Deus Ex Macchiato

Bloomberg tells us that

The Options Clearing Corp. threatened to liquidate Lehman Brothers Holdings Inc.’s trading positions in the 2008 financial crisis unless Barclays Plc bought its brokerage and took on the defunct firm’s obligations, a lawyer for the U.K. bank told a judge… A similar liquidation of Lehman derivatives the same month by options and futures exchange CME Group Inc. cost Lehman’s creditors $1.2 billion, according to a report by bankruptcy examiner Anton Valukas.

Motivated by this, let me ask a hypothetical question. Suppose a firm has an asset which, were the firm to be a going concern, would produce cashflows with the PV of 100. However, the firm is not a going concern, and on forced sale, the asset is worth 60. A party approaches the liquidator and offers 80. There are no other bidders. Should the liquidator accept?

The standard theory of the duty of liquidators says yes: 80 is more than 60. This, it seems to me on a naive reading of the article (and with the usual I am not a lawyer caveats), is all that is going on here. Barclays offered less than the assets were worth as a going concern, but more than they would likely fetch in a forced sale. It’s tough for the creditors, but not as tough as a forced sale. Going concern value is not the same as forced sale value. Nothing to see here, move on.

Posted in: Clearing and Collateral, Legal Risk and Trade Documentation by David /
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Suppose you find yourself in a situation where you have to leave money with a financial institution. If it isn’t a deposit, then it won’t be covered by any deposit protection scheme. How can you protect yourself against the institution failing? The answer always used to be, make sure that the money is classified as client money and fully segregated. That is, the firm has to keep it somewhere apart from its own money, and you can identify and reclaim it in the event of default. How that works is horribly complex, as are the regulations for client money, but the idea is simple enough.

Now, in CRC Credit Fund Ltd and others vs. the Administrators of Lehman Brothers International, the Court of Appeal has thrown a spanner in the works. They have ruled that what counts as client money is not the money that has been properly segregated, but rather that it also includes funds that should have been but weren’t. [The usual 'I am not a lawyer, this is not advice' caveats apply here and throughout.] That’s hideous. It means that there is no point in checking that your funds have been properly segregated. Client money does not form multiple segregated accounts, one per client, you see: it is one big lump, a totality of client money against all client claims. That means that if anyone has not had their funds seg’d (you knew it was only a matter of time before the jargon hit), then everyone’s properly seg’d funds can be used to pay them in the event of the insolvency of the firm. I would have thought that that blows rather a large hole in the UK’s client money regime. Certainly if the judges were trying to make the UK regime safer, it is not clear that they succeeded: arguably, they have made it rather less safe.

Posted in: Legal Risk and Trade Documentation by David /
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I should admit from the outside that I have, very rarely, worn a cravat. It was however ironic. Or some such similar excuse.

With that out of the way, let’s turn to Morgan Stanley and their dead presidents. The problem for MS is that there are some suggestions that it misled investors. These are similar to the Abacus accusations against Goldman although, so far as I know, there are no formal charges thus far, although there is apparently an investigation.

Let’s put this into context. To do that, consider the following. A trader at BBB (Big Bad Bank) decides that her life would be easier, and she could make more money, if she could put some long dated equity put options. In fact, most equity derivatives traders would love to do this as running a equity derivatives book which is long vega in the wings is safer than running it short. The problem is because lots of people want this position, it is hard to acquire, and usually expensive. But the BBB trader has an idea. She contacts a large, credit worthy corporation who she thinks might sell her the puts. And, lo, they do.

Now what we have here is a trade entirely structured to meet the firm’s risk management objectives. No consideration has been given to whether the trade is suitable for the customer: they are simply a convenient supplier of what is needed. In the current climate you might conclude that something must be wrong.

What if I tell you that the corporation is Berkshire Hathaway and that Warren Buffett personally agreed the trade?

There are two sides to every transaction. Someone wants to buy and someone wants to sell. Now, contrary to popular belief, this is not a symmetric situation. Both can win: both can lose: or one can win and one can lose. (This is because one party might be hedging and the other might not be: if a call goes up, an unhedged long might make money, if the short hedges, then they can make money too depending on the level of delivered volatility vs. the price of the option. But that is a story for another day.) But even if it were symmetric, provided that they both know what they are doing, and information asymmetries have been overcome, why should we not let caveat emptor have a role?

It may well be that Morgan Stanley structured a trade because they wanted to go short. I don’t see a problem with that. No one was forced to buy CDO tranches. Just because you lost money doesn’t mean that you were necessarily cheated. It just means that you are not as smart as Warren Buffett. But then who is?

Update. Some of the MS deals have reinvestment risk (sometimes known as extension risk). That is, rather than the CDO amortising as the underlying bonds do, the funds are reinvested in new collateral. Bloomberg quotes an Ambac executive regarding this risk:

“I can’t imagine anybody would take that bet knowingly… You’re overriding the natural process of risk-mitigation.”

Resisting manfully the temptation to make sarcastic remarks about anyone listening to Ambac talk about risk, I will say that lots of people did take that bet knowingly. Investors wanted term deals. They clamoured for them. Managing the uncertain flow of cash from an amortising mortgage deal was too much trouble, and they preferred something that looked more like a corporate bond.

The idea that there is a ‘natural process of risk-mitigation’ is absurd. There’s nothing natural about risk-mitigation. It is something you choose to do because you don’t like a risk. Of course, that assumes that you thought about the risk and made a decision. Perhaps if more investors in deals with extension risk had done that, we would be in better shape.

Posted in: Legal Risk and Trade Documentation, Securitisation and Tranching by David /
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Deus Ex has tried, and mostly succeeded, to post daily since the start of the financial crisis. Now, though, the posting rate has slowed, and that will probably not change, at least for a while. The reasons are multiple: there is a new stridency about much financial blogging, which I do not want to emulate, and which is clearly a risk; there is a new hostility, too, with both readers and writers willing to blame before seeking to understand. I heard a new definition yesterday of a financial derivative: it is of course that instrument which takes the blame in any problematic situation, regardless of its role.

Clearly regulatory changes are needed. We have argued that all along. But much of what is being proposed at the moment is disproportionate, ill-designed, and badly targeted. Some of it will even make matters worse. (A good example is central clearing: if you can only clear 75% of trades – and that is likely to be the case for some years, regardless of regulatory pressure – then for most counterparties, central clearing will actually increase credit risk, as some of the clearable trades will be offsets for the non-clearable ones.)

The Goldman vs. SEC case also worries me greatly. This is not because I don’t think Goldman did anything wrong: I have no idea if they did anything wrong. But the disconnect between what the case is about and what it is portrayed as being about is deeply unhelpful. The complaint accuses them of failure to disclose relevant information. This has been reported as designing a security which they knew would fail. One can easily be guilty of the former without having contemplated the latter. So, while the headline ‘Goldman accuses of fraud’ might be helpful for certain political agendas, it is actually somewhat distant from the truth.

In an effort to retain a degree of equilibrium, therefore, and to try not to fall into the trap of writing knee jerk posts, Deus Ex is going to slow down. Expect slightly longer posts, rather less frequently.

Posted in: Legal Risk and Trade Documentation, Mother of all Bailouts, Regulation by David /
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With the (justified) fuss over Repo 105, some of the earlier material in the excellent report by Anton Valukas of Jenner & Block on the Lehman failure seems to escaped much comment. Here, then, I would like to comment on the rather depressing perspective the report casts on risk management. My sources are in volume 1 of the report, and I’ll cite the starting page number of the relevant section as I go.

First the risk management failings as identified by the report:

• One of Lehman’s major  risk  controls was  stress  testing.  As Lehman’s exposure to  real  estate  and  private  equity grew, the firm did not modify its stress testing to address its evolving business strategy, so the largest risks were not stress tested, or were tested inadequately (pg. 66). 
• Lehman had a series of “risk appetite limits” that it considered the “center of its approach to risk.” Yet Lehman was repeated over both the whole firm limit and its concentration limits. It repeatedly raised the limits yet still violated the increased limits (pg. 71).
• Management’s presentations to the board about risk were limited, optimistic, and in places misleading (pg. 92, 116, 139). In particular board risk information did not include all transactions which, had they been included, would have shown the firm to be substantially in excess of its risk limit (pg. 141).
• Lehman did not even have an ALCO until July 2007, and came to realise the need to manage their daily liquidity properly only very late in the Crunch (pg. 125).
• Materials presented to the board also overstated Lehman’s liquidity position and did not mention the firm’s internal view of the problematic nature of its funding (pg. 148).
• The firm’s Risk and Finance committee was not kept informed of the results of the worst stress tests, nor were they aware of substantial changes to the risk appetite calculation (pg. 155).

As corporate governance failures relating to risk go, those are substantial.

Now the good news for Lehman execs:

The Examiner Does Not Find Colorable Claims That Lehman’s Senior Officers Breached Their Fiduciary Duty of Care by Failing to Observe Lehman’s Risk Management Policies and Procedures …

The Examiner Does Not Find Colorable Claims That Lehman’s Senior Officers Breached Their Fiduciary Duty to Inform the Board of Directors Concerning the Level of Risk Lehman Had Assumed.

This is not because they didn’t do anything wrong, but simply because the standard of proof under Delaware law is so high. Thus for instance (pg. 184)

During 2007, there were a number of instances in which management did not provide information to the Board. For example, management did not disclose its decision to exceed or disregard the various concentration limits applicable to the leveraged loan business and to the commercial real estate businesses, including especially the single transaction limit, contrary to representations to the Board that management took steps to “avoid [] over‐concentration in any one area.”

Yet because the board did not explicitly direct management to provide it with this information, management are fine. As Valukas says, Establishing a violation of the duty of candor with respect to risk management is particularly difficult.

The Directors too are off the hook: the examiner did not find Colorable Claims that they breached their Fiduciary Duty by failing to monitor risk either.

The firm left the impression that their risk controls were firm, when in fact they were advisory, and that advice was rejected. Thus for instance (emphasis mine):

Lehman’s management decided to treat the firm’s risk appetite limit as a soft limit rather than as a meaningful constraint on management’s assumption of risk.

This, it seems, is fine, at least under Delaware law. Management can behave like this and the Board can oversee it, and no one can sue when it goes wrong. That surely is one of the lessons of Lehman. If we want better risk management, then we need changes in the US regulatory framework so that when something like this happens again — as it will — someone senior goes down for it. The FSA in the UK already has such a regime, through its approved persons regime. (This was introduced after Barings, when the directors managed to successfully argue that no one was responsible for the failures of control that let Leeson bring the bank down.) The Americans need something like it – or they might as well abandon any pretence that risk management acts as significant protection for their firms.

Update. It belatedly occurs to me that Sarbanes Oxley might do the job. Does anyone know? If it does, why doesn’t Valukas think there is actionable case?

Posted in: Legal Risk and Trade Documentation, Risk Management by David /
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This is a dissection of one of the most ill-informed NYT editorials it has ever been my displeasure to read. The column tackles OTC derivatives with a blend of ignorance, paranoia, and prejudice that is deeply disturbing in a paper that aspires to a high standard of journalism.

Let’s pick a few doozies.

These particular — and particularly complicated — instruments are traded privately among banks, their clients and other investors with virtually no regulation or oversight.

No, no, no. Bank derivatives trading is regulated: there are capital requirements, conduct of business requirements, and so on. There have been for many years. What wasn’t well regulated was certain US derivatives activities of broker/dealers. Given that there aren’t any broker/dealers left – they all became banks – this is not a problem.

A big part of the problem is that derivatives are traded as private one-on-one contracts. That means big profits for banks since clients can’t compare offerings.

No. Many OTCs, including swaps, CDS on hundreds of names, and OTC FX options, are liquidly quoted, and prices are more reliable on many of them than on most exchange contracts.

That is why it is so essential to move derivative trades onto fully transparent exchanges.

How would that help? An illiquid market on an exchange is more confusing than an OTC one. At least with the OTC market, you can see that there are no prices. With the exchange, you get stale prices reported as facts, confusing the unwary. Liquid markets don’t need to be moved to exchanges, and illiquid ones are not much improved by the move.

Effective trade reporting is a separate matter: this is being achieved via mechanisms such as the DTCC reporting of credit derivatives. It does not require an exchange.

It is worth noting here that the exchange have been extremely effective at using the crisis as a tool to get more business. If they can persuade legislators that all the world’s financial problem can be solved by putting OTC derivatives on exchange, then their shareholders will be very happy. But they are simply a lobby group: we don’t have to uncritically believe all their PR.

Derivatives investors who stand to make huge profits if a company or country defaults, for example, might try to provoke default — a situation that regulators should be able to prevent.

The problem isn’t going to be solved by banning CDS. What we need is proper contract design which ensure that the voting rights of creditors go with the risk. This is a matter of derivatives documentation – and it should be relatively easily solvable.

No one could argue that derivatives markets are perfect, nor that the regulatory framework for them could not be better. But pedalling lies, half truths, and remedies that won’t work or aren’t necessary is not the answer. Can we please have some informed debate about derivatives reform?

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation, Regulation by David /
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FT Alphaville reports

Most CDOs have overcollateralisation tests that are triggered if the CDO’s collateralisation levels fall below its minimum requirements, as defined in the deal. For certain CDOs, if that happens it’s counted as an event of default — triggering a potential reshuffling of payments for investors.

Whoever thought that this was a good idea? Using OC as a early am test makes sense: it gives senior investors more protection by giving them time to am out before the cashflow falls enough to endanger the coupons on their notes. But making it an event of default seems entirely unnecessary as it is not clear that any of the notes actually are in default: there could be enough value in the collateral to guarantee their eventual repayment. Now, of course, we are seeing some structures hitting these triggers:

Euromax IV is a €200m CDO backed by mezzanine residential and commercial mortgage-backed securities (RMBS and CMBS)… [It is] one of the first Fitch-rated European CDOs to breach an event of default based on its overcollateralisation trigger, according to a statement published by the ratings agency late Tuesday.

Fitch says:

A total 14% of Fitch-rated European SF CDOs (11 transactions) have an EOD OC ratio trigger. In Fitch’s view, as the performance of underlying SF assets continues to deteriorate, more than half of the 11 transactions are likely to breach their EOD OC ratio triggers over the next year.

The key point is that in some of these transactions, the EOD may lead to early liquidation of collateral rather than just interest diversion: or at least the potential for senior note holders to vote for such a thing. That would almost certainly get them off risk faster, but the consequences for junior note holders would be nasty. Caveat lector.

Posted in: Legal Risk and Trade Documentation, Securitisation and Tranching by David /
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In general I am a staunch defender of credit derivatives: they make the credit markets much more efficient; they help to companies honest by letting traders short a credit; and the ability to hedge credit lets banks lend more. However, it has to be said that creditor’s rights can be a problem with credit derivatives. Specifically if I own a bond (or make a loan) and have credit protection on that exposure, I may have the right to vote in creditor’s proceedings, such as restructurings, but I may have a different incentive to vote, or no incentive at all, thanks to the credit protection. This situation is sometimes called an `empty creditor’.

A particular problem is that an investor can sometimes buy bonds for less than par, buy CDS on those bonds, then get paid par if there is a credit event. They are incentivised to vote the bonds in such a way as to maximise the likelihood of that credit event, not to ensure that the company survives (or even that the bonds have the highest ultimate payout).

Now an interesting riff on the problem of empty creditors has come up. Risk.net reports that:

Goldman Sachs stopped making markets in bonds and credit default swaps on US freight company YRC Trucking for around two weeks from December 16… The decision to stop quoting on YRC is understood to have been taken at a very senior level in Goldman, after freight union International Brotherhood of Teamsters (IBT) sent letters to congressmen, senators and state attorneys-general accusing the bank of encouraging investors to torpedo YRC’s restructuring – which would have threatened the jobs of around 30,000 IBT members.

Goldman quickly threw its weight behind efforts to help the company stay on its feet, sourcing additional bonds for investors that wanted to vote in favour of the restructuring, which subsequently went through successfully… the union obtained screenshots of a Bloomberg run sent by a Goldman trader on December 16, quoting prices on three YRC bonds and – on the same screen – CDSs in the trucking company. This was, they argued, proof the bank was encouraging empty creditors to build basis packages in YRC with the aim of killing the company.

Kudos to the teamsters: that was smart. Taking out an investment bank at the crucial time worked well, and Goldman was the obvious choice given their elevated reputational risk at the moment. There is a lesson here for subsequent distressed restructurings.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation, Reputational Risk by David /
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MBIA, once one of the most important monoline insurers, is sueing Credit Suisse for pervasive and material misrepresentation of the risk that they insured on RMBS. From Bloomberg via FT alphaville:

A Credit Suisse Group AG unit was accused in a lawsuit by MBIA Insurance Corp. of making fraudulent misrepresentations about mortgage-backed securities… [in a] transaction that was sponsored, marketed and serviced by the Credit Suisse units…

“CS Securities fraudulently induced MBIA to participate in the transaction,” MBIA said in the complaint. MBIA said the bank claimed it had “used certain strict underwriting guidelines to select the loans sold into the transaction when in fact it did not.”

So far, so ordinary. Insurers takes risk, insurer takes hit, insurer claims it did not know what it was doing because the client did not tell them everything, insurer sues is a sadly common story. But this one gets better:

Since the transaction closed, the securitized loans have defaulted “at a remarkable rate,” MBIA said.

“Through Oct. 31, 2009, loans representing more than 51 percent of the original loan balance, or approximately $464 million, have defaulted and been charged-off, requiring MBIA to make over $296 million in claim payments,” MBIA said.

MBIA said that a review of the defects of the loans included in the transaction show they were “systematically originated with virtually no regard for the borrowers’ ability or willingness to repay their obligations.”

One might wonder why MBIA did not notice this before they agreed to take the risk. So (as FT alphaville puts it) in order for MBIA to succeed, it will have to convince a court that its much-vaunted underwriting and due diligence weren’t actually all that great. Mind you, given that MBIA have gone from being AAA-rated to BB-, that might not be too much of a surprise to some people.

Posted in: ABS, Legal Risk and Trade Documentation, Monoline, Mortgages by David /
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‘Be careful what you wish for’ might be a good motto for some participants in the CDS markets, given the recent auction results. To recap a rather complex story, in what was known as the small bang, the industry has recently moved to settling CDS contracts after a credit event using one or more auctions. Bloomberg takes up the story like this:

Thomson provided the first test of the procedures for settling contracts triggered by a restructuring in Europe when it said in August it was deferring payments on $72.5M of 6.05% private notes due this year.

(The ISDA press release on the Thomson restructuring event is here.)

The system for restructurings uses multiple auctions that set different payouts based on swap expiration dates. Dealers couldn’t settle the Thomson contracts with simpler failure-to-pay procedures that produce one recovery value because they were unable to prove the electronics company defaulted…

To determine the size of the payouts on contracts covering $2B in debt, bonds and loans were split by maturity date ranges into three so-called buckets and sold at auction.

Contracts that expired on June 20, 2012 — the first bucket’s latest date — sold for 96.25% of the face amount, meaning swap holders received 3.75% of the amount covered. Swaps expiring a day later paid 34.875% because the debt in that bucket went for 65.125%.

Holders of June 20 swaps covering 10 million euros in debt got 375,000 euros, while those with June 21 contracts received almost 3.5M euros. Swaps that terminated after Oct. 24, 2014, paid the most, 36.75%.

The Reuters story on the auctions is here. This emphasises the obvious: if you had sold cash settled protection in the two and a half year bucket, and you were in the auction, then you would probably be very happy. On the other hand, note that protection buyers did not have to be in the auction, and many weren’t. As Reuters notes, as of November 13th, 1,543 contracts remained, amounting to a gross notional exposure of $7.29B and a net $942M, according to the latest data from the DTCC.

The disparity was a result of too few securities in the first bucket to settle swaps, according to Matthew Leeming, a London-based strategist at Barclays. “An imbalance of supply and demand for the deliverables can affect the recovery rate,” he said in a note.

Because they were part of industry indexes, swaps referencing the company “dwarfed the amount of Thomson debt,” said Teo Lasarte, an analyst at Bank of America-Merrill Lynch in London.

The more swaps there are, the more investors with stakes in the contracts need bonds to settle them. About 81 million euros worth of debt was auctioned from the first bucket, compared with 221 million euros and 148 million euros from the second and third, according to data released by auction administrators Markit Group Ltd. and Creditex Group Inc.

This problem of more CDS than outstanding debt is well known – being able to sell more CDS than there was debt was the reason that Amherst could profit from JPM, for instance. Good trade reporting from central counterparties should eventually make this situation a lot less likely since market participants can at least now see how much is out there. But in the meanwhile situations like this do not cover the CDS market in honour, especially if many market participants spurn the auction process. Another bang may be needed before we get this right.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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The standard argument that credit derivatives are not insurance runs in brief:

• They require no insurable interest;

• They require no proof of loss; and in particular
• The payout is independent of the counterparty

All of this is standard, and goes back to an opinion of Robin Potts. Now, with ill-advised US action to regulate some credit derivatives activity as if it were insurance deferred, there is a new and more comprehensive account of the issues from M. Todd Henderson.

Henderson does a reasonable job, although the case seems a little over-argued to me. In particular, credit derivatives product companies (CDPCs) are much like insurers in financial substance – as was the Financial Products Group of AIG. So arguing from the perspective of the need to regulate insurers not applying to companies engaging in CDS may involve ground that is not firm. Where Henderson is good, though, is pointing out where risk shifting and pooling contracts in other spheres do not constitute insurance. For instance, if I set up a company to sell naked puts to commodities producers, and invest the premium, then I am acting as a pooling and risk shifting enterprise, but not an insurance company. The paper is worth a read if you have an interest in these matters even if it does seem to me a little propagandist.

Update. It is worth pointing out that the ‘insurance’ vs. ‘not insurance’ question is about more than regulation. It also affects accounting – insurers have their own accounting framework which is rather like accrual – and taxation. Given that much of the need to regulate CDS relates to counterparty credit risk, it seems that a much more cost effective fix to the vulnerabilities revealed by AIG is simply to do what we are doing anyway – set up a central clearing and market data reporting entity. Add in a reclassification of financial insurance as a derivative, enforce fair value requirements, and prudent capital requirements, and you would have a reasonably robust regulatory framework without the need to get insurance regulators involved.

Posted in: Credit, Insurance and Actuarial Practice, Legal Risk and Trade Documentation, Regulation by David /
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ISDA will soon become NASDA, at least if the US bankruptcy courts have anything to do with it. First the background: the way ISDA contracts should work is that if one party to them suffers a termination event, the whole portfolio of derivatives between the two parties terminates, with one net payment being due. Termination events include bankruptcy, obviously, but they also include rather more events, so derivatives termination often happens before a bankruptcy filing.

If that payment is from the party suffering the event, then it is a senior claim against them, and in bankruptcy the other party typically gets recovery on it. If it is to the affected party, then it must still be made in a timely fashion. This is important for two reasons. Firstly it gives certainty of the amount of loss: if you are owed money, you know exactly how much. In contrast if you had to go on paying and receiving on the derivative, your loss might increase due for instance to movements in the swap curve. Secondly it gives certainty of the timing of loss: you know that you are out of the contract, and you can go elsewhere and rehedge your risk. Because recoveries are uncertain until bankruptcy proceeding end (many years later), if you had to carry on performing, you would not know how hedged you were. (More background from Nutter is here.)

Now what appears to be the bombshell, from Finance Asia, via FT alphaville:

an American court handling Lehman’s bankruptcy … has found that derivatives counterparties have just two options: either keep the agreement in place and keep paying the premiums or terminate the contract and pay any money owed to the insolvent counterparty.

If I am reading this correctly, in particular they have found that counterparties who are owed money do not have a claim for the net present value of their contracts against the bankrupt entity, and must instead carry on paying. In other words, close out with netting as envisaged by the ISDA master does not work in the US.

This is absolutely huge. GuyLaine Charles points out in the New York Business Law Journal that the Lehman Debtors had 6,120 outstanding ISDA Masters, in which they calculated that they were owed $23.8 billion, and that they owed $13 billion. These are typical sums for a reasonable (but not market leading) dealer. For JPMorganChase, I would not be surprised if the sums were ten times that size. So close out netting really matters. If it doesn’t work in America, expect the ISDA name change shortly.

Update. It turns out not to be as bad as all that. First note that the relevant case is Metavent Corporation vs. Lehman Brothers Special Financing Inc. LBSF is a guaranteed by the Lehman parent, Lehman Brothers Holdings Inc., which is why a US judge is ruling on the case: most Lehman derivatives in contrast are with non-US subs, notably the UK broker/dealer Lehman Brothers International Europe, and so are not covered by the ruling.

Second and more importantly, what Metavent did was to suspend payments on the swap with LBSF without calling early termination. Basically it was taking a punt that the swap would move more out of the money and hence its loss would be reduced. The case revolves around whether you can do that or whether you have to terminate in a timely manner on bankruptcy of your counterparty. Frankly, I wouldn’t blame the judge if he found in Lehman’s favour: the idea that you can not perform on a derivative yet not call an early termination event appears fairly unreasonable to me.

For further background from Cadwalder, see here; Freshfields’ take is here.

Posted in: Legal Risk and Trade Documentation by David /
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This is a geeky post about the CDS market.

The newswires have been buzzing recently with news of a ‘daring’ CDS trade by Amherst Holdings. I didn’t comment on it at first as I didn’t understand the trade from the initial news items, but I now think it is possible to work out what’s going on.

Let’s start with the bonds this trade refers to. They are subprime MBS. Like most MBS, these are amortising, prepayable bonds. The fact that these are amortising bonds means that the face value of the security is irrelevant: what counts is the principal balance at the time the trade was done. [Quite a lot of the stories were confused about this point, so it is worth pointing out.]

So, let’s say we have some bonds with $100M left to repay.

The next bit that is tricky is the nature of the CDS protection sold. Everyone agrees Amherst sold protection and some banks bought it. But what protection exactly? It is most common for CDS on MBS to be pay as you go, meaning that the protection sellers compensates the protection buyer for principal deficiencies as and when they occur. There is no event of default as such, unlike corporate CDS. [To be strictly honest, there may be an event of default as well, such as bankruptcy of the issuing SPV, but that is irrelevant for our purposes.]

Let’s suppose then that Amherst sold pay as you go protection on $100M of bonds.

Since the bonds were thought likely to repay little to nothing of the outstanding principal balance, the banks paid Amherst, say, $80M up front for their protection. [There may have been an ongoing coupon as well, but we'll ignore that.]

Amherst then paid the servicer to buy out the underlying mortgages and pay off the bonds. Thus the bond holders got their $100M. The servicer could do this because the bonds had a 10% clean up call, meaning that if more than 90% of the face had amortised, they could repay the remaining principal balance at any time. [So to keep with the example, the face amount was more than $1B.] 10% cleanup calls are common in ABS, and they are what makes Amherst’s trade work*.

Now, here’s the confusing part. Who won and who lost?

First the banks. If they had held the bonds, then they would be about flat. $80M for CDS protection paid out, but $100M paid back is a $20M profit, from which subtract the (few cents) cost of the bonds. So the only way the banks could have lost massively on the trade, as reported, would have been if they had been net short the bonds. That is, they did not own the bonds, and bought protection, betting that total losses would be more than $80M. The losers, then, were parties who did not own the bonds and who did not realise the significance of the cleanup call to their short.

[The WSJ story suggests that JP Morgan lost money but that RBS and BofA didn't. This would be consistent with JP being net short, while RBS and BofA had a negative basis trade on, i.e. owned the bonds and bought CDS on them. The presence of net shorts is also consistent with the WSJ's suggestion that more protection had been traded than the notional of bonds outstanding.]

Next Amherst. They had the $80M of CDS premium. But how much did they have to pay to get the bonds repaid? Clearly a logical answer would be about $80M. Therefore the only way that Amherst could have made money would have been if they had sold more protection than there were bonds – $200M say rather than $100M. Say they sold $50M to JPM, $50M to RBS and $50M to BofA. Then they would have had to pay $80M, roughly, to buy back the mortgages behind the RBS and BofA CDS, but the JPM CDS was not backed by any bonds and so the $40M premium from JPM would be straight profit.

In other words, the only way Amherst could have made a lot of money on this trade would have been if it sold more protection than there were bonds. The only way that the banks could have lost money would have been if they bought more protection than there were bonds. In a situation like this someone was always going to be squeezed. It’s just that this time, that party wasn’t an investment bank.

The lesson of this amusing little situation? Nothing more than read the small print. The buyers of protection — and in particular naked shorts — should have understood that arbitrary action by servicers is possible, and that in particular the 10% clean up call could be exercised. This is a much bigger risk late in the amortisation profile of a bond than early, but it is there for most ABS. Caveat emptor.

* Contrary to what Willem Buiter writes in his blog, if you own 100% of a bond, you cannot necessarily control whether it defaults or not. A default on a public security is a default, regardless of who is affected.

Another mistake Buiter makes is assuming that centralising CDS trading would not have helped in this situation. It would certainly have helped the banks to avoid their losses, in that the size of Amherst’s long vs. the cash would have been obvious thanks to trade reporting. Personally I don’t particularly feel the need to help the CDS trading desks of investment banks, mind you.

Posted in: ABS, CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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From Ken Lewis’ testimony to the House:

In mid December… I became aware of significant, accelerating losses at Merrill Lynch, and we contacted officials at the Treasury and Federal Reserve to inform them that we had concerns about closing the transaction. At that time, we considered declaring a ‘material adverse change’… Treasury and Federal Reserve representatives asked us to delay any such action, and expressed significant concerns about the systemic consequences and risk to Bank of America of pursuing such a course.

No one would expect a CEO to tell less than the full truth in a setting like this. But this must surely add fuel to the fire of shareholder litigation burning under BofA.

Update. More (unhelpful to Ken) docs here.

Posted in: Legal Risk and Trade Documentation, Mother of all Bailouts by David /
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In the FT, Aline van Duyn comments on the Geithner derivatives reforms:

In Mr Geithner’s vision, banks, investors and companies that use derivatives will have to register their activity. In this way, regulators will be able to see the whole picture of risk that has been built up in the financial system. These players in derivatives will all have to put some money aside in case their bets go sour. The amount of bets will therefore be limited. Large parts of the markets will be cleared centrally, which means that the default of a big bank at the centre of the market will not set off a daisy chain of defaults. Regulators will finally have specific jurisdiction over these financial instruments…

First, what is a “standardised” derivative? Is the cut-off size or simplicity?

That is relatively easy. Most banks’ derivatives book – and certainly all the big players’ books – are mostly vanilla. If you called ’standardised’ a plain vanilla interest rate or cross currency swap, forwards, FRAs, caps and floors, plain vanilla swaptions into plain vanilla swaps, and plain vanilla options on single FX rates, equities, equity indices and commodities, (plus the already-DTCC cleared credit derivatives) you would have not just 80% of the industry, but probably more like 90%. Just centralising the clearing of these simple instruments would dramatically reduce counterparty risk and improve market transparency. If you added in basket options, asians and barriers, you would certainly have more than 95% of the industry.

Second, will plans to shift to centralised clearing include derivatives contracts that already exist, or just new ones? This is a vital issue: the risk in the financial system is largely the result of existing contracts. And, as the people still employed at AIG are realising, you cannot just throw these contracts into the river.

There is no reason not to novate old contracts into the new system. It will take time, but you can do it, especially for the inter-dealer business.

Third, who is subject to the regulations? Banks, certainly; large hedge funds, probably. What about smaller investors or companies such as airlines that use derivatives to hedge oil and currency positions?

Regulated banks and hedge funds, plus anyone else with more than a 1% market share, say, in a given market, or anyone the market regulator tells to use the system. The advantages to the banks of central clearing would be large enough that they will pressure big clients to move onto the system anyway.

Aline raises some reasonable objections, but in this case I do think that you can remove 80% of the risk for 20% of the effort.

Posted in: Credit, Legal Risk and Trade Documentation by David /
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Bruce Krasting has an interesting story on sub-prime related litigation in Massachusetts:

Goldman has agreed to pay the state of Massachusetts $60 million to settle a dispute regarding Goldman’s “predatory lending” practices in and around Boston. $50 million will be made available to reduce the loan principle on 714 individual mortgages… In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today.

As Bruce says, this is not a big deal for Goldman — but it might set a nasty precedent for those higher up the subprime ABS underwriting tables, notably BoA (labouring under both Countrywide and Merrill) and Citi. You can expect this story, like Enron-related litigation, to run and run.

Update. A different account of the case from Jonathan Weil at Bloomberg is here. His take is that Goldman paid greenmail to Mass, perhaps to avoid the disclosure associated with a full hearing. His article certainly makes interesting reading.

Posted in: ABS, Legal Risk and Trade Documentation, Photography, Securitisation and Tranching by David /
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From Bloomberg:

MBIA Inc. was sued by Third Avenue Management LLC… over claims the insurer’s split of its bond-insurance businesses hurts debt holders.

Three mutual funds managed by Third Avenue bought notes issued by MBIA Insurance Corp. in February 2008 based on assurances that the company was recapitalizing following losses in its structured finance insurance business…

MBIA, the largest bond insurer by outstanding guarantees, said in February it was transferring $5 billion in cash and its public finance business to another entity that has no obligation to the notes, Third Avenue said in its statement.

Posted in: Legal Risk and Trade Documentation, Monoline by David /
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Relax, it will happen soon. And that counterparty will be JP Morgan.

Posted in: Legal Risk and Trade Documentation, Markets by David /
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Suppose a bank buys an option written by a corporate. It ends up in the money. The bank hopes that the corporate will pay out.

But what if lots of other banks have bought the same type of option from lots of corporates. Very few of them hedged, and all the options are far in the money.

Now the banks have a systemic problem. Perhaps many of the corporates cannot afford to pay. In any case, their losses may be sufficient to cause government intervention. The banks may be caught in a storm of protectionism.

It seems, according to FT alphaville, that this is possible for the counterparties to Eastern European corporates on FX options. The corporates, in many cases I am sure with full understanding of the risks, sold zloty, koruna and forint downside as a Euro convergence play. All three of these currencies have fallen: the corporates have taken significant losses. And now, of course, the lawyers are getting involved.

The lesson, then, is that it is good to be right when selling options. Being a little bit wrong is bad. But if you are really really wrong, and lots of other people are too, that’s fine, because the government will probably bail you out.

Posted in: FX, Legal Risk and Trade Documentation by David /
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Confirming the insurance industry habit of substituting claims adjustment for underwriting diligence, MBIA is suing Countrywide according to Housing Wire:

The breach-of-contract lawsuit, filed in New York State’s Supreme Court, suggested that Countrywide developed a “systematic pattern and practice of abandoning its own guidelines for loan origination,” in effort to inflate its market share during the mortgage-lending boom. MBIA accused Countrywide of knowingly negotiating riskier loans “no matter the cost to borrowers, investors or guarantors like MBIA.”…

Overall, the case involves 10 residential mortgage-backed securitizations of more than $14B in mortgage loans.

This is going to be interesting. On the one hand, it seems obvious that mortgage quality did decline in the last years of the Greenspan boom. But can MBIA really prove that Countrywide abandoned its own loan underwriting standards – rather than simply changing them to adjust to `market conditions’ – and that that was a breach of contract of the financial guarantees? If it can, we are going to see a lot more wriggling from the wrappers, and the lesson from Hollywood Funding – that insurers can’t always be trusted to pay when you think they have written protection – will be driven home to a lot more people.

Posted in: Insurance and Actuarial Practice, Legal Risk and Trade Documentation, Monoline by David /
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It is reasonably well known in the derivatives markets that a lot of AIG FP’s CSAs have collateral on downgrade clauses. Specifically AIG FP has to post more if the AIG parent company is downgraded. The parent is on downgrade watch. Market gossip has it that the amount of collateral required is substantial, probably (irresponsible rumour has it) more than $10B. So AIG will borrow from the FED (or as FT alphaville has it, give a bridge loan to itself) and pledge it straight back to, err, the FED’s clients and their peers. Seen that way it makes complete sense for the FED to lend…

Posted in: Credit, Legal Risk and Trade Documentation by David /
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Ah, the lawyers may be slow, but they are remorseless. Like the slugs in my friend’s garden, there is little you can do to stop them. From the FT:

Abu Dhabi Commercial Bank’s class action lawsuit for fraud, negligent misrepresentation and unjust enrichment over its investment in a complex fund is a fascinating collection of details and allegations that cut to the heart of the credit boom and messy aftermath…

ADCB bought mezz notes paying Libor plus 150 and rated single A: these are now worth squat. Back to the FT:

ADCB’s suit accuses Morgan Stanley, Bank of New York Mellon, Moody’s Investors Service and Standard & Poor’s of misleading investors about the quality of assets the Cheyne vehicle bought and held from its inception in 2005 to its collapse just two years later.

This will be dramatic, even if it is the slow moving drama of a test match. I look forward to the show.

Posted in: Legal Risk and Trade Documentation, SIVs and Conduits by David /
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From Bloomberg:

Thirteen “major” dealers of credit-default swaps agreed “unanimously” that the rescue constitutes a credit event triggering payment or delivery of the companies’ bonds, the International Swaps and Derivatives Association said in a memo obtained by Bloomberg News today.

So the CDS are triggered. What I urgently want to know is is this a termination event on the enormous portfolio of IRD that Fannie and Freddie have as hedges against prepayment risk. Remember these two are amongst the largest players in the interest rate derivatives market, mostly as buyers of convexity. I can’t believe many people want an unwind so the situation should be manageable.

Update. Just in case you are not a regular reader of the components of the major credit indices, it is worth point out that Fannie and Freddie are both in the CDX.

Posted in: CDS and Negative Basis, Federal Agency, Legal Risk and Trade Documentation by David /
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Lawyers to your keyboards. Ambac is pushing ahead with the good insurer/bad insurer model. From Bloomberg:

Ambac rose as much as 15 percent in late trading as Wisconsin regulators, which have jurisdiction over the New York-based company, approved a plan to move $850M out of Ambac Assurance Corp. into the new business, according to a statement today. Ambac is seeking to obtain an AAA credit rating … for Connie Lee.

Apart from the obvious questions — who gets the capital, who gets the muni derivatives, and why anyone thinks structured finance counterparties might be remotely comfortable with all this — don’t we have a bad enough history with two syllable first name one syllable second name companies? I mean, Indy Mac, Fannie Mae, Freddie Mac, … Connie Lee — it is not encouraging, is it?

Posted in: Legal Risk and Trade Documentation, Monoline by David /
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Sometimes I wonder if the FT is sponsored by Euronext or the CBOT. Today there is an article by Aline van Duyn on derivatives and termination events. She points out, quite reasonably, that Fannie and Freddie are amongst the largest dollar interest rate derivatives counterparties – because they are hedging the prepayment risk of their mortgage books. Conservatorship is a termination event so any restructuring of the GSEs will need to be mindful of that.

Bizarrely, then, she uses this as the platform for an anti-derivatives screed. She moves seamlessly to credit derivatives – without any logical connection of course other than the D word – and starts talking about derivatives timebombs. Why does no one ever talk about bond market timebombs? Could it be that it is easy to pick on the derivatives markets? Perhaps journalists – like the government official van Duyn imagines in her article – need to spend more time learning about derivatives before blaming all the markets worries on them.

Posted in: Legal Risk and Trade Documentation by David /
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No, I don’t have anything to say. I just like FT Alphaville’s coinage.

Oh all right there, I will say something relevant… Here’s a nice article in the FT about Tranche Warfare. You will of course be astonished, especially if you have read this, but:

Some of the CDO and CDS documents leave a lot to be desired, and contain basic errors. The fear is that, as the courts get involved, we are going to have some unpleasant surprises.

Posted in: Legal Risk and Trade Documentation, Securitisation and Tranching by David /
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Recent articles (see for instance here, here, here, and here) have spurred a concern that I confess should have occurred to me earlier. What can cause an event of default by a monoline, and what happens next.

The first issue concerns the effective recovery for ISDA claims against a monoline. Here the crux is the relationship between the holding company and the insurer. As I understand it, most monolines are structured with a listed holding company and a regulated insurance sub. Obviously insurance contracts, including financial guarantee policies (whether transformed into CDS or not), are written by the insurance company, and so the insurance company has most (but not all) of the group’s capital to support this risk.

Which group company writes CDS? My suspicion is that it has often been the holding company. If the regulator seizes the insurer, it is almost certainly (but check your docs) an event of default on the CDS. But in that case the regulator will almost certainly not permit CDS counterparties to be paid at the expense of claims paying ability for the insurance business – they won’t let the money out of the insurer. The holding company will be left with a whole lot of liabilities and essentially no assets beyond a worthless stake in an insurer the regulator has taken over.

This is of course also an issue if you have debt issued by the holding company, or if you have transacted CDS referencing that debt. As Linklaters pointed out a few months ago, credit events can include quite minor regulatory intervention. I suspect that after such an event recoveries might be very low even if the operating sub is still perfectly capable of paying insurance claims.

Update. FT alphaville has additional reporting on FSA, CIFG and FGIC here, following their earlier story on MBIA. What I can’t see in the material I have read so far is whether a breach of regulatory capital requirement of the insurance sub is likely to be credit event on (a) CDS written by the parent and/or (b) CDS referencing the parent.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation, Monoline, Regulation by David /
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In an important case for the structured finance market, Merrill has won a court ruling in its favour in a case against XL. Reuters reports:

Security Capital Assurance had said it severed seven credit guarantee contracts with a Merrill unit because the investment bank had given key rights promised to SCA under the contracts to at least one other party.

SCA said its XL Capital Assurance unit was promised control rights on the $3.1 billion of portfolios it had guaranteed for Merrill Lynch International, but Merrill Lynch had given those same rights to one or more third parties.

By terminating the contract, SCA was hoping to get out from under an obligation that could cost it hundreds of millions of dollars.

Basically the case was about who in the tranche structure controls voting rights on the underlying collateral: it appears that SCA was insuring a mezz tranche while MBIA was above it. SCA seems to have argued that the MBIA contract had voting rights that belonged to them. According to Bloomberg:

Merrill argued that, even though Armonk, New York-based MBIA was covering CDO tiers more senior to those insured by XLCA, the bank could still vote the shares according to XLCA’s directions.

The case is important because if the assignment of voting rights is unclear, or subject to later litigation despite the provisions of the documentation, any writer of protection on a tranche potentially has wiggle room to avoid payment. I just hope for the sake of the broader structured finance market that the docs here hold up to further legal scrutiny.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation, Securitisation and Tranching by David /
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Yes, and here’s why. (This example is taken from a paper by Markus Brunnermeier.) Suppose we have a circle of identical interest rate swaps: A B C D and back to A. All parties are fully market risk hedged. B wants to reduce its counterparty risk so it offers to assign A its swap with C. A refuses because it is troubled by C’s credit quality. Therefore B has to continue to put up capital to support its exposure to both A and C.

With a central counterparty P however, everyone would face P and these issues would not arise.

Posted in: Credit, Legal Risk and Trade Documentation by David /
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We are in the middle of a furore about the OTC markets: see for instance here for John Dizard in the FT. Now I can’t argue that the OTC markets are perfect. But just moving an illiquid, hard-to-value contract from OTC to exchange-traded won’t necessarily make it any more liquid or easier to value. Indeed it may make things worse because a stale or bad mark from the exchange might be credited with a spurious authority. At least with the OTC market you get a sense of the real liquidity of a product.

Lest you think I am making all of this up, here, courtesy of Yahoo (the Bloomberg screens have more data and hence make the point less well) are the June equity options on Dow Chemical, a large liquid U.S. stock.

Notice the volumes: for the far out of the money options, they are tiny. The quotes on the at the money’s are fine, as are the slightly out of the money options. But do you really believe that the prices of the 30, 55 or 60 strike calls are correct given the low volume and low open interest? And if these issues arise on something as well known as Dow, imagine what the exchange prices for far out of the money options on less liquid stocks are like, and then tell me putting CDS trading on exchange will cure all the market’s ills.

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation, Liquidity and liquidity risk by David /
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Take an OTC market that has grown really, really quickly. It’s a safe bet that there will be documentation difficulties. After all, documenting all of those trades is a lot of work. For credit derivatives it is a particular problem in that there have been several sets of ISDA definitions (including the 1999 definitions, the 2003 definitions and the 2005 supplement – and that’s without worrying about pay as you go credit derivatives). Regulators have been worried about credit derivatives documentation for a while: see here for an FSA ‘Dear CEO’ letter about getting your docs signed and here for an earlier news story.

Now it seems that legal risk is starting to really bite. The FT reports that

[...] more than 100 collateralised debt obligations (CDOs) and structured investment vehicles (SIVs) have already entered the murky post-event of default (EOD) state. This number will grow in the coming weeks.

Unfortunately, the legal documents that govern these transactions are so poorly written – full of ambiguities, inconsistencies, “circular references” and worse, contradictions – that many investors, trustees and respective legal advisors do not know how to interpret them.

For instance, in a number of cases it is not clear whether the assets should be sold (liquidation) or let to run off (acceleration). Moreover, even the rules to distribute the money post-EOD (who gets what) are unclear.

This is completely unsurprising. Desperate lawyers struggling to document the last trade before the next one closes make mistakes – anyone does if they are under enough time pressure. No one hired enough lawyers in the good times because there weren’t enough lawyers: the market had grown faster than the skill base supporting it. What happens next will be insightful.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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Bloomberg reports:

Citigroup Inc. and Wachovia Corp. were sued by a hedge fund claiming the banks wrongly forced it to pay more than necessary on insurance derivatives contracts.

VCG Special Opportunities Master Fund Ltd., an Isle of Jersey, U.K.-registered fund, claimed Citigroup asked it to deposit additional sums as collateral for the contracts, eventually costing it about $18 million, according to a lawsuit filed Feb. 14 in Manhattan federal court. The hedge fund, previously called CDO Plus Master Fund Ltd., made similar claims against Wachovia in an earlier complaint.

This is the tightrope prime brokers are walking at the moment. Be too generous on margin, and you don’t have enough collateral if the fund fails. Be too tight, and they sue you. In ordinary markets at least if you are within the bid/offer you have some protection. But in current markets, there is no bid or offer, often, which makes life rather more difficult.

Posted in: Legal Risk and Trade Documentation, Markets by David /
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There is a somewhat alarmist article by Satayjit Das in the FT currently concerning CDS. Das apparently used to be a practitioner so he does not have the excuse of being a journalist. Let’s see what he has to say:

May 2006, Alan Greenspan, the former Federal Reserve chairman, noted: “The credit default swap is probably the most important instrument in finance. … What CDS did is lay-off all the risk of highly leveraged institutions – and that’s what banks are, highly leveraged – on stable American and international institutions.”

The reality may prove different.

Fair enough so far: ‘all of the risk’ was bound to be an incendiary phrase.

The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who for a fee indemnifies the protection buyer against credit losses. Current debate has focused on the size of the market. But the key problem is that a combination of documentation and counterparty risks means that the market may not function as participants and regulators hope if actual defaults occur.

Hoping is not a robust way of managing risk. Documenting the trade that you intended (rather than an entirely different one) is usually a better defence. Just as you should always read the prospectus before buying a security, so you should also understand the documentation of a derivative in detail before assessing the extent to which it hedges your risk. This is hardly new, or difficult.

CDS documentation, which is highly standardised, generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are also technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, for example, the volume of CDS outstanding was $28bn against $5.2bn of bonds and loans. On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

A CDS is a derivative. Its price is derived from the underlying. The clue is in the name. And yes, like many derivatives, there can be a squeeze on the underlying. This happens in commodity derivatives in particular, yet Das does not suggest that these are imperfect hedges as a result (remember the Hunt Brothers and silver). Why pick on CDS?

Shortage of deliverable items and practical restrictions on settling CDS contracts have forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement (based on the market price of defaulted bonds) for physical delivery. In Delphi, the protocol resulted in a settlement price of 63.38 per cent (the market estimate of recovery by the lender). The protection buyer received 36.62 per cent (100 per cent – 63.38 per cent) or $3.662m per $10m CDS contract. Fitch Ratings assigned a recovery rating to Delphi’s senior unsecured obligation equating to a 0-10 per cent recovery band – far below the price established through the protocol. The buyer of protection may have potentially received a payment on its hedge below its actual losses – effectively it would not have been fully hedged.

Yes, that is recovery rate risk. You get exactly the same phenomenon if you sell a bond post default before the actual workout is known. But presumably if you had a bond and a CDS, the CDS cash settlement would match where dealers were trading the bond, so the fact that the subsequent recovery was different would not matter as you would have settled the CDS and sold the bond, leaving you with no exposure. Of course if you were using the CDS to protect a non tradeable loan, then you could get caught out, but that is basis risk not recovery risk.

Is it just me, or is there a massive dose of caveat emptor missing from all this? The buyers of CDS are not retail investors: they are banks and hedge funds, and it is their job to understand the details of the trades they undertake. Just because something doesn’t do what you think it ought to doesn’t make it bad — it just means you have not done your homework.

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. Some 60-70 per cent of ultimate CDS protection sellers are financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented. Recently, Merrill Lynch took a charge of $3.1bn against counterparty risk on hedges with financial guarantors.

The term ’substitute’ may be a little misleading here. There is only a direct credit risk if there is a credit event. Therefore the CDS buyer is exposed only to both a credit event then a default of the CDS counterparty. If the counterparty defaults first, they have a claim to the value of the current mark to market of the CDS against the counterparty.

In the case of hedge funds, the CDS is marked to market daily. Any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. As the case of ACA highlighted, banks may not be willing or able to close out positions where collateral isn’t posted. Collateral models also use historical volatility and correlation that may underestimate the risk.

Ice cream makers which use vanilla when you wanted chocolate may produce the wrong flavour too. Most banks – and most cooks – are aware of the need to use the right tool for the job. Moreover (as Das does not make clear) VAR based collateral models which cross margin a whole portfolio of exposures may underestimate risk due to giving too much benefit for diversification within any derivatives portfolio. (I have discussed credit support default earlier so I won’t go into more details here, suffice to say that the issues are not unique to CDS.)

Clearly a number of people have it in for credit derivatives right now. I’m reminded of the ill conceived (and subsequently abandoned) rules on credit risk mitigation proposed in the first consultative papers on Basel 2. It is sad, though, to see the FT jumping on the bandwagon. Like any tool CDS can be used well or poorly. If you want a complete hedge to a credit exposure, sell it. If you don’t want to do that then you have to understand how the derivative behaves as the underlying exposure moves, just as in any other risk mitigation situation. CDS are neither uniquely dangerous nor a miraculous answer to any credit risk problem. Demonising a structure helps no one, however easy a target it offers. Or as my old boss used to say: if you want a complete hedge, buy a garden.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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The FT has an article on the failure of SCC, a Dublin-based credit derivatives product company or CDPC. SCC was only twenty five times leveraged, a relatively low level compared with some of the other CDPCs. But it did have a small absolute level of capital, $200M, and no rating.

What is interesting is why SCC collapsed. It wasn’t that it had written CDS on underlyings that defaults. No, as with ACA, it defaulted because it could not post sufficient collateral. Let’s pick up the story with the FT:

Court documents from Nomura’s attempts to liquidate the company and SCC’s successful response to secure a Chapter 11-style restructuring show that between the end of June and August 16 last year, collateral demands rose from $55m to $438m. SCC managed to put up $175m worth before running out of funds and sparking Nomura’s High Court petition to have the firm liquidated.

The ravages wrought by mark-to-market accounting are visible in the tens of billions of losses among investment banks, the collapse of the structured investment vehicle industry and in the ever-more precarious position of the bond insurers.

And yet, credit losses from actual defaults outside of the US subprime mortgage market remain minimal. SCC told the High Court that expected losses over the life of its contracts would be a fraction of the collateral it had to post.

Now of course we have no idea whether SCC is right about that claim or not, but the key point is that credit support default is a real honest to goodness game over default. The relevant question for a CDS counterparty is therefore not only whether they are sufficiently well capitalised to remain solvent under a claim: it is also whether they are sufficiently liquid to be able to adhere to the terms of their CSA. It’s the volatility of the mark to market of their portfolio that matters, not only the ultimate loss. Did the prime brokers think about when they were buying protection I wonder?

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation, Monoline by David /
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The WSJ reports an amusing scrap over Sagittarius, a $985M CDO sold to investors in March by Wachovia and structured, it appears, by Deutsche (who is the trustee). Several UBS funds are investors, and an MBIA affiliate, LaCrosse, is a swap counterparty to Sagittarius. Sagittarius has MBS assets so apparently there was a default event. What happened next is the interesting part:

The day after the event of default, LaCrosse sent Deutsche Bank a letter saying that no interest or principal should be paid to other junior noteholders.

Other investors, unnamed in the legal filing, disagreed, telling Deutsche that MBIA’s position “is neither reasonable nor correct,” according to court papers filed by Deutsche Dec. 3. These other bondholders also might disagree about how they would share continuing payments, assuming they got any money. The disputed payments total several million dollars and will pile up until the dispute is settled, according to a person familiar with the matter.

With its legal filing, Deutsche is essentially asking the court to guide it on whom exactly should be paid.

It appears MBIA’s view is that it is supersenior via the swap, and hence no one should get any cash until they are whole. The others, unsurprisingly, disagree. In any event this highlights the importance of understanding where any derivatives sit in seniority vis a vis the note investors. Default contingent market risk can be ugly, and it’s quite hard to hedge.

JP has the right take here I think. Analyst Chris Flanagan wrote in a report recently:

“If there’s one safe prediction for 2008, it is that legal teams will be busy”.

May all your reindeer in 2008 be made of pecans, or not, as you desire. Unless you are a lawyer, of course. They can find their own nuts.

Posted in: ABS, Legal Risk and Trade Documentation, SIVs and Conduits by David /
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An interesting article in the FT on the standardisation of documentation for synthetic CDOs raises an interesting point. Whenever ISDA has standardised documentation before, the article claims, extra liquidity has resulted. Leaving aside the occasions when it took more than one stab to get the docs right — the issues over restructuring and what a contingent obligation is exactly spring to mind — it seems like that the FT is right on this occasion. So given how much the market makes on a new instrument, shouldn’t the banks be falling over themselves to pay for more ISDA lawyers? It does at least appear that this is one case where everyone spending a pound brings most people much more than a pound back.

Posted in: Legal Risk and Trade Documentation by David /
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