005 but market variation was hidden in the shear size of the derivatives with variation determined by the idealized stochastic model.

[mhaze]

Do we have approximate numbers on dollar value and dollars leveraged on the questionable derivatives, relative to the market values of the stocks underlying them?

Isn't it fair to say that while Black Sholes implies one way cause and effect A->B, in reality we have had cause and effect running A<->B.

[Darth Rotor]

My Wan, my take from your OP is that this self-referential system (Godel wept, the crash is not his fault) seems to have taken on the characteristic of economic woo among a significant percentage of those in the financial, and financial services, industry.

Am I close?

DR

[DanishDynamite]

Most of us has heard about how shocked Greenspan was at the market crash. This sent me on a paper trail of the theory behind mortgage derivatives. It starts with an equation invented by economics Nobelists Robert Merton and Myron Scholes. I'll try to explain what's behind this equation.

The problem is how to evaluate risk of a stock option (http://en.wikipedia.org/wiki/Option_(finance)), a classic problem in economics. What this equation does is to avoid the problem of risk premium value of an option by a very simple mechanism. Suppose you own stock S. You can essentially remove your risk of owning this stock by writing two options for this stock. In essence betting that the stock will both rise and fall. By doing this the market value should be such that the return is zero, or more specifically equal to that periods risk free treasury bill return. It didn't remove the risk it just recognized the risk was already accounted for in the pricing of the stock. It is actually quiet a beautiful method and worked quiet well in the risk assessment of stock. So why did it break and make Greenspan look like a bumbling fool?

The market qualifies for what is called a self referential system. Self referential system are at the crux of many modern day paradoxes. It's even behind an ingenious interpretation of Quantum Mechanics. Consider an absurd example of someone finding a full proof method determining what a stock will do 24 hours in advance. You get ultra rich and world famous for your method. However, now everybody knows how this method works and the no risk means that investors will change market dynamics such that there is no return on the method because it is risk free. Market feedback does not allow risk free money. So what changed when these derivatives based on this equation went on the market?

Notice that the central assumption of the equation was that the stock valuations set the zero-sum point of the game. Perfectly true and valid assumption at this point. However, these same stock are now packaged into derivatives and these derivatives now determine stock valuations, not the stock themselves on which the assumption of the equation depended. Without the underlying stock setting the derivative valuations the equation begins using the value of itself to try to determine the value of itself. It becomes totally insensitive to any actual value of the packaged stock. The risk free zero-sum approach to determining risk valuation then creates a humongous over-capitalization of the mortgage market exacerbating the situation. It couldn't do anything but stretch until it broke no matter how much care was given.

Of course you can still blame Nobelists Robert Merton and Myron Scholes. They have been un-repentantly sloppy in so many economic issues, especially with regard to feedback mechanisms. They attempted to use the market feedback mechanism against itself and lost. The sad thing is now governments are questioning the legitimacy of the free market itself.
I blame stupidity and greed. Stupidity on the part of the legislators and their lack of instigating sufficient overseer institutions w ith real powers. And greed in the sense of the unscrupilous who repackaged the sub-prime loans into shiny new bottles.

[my_wan]

Do we have approximate numbers on dollar value and dollars leveraged on the questionable derivatives, relative to the market values of the stocks underlying them?

Isn't it fair to say that while Black Sholes implies one way cause and effect A->B, in reality we have had cause and effect running A<->B.

Here's the thing. Without the derivatives then those few initial bad mortgages would have been inspected for sufficient constraints on risk and those conditions thought to cause it weeded out or sold at much higher risk. Being packed into derivatives they were a minor blimp on the total value of the derivative and where therefore allowed to propagate.

It's not cause and effect being argued, it's a case of information flow. If the information about A says that B=A*N and then we replace all A with B we no longer have the information about all A's to set the value of B. The value of A becomes B/N where we must consider all A's equal regardless of the drift in risk associated with individual members of the set of
A. Our knowledge of where the risk is changing is hidden somewhere in the averages of B. It's the same thing when we must give up on knowledge about the position/momentum of any given air molecule to talk about temperature.

My Wan, my take from your OP is that this self-referential system (Godel wept, the crash is not his fault) seems to have taken on the characteristic of economic woo among a significant percentage of those in the financial, and financial services, industry.

Am I close?

DR

Yes, that is a reasonable assertion from my claim. They do have a Nobel Prize to reject the woo claim but authority does not make right. As I continue to study this it has become apparent that it was well known that the price valuation scheme was suspect as soon as any derivative actually went on the market. It continued for no other reason than the fact that it was profitable at the time.

I blame stupidity and greed. Stupidity on the part of the legislators and their lack of instigating sufficient overseer institutions w ith real powers. And greed in the sense of the unscrupilous who repackaged the sub-prime loans into shiny new bottles.

Stupidity is subjective. We depend on greed for a free market to work efficiently. We also depend on this greed operating within the confines of an agreed set of rules and anti-trust laws to avoid a virtual dictatorship, like Ma Bell used to be. You can call those that repackaged mortgages into "shiny new bottles" (actually a GSE or two) unscrupulous but there was a Nobel Prize lending legitimacy to the practice. Traditionally market forces defined what was and wasn't a sub-prime mortgage on a per case basis. These same market forces that allowed the relaxation of the rules under the derivative scheme. Except this new scheme was blind to individual cases, only the averages counted. As long the the market demanded these mortgages as-is they would continue. Regulation may have required them to maintain greater cash reserves but wouldn't tell them they couldn't loan money to people. It was therefore inevitable regardless of regulation.

Even with the derivatives if the drift in risk happened slowly enough corrections could have been made. However, demand was so great for mortgages that to land them requires greater incentives. The teaser rates, interest only, etc., for X time was like setting a time bomb that prevented the macro-economic picture from showing the true drift in risk for X amount of time. These bombs will continue going off for this same X amount of time. However, the market demand is what determines what is and isn't acceptable risk. The ability to flip property to a new owner through easy credit is what kept these time bombs in check for the moment. It was Greenspan in 2004 that encouraged these alternative loan products.

Final note with regard to regulation. These mortgage derivative markets were created by Fannie Mae and Freddie Mac. Neither of which is a private business. They are GSEs (government sponsored enterprise). They were created by the government with lots of special privileges that no private financial institution had. They had a fed rate credit line and regulation of private institutions did not apply to them. They were essentially a government created monopoly. None of the regulations on the books for private financial institutions even applied to them. Private financial institutions and individuals could however invest in and insure them thus leaving them and the whole system exposed to the risk. On the other hand the individual mortgages that they underwrote were generally less risky than the average mortgage.

In theory derivatives are supposed to be a zero-sum game. If somebody loses money it means somebody made that same money and visa versa. Only problem is that now there is nobody to pay the winner because the real estate can no longer be flipped to a new owner without heavy losses. It was this ability to flip the property that kept the higher than normal default rate manageable.
http://www.portfolio.com/views/blogs/market-movers/2007/07/02/when-mortgage-derivatives-get-included-in-cdos

Rough timeline: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=98030&t=01004109049910303346

[mhaze]

Here's the thing. Without the derivatives then those few initial bad mortgages would have been inspected for sufficient constraints on risk and those conditions thought to cause it weeded out or sold at much higher risk. Being packed into derivatives they were a minor blimp on the total value of the derivative and where therefore allowed to propagate.

It's not cause and effect being argued, it's a case of information flow. If the information about A says that B=A*N and then we replace all A with B we no longer have the information about all A's to set the value of B. The value of A becomes B/N where we must consider all A's equal regardless of the drift in risk associated with individual members of the set of
A. Our knowledge of where the risk is changing is hidden somewhere in the averages of B. It's the same thing when we must give up on knowledge about the position/momentum of any given air molecule to talk about temperature.....Well, I then must ask: Are you forgetting the 7-28-08 bill signed by Bush that guaranteed 300+B of mortgage subprimes? I calculate this to have been ample to handle all subprimes that did or might fail. Thus they were in fact elevated to the stature of regular federally insured loans.

This should have propagated thru all subprimes and firmed up all values of derivatives based on subprime. The obvious exception would be cases where one of many Slick Shysters takes subprime X and puts it in Derivative A, B, C and D (essentially selling the same thing multiple times). Which is jail time for the perp ...

[hamelekim]

Greenspan isn't shocked, he knows human nature, he worked in the banking industry for decades. He's just covering his ass at this point. There were numerous economists who said this would happen, they've been saying it for a long time too. The people who dismissed them either ignored the real evidence or they knew what would happen but let it occur anyway, for whatever reasons.

[my_wan]

Well, I then must ask: Are you forgetting the 7-28-08 bill signed by Bush that guaranteed 300+B of mortgage subprimes? I calculate this to have been ample to handle all subprimes that did or might fail. Thus they were in fact elevated to the stature of regular federally insured loans.

This should have propagated thru all subprimes and firmed up all values of derivatives based on subprime. The obvious exception would be cases where one of many Slick Shysters takes subprime X and puts it in Derivative A, B, C and D (essentially selling the same thing multiple times). Which is jail time for the perp ...

I haven't forgotten. This was essentially a stop gap measure though that didn't by any means fix the root of the problem. Even if it payed for every single foreclosure on the books for the foreseeable future the only way to prevent a crash at that point was to continue growing the bubble. Which would only make it worse in the future. The sub-prime borrowers were tapped out and investors were realizing the trouble we were already in. The damage was already done before the collapse and the value of sub-prime derivatives could not be maintained even if the principle was safe. Bubbles always create collateral damage when they pop and the only way to stop a bubble from growing is to pop them. Throwing money at it may ease the repair afterwords but in no way prevents the damage. Once the market dries up then the banks can no longer liquidify their mortgages. Those caught holding positions with these mortgage derivatives are hurt financially and a large portion of their assets may be gone. Even without a single shyster in the bunch it's going to hurt, a lot. Shysters do make it worse.

I don't know of any cases were the same mortgage was placed in multiple derivatives. This would definitely be jail time for those caught, unlike the naked shorts which is essentially counterfeiting stocks itself. We should have no patience for the shysters and little pity in giving them some hefty jail time and fines. We must be careful about who we make the demons out to be though. Even if everybody followed the rules this mortgage bubble was going to hurt badly when it popped.

Greenspan isn't shocked, he knows human nature, he worked in the banking industry for decades. He's just covering his ass at this point. There were numerous economists who said this would happen, they've been saying it for a long time too. The people who dismissed them either ignored the real evidence or they knew what would happen but let it occur anyway, for whatever reasons.

Yes he knows his stance was a mistake now, or should. It really depends on the ontology he attaches to the concept of statistics. He might still hold some notions that this was a freak accident, which can happen rarely, but it's not a very solid position to hold right now. He did buy the theory in 2004 though. There was even a Nobel prize given on the notion that it would work. You must remember that Greenspan thinks almost completely in terms of macro-economics. When demand is created that greatly outpaces supply then the pressure to meet that demand creates all sorts of strategies, even criminal strategies. Greenspan himself suggested in 2004 that alternative debt istruments should be developed. You can look at all the multiple strategies and say this or that strategy was wrong or caused the collapse of demand. Yet it was the mechanism that created the huge demand at the root of the issue. No amount of regulation on supplying that demand is going to stop the bubble from growing so long as that demand exist. The demand was created on the false notion of risk control. The notion that even in a market downturn you could hedge your funds against loss by the mechanism of put-call parity. In a market crash there is no put-call parity, it's all one sided. When people realize that valuations are well in excess due to underestimation of risk you get a crash. It was the Black-Scholes equation or similar thinking that created both the demand due to the perception of low risk and the crash when the bubble got so big that investors started realizing how vulnerable they were, or worse that their portfolios were drying up before they knew what was happening. Any financial institution that actually understood the risk beforehand could have easily avoided getting hurt by the collapse, or even profited from it. Why didn't they? Because they believed they were well hedged and safe.

[mhaze]

I haven't forgotten. This was essentially a stop gap measure though that didn't by any means fix the root of the problem. Even if it payed for every single foreclosure on the books for the foreseeable future the only way to prevent a crash at that point was to continue growing the bubble. Which would only make it worse in the future. The sub-prime borrowers were tapped out and investors were realizing the trouble we were already in. The damage was already done before the collapse and the value of sub-prime derivatives could not be maintained even if the principle was safe. Bubbles always create collateral damage when they pop and the only way to stop a bubble from growing is to pop them. Throwing money at it may ease the repair afterwords but in no way prevents the damage. Once the market dries up then the banks can no longer liquidify their mortgages. Those caught holding positions with these mortgage derivatives are hurt financially and a large portion of their assets may be gone. Even without a single shyster in the bunch it's going to hurt, a lot. Shysters do make it worse.

I don't know of any cases were the same mortgage was placed in multiple derivatives. This would definitely be jail time for those caught, unlike the naked shorts which is essentially counterfeiting stocks itself. We should have no patience for the shysters and little pity in giving them some hefty jail time and fines. We must be careful about who we make the demons out to be though. Even if everybody followed the rules this mortgage bubble was going to hurt badly when it popped.
Yes, but if we exclude the 7-28 bailed out subprimes what we are left with is the overall effect of a drop in housing values - note this affects 100% of the market, not 3% (subprimes) Never before has a natural correction in property values caused anything like this.

Sort of related-

http://www.minneapolisfed.org/research/WP/WP666.pdf

I'm still pondering your concept of
"risk control/even in a market downturn you could hedge your funds against loss by the mechanism of put-call parity"
And the necessary corellary of how stupid people would have to actually believe it.

[Uncayimmy]

I blame stupidity and greed. Stupidity on the part of the legislators and their lack of instigating sufficient overseer institutions w ith real powers. And greed in the sense of the unscrupilous who repackaged the sub-prime loans into shiny new bottles.

C'mon, now, lots of people were greedy and stupid, and that includes the Average Joe on the street. The housing market (like the .com boom before and the oil futures market afterwards) was driven by speculation. Real estate typically appreciates over time. If the appreciation is abnormally high, ask yourself why. If there's no "real" explanation like population growth or running out of land, then what is it?

If a home appreciates by 50% in two years due to speculation, then chances are that it's going to slide backwards at some point. Speculation has to end eventually. There were a number of loan packages that were excellent for speculation, but people started using them to buy homes after selling their current home. Now they are sitting in homes where they have very little invested and the loan amount is greater than selling price. Lots of people are just giving them back to the bank. Other people counted on future appreciation in order refinance in a way they could afford. Now they're screwed.

The banks were just as stupid for making too many of these loans. Multi-family buildings were also hit hard, but it was the same stupidity on both sides. If a building was going for $35K per door in 2004 and now they are selling at $80K per door, are they really *worth* that much? Not really. Are the rents going to go up accordingly? Maybe for a while, but they, too, will drop. Remember, the investors who didn't sell could still afford to undercut the recently purchased buildings.

Lots of people made lots of money, including Average Joe. But when the music stopped, there weren't enough chairs left for everyone to sit down.

In the future how do you deal with a speculative market? I'm no finance expert, but I say you have to take a hard look at appraisals and/or the loan to value percentages. Common sense says that if a building/home appreciated at X% over the last 10 years and at 4X% over the last three years, then the value is most likely overstated. But the bank appraisals *only* looked at the most recent sales.

So either you change the appraisal formula (tricky) or simply decrease the loan to value percentage. Not only does this make the loan safer, but it has the added effect of applying friction on the speculative market. But the key is you can't just look at a six month snapshot to truly appraise the value of real estate.

Of course, doing this means people make less money. Sigh...

[my_wan]

Yes, but if we exclude the 7-28 bailed out subprimes what we are left with is the overall effect of a drop in housing values - note this affects 100% of the market, not 3% (subprimes) Never before has a natural correction in property values caused anything like this.

Sort of related-

http://www.minneapolisfed.org/research/WP/WP666.pdf

In the S&L crisis of the 80s banks lost more money than they had made previously in the history of banking in the US. I presume that is un-adjusted dollars. The biggest difference here, the reason such a correction had such a far reaching effect, is that this time the cost/risk was bundled with through derivatives in the portfolios of from nearly every sector of the economy. This includes 401Ks, life insurance, mortgage insurance, bank assets, business assets, etc. My response to the put-call parity issue below articulates this even more.

The S&L crisis was also different in that the increasingly risky behavior was an attempt to survive rather than simply profit. Thanks for the link, that is interesting.

I'm still pondering your concept of
"risk control/even in a market downturn you could hedge your funds against loss by the mechanism of put-call parity"
And the necessary corellary of how stupid people would have to actually believe it.

This concept was not mine but has been a fundamental economic assumption since well before even Black–Scholes. When supply and demand is at or near equilibrium this assumption is more than reasonable. Black–Scholes used this put-call parity as the foundation for how to go about evaluating the price/risk of derivatives, then replaces the stock itself with a derivative of the stocks. It spread the risk of a few bad loans over a large group of loans making stock in the derivative safer in theory. This created a huge demand well in excess of the supply of mortgages which is not accounted for in the original put-call valuation. It also made it nearly impossible to see the growth in the risk of these loans because it was spread over such a large group of loans that appeared good at the time. Had these bad loans been restricted to the smaller entities making them, or the specific underlying stock, the real risk as well as the source of that risk would have been obvious years ago. This is what I mean when I claim that derivatives break the price/risk mechanism they depend on for legitimacy, i.e., when the derivatives replace the underlying stock as the stock being traded.

I used to think that as our economy gained in size and diversification that the effect of crisis in a particular area on the whole economy would be greatly reduced. Boom/bust cycles are an economic reality no matter what we do to try and control them. Even core industries like steel and energy could benefit from diversity to some extent. Any particular sector could go through boom bust cycles without much meaning to the whole economy. Derivatives attempts to provide a safety net against bust cycles by spreading the bust cycle throughout the whole system. It therefore lets the bust cycle propagate on a grand scale undoing the safety net we get from economic diversity. It trades individual risk for systemic risk.

[my_wan]

<sniped>
I snipped the whole post for brevity but I wanted to note that I couldn't find a single point to take issue with in that post.

[DanishDynamite]

C'mon, now, lots of people were greedy and stupid, and that includes the Average Joe on the street. The housing market (like the .com boom before and the oil futures market afterwards) was driven by speculation. Real estate typically appreciates over time. If the appreciation is abnormally high, ask yourself why. If there's no "real" explanation like population growth or running out of land, then what is it?

If a home appreciates by 50% in two years due to speculation, then chances are that it's going to slide backwards at some point. Speculation has to end eventually. There were a number of loan packages that were excellent for speculation, but people started using them to buy homes after selling their current home. Now they are sitting in homes where they have very little invested and the loan amount is greater than selling price. Lots of people are just giving them back to the bank. Other people counted on future appreciation in order refinance in a way they could afford. Now they're screwed.

The banks were just as stupid for making too many of these loans. Multi-family buildings were also hit hard, but it was the same stupidity on both sides. If a building was going for $35K per door in 2004 and now they are selling at $80K per door, are they really *worth* that much? Not really. Are the rents going to go up accordingly? Maybe for a while, but they, too, will drop. Remember, the investors who didn't sell could still afford to undercut the recently purchased buildings.
In short, there was no reason for the bank not to make ridiculously unsound house loans.

What garbage!

As oon as the worth of a house rises above "real" income increase, even an idiot would know that a Bubble was occuring.

[my_wan]

In short, there was no reason for the bank not to make ridiculously unsound house loans.

What garbage!

As oon as the worth of a house rises above "real" income increase, even an idiot would know that a Bubble was occuring.

That is by no means what UncaYimmy stated. He quiet clearly stated, "The banks were just as stupid" and "it was the same stupidity on both sides". How this gets construed to mean, "there was no reason for the bank not to make ridiculously unsound house loans", is beyond me. I will give your "garbage" quote credit in that if he had meant what you interpreted it would in fact be garbage. As it turns out the "garbage" quote belongs elsewhere.

[Francesca R]

Are people "stupid" just because they fail to get out of a highly appreciating asset before it falls, or are they still stupid even if they find that "greater fool" to sell to in time?

Are they "smart" if they short the highly appreciating asset in anticipation of a rapid fall and they profit from that, and are they still smart if they short the appreciating asset but greater fools drive them into a loss (on which they choke) before they are able to profit from a later price fall?

In other words, are you (my wan) awarding the label "stupid" (and by implication "not stupid") purely on the basis of realised P&L?

[my_wan]

Are people "stupid" just because they fail to get out of a highly appreciating asset before it falls, or are they still stupid even if they find that "greater fool" to sell to in time?

Are they "smart" if they short the highly appreciating asset in anticipation of a rapid fall and they profit from that, and are they still smart if they short the appreciating asset but greater fools drive them into a loss (on which they choke) before they are able to profit from a later price fall?

In other words, are you (my wan) awarding the label "stupid" (and by implication "not stupid") purely on the basis of realised P&L?

Very reasonably question. Personally, except by proxy in defending UncaYimmy, I avoided the label "stupid". My only reference to the term prior to that was to say, "Stupidity is subjective". I didn't object to UncaYimmy's use of the term as it was used as a direct objection to DanishDynamite's assertion of, "I blame stupidity and greed". UncaYimmy's use was then merely a logical device to show that the term belonged equally, if at all, across all spectrums of people, including the "average Joe".

The speculators win, lose, or draw that was in it to try and time the short term market are not the relevant group under consideration here. Black–Scholes isn't designed to say anything about these tactics. Their successes and failures are independent of any long term viability of the stock. The relevant group that could arguably qualify for such a label is the institutional investors in it for the long term security Black–Scholes was designed for. This includes some 401k management, some banks, lots of life insurance policies, loan default insurance, etc. AIG got into financial trouble because they never considered the possibility that one loan default could have any effect on the odds of another default. If we accept the "stupid" label wrt the mortgage crisis at face value then even the Nobel Prize committee qualifies. Neither I nor UncaYimmy made in claims of the term being relevant in assigning blame. Me by avoiding the term, even the OP title says "nobodies fault", and UncaYimmy by using it as a rhetorical device to show lack of relevance.

[Francesca R]

Well I still can't really work out what this topic is about. Is it something to do with the belief in log-normal price changes? Persistently diversified mistakes? Excessive leverage? What? Thanks

[Uncayimmy]

Thanks to My_Wan for stepping in for me as needed. You're right, I used the term "stupid" because DanishDynamite chose to use it. I don't think it's the right word, but whatever it is, it was spread around pretty evenly.

I'm not an economist, so I'm sure I will miss some minor and probably major points. However, I'm gonna take a stab at it. If I understand My_Wan's point, it goes something like this


Average Joe figures the bank won't make him a loan that's a bad risk (I hear this all the time).
The mortgage officer figures underwriting won't make a bad risk loan.
Underwriters figure their guidelines won't let them make a bad risk loan.
The folks writing the guidelines know there is risk, but work to make it merely a calculated risk.
The people selling the loans figure that ultimately the market will determine what's bad risk or not. If they can sell the loans, they must be okay.

The market, however, is not seeing individual loans. The risky paper is bundled with the good paper. The bundles began determining the value of the individual loans rather than vice-versa. It's not immediately apparent that there's a problem somewhere. When the problems do creep up, the banks have to change their guidelines. This works its way back upstream.

It now becomes harder to buy property because the financing is tougher to get. This means less demand for any given property. Less demand means lower prices.

When the selling prices go down, one thing that happens is that people can't refinance like they expected and needed to. This causes them to default. The default moves downstream to all the bundled mortgages and makes them worth less than before. This in turn comes back upstream in the form of tougher lending requirements. This in turn reduces the amount of credit available. This lowers demand. This lowers prices even more.

You end up with another kind of foreclosure: People who put very little down on their homes. The loan balance exceeds the selling price of the home. Since they have very little invested, they don't want to make payments on a $400K home that is valued now at $320K. It's not that they can't afford, they just prefer not to, so they give it back to the bank (let it foreclose or do a short sale). If they had put down $80K, they would probably still be making payments to protect that investment.

These two general types of foreclosures result in more homes for sale. So, while at the same time we've decreased the buyer pool due to credit we have *increased* the number of homes for sale.

There are lots of other factors at play, but in my mind they can be left out for now.

So, where did things go wrong, so to speak? The problem was in the market for the mortgages. Since they were bundled up, it was harder to see the problems. The bundles then began driving the price of the individual papers rather than the other way around. This allowed more of these risky loans to be made before the system started regulating itself. By then the bubble was too big.

Then again, *every* single entity involved had the opportunity evaluate the risks. Nobody forced anybody to place offers higher than the asking price the morning the house went on the market and *before* even seeing it. Nobody told people to sell their homes, spend the equity on vacations, and buy a more expensive home with very little down. Nobody made anybody gamble on their primary home hoping that it would appreciate enough so they could afford it.

Nobody forced the banks to think in six-month snapshots in order to set the value of a property. Nobody told them they weren't allowed to reassess their risk guidelines, which were based on a stable market, not a bubble. And nobody told investors that these loan packages were risk free and that they could assume everything was hunky dory.

In and of themselves sub-prime loans were not the problem. Speculating is not itself a problem. Using your equity instead of putting it into your next home is not itself a problem. The problem is balance. The market didn't correct itself in a timely fashion.

So, we're back to the subject: the crash was nobody's fault (or everybody's fault).

[my_wan]

Again UncaYimmy has posted a reasonably valid caricature of the situation even if the details may vary a bit. My main argument is that trading derivatives rather than the underlying stock breaks the ability of the market to correct itself in a timely fashion. The value of the derivatives was designed to be set by the underlying stock value, not the other way around. The derivatives simply don't contain the same feedback information needed for timely market corrections because increases in risk gets averaged out making them essentially invisible in the short term. Also hidden by these derivatives is which practices created what level of risk. UncaYimmy was correct in saying the problem was market balance. At the market level its the balance between value and risk. The Black–Scholes valuation method depends on a nearly perfect relationship between value and risk for the valuation method to have legitimacy and reduce the institutional risk through averaging the bad loans. Yet the averaging breaks the ability of the market to track the changes in the risk/value ratio in a timely manner or even the specific source of the changes in risk.

[Uncayimmy]

I created a caricature? I didn't even know I was an artist! :-) Seriously, though, I think that's a good description of what I wrote. It's more complicated than I described or even understand.

[Francesca R]

[ . . . ] So, we're back to the subject: the crash was nobody's fault (or everybody's fault).Well, "everybody's fault" sounds more like it to me. And when everybody makes a mistake in the same direction (positively correlated) then the effects can be too adverse for everyone involved to bear, which means that the cost explodes externally, and if there is an external authority it has little choice but to come to the rescue. It then has a legitimate incentive to re-rig incentives so that a repeat occurrence is a lot less likely. Although as history records, excessive correlated leverage seems to have a way of manifesting somewhere new, eventually.

I don't know that the Black-Scholes forumla has much to do with this. Bubbles and busts predate it by a few centuries. It is not within governments' powers to dictate what risk assessments participants make, but it is within their power to impose its own in the form of restrictions of leverage, in the public interest (the public has a legitimate interest in not being adversely affected by unrelated private decisions working out badly for those deciders)

[Francesca R]

My main argument is that trading derivatives rather than the underlying stock breaks the ability of the market to correct itself in a timely fashion.I don't see why. In any case, markets have the ability to be "incorrect" regardless of complex derivatives. Plenty of auctions of (unleveraged) claims attest to that.

The value of the derivatives was designed to be set by the underlying stock value, not the other way around.Both of a derivatives price and an underlying security price are set by market supply and demand. What you might mean is that if the open interest in one of these is much larger than it is in the other, then it is not possible (for everybody) to arbitrage between the two of them in a panic.

The derivatives simply don't contain the same feedback information needed for timely market corrections because increases in risk gets averaged out making them essentially invisible in the short term.I don't see what is being "hidden" in respect of market price risk. There are several things that are not, and never were embedded in the Black-Scholes equation, such as the third and fourth moments of variation (skewness, kurtosis). There is also the observed reality that market prices are not fully explainable by any well-known parametric function (and neither can they be fitted to a true scale-invariant power law function, although that does contain an enlightening model of "correlated mistakes"). These things are often neglected and/or not understood, but they are not hidden. They are overlooked at the user's peril, but competitive pressures incentivise such behaviour, as can moral hazard.

[my_wan]

I don't see why. In any case, markets have the ability to be "incorrect" regardless of complex derivatives. Plenty of auctions of (unleveraged) claims attest to that.

The reason why is because in all cases where you average groups together you give up information about individual members of that group. Consider 20 bags of marbles mixed together and a count of the broken marbles is 5% of the total. If 100% of the broken marbles came from bag 5 you can no longer determine that fact from the average. They are now mixed in a single bag containing all 20 bags of marbles. Without the mixing and averaging of your marbles you may have learned that you could have avoided broken marbles simply by avoiding marbles from company X. Since company X is now just as successful at selling you cheap worthless marbles company Y and Z must now borrow from company Xs practices of selling cheap marbles to compete. How many broken marbles will you tolerate before you quit buying any marbles at all? So yes, you can be incorrect in the initial value you paid for the marbles from company X. Only through derivatives will you continue buying from company X thus propagating the practice of selling broken marbles through the other companies. It can just as easily be the model number of the marbles as it is which company they came from, like the credit worthiness and terms of the mortgage in question.

Yes markets often do massive corrections of (unleveraged) claims but only in leveraged claims must the corrections unduly extend across otherwise healthy sectors of the market. This is because the derivative itself cannot distinguish between the parts needing correction and the healthy parts simply averaged in.

Both of a derivatives price and an underlying security price are set by market supply and demand. What you might mean is that if the open interest in one of these is much larger than it is in the other, then it is not possible (for everybody) to arbitrage between the two of them in a panic.

True. However, like the broken marbles, price is set by market supply and demand. Demand for 95% good marbles is certainly higher than demand for 100% broken marbles. Derivatives allow credit J and/or terms K that produce well above 5% broken marbles to trade at the value of only 5% broken. No that is not what I mean. Arbitrage limits are the same whether it is derivatives or not. Arbitrage is possible in both cases under normal trading and not possible in both cases in a freefall sell off. What I'm talking about is the information lost in the averaging of derivatives.

I don't see what is being "hidden" in respect of market price risk. There are several things that are not, and never were embedded in the Black-Scholes equation, such as the third and fourth moments of variation (skewness, kurtosis). There is also the observed reality that market prices are not fully explainable by any well-known parametric function (and neither can they be fitted to a true scale-invariant power law function, although that does contain an enlightening model of "correlated mistakes"). These things are often neglected and/or not understood, but they are not hidden. They are overlooked at the user's peril, but competitive pressures incentivise such behaviour, as can moral hazard.

What is being hidden is the source of the risk. Like the 20 bags of marbles the derivative must simply assume that the broken marbles is systemic of all bags of marbles. In fact the vast majority were the result of credit J and/or terms K of a small number of loan practices that couldn't be tracked by the derivative valuations. You can rightly say they were not hidden because those bad marbles showed in the 5% broken rate. Except in cases were introductory periods were followed by draconian payments, which was hidden by flipping the house prior to defaulting. However, in order for a mortgage broker to compete on equal grounds they must adjust credit J and/or terms K more in line with that 5% or be driven out of business by the competition. It is not the bad marbles that was hidden, it was the source of risk defined by credit J and/or terms K. Market forces then dictate that this 5% must increase until nobody can sell marbles anymore without taking a loss.

The mortgage turnover rate and easy credit allowed the system to play hot potato with the risky mortgages where the property was flipped prior to the mortgage going bad. This allowed a 45% broken marble rate to show only 5%. Ever watched the TV shaw called 'Flip This House' on A&E? Homeowners were using the same loan terms as these speculators to buy more house than they could afford and flipping them a year later to avoid defaulting the loan. If your a mortgage broker that says no to this you don't stay in the mortgage business.

[mhaze]

The reason why is because in all cases where you average groups together you give up information about individual members of that group. ....

Not intending a derail, but I would like to get ahold of scanned copies of some of these derivatives and credit swapagreements which are the facts at the basis of the discussion.

Anyone know where/how they could be had?

[Francesca R]

I would like to get ahold of scanned copies of some of these derivatives and credit swapagreements which are the facts at the basis of the discussion.

Anyone know where/how they could be had?Credit default swaps are traded between institutional market participants and normally executed under the undertakings of an ISDA Master Agreement (1992 or 2002), that would already be in existence and signed by the two counterparties to the swap. (ISDA (http://www.isda.org/) = International Swaps and Derivatives Association, which is not a regulatory body but a trade organisation that exists to promote "best practice", and the industry)

See here (http://www.isda.org/publications/isdamasteragrmnt.html), and here (http://www.isda.org/publications/isdacredit-deri-def-sup-comm.html) for CDS supplements. (You have to buy the relevant literature and it is not brief. This may affect your desire to research it ;) )

An individual swap contract executed under an ISDA is not something I can find a template of on the net, but is a statement of the terms of what each party pays and receives. Usually one of those is LIBOR plus/minus a spread and the other is the return of, well, anything pretty much.