Credit Derivatives & Other Acts of Satan

1. Credit Derivatives & Other Acts of Satan Remarks by Christopher Whalen to The Icelandic Financial Services Association April 15, 2008 www.institutionalriskanalytics.com

2. What is a Credit Default Swap? • A CDS is a private contract between two parties who wish to take a position regarding the probability of default or P(D) of a given obligor. Despite name, CDS encompasses all market & credit risks regarding an obligor. • Not a true “swap” where value is exchanged between parties, a CDS is more akin to an insurance or gaming type instrument, where one side pays for protection against events.

3. What is a Credit Default Swap? • Originally, CDS required the seller of protection to deliver the underlying debt in order to collect on the insurance or wager, creating a direct link to the underlying basis. • With default by Delphi in 2005, however, when speculative positions outnumbered eligible debt 30:1, CDS contracts moved to a largely cash settlement process, where no connection to the underlying basis exists.

4. What is a Credit Default Swap? • A cash settlement CDS contract allows a speculator to write unlimited amounts of short put positions with little margin or accountability to dealers and/or regulators. • CDS creates “net” incremental systemic risk in the global financial system by layering leverage and new counterparty risk between the clearing banks, dealers and funds a la Bear, Stearns failure.

5. What is a Credit Default Swap? • Some hedge funds treat CDS as a convenient Ponzi scheme, writing short positions with no capital to back these contingent obligations and booking fees as current income. • The ability of writers of protection to generate income at little or no capital cost creates vast moral hazard in the markets. Since hedge funds have no capital or reserves, the ability to perform on future obligations is doubtful.

6. The CDS Daisy Chain “In the OTC derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party. It's an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit. The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps… Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don't know who will wind up with obligations they thought they had insured against and they can't meet.” Martin Mayer Barron’s 4/14/08

7. What Drives CDS Spreads? • Spreads on the cash debt and/or equity instruments of the obligor. • Implied and/or actual volatility in the debt/equity/options instruments of the obligor. • Speculative volume in all securities of the obligor.

8. How Influential Are Speculators? • Speculative flows in the underlying debt and/or equity of an obligor are the chief influence on pricing. • “Hedging” in a given name is arguably the second most important influence because of the speculative nature of the CDS markets.

9. How Do Speculators Operate? • Hedge funds frequently collude with one another and dealers to coordinate and magnify the effect of “bear raids” on specific obligors in violation of US securities laws. • Using a network of traders, journalists and other surrogates, hedge funds are able to increase the effect of leveraged short sales against specific names in the CDS markets.

10. What Do CDS Spreads Say? • Are CDS spreads a good indication of obligor credit quality? No, the lack of a physical connection to the underying cash basis mutes the direct tie to obligor P(D). • CDS spreads are, however, a good EMT barometer of short-term market sentiment regarding how sophisticated investors/ speculators perceive the health of an obligor or market.

11. Valuing CDS Spreads • There are a number of ways to value a CDS, but the two key reference points are a) the yield spreads of underlying debt and 2) the volatility of equity/options. • Since some traders use CDS as a means of hedging equity volatility, valuation becomes a much more complex task than merely comparing CDS spreads to bond yields.

12. US Banks & Derivatives • U.S. commercial banks generated $2.3 billion in revenues trading cash and derivative instruments in Q3 2007, down 62% from the $6.2 billion reported in Q2. • Bank derivative contracts remain concentrated in interest rate products, which represent 81% of total notionals.

13. How to Counter “Bear Raids” • A coordinated legal and financial response to hedge fund collusion may be effective in defending against the most serious types of market manipulation. • Avenues of action include state-to-state cooperation, enforcement actions by home nation supervisors, civil litigation against specific hedge funds, and market action.

14. Corporate Offices Lord, Whalen LLC dba “Institutional Risk Analytics” 371 Van Ness Way, Suite 110 Torrance, California 90501 Tel. 310.676.3300 Fax. 310.943.1570 info@institutionalriskanalytics.com WEBSITE: www.institutionalriskanalytics.com For inquiries contact, R. Christopher Whalen Head of Sales and Marketing Tel. 914.827.9272 Cell. 914.645.5304 cwhalen@institutionalriskanalytics.com Contact Information www.institutionalriskanalytics.com