They’rrrre baaack. It’s leveraged supersenior kids, but not as you know it. Specifically not as you know it because the new ones are not non-recourse on the leverage, so they have no gap risk for the seller. Now, there are some not-entirely-accurate statements going around about what is actually happening here, so let’s look.
How would you synthesize a leveraged supersenior position? Well, take the underlying CDO, and sell the junior for a fair price. Then take the senior, put it in an SPV, and fund that vehicle by (i) a lower tranche equal to the LSS investor’s initial investment and (ii) an upper tranche which is wrapped by the LSS investor. The fair LSS coupon is then determined by the total carry available on the senior minus what an investor in the upper tranche would need for bearing the joint default risk of the LSS investor and the upper tranche of the senior tranche of the underlying loans.
Seth Berlin has a useful summary of the potential advantages and disadvantages of CDS futures over at the OTC space. I particularly like his characterisation of a tipping point which, if reached, could result in an avalanche of liquidity – or if not reached, would result in the futures sliding into irrelevance. We’ll see.
From 2018, the so-called “bail-in” regime can force shareholders, bondholders and some depositors to contribute to the costs of bank failure. Insured deposits under €100,000 are exempt and uninsured deposits of individuals and small companies are given preferential status in the bail-in pecking order.
While a minimum bail-in amounting to 8 per cent of total liabilities is mandatory before resolution funds can be used, countries are given more leeway to shield certain creditors from losses in defined circumstances.
Under the compromise, after the minimum bail-in is implemented, countries are additionally given an option to dip into resolution funds or state resources to recapitalise the bank and shield other creditors. The intervention is capped at 5 per cent of the bank’s total liabilities and is contingent on Brussels approval.
Anyone wanna buy two new credit derivatives, one with an 8% digital payout on bail-in, the other a 2nd loss instrument on the remaining 92%?
ISDA is consulting on a proposal to add another credit event… The proposed criteria for the credit event would be a government authority using a restructuring and resolution law to write down, expropriate, convert, exchange or transfer a financial institution’s debt obligations… the rules would allow written down bonds to be delivered into a CDS auction based on the outstanding principal balance before the bail-in occurred.
Investors are buying protection on European banks on the basis that banks and sovereigns are so intimately linked that any increased risk of a sovereign default will increase the value of a bank CDS in a similar way to a sovereign CDS.
“The big downside of the ban is that it is likely to increase borrowing costs for financials,” said Michael Hampden-Turner, Citigroup credit strategist.
“It is hardly good for Spanish and Italian banks if the cost of borrowing is being squeezed up on the back of European regulation.”
Essentially then national champion banks are being used as proxies for the sovereign, with CDS buying (driven in part by CVA hedging) pushing out these banks’ credit spreads. The only way this loop will be broken will be if sovereigns either post collateral against their OTC derivatives (unlikely) or clear (somewhat more likely, but with its own problems).
From the new Basel consultative document BCBS 245:
Credit protection costs will be considered material when the risk weight on the exposure in the
absence of credit protection would otherwise be greater than 150% at the time the credit protection is bought…
A bank must calculate the present value of material credit protection costs … if such costs have not been recognised in earnings … The present value should be treated as an exposure of the bank and be assigned a 1250% risk weight.
I don’t see that this really helps that much, as you can always mix in ‘good’ stuff to lower the risk weight below 150% and so be out of scope of the rule.
His grief is for PAF2, an innovative regulatory arbitrage ahem I mean risk transfer deal whereby CS had their bonus pool write protection on a mezz tranche of derivatives receivables to get CVA capital relief. Or not. This deal probably wouldn’t have worked in most jurisdictions, and even in Switzerland it seems that its days are numbered. As IFRE tells us:
Credit Suisse may be forced to scrap or, at the very least, radically restructure [the deal]
The problem is that CS had to get protection on the senior to get relief, and no one really wanted to write that for what CS wanted to pay, so CS had to reduce the liquidity risk of the senior CDS by agreeing that if there was ever a payment on the senior, they would lend the counterparty the money to make it. So if the world goes to hell and CS lose a lot of money on counterparty credit risk – really* a lot of money – then they make a claim on the senior CDS which CS’s counterparty pays with money they have just borrowed from CS**. Um. Is that risk transfer?
As Matt says, Basel says no. Hence the problem.
Now, unlike Matt, I’m not sad, because this deal should never have worked. Regulatory arb that finds a clever way to transfer risk at the right price in order to exploit mis-designed rules is fair enough; reg arb that purports to transfer risk but doesn’t seems to me to be basically an arb not of the rules but of the regulator’s understanding of the trade. Unless, that is, they understood it but didn’t see the problem, in which case we have a bigger issue.
*Matt seems convinced that the senior attachment point was so high there was practically zero risk in the senior; I haven’t seen the trade details so I don’t know, but I will say that wrong way and concentrated sovereign risks can be significant in derivatives receivable securitisation structures, so one would want to be rather careful about the modelling before asserting something like that.
**And which, it appears, they can ‘pay back’ – in a very loose sense – by assigning the CDS back to CS.
What’s a credit event? It’s a difficult question. Dealbreaker is exercised on this, or more specifically on the issues with CDS protection holders getting paid on some unusual credit-event-like happenings:
There are bonds.
You buy CDS that is supposed to pay off if something goes wrong with the bonds.
Something goes wrong with the bonds, insofar as they poof into some weird garbage-y thing or assortment of garbage-y things.
You can scoop up garbage-y things to your heart’s content, but the contract doesn’t let you deliver them into CDS in a way that achieves the sensible result.
Sensible Result = Face Value of Bond minus Value of Package of Garbage-y Things You Got For Your Bond
So you get less than Sensible Result, and are screwed, and the CDS seller has a windfall.
This is a reasonable criticism. Certainly it seems odd that in something like the SNS Reaal bail in, sub CDS have not yet triggered (although they might today). Moreover, even if the CDS do trigger, because in SNS’s case the bonds have been expropriated, physically settled CDS holders may not have anything to deliver. Thus there are really two issues: the problem of what is and is not a credit event (a perennial issue in the CDS market); and the problem that even if there is a credit event, the things that the bond turned into (including, err, thin air) might not be deliverable. As Dealbreaker says
It may be “difficult to formulate contracts in an entirely watertight fashion,” but getting to a seaworthy concept doesn’t seem all that hard: essentially, define “Reference Obligation” to mean “(i) the Reference Obligation or (ii) whatever package of things the Reference Obligation poofed into in a Credit Event.”
Wall Street financial engineers have devised a new way to combat declining trading in the credit derivatives market – they are revamping an index to add financial instruments that do not exist… Markit, will cross a Rubicon and begin to include three companies in its North American high-yield CDX index for which no bank is offering a CDS.
Markit and derivatives traders hope the addition of CIT Group, Charter Communications and Calpine Corp will force banks to launch CDS on the three companies.
Now admittedly the chances of one of the three having a credit event before the banks get around to trading CDS on them are low – but it would be a real mess if it happened.
Greek CDS typically trade under Old R restructuring. That fact could be become rather important soon. In Old R trades there is no limit on the maturity of the deliverable obligation, and no tranching in the auction post credit event. That in turn means the cheapest to deliver option may be quite valuable – there may be quite a large spread between short and long-dated bond prices post restructuring. Thus going into the event you can expect the CDS spread/bond spread relationship to be interesting. Everyone who entered into negative basis trades on Greece knew all this, right?
…Old R trades won’t have bucketed auctions even when the credit event in question is a restructuring.
So the question becomes whether anyone wrote CDS contracts with anything other than Old R trades on Greece. If there are MR or MMR trades there would have to be an auction with buckets.
Now, FT Alphaville didn’t think anyone had MR or MMR trades on Greece. Or, if they did, we thought it would be a booking error that would be cleared up.
But then, we saw this in a note from JP Morgan on February 24th (emphasis ours):
A problem might arise with the CDS contracts that have Mod R or Mod Mod R clauses. Western European sovereign CDS generally use the clause “Old Restructuring” (Old R). Under Old R, there are no maturity limits on deliverables, hence for the majority of the Greek CDS contracts currently in place there will be a single auction with bonds up to 30y maturity deliverable without multiple maturity buckets. But there is a small portion of Greek CDS contracts with Modified Modified Restructuring clauses (Mod Mod R), which means that for these contracts there will be several auctions for multiple maturity buckets. For the settlement of these CDS contracts, there might be bond deliverability shortage for shorter maturity buckets up to 10 years, where only international law bonds will be deliverable, creating some room for a squeeze in the auction process. But again, the universe of these CDS contracts (Mod Mod R) is rather small.
Now, that’s weird.
That was the first we’d ever heard of Greece CDS trades with MR or MMR. And we’re still thinking that someone at some point made a mistake.
Not necessarily. Restructuring is just a convention. You can negotiate whatever you want. Maybe someone needs restructuring to get capital relief*. Maybe they are doing a basket and they want the same restructuring choice on all the names in the basket. Maybe they just ticked the wrong box. But once you have agreed to, say, MMR, changing it to Old R is going to cost something. Pretty soon we’ll see if it was worth paying or not…
Now it is nearly the weekend, and I don’t plan on spending it thinking about CDS, so let me leave you with one of the more interesting google hits on ‘Old R’. Can anyone tell me what a single Oerlikon is and how it might help me in a bond auction?
*That, BTW, is why US corporates trade on XR – the FED does require restructuring as a credit event to give capital relief, while European regulators do. For extra amusement, read the letter from the insurers to ISDA over Xerox. It is in appendix one of this document, the choice sentence being ‘The current definition of Restructuring is clearly not workable if it is susceptible to the misinterpretation, as it apparently is in the minds of certain market participants, that there has been a Credit Event with respect to Xerox.’
I have been mean about Felix Salmon in the past, but this piece is really good.
The basic problem is this. If I have bought protection on 100 notional of a bond then I expect to be able to deliver whatever 100 notional of the bond turns into after the restructuring event, even if there is collective action and an exchange into new bonds. So if my 100 turns into 20 notional of new bonds which actually trade at 21 post exchange, I should be settled on the value of those 20 notional.
Felix points out that sovereign CDS documentation doesn’t track notionals, so I have to deliver 100 notional of new bonds, even if it was not a 1 for 1 swap. (Benton!)
Surely this is relatively easy to fix. All we need to say is that if 100 of old bonds turn into 20 notional of new bonds, an apple and two chocolate eclairs, I can deliver 20 new bonds, a pumpkin and two chocolate eclairs into the auction and get 100, or alternatively get cash settled on the current market value of 20 new bonds, a pumpkin and, yes, two chocolate eclairs. (For the avoidance of doubt, the chocolate eclairs are clearly the most valuable part of the package.)
In the mists of time, pretty much when dragons walked the earth, CDS referenced specific bonds.
What that meant was that if there was a credit event on that bond then you got to deliver that bond or were cash settled* on the value of that bond after the credit event. This meant that if you owned that bond and the CDS on it, you were hedged against the consequence of credit events (although obviously not against things that turned out not to be credit events**).
This was really good in that there was little basis risk between the CDS and the bond. But it was really bad in that it made CDS fairly illiquid. In this setting, a 1 year CDS on say the UK 4¾% Treasury Stock 2015 is not the same as one on the 4% Treasury Gilt 2016 despite the fact that both bonds are senior obligations of the UK government and both cross default. It would be really hard to imagine a credit event on the 4¾s of 2015 that wasn’t also a credit event on the 4s of 2016 – and vice versa – yet these two CDS are not in any way fungible. That reduces liquidity dramatically, and it means that dealers have to hedge each CDS with its underlying bond (or another CDS referencing the same bond). Well, either that or take basis risk anyway.
The market decided that it preferred some deliverability risk to illiquidity, so instead of trading CDS that referenced specific bonds, it began to trade CDS that referenced a specific obligator. You bought CDS on the UK (or more specifically on senior unsecured UK government obligations) rather than on a given bond. That single step dramatically increased liquidity, but it brought deliverability risk in cash settled CDS: you now no longer knew that the price the CDS settled at would reflect the value of the bond that you owned, as the settlement process was determined with respect to a basket of instruments.
Now all of this was long before the auction process was developed, and it was the key decision that meant that CDS were not as good a hedge as they used to be. The market chose to trade a product that hedged individual bonds less well in exchange for having a more liquid instrument. Now I am not going to take a position on whether that was a good choice or not, but I will say this. If you want a CDS that references a particular bond, and whose settlement amount is determined by the price of that bond after the credit event – or which allows you for sure to deliver a given bond – then buy one. Yes, it will cost you more than a standard CDS that is more liquid. It won’t have a readily observable price (although one might assume it would mostly trade in line with more liquid standard CDS). It will be hard to trade. But if you want a Ferrari, why are you buying a Ford?
*Of course, you want to be rather careful how a cash settlement amount on an illiquid bond is determined.
**Cf. restructuring. That is a different story, which also must be understood in any analysis of what CDS do and don’t do.
IFR has an interesting article on the Seat Pagine credit event. My guess, having no particular private knowledge of the situation, is that the release of the hitherto private loan agreement between SEAT and the SPV may have been intended to satisfy the ‘public information’ requirement of the credit event definitions.
FT alphaville has a nice summary from Lewis Alexander, Nomura’s chief US economist, on how Dodd Frank has reduced the powers US regulators have to intervene in financial institutions. The bottom line is that while the reforms (combined with Basel III and the SIFI requirements) do in some ways make US banks more robust, the FED/FDIC/OCC complex now has less ability to help individual firms.
A provocative but perhaps amusing quote from Philip Pilkington: “Austrian economics provided a metaphysical-theological basis for what is today called ‘libertarianism’ – a popular, dogmatic political cult in the vein of Marxism-Leninism.”
Bloomberg has a story about some damning testimony from CME chairman Terrence Duffy to the U.S. Senate about Corzine’s knowledge of (presumably illegal) transfers of funds from customer accounts. That’s not what interests me, though, juicy though it is. Rather I want to highlight how the story describes the CME chairman’s role:
Duffy, whose company is MF Global’s regulator and principal exchange
That’s right. The CME is both a shareholder owned for profit firm which makes money if its members trade more, and the regulator of those members. Gosh, isn’t it amazing something went wrong?
Update. In an exclusive (well, only shared with 594,861 youtube viewers), we have Duffy’s actual statement. Probably.
(I particularly like the line ‘my morals got me on my knees I’m begging please stop that rehypothecation’…)
To the extent that other market participants think that such CDS are now worth less because of politicians’ attempts at financially engineering around a credit event for Greece, that will cause spreads to move tighter, making the arb cheaper. Go Team Basel III!!
Yeah, the less the market believes that CDS hedge, the cheaper they are, and so the cheaper the CVA hedge is to put on.
We haven’t even mentioned the death spiral whereby sovereign CDS widen out and CVA desks are obliged to buy more, driving spreads higher… That’s one crowded trade all pointing in the same direction. Keep this in mind the next time spreads are widening out and politicians howl about the evil speculators that are exacerbating moves in the market (psst they may just be CVA desks following Basel regulations).
Exactly. CVA convexity is a big deal.
It’s also worth reiterating that nearly all sovereigns do not post collateral, but do demand it themselves — the dreaded one-way CSA. Banks have been trying to encourage sovereigns to start posting collateral so that they wouldn’t have to hedge against with CDS quite so much.
With the exception of a few minor countries (Portugal, for instance) they have not had much success. If sovereigns would agree to full two ways CSAs (zero threshold, daily collateral, cash only), then the CVA problem goes away. But, for now at least, they won’t, which is a shame as that is the only sensible way out of this mess.
It is with a heavy heart that I tackle this – but given recent events, the question of what risks purchased CDS protection on a bond hedges against cannot be ignored.
Here’s the issue. Suppose I buy a bond, and I buy CDS to maturity of the bond. Then if the bond defaults, the CDS pays out right?
Well, kinda. First clearly I have counterparty risk on my CDS provider. That can be managed with collateral, so assume I have enough of that too.
Second when do I get a payout on the CDS? The answer is ‘When the ISDA determinations committee votes that a credit event has happened’. Sadly we know from the example of Greece that some things that look a lot like default to the naive observer aren’t in fact credit events. Now certainly caveat emptor applies here: before buying a CDS I should have understood exactly what kind of thing it is. (See here for a nice discussion from FT alphaville on the evolution of CDS documentation.)
With a title like that, you know this is going to be technical. So I am going to assume you know what CVA is. The key point in hedging the credit spread sensitivity of the CVA is to note that you can calculate the sensitivity of the CVA to a small (1 basis point say) move in credit spreads and buy CDS with equal an opposite sensitivity. That way if the credit spread moves, the P/L in the CVA is offset by that in the CDS (ignoring gamma effects anyway) and hence you are hedged.
Unfortunately, you are not hedged on a jump to default, at least with standard single name CDS. This is because a portfolio of derivatives are not deliverable into the CDS, so you can’t just hand over the thing that generated the CVA and get its par value. (This is true even if the portfolio of derivatives has close out value exactly equal to the CDS notional you have bought – the point isn’t what it is worth; it is that it is not deliverable.)
Now you might argue that ISDA receiveables are pari passu with senior debt and hence a cash settled CDS should be fine. There are several problems here. First, the cash settlement amount depends on an auction, and that has its own dynamics. The amount fixed here may turn out to be rather different from the eventual senior debt recovery. Second, events of default on derivatives are often wider than those on senior debt, so you may be able to close out the derivatives before there is a senior default. This again gives rise to a basis risk between the derivatives recovery and the CDS recovery. Finally, because of the deliverability issue discussed above, some (many?) supervisors do not give credit for CDS bought against CVA in the default part of the counterparty credit risk calculation. (The Basel 2 piece not the Basel 3 CVA charge.) This means that CVA hedging does not reduce regulatory capital right now. Messy, that, isn’t it?
FT alphaville suggests that a consequence of the CFTC proposed rule whereby sovereigns (except the US, naturally) will have to post collateral to US swap dealers on OTC derivatives is that US swap dealers won’t do many trades with sovereigns. They are of course right. The large European, Asian and Latin American debt management offices will not post collateral at the whim of the Americans – or anyone else.
Should they (and indeed the US government) be obliged to post? Well, it depends. If they had to, they would have to find the money from somewhere, and that would increase their levels of debt. On the other hand, one way CSAs, whereby the dealers have to post collateral to the sovereign but not vice versa, are a liquidity drain on the banking system.
The clinch argument for me, though, is CVA. Uncollateralised derivatives create a big CVA. (See here or here for a description of CVA and how it arises.) Basel 3 will require banks to hedge their CVA well or take capital against it. Critically this includes CVA from sovereign transactions. The way you hedge CVA is to buy CDS. Thus when you see a picture like these two from the Alphaville post:
The prior post suggests that there is only $4-30 Billion net notional of CDS on even the biggest countries. My guess is that the major swap dealers need a good deal more liquidity than that to hedge their collective CVA position without moving the market.
The Basel 3 CVA rules, then, are a huge shot in the foot for governments. (A 50mm shell in the foot, maybe.) By forcing banks to hedge their sovereign CVA, they have increased the demand for sovereign CDS. That drives out spreads, which in turn increases borrowing costs for governments. The problem could be largely solved if sovereigns would agree to post collateral – but they won’t.