In light of the ongoing financial turmoil that surrounds our economy these days, there have been all kinds of terms thrown around the airwaves that seem to do nothing but provide confusion to the regular Joe.  So I thought I’d start picking out a few of these less familiar terms and explain, in English, what they really mean.

Take Credit Default Swaps (CDS) for instance.

A credit default swap is essentially a contract by which a buyer of the contract makes regular payments to the seller of that contract, and in return will get a payoff if a credit instrument, such as a bond or other financial note, goes into default.  You could also think of a CDS as insurance against default of a particular entity.

The price of the contract (also referred to as the spread) is the price in which the buyer will pay annually over the terms of the contract.  If the CDS spread of a particular institution is 25 basis points, the buyer will have to pay $2,500 annually on $1 million worth of default protection.  Naturally, the higher the spread, the more likely the institution will default.

How about an example?

Let’s say you’re not sure that Million Mile Auto Works will survive this economic mess, and will probably default on a loan from a bank. The spread on the company is 52 basis points, and you are so sure of this that you’re willing to take out $1 million worth of insurance.  You draw up a contract between you and a bank offering the CDS for a 10 year term.

So you start paying out $5,200 per year on terms defined in the contract.  If Million Mile Auto Works defaults on a financial instrument defined in your contract, you get paid the $1 million upon that default (the payout is based on the terms negotiated in the contract, and is not necessarily exactly $1 million).

So what happens if the company doesn‘t default?

You keep paying the $5,200 to the bank until the end of the contract, and you’re done.  You’re out.  You have no return.  At the end of 10 years you would have a $52,000 loss.

So you pay this to a bank and not the company?

Yes and no.  Million Mile Auto Works could write their own contracts for CDSs, or it may be a bank writing CDS contracts, and that bank may have no involvement with the reference entity at all.

Could a company buy a CDS against another company it does business with?

Yes, and this would be a hedge against the liability in that relationship.  Let’s say your company sells widgets to another company, and your company provides the other company a million dollar line of credit to purchase those widgets.  To hedge that line of credit (i.e. to offset the risk that the other company won’t pay on their credit) your company buys a million dollar credit default swap at some spread.  If the company pays off the line of credit, you lose money through the payment of the CDS, but at least the company paid off the line of credit.  If they default on that line of credit, your company is paid on the $1 million contract.

Sounds complicated!

It’s a fairly sophisticated financial instrument that was developed back in 1997 by a group of people working for JPMorgan Chase. The concept was drawn up and inserted within a 11,000 page bill and pushed through congress on the last day before the Christmas holiday with no debate in either the house or senate.

CDSs can be used as a financial tool to protect against default, but they’re not for the average investor.  With the lack of transparency in todays financial system, it would be tough to determine the terms of a CDS contract.

Finance, Wall Street Lingo CDS, Credit Default Swap, hedging

Sometimes you have to go with your gut, and when your gut ends up being right, you get this warm and fuzzy feeling that you may actually know a thing or two.

Frequent readers of The Corner Office Blog know that I’ve been bearish of Chesapeake Energy (CHK: chart, web, Y!) due to their huge amount of debt (and the pilfering of shareholders to pay off that debt by diluting the stock) when commodity prices were at record highs.

I’ve owned CHK before and have made money off the stock, but when credit started tightening over the last year to 18 months, I knew CHK would end up with a target on its back just due to the debt alone.

Well, it seems the debt has come back to haunt Chesapeake, along with an in-house trading philosophy that ended up costing the company $1.6 billion on paper, and forced CEO Aubrey McClendon to sell all of his own companies shares involuntarily.

Here’s how it all went down.

Chesapeake was making money hand over fist when commodity prices were high, just like any other player in the field.  Then, their trading operations made the gamble that the run on oil and gas wouldn’t continue.  So the company bought options and other financial vehicles to lock in the current rates (around $120/bbl for oil at the time) to protect from what they saw as an expensive downside risk (also known as hedging).

So what happened?  Oil continued to rise to a high of just over $145/bbl in July of this year.  That’s actually a good thing for Chesapeake, right?  Not necessarily.  Since Chesapeake hedged their oil at $120, they were only getting paid $120 for every barrel they pumped, not $145 that was the current market price.  Again, they’re still making boo-coo bucks at $120 oil, but they could have been making more.

The fact that they could have been making more shows up as a loss on the balance sheet.  All in all, Chesapeake could have made as much as $1.6 billion more if they had not hedged their oil and gas at lower prices.  So this goes as a loss on the books for the second quarter.

What effect does the debt have?

Creditors typically want to see that their their loans are safe, and as such they write in certain conditions that if met, they reserve the right to call the note.  Sort of like having a margin call if you can’t maintain the margin requirements. Read more…

Energy, Investing, Oil & Gas CHK, hedging, margin, oil and gas