A good deal of what I do as an investment advisor is try to explain to clients certain finance-related concepts that they might read about in the paper but, because they're not in the business, don't completely understand. I didn't think I would do much of this but to my surprise I've found I enjoy it, and am pretty good at it I'm told.
I believe part of what I could offer a family office client/employer is the ability to explain investing to the non-expert. At the risk of "talking my own book," in my experience most finance professionals are actively bad at this. Maybe they have no patience to explain things, or they think it's beneath them to have to deal with such simple things, or, worst of all, they don't understand what they're doing well enough to explain it to someone else. Or maybe the ability to teach well and like it is independent of your underlying motivation.
My philosophy of explaining things is as follows: Leaving aside the benefit others get, from a purely selfish POV your ability to explain a complicated subject to a non-expert can only help you. As Vince Lombardi or Peter Lynch demonstrated, (who if I'm not mistaken both received a Jesuit education, which stresses the ability to explain from first principles. Maybe a topic for another post.) the ability to teach something so that everyone can understand it is a mark of your own ability to understand and think. Plus it tests your ability to discard the jargon that all priesthoods set up "as a conspiracy against the laity." Warren Buffett is the king of this. However, like Einstein, I believe that everything should be made as simple as possible . . . but no simpler.
On that note, and in the hopes of advancing my career prospects, I will be posting some of my answers to the "Could you please explain . . .?" questions I get from clients and friends. Starting with the following question from my law school friend: "Could you please explain CDS (credit default swaps)?"
1) A credit default swap (CDS) is a form of insurance
for bondholders. Anyone who holds a bond is exposed
to the risk that the bond will default, in which case
the bond either becomes worthless or worth only a
fraction of par, depending on its recovery in a
bankrputcy or restructuring.
2) The idea of insurance simply means that in
exchange for a payment to someone else, the person
exposed to the bond's default risk transfers that risk
to someone else.
3) Mechanically, in a CDS there are two parties: the
buyer and the seller (or writer). Back in Garden of
Eden days, the buyer was a bondholder worried about
the likelihood of his bonds defaulting, and the seller
was a Wall Street bank with a good enough credit
rating to ensure performance. Today CDSs are used for
hedging and speculation, so the buyer can be anyone
and the seller can be anyone.
4) Just about all CDS contracts state the security in
question (e.g. the unsecured debt of )
and the two initial counterparties (buyer and seller).
The buyer of protection agrees to pay an annual fee
to the seller. This fee is usually stated in terms of
basis points of par. Think of it as an insurance
premium, no different than a car insurance premium.
5) If all goes well and the bond pays off at
maturity, the premium payments are "wasted": the
bondholder's total return is whatever interest and
principal paid him, muinus the CDS
insurance premiums paid to the CDS writer. The writer
of the CDS, on the other hand, is a winner to the tune
of whatever CDS payments he received during this
period, just as is the winner when your car
doesn't crash. Neither the CDS writer nor has
to do anything else.
6) If, however, the bond defaults, the writer of CDS
protection is now on the hook. The buyer of the CDS
is entitled to be made whole. There are two ways to
do this. The first is physical settlement: the
holder of the defaulted bond physically delivers it to
the CDS writer, and in exchange receives in cash the
par value of that bond. Now the CDS writer is the
holder of a crappy defaulted bond and will try to get
whatever it can for it. The second way is cash
settlement: Both parties wait to see what the
defaulted bonds recovers in bankruptcy or
restructuring, let's say 40% of par, then the writer
of the CDS pays the buyer an amount in cash equal to
the difference between par and the recovery amount.
So in this case, the CDS buyer keeps his bond and gets
40 cents on the dollar for it, then receives cash
worth 60 cents on the dollar from the CDS writer, for
a total of 100 cents total value, making him whole.
7) Note that is not a counterparty to
the CDS contract. It just issues the bonds to the
market and goes about its business, while others
create contracts among themselves that reference the
GM bonds (called the "reference security" in the CDS
8) Also note that the buyer of the CDS is not
required to be an actual holder of the bond in order
to enter into a CDS contract. He can just be a
speculator willing to make a few premium payments to
someone else in exchange for that someone else's
promise to pay him 100 cents on the dollar if some
reference security out there defaults. Today there
are many more CDS contracts written than actual
reference securities out there.
9) Finally note that the writer of the CDS is just
selling a promise: a promise to pay some value in the
future if certain events happen. Therefore the CDS
contract is only as good as the ability of the CDS
writer to keep its promise.
10) Why is this all becoming so important now that
the WSJ is constantly writing about it? Basically two
things are going on:
a) Many of the bonds that had CDS contracts
written on them long ago are starting to default, or
threatening to default. Not so much the vanilla
corporate bonds like GM, but rather the complex
mortgage-backed bonds, especially those tied to
subprime mortgages. Bondholders who used to be happy
to receive their coupons and wait for maturity are now
saying "sh-t, these bonds I own will default.
Fortunately I have insurance and can be made whole.
Unfortunately the person who promised me the
insurance--MBIA, AMBAC, AIG, etc.--made the same
promise on billions of dollars of other bonds. So
maybe my insurance is worthless, which would suck. I
thought these bonds would be worth 100 cents come hell
or high water, but now I may have to mark them down on
my balance sheet."
b) The writers of these CDS contracts put them
on their balance sheets as "assets." Actually, they record
the premiums they receive as assets, and the fair value
of their potential obligations are recorded as liabilities.
If the fair value of these liabilities goes down, the
corresponding increase in shareholders' equity represents
the "profit" from writing the contract. It's complicated.
Think about it this way: If you're party to a contract
that entitles you to receive regular payments (CDS premiums
in this case) and only under certain circumstances to pay out
to someone else (CDS settlements), then the fair value
of the liabilities depends on the probability you'll
have to make your settlement payments in the event of a default,
the magnitude of those payments, and the
(prevailing interest rates). The market now perceives that
the first of those variables, the probability you'll have to keep
your promise to make the CDS buyer whole in the event
of default, is way higher now. So all CDS writers are
having to mark up the liabilities associated with
their CDSs, sometimes very painfully--MBIA and AMBAC
are in danger of going under, AIG just took a multi-billion