Deus Ex Macchiato

Rajiv Sethi is a clever guy and I have respected his work in the past, but I think that he is materially mistaken about naked CDS. In a recent paper with Yeon-Koo Che he writes:

Those who are most pessimistic about the future prospects of the borrower will be inclined to buy naked protection, while those most optimistic will be willing to sell it.

This is the first, and most important misconception. CDS trading is not about speculating on default: it is about credit spread movements. In other words, people do not buy CDS protection, typically, because they think that the market view of default is too optimistic; nor do they sell it becase they are optimists on the credit. They buy CDS because they think that the credit spread is going to go up: they sell it because they think that it is going to go down.

The next error is to suggest that protection sellers

… have to support their positions with collateral, which they do by diverting funds that would have gone to borrowers in the absence of derivatives.

This too seems to me to be a huge stretch which requires considerable justification. Collateral is usually cash, and it earns OIS. To turn liquidity into a risk position involves an asset reallocation decision which, if made generally across a bank, would dramatically change its risk profile. No, if there were no derivatives, it is highly likely that that money saved from not having to post collateral was invested in FED funds, or in some similar low risk, low return form.

Next we get to something that I think the authors should do much better. They gaily state

For reasons that are already clear from the baseline model, we find that … [some situations] involve more punitive terms for the borrower when naked credit default swaps are present than when they are not.

Given that this is the major conclusion, to say that it follows from the (in detail unspecified) model is, to put it politely, sleight of hand. If we look at the detailed paper, we find a slightly more nuanced exposition:

The availability of such contracts [as naked CDS] can shift the terms of debt contracts against borrowers by inducing optimistic investors to divert their capital away from financing real investment and towards the support of collateralized speculative positions.

In other words, the conclusions rely on the assumption that CDS protection sellers would otherwise take credit risk with their collateral, something that is highly unlikely. Typically CDS protection buyers, especially naked ones, value CDS precisely because of their liquidity and their leverage, neither feature of which is present in the bond market (unless you repo the bond – but that is another story). Thus what appears to be a carefully, academically rigourous critique of naked CDS is nothing more than a farrago of erroneous assumptions and conclusions. Caveat lector.

Update. Bug that Rajiv pointed out fixed above.

Posted in: CDS and Negative Basis by David /
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A couple of thoughts about sovereign CDS. I’ll kick off with an article from Derivatives Week. They say (from behind a firewall):

Increased hedging by banks has been an influential factor behind moves in sovereign credit default swap spreads, according to the Bank of England. In its quarterly bulletin, the central bank said that according to its contacts in the industry, specific counterparty valuation adjustment desks of banks with large uncollateralized foreign exchange and interest rate swap positions with supranational or sovereign counterparties have been hedging positions in the sovereign CDS markets.

(The Bulletin is here.)

This is a classic example of unintended consequences. One element of Basel 3 is a capital charge for the variation of counterparty valuation adjustment – basically the adjustment derivatives traders take to reflect the credit quality of their counterparties. The CVA is largest on uncollateralised swaps: collateral reduces it massively. And which is the most significant class of counterparties who refuse to post collateral? Sovereigns and supranationals. Therefore making banks hedge their CVA better has the effect of forcing them to buy more sovereign CDS, which in turn may increase government borrowing costs. Spread widening isn’t necessarily caused by the evil CDS market speculating on sovereign default; instead it may well be regulatory action that is the cause.

What to do about it? That brings me to my second, more speculative riff. Whatever the cause of sovereign CDS spread widening, if governments don’t like it, the answer is clear. Write CDS on yourself. The principle is actually well established in the corporate area. An ISDA claim is pari passu with senior debt, therefore in the event of default a self-written CDS gets recovery. (OK, it is a little more complicated than that given the auction process, but it’s broadly right.) Therefore if you think, say, recovery = 33%, a self written CDS is equivalent to a CDS written by a risk free counterparty on a third of the notional. Governments need simply go into the sovereign CDS market and write protection on themselves in crushing size. That would bring spreads in fast, and raise them some premium income in the process. Simples.

Posted in: CDS and Negative Basis by David /
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As was always very highly likely, Greek default has been averted. You might add ‘for now’, and certainly the omens are not entirely good. However in looking at the PIIGS one must understand the context: the Euro project, as we have previously commented, is not primarily an economic one. It is political. This means that things will be done which are perhaps not rational economically. If you bet against Greece, you are not betting on the Greeks failing to sort out their problems. You are betting against the rest of the Eurozone, and Germany in particular, not supporting them. Despite Germany becoming more selfish recently, this seems unlikely: a lot more unlikely than the markets are estimating, anyway. I still like selling first to default protection on the PIIGS: if Citigroup and JPMorgan are too big to fail, how much more so are Greece, Portugal, Ireland, Spain and Italy? The Eurozone may seem disorganised, slow to react, and sclerotic. It might have labour markets which frighten economists, pensions deficits going to the sky, and low growth. But it is one of the richest areas in the world, and it will remain such. It can afford to rescue its members, and my guess is that if push comes to shove, that is what will happen.

Posted in: CDS and Negative Basis, Markets, Sovereign Default by David /
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Rather like Lost, the Monoline Death Watch has been going on so long that one can neither remember all the twists and turns, nor rouse much enthusiasm for the final denouement. Still, the news from Bloomberg that Wisconsin Insurance Commissioner Sean Dilweg

is taking over a portion of Ambac’s policies to protect municipal bondholders who count on the company’s guarantees. He halted payments on the $35 billion of mortgage bond policies and other contracts

The press release is here: comment from Rolfe Winkler (who seems to be a rather less hysterical and better informed Reuters blogger than Felix Salmon) is here.

Basically Dilweg is segregating the muni insurance business written by Ambac Assurance Corp from the bad stuff, primarily CDS on ABS. The CDS counterparties will get 25 cents on the dollar or so, plus a share in any eventual upside from there. This is an event of default for credit derivatives referencing Ambac.

Update. There is a provocative post on the legal implications of the segregated account approach Ambac has taken by Stephen Lubben at Credit Slips here. I’m not up to speed with the details here, but it certainly seems that the possibility of being forcibly novated into a position with less access to liquidity and much less capital might be troubling to a counterparty…

Posted in: CDS and Negative Basis, Monoline by David /
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Felix Salmon appears to have spotted something which casts a whole new light on the pro exchange slant of the Dodd bill:

Dodd’s wife, Jackie Clegg, is a director of the CME, which paid her $153,219 in 2009; she also owns shares in the company worth about $235,000.

If this is true the industry should scream conflict of interest rather loudly.

Posted in: CDS and Negative Basis, Regulation by David /
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As I expected, given the primarily political rather than economic character of the Euro project, Greek has been propped up.

This is both rational on a standalone basis, and as a signal to the markets. If Greece had defaulted, the pressure would have been huge on the rest of the the PIIGS. Sell one year first to default protection on Portugal, Ireland, Italy and Spain before the spreads come in too much.

Posted in: CDS and Negative Basis, Markets, Sovereign Default by David /
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Wolfgang Münchau suggests in the FT

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point.

This is nonsense from start to finish. Buying a bond is a pure speculative gamble too. There is nothing holy about being long, nor diabolical about being short. Shorts make the market more efficient, as all hardened speculators, and a good many other people – but clearly not Münchau – know.

FT alphaville has a longer defence from the excellent Sam Jones here. Frankly Münchau isn’t worth it.

Posted in: CDS and Negative Basis 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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‘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 markets are all over the place today. That spells opportunity. For me the glaringly good one is Greek sovereign CDS: as Ibex Salad pointed out in a comment on my previous post on spread widening, from a fundamental perspective, this looks like money for old rope. Yes, spreads could widen further, so don’t buy a product with a spread trigger, but otherwise selling protection on Greece for over 200 running looks like a no brainer.

Here’s the spread history, courtesy of FT alphaville:

If you have even stronger nerves, consider a short in gold (ideally priced in Euros or Yen…)

Posted in: CDS and Negative Basis, Markets, Sovereign Default by David /
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FT alphaville picks up some research from Paribas on sovereign CDS spreads. The claim is that spread widening in the peripheral EU countries are being driven by ECB policy: The ECB signalled on Friday that it would soon start retracting some of the liquidity provisions it put in place last year, in a bid to stop some of its lower-rated members from using them for financing investments in their own local government bonds — something that had helped keep European sovereign spreads tight. Certainly ECB action could cause a weakening in demand for certain government bonds as the ability to finance them cheaply and earn carry disappears. Spreads are definitely widening, as the illustration shows. (This story would be a little more compelling if we could see the historical spreads for Greece, Poland, Slovakia etc., but it is safe to assume that these have blown out too.) Is this all ECB driven?

I suspect not. In particular there is a popular credit derivatives product which packages up a leveraged sovereign CDS in a note. Essentially the buyer of the note gets an enhanced return in exchange for selling CDS on a multiple of their notional at risk. The catch with these products is that they do not just trigger on an ordinary credit event: in order to protect the selling bank, they also trigger on spread widening. Thus for instance on popular version of the product in 2008 year paid Libor plus 1% or so in exchange for seven times leveraged exposure on Spain, with a trigger if the Spanish sovereign CDS spread hit 100 – a level it is perilously close to today. These notes are reasonably subtle products in that they can seem to the naive like simple speculations on sovereign default – and no one expects Spain to default. But the spread trigger means that they are in fact rather sophisticated forms of credit spread option. The note issuers hedge by selling sovereign CDS on the other side. All else being equal, this should act as a brake on spread widening, as note buyers take advantage of better spreads to sell more CDS.

But who are the buyers of sovereign CDS on the other side of this and other trades? There is much less pressure to do negative basis trades on government bonds as there is little regulatory capital advantage. So what puzzles me about the spread action is who is paying these high prices to buy sovereign protection, especially on the better quality names. That is the real answer to the spread widening puzzle.

Posted in: CDS and Negative Basis, Derivatives, Hedging and Convexity, Sovereign Default by David /
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Here is an interesting idea. The FDIC are suggesting that if a

large systemically important institution is put into receivership by the FDIC and there are not enough assets to cover the cost of unwinding it to the government, all secured claims would be automatically converted into unsecured loans with a haircut of up to 20%.

The original Reuters story is here, and comment from Across the Curve, based on Barclays research, is here.

This idea appears to be gaining traction. FT Alphaville reports on an amendment which passed yesterday in the House. Proposed by representatives Miller (D) and Moore (D), this would implement the FDIC proposal. In particular, as Across the Curve points out, it would have significant implications for the repo market, since even a fully secured repo would take a 20% hit in the event of FDIC intervention.

Is this good or bad for financial stability? It is frankly rather difficult to say.

On the one hand, it would encourage creditors to review the credit quality of counterparties rather better. But it would equally encourage a rush for the exit as an institution became troubled, and exascerbate funding liquidity risk. Remember it was counterparties declining to roll repos that caused the demise of both Bear Stearns and Lehman. So this rule change, if enacted, would make it more likely that secured funding is withdrawn as confidence is lost. That is pretty likely anyway, however, so it could be argued that the downside is not great. It might well encourage the development of a market in CDS on repo receiveables though…

Posted in: CDS and Negative Basis, Credit, Liquidity and liquidity risk, Regulation by David /
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There has been a lot of discussion recently about the SIGTARP report on the AIG bailout. See for instance here for Krugman, here for Naked Capitalism, and here for the Big Picture. At first I shared this outrage: Geithner undoubtedly underplayed his hand, and showed his usual snivelling obeiscance to the banks. But does it, in this instance, matter much?

What did he really do? He loaned AIG money, at a penal rate, so that they could meet margin calls on CDS. Derivatives receivables are technically pari passu with senior debt (and in practice better than that, due to a wide definition of default in the CSA), so he did nothing worse than lend money to AIG’s counterparties. He did not recapitalise them covertly: these payments were debt, not equity. And many of the counterparties, Goldman included, could have borrowed directly from the FED at that point. By allowing AIG to make the payments, he injected liquidity, and prevented a potentially systemic failure of the CDS market. Moreover, AIG (and thus the taxpayer) is on the hook for the performance of the CDS it had written anyway, and in due course we will see how that goes: the collateral payments were merely based on the current mark to market. If conditions improve (as they have done), AIG and thus the taxpayer will get the money back, with interest.

In conclusion, then, there are many, many things that we can criticise about Timmy’s actions (and inactions) during the crisis. But the AIG margin payments are not on the top ten Timmy screwup list.

Posted in: CDS and Negative Basis, Mother of all Bailouts by David /
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Could another Gillian Tett-style disaster shake financial journalism again? It is not an entirely idle question. This month, there has been plenty of hand-wringing from those who built a career on the Lehman Brothers collapse. But behind the scenes the issue of bad journalism – and journalists inability to understand the credit derivatives market – is currently provoking even more debate.

OK, I can’t be bothered to rewrite the entire article.  But suffice it to say that Ms. Tett has struck again with her own unique blend of selective facts, innuendo, and common or garden error. For instance, here is a part of her second paragraph:

…the US government used tens of billions of dollars to honour [AIG's CDS] deals, benefiting groups such as Goldman Sachs, Société Générale and Barclays. And that money, remember, will not return to the Treasury’s purse (unlike the sums invested to boost bank capital, say).

No. Firstly some of the money will return if the ultimate level of defaults proves lower than implied by CDS spreads at the time of the collateral calls. This is highly likely. And secondly given that it is a debt obligation of AIG – as it was borrowed from the Treasury under a credit line – the AIG bailout provides a better quality asset for US taxpayers than equity capital.

Then we have straightforward alarmism:

belatedly – regulators and banks are watching net data instead.

No, Gill. Regulators and banks have always watched net data. It is only journalists who ever thought that gross notionals meant anything.

Lacking any form of actual news or insight, Ms. Tett is forced to conclude with non-specific worry:

not everything in the market today looks rational… And while regulators keep prodding banks to become more transparent in relation to counterparty risks, many are still dragging their feet on data provision – and the question of how many deals are actually placed on clearing platforms. No wonder western finance leaders keep muttering that the “too big to fail” problem remains; one year on, the ghost of AIG refuses to die away.

Note the conflation of counterparty risk with CDS, with no mention of the other areas of OTC derivatives, securities lending, and repo that give rise to it. Then we have a complete not sequitur into too big to fail. If this article were a cake, it would probably be asparagus and coffee cake decorated with anchovies.

Posted in: CDS and Negative Basis by David /
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In the old days of equity derivatives, one of the main instruments was the covered warrant. This was a call option (usually – put warrants are uncommon) issued by a bank and traded as a security: it gave the holder the right but not the obligation to buy some number of underlying shares at a fixed price. This market still exists, and is reasonably active in some countries.

The term ‘covered’ come from the early regulatory framework. In order to prove to the exchange that the issuer of the warrant could meet their obligations, they had to keep some or all of the underlying. This position in the underlying was known as the cover: it ensured that if the warrant ended up in the money, the issuer could deliver shares to the warrant holders. (Obviously if a corporate issues warrants on itself, then there is no problem: an entity can always print more of its own shares. The issue arises when a bank issues warrants referencing shares in another corporation, often without that corporation’s permission or support.)

The cover requirements were supposed to ensure that squeezes did not happen whereby the issuer was forced to pay higher and higher prices to buy shares against the warrants that they hold. This is an issue with less liquid underlyings, especially ones where most of the liquidity is controlled by a small number of parties. By forcing banks to buy the underlying before issueing the warrant, exchanges made market disruption much less likely.

There is definitely something that we can learn from this piece of market history. When derivatives traders are forced by regulation to have a matching position in the underlying, then:

• There is a natural limit on the size of the market;
• Both derivatives and underlying markets are more orderly; and
• The issuer’s risk is automatically limited.

When that is not the case, things can get a little crazy. Let’s look at two examples.

The first is the CDS market. I am a supporter of this market, and I view many of those who wish to limit CDS trading as uninformed, hysterical or both. (People called Gillian who have a book to plug may well fall into this category.) However, there is one reasonable objection to CDS, and that is that it sometimes allows the tail (the derivatives market) to wag the dog (the underlying bond or loan market). I have no objection to letting people short credits, but doing so by CDS can provide more protection sellers than there are bonds, creating exactly the sort of squeeze post default that the cover requirements eliminated for warrants. The lack of a borrow market for corporate bonds is the real culprit here. Perhaps one solution would be to keep the CDS market as is, but to require that naked shorts pay a credit borrow fee to a holder of a deliverable instrument. This fee would be in exchange for the bond or loan holder agreeing not to buy protection on it or lend it to anyone else: the fee would automatically ensure that no more CDS protection was sold than there were bonds (or loans) extant which would at least make it more likely that the CDS settlement was orderly.

Second, the commodities market, specifically oil. This post was inspired by a fascinating article on the oil market from the Oil Drum (via FT alphaville). One part of the author’s arguments is that the existence of an enormous market in financial contracts on oil has resulted in considerable price volatility – perhaps even price manipulation – which is in the interests neither of producers nor consumers of physical oil, but which benefits intermediaries such as the investment banks considerably. Certainly if one believed that this is true – and the evidence is impressive – then again the solution is obvious: require all derivatives positions to have a physical hedge. If you are short, then you have to own the underlying. If you are long, then you have to borrow the underlying. A given barrel of oil can act as the hedge for just one contract. And you can only use deliverable oil – stuff in tanks – not oil that is still in the ground.

Posted in: CDS and Negative Basis, Derivatives, Hedging and Convexity, Markets by David /
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The Economics of Contempt has a nice historical summary:

the first major restructuring that I can remember being significantly hindered by CDS was Marconi, and that was back in 2001-2002. Marconi was negotiating a restructuring with a bank syndicate, but for a long time certain syndicate participants (cough, UBS, cough cough) refused to agree to any restructuring that didn’t constitute a “credit event” under the 1999 ISDA Credit Derivatives Definitions. The holdout banks had purchased CDS on Marconi to hedge their exposure, and if they were going to agree to a pretty drastic restructuring, they wanted to make sure they got the benefit of their hedges. After more than a year of restructuring negotiations, the banks agreed to a debt-for-equity swap that qualified as a credit event under most of the CDS contracts, but also pretty much wiped out shareholders.

Mirant Corp.’s 2003 bankruptcy was also largely a result of CDS. Several creditors had purchased CDS protection on Mirant, and one major creditor in particular, which rhymes with Pitigroup, was relatively open about the fact that it didn’t agree to a restructuring because it needed a bankruptcy filing to trigger its CDS contracts referencing Mirant. The bank that rhymes with Pitigroup’s refusal to agree to a restructuring (which came at the last minute and was a big surprise, if I remember correctly) effectively torpedoed any chance Mirant had of avoiding bankruptcy.

I’m not personally familiar with Mirant, but the Marconi example is certainly a good one. There is a definitely a good case that rights to sit at the creditors table should sit with the risk holder, not the bond holder.

Posted in: CDS and Negative Basis by David /
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Martin Wolf, quoting Mervyn King, writes in the FT:

‘My word is my bond’ are old words: ‘My word is my CDO-squared’ will never catch on.

He’s right, but it is a shame. After all, we need a convenient shorthand for ‘My word is badly structured and likely to lead you into trouble’.

Posted in: CDS and Negative Basis by David /
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How can you not like something that begins ‘Emerging Markets and derivatives are like alcohol and barbiturates: each on its own has attractions but create a recipe for choking on one’s own vomit when combined‘? It’s about nefarious doings in the CDS market on the Kazakh bank BTA, and it is here.

Posted in: CDS and Negative Basis by David /
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AIG’s collateral postings after the rescue are well known – essentially the firm was saved so that it could continue to fulfil its obligations to the banking system, notably under the CDS it had written. AIG before the fall has received less attention. But now Bloomberg has done some digging, and the story of the collateral calls that brought AIG down is emerging.

Goldman Sachs Group Inc. and Societe Generale SA extracted about $11.4 billion from American International Group Inc. before the insurer’s collapse as the firms demanded to hold cash against losses on mortgage-linked securities, … “It was precisely that drain of liquidity to Goldman and SocGen that put AIG in a position of illiquidity and ultimately threw them into the government’s arms,” said Charles Calomiris, a finance professor.

Including collateral from before and after the rescue and payments made by Maiden Lane III, a vehicle created by the Fed to retire the swaps, Goldman Sachs received about $14 billion from AIG, Societe Generale got $16.5 billion, and Deutsche Bank AG received $8.5 billion.

Posted in: CDS and Negative Basis, Clearing and Collateral, Credit, Mother of all Bailouts 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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Sometimes, when you have written about a topic, you pick up something someone else has written and are just blown away by the author’s understanding and insight. Let’s just say that this did not happen to me with Gillian Tett’s book on credit derivatives and the credit crunch.

Posted in: CDS and Negative Basis, Publications by David /
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CDOs are complicated. In particular, many of them have waterfall structures that include diversion tests – if x then tranche y gets some money, otherwise it goes to tranche z. Unsurprisingly, trustees sometimes get these tests wrong. Expected loss has found an example: I do encourage you to read it if you have an interest in either structured finance or operational risk.

Posted in: CDS and Negative Basis, Operational Risk and Rogue Trader by David /
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I have made a bit of a sideline in highlighting some of the less helpful comments on the CDS market. It pains me to include a man I generally respect, Paul Krugman, in the list of people who have got the wrong end of the stick.

He first quotes marketwatch:

The spreads on credit-default swaps for U.S. government debt jumped to 97 basis points Tuesday, nearly seven times higher than a year ago and 60% higher than the end of last year, to a level roughly in line with those of France, according to data supplied by Markit.

Then he opines:

Has the risk of a US government default risen? Probably. Nonetheless, the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?

The answer is that it does not matter (much). Most CDS trading is about views on the spread, not views on default. People buy CDS on the US government because they think the spread will widen and they can close out at a profit, not because they think that default is likely. Therefore the CDS market often tells you rather little about default: what it tells you about is market participants expectations of spread movements. CDS spreads go out when there are more buyers of protection than sellers. That is the only reason spreads move. Any connection between CDS spread movements and expectations of default is a modeling assumption, and one that is particularly dubious at the moment.

Posted in: CDS and Negative Basis, Credit, Sovereign Default by David /
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Corporates trading through their sovereign in the CDS markets, from Zero Hedge:

Posted in: CDS and Negative Basis, Sovereign Default by David /
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I should buck up, I know. The current furore over credit derivatives may well come to nothing. But when I read something like Soros’ article in the FT today, my heart sinks. Let’s play spot the fallacy.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds.

So how can you explain the growth of CPDCs, who are long risk only CDS investors, or for that matter the long risk portfolios at the monolines and AIG? In reality the fact that CDS allows unfunded risk taking trumps the ability to go short in stimulating demand.

Note too that there can be no asymmetry in the market: you can’t sell CDS protection unless someone buys it and vice versa.

…US and UK government bonds… actual price[s are] much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.

No they are not. (I don’t believe in the strong form of the efficient market hypothesis either, but this is not evidence for or against it.) CDS spreads include counterparty risk effects and liquidity risk on the possible future margin. Bond spreads include funding premiums. They are literally incommensurate since to have hedged positions (bond plus CDS) you need to be able to fund the bond to term at a fixed cost and to have no counterparty risk on the CDS provider.

I have an unworthy, low conjecture. It is that the age of a commentator is directly related to their hostility to CDS. The older someone is, the later they are likely to have come to the CDS market. And the less likely they are to understand it.

Posted in: CDS and Negative Basis by David /
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There have been a few posts around recently about losses on negative basis trades. These were apparently (one of) the source(s) of Merrill’s recent loss. But I had not seen a convincing explanation until I came across this post from Zero Hedge. This picture is particularly eloquent:

At the time of the Lehman bankruptcy, it shows the spread had blown out over a thousand basis points. Now, given there is little liquidity in this stuff, Merrill is unlikely to have taken most of the trades off. So if this is the main cause of the losses, they will come back as the basis gets back to normal.

Posted in: CDS and Negative Basis by David /
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The ignorant journalist’s favourite whipping boy, the CDS market, gets another undeserved beating today, this time from Alan Kohler in the Business Spectator. Managing a considerable density of mis-information, Mr. Kohler is rather histrionic:

As the world slips into recession, it is also on the brink of a synthetic CDO cataclysm

Would that be a cataclysm like the Lehman CDS one, or like the Fannie and Freddie one? How would sir like his non-event today?

The triggering of default on the trillions of dollars worth of synthetic CDOs that were sold before 2007 could be a disaster that tips the world from recession into depression. Nobody knows, but it won’t be a small event.

Or just perhaps it will be totally orderly just like all the other CDS settlements so far.

CDOs were invented by Michael Milken’s Drexel Burnham Lambert in the late 1980s

No, CMOs were invented by the Freddie Mac in 1983. The first CBOs were based on that structure.

About a decade later, a team working within JP Morgan Chase invented credit default swaps, which are contractual bets between two parties about whether a third party will default on its debt. In 2000 these were made legal

Again no. They were legal when they were first traded, in the early 1990s. (U.S. law, it may surprise Mr. Kohler to learn, is not the only relevant one.) At this point I have to confess I gave up. Anyone who makes that many basic errors in the first few paragraphs while using over-blown and emotive language does not deserve to be read.

Posted in: CDS and Negative Basis by David /
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Felix Salmon has a nice piece on AIG FP’s strategy and why it went so badly wrong.

When AIG wrote protection on CDOs and the like, it got insurance premiums in return, and considered those premiums to essentially be free money, since (according to AIG’s own models, and those of the ratings agencies) the chances of those CDOs defaulting were essentially zero.

…AIG’s biggest mistake was in failing to realize that this business couldn’t scale in the way that most insurance does scale. Most insurance does scale: if you insure a house against fire, for instance, it’s easy to lose much more money than was paid in insurance premiums. But if you insure houses across the country against fire, you’d need a nationwide conflagration in order to lose lots of money.

… The reason AIG’s models said the CDOs couldn’t suffer any losses was that house prices don’t fall in all areas of the country simultaneously. Since AIG was only insuring the last-loss CDO tranches, investors with lower-rated tranches took the risk that prices in Florida, or Arizona, or California might fall. AIG would only lose money if prices fell in all those states at once — which is, of course, exactly what happened.

In other words, AIG’s models assumed default correlation would be low, and that there was a good measure of diversification benefit between the different CDOs it had written protection on. In reality once house prices turned down there was very little diversification, default correlations leaped up, and the mark to market on many of AIG’s contracts turned against them, necessitating the collateral postings that brought the insurer into the welcoming arms of the FED.

Posted in: CDS and Negative Basis, Insurance and Actuarial Practice, Model risk by David /
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AIG wrote CDS protection to a bunch of banks. Spreads have blown out and AIG is not AAA, so they have to post collateral. They couldn’t, so the FED lent it to them at Libor + 850. That was last month’s story.

This month’s story is a new bailout. Let’s see if we can follow the story in the WSJ:

Many banks that previously bought protection from the insurer on securities backed by now-troubled mortgage assets stand to recoup the bulk of their investments under a plan by AIG and the Federal Reserve Bank of New York to buy around $70 billion of those securities via a new company. These securities are collateralized debt obligations backed by subprime-mortgage bonds, commercial-mortgage loans and other assets.

…

The banks also will sell the CDOs to the new facility at market prices averaging 50 cents on the dollar. The banks that participate will be compensated for the securities’ par value in exchange for allowing AIG to unwind the credit-default swaps it wrote.

So the Journal is suggesting that the new facility will buy the securities and cancel the CDS AIG has written. Note that that does not just get the banks off AIG counterparty risk: it also frees up funding for the underlying assets. If eventual recoveries are greater than market prices predict, then the new entity at least gets to keep the difference. Still, it does seem a strange way to proceed. Even if you thought that it was important to ensure that the protection buyers did not lose – clearly a key feature of the bailout – why would you buy the underlyings rather than simply loan AIG money to meet collateral calls and recapitalise them if necessary?

Posted in: CDS and Negative Basis, Mother of all Bailouts by David /
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Alea had a misleading note on the DTCC reporting of credit derivatives. I usually like Alea, but this post, suggesting there were only single digit numbers of contracts on many of the ABX subindices, gave the wrong impression. Turning to the DTCC itself, we find net notionals in most of the subindices in the single digit billions, with high hundreds or low thousands of contracts.

Posted in: CDS and Negative Basis by David /
2 Comments

The Basel Committee’s two papers on incremental risk in the trading book (incremental to that captured by VAR, that is) – here and here – led me to muse on what the real dynamics of risky bond prices are.

Firstly clearly there is an interest rate risk component. Let’s ignore that as it is the best understood.

Second there is jump to default risk. The phrase itself is slightly misleading in that bond prices often fall a long way in the period before default, and indeed recoveries are sometimes higher than pre-default bond prices would suggest. Skip to default might a better term. Still, the idea that there is a jump process which can cause non-continuous changes in risky bond prices is reasonable.

Then there are ‘everyday’ movements in credit spreads. Now, here’s the six hundred and forty billion dollar question (OK, OK, not the size of the corporate bond market I know) – if you take out the jumps, is what you are left with even vaguely normal? My guess is that it isn’t, and that autocorrelation is significant even after jumps have been taken out. The hard part is that you need a lot of credit spread data to look at this kind of thing, and it isn’t easy to come by. CDS data won’t do in this instance simply because single name CDS have only been liquid for ten years or so, and you’d at least want data going back well before the ‘98 LTCM/Russian crisis. I’ll get around to this sometime soon…

Spread dynamics are the flipside to my earlier post on what CDS spreads mean: that was about what causes the spread to move; this is about how you can model those movements.

Posted in: CDS and Negative Basis, Credit, Financial Models by David /
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Naked capitalism suggests that some observers are perplexed by widening CDS spreads on US government debt.

How, they ask, could a private sector contract against default be expected to pay out in the case of a US government default – which would be the equivalent of a nuclear explosion in the financial markets?

The ten year Euro-settled spread has gone out considerably:

All that is going on, of course, is that people are buying the contract because they think the spread will go out further. That will happen if more people buy it. More buyers than sellers equals rising prices. The actual default of the US has little to do with it for the buyers: they care about spread movements, and making money from them. Sellers are presumably happy to take what they view as an immaterial risk.

Update. Bloomberg has an article which confirms the idea that a lot of CDS trading is driven by speculation on the spread rather than insurance against default. They report that the most active contracts recently include those on Italy and Spain. Dubious though both countries’ finances may be, default from either is vastly unlikely – but spread widening is rather likely.

Posted in: CDS and Negative Basis by David /
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From Reuters:

Credit strategists at ING said on Thursday that credit derivatives were being unfairly blamed by politicians and commentators for the near meltdown of financial markets…”The CDS (credit default swaps) market is being used as a scapegoat for political and economic goals,” ING credit strategist Jeroen van den Broek wrote in a note to investors.

Quite right too, and I have been saying so for months. This particular goat (sheep, whatever) is pretty safe.

As per my earlier post, Reuters reports that the Lehman settlement is a non-event. There a nicely written elaboration from Felix Salmon on portfolio.com here, and a broader FT alphaville defense of derivatives here.

Posted in: Art, CDS and Negative Basis by David /
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Let me offer an analysis of much of the media coverage of credit derivatives recently.

“Credit derivatives traders eat babies. Now XYZ event will tip the financial system further into chaos thanks to these dastardly instruments…”

(XYZ = Fannie/Freddie credit event, Lehman credit event, …)

“On the eve of the auction for XYZ we spotlight the satanic unregulated* credit derivatives market…”

[The event happens. Settlement is orderly.]

“XYZ event was OK, we suppose, but the NEXT event will truly cause the end of the world thanks to the inexorable evil of credit derivatives.”

The DTCC has an antidote. I doubt many bloggers or mainstream journalists will read it.

* Where by ‘unregulated’ we mean of course ‘unregulated apart from the regulation’.

Posted in: CDS and Negative Basis by David /
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From the Economist a couple of CDS spreads:

Campbells Soup 17 basis points

United States of America 19.8 basis points

(And Morgan Stanley is over 2000, if you can get it.)

Posted in: CDS and Negative Basis by David /
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From Reuters, initial indications for today’s auction:

Remember, kids, while senior unsecured recovery can’t be lower than sub in the actual bankruptcy hearings, it surely can in a CDS auction.

Update. Final results in:

Alea suggests that the recovery mismatch is due to a cheapest to deliver effect as the zeros are deliverable into the senior swaps (list of deliverables here). Personally I think it is partly because there is a lot more liquidity on the sub than the senior. In particular naked shorts played with the sub (partly to hedge nationalisation risk). A lot of those are short covering now, whereas the senior was typically a credit risk management trade rather than speculation.

Posted in: CDS and Negative Basis by David /
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FT alphaville has the details in a most impressive post.

Posted in: CDS and Negative Basis by David /
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According to Bloomberg:

New York State will begin to regulate part of the $62 trillion market for credit-default swaps, Governor David Paterson said.

The state will treat contracts in which the buyer also owns the underlying security as insurance, Paterson said today in a news release.

That’s it then. London always was ahead of New York in structured credit: now, provided we do not do something similarly stupid, we can own this market.

It is worth pointing out, en passant, how successful treating credit derivatives as just another insurance contract has been so far. The largest two firms to adopt that paradigm were MBIA and Ambac. Unless you count AIG of course. Still, New York will still have better looking trucks.

That’s something. But it doesn’t produce jobs for the geeks.

Update. The Economist has a nice article, Guilt by suspicion, about the benefits of derivatives and the mud slung at them. I do think it is worth remembering that the cause of all of this mess was not derivatives, it was mortgages.

Posted in: CDS and Negative Basis, Credit, Insurance and Actuarial Practice 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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Accrued Interest has a fascinating data point on the troubles of the financials at the moment: Citi’s latest five year was done at 337 over Treasuries or roughly 235 over Libor.

AI then suggests that there is an arb between CDS at 160 over and the bond at 239 over. In ordinary conditions that would be true because in ordinary conditions a trader would assume he or she could fund the bond at Libor flat, buy the CDS at 160, be risk flat, and make 79 running. But… firstly at the moment there aren’t many Libor flat funders. The C deal discussed is evidence enough of that. And second you are only risk free if the CDS is guaranteed to pay – and which counterparty can be sure of that for in a situation where Citigroup is in default? The 160 over then does not reflect the real cost of being sure of protecting Citi debt, but rather the credit weighted average cost across typical CDS counterparties: buying protection on C from Berkshire Hathaway, say, would probably be more expensive (it certainly ought to be if Warren’s folks are sharp).

A trade like long the debt long CDS protection only makes sense if (Bond spread over Libor – my funding cost over Libor to term) > (CDS spread + cost of complete credit protection on CDS counterparty for CDS receivable). The 2nd and 4th terms are typically small in an ordinary market. But this ain’t no ordinary market.

Posted in: CDS and Negative Basis, Liquidity and liquidity risk by David /
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Some old research from, of all people, Bear Stearns, makes fascinating reading. It is about delta hedging CDX and iTraxx tranches, just about the simplest possible hedging problem in structured credit (in that index itself is the hedge, and both that and the tranches are liquid).

Suppose we have sold a tranche of the CDX. What it the delta with respect to the index? The standard definition would say something like

delta = (price of tranche at index spread plus 1bp – price of tranche at index spread) / 1bp

But there is a hidden correlation assumption: we calculate this delta at constant base correlation. Thus delta hedging will only be P/L minimising if

• spread movements are small;

• rehedging is possible after a small spread movement; and
• base correlation remains constant.

The first two assumptions have not held recently with even the hitherto liquid CDX and iTraxx displaying jumps and illiquidity. But interestingly even back in 2004 the last one was known not to hold either. Here is the tracking error of delta hedging each of the CDX tranches from the Bear’s research:

And here are the realised deltas (i.e. I think the best deltas ex post) vs. the calculated ones (ex ante from the model):

And remember, that is the easiest hedge in structured credit. If the simplest position to hedge when the market was not particularly troubled gives you 3% tracking errors, what is it like trying to delta hedge a bespoke hybrid CDO at the moment?

Posted in: CDS and Negative Basis, Derivatives, Hedging and Convexity, Model risk 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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That is not quite such a stupid question as it first appears. Consider an industrial corporate. The CDS spread on a company like this reflects were buyers and sellers of credit protection are willing to deal. If the corporate is liquid in the CDS market – roughly 1000 are – then there is typically a two way market and the CDS spread provides valuable information on the market’s perception of the company’s credit worthiness. Notice that typically counterparties in the CDS market are financials, often well-rated ones – so counterparty default risk is fairly low – and that the default correlation between the typical underlying company and protection providers is also low.

But now consider the monolines. Firstly CDS on them is not a two way market at the moment. There are lots of people who want to buy protection and few new sellers. It has been that way for a while. And secondly the default correlation between the typical monoline and the typical CDS market counterparty is much higher than for most other CDS references: a world in which Ambac is in default isn’t good for JPMorgan, for instance. Therefore one could expect a fairly big difference between quoted CDS market spreads on the monolines and where you could actually get a trade done with an uncorrelated high quality counterparty (the German government, say).

I am not saying that the monolines should not trade at hundreds of basis points or that Moody’s implied ratings are necessarily wrong. But I do think one should be cautious about what Ambac or MBIA’s CDS spread means exactly.

Posted in: CDS and Negative Basis, Markets by David /
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Continuing a long tradition of dissing something you don’t understand, Gretchen Morgenson has an ill-informed article in the NYT on a dispute between UBS and a hedge fund over a CDS. Let’s start with the errors:

INVESTORS don’t often get a peek inside the vast, opaque and unregulated world of credit default swaps, those privately traded insurance contracts that essentially allow participants to bet on or against a debt issuer’s financial condition. (Remember, these are the same instruments that played such a pivotal role in the collapse of Bear Stearns.)

Plain wrong. Lack of liquidity played a pivotal role in the collapse of the Bear. CDS had little to do with it.

There is no central market where investors can watch credit default swaps trade and see their prices. Each transaction is conducted away from regulators’ prying eyes.

Again wrong. Regulators have the right to look at all transactions, OTC or otherwise. FSA for instance has a legal right to demand any document at any time: the FED is similarly engaged with its firms’ OTC deals. If UBS’s regulators can’t see its CDS exposure that has much more to do with Swiss Banking law than with CDS. As I pointed out earlier, just because something is on exchange does not mean that price discovery are reliable: in many ways CDS levels are more readily available and liquid than most exchange traded single stock options.

The article does then make a not-entirely-terrible job of explaining the dispute between UBS and the fund. It appears an MD at UBS (who I am assuming is a sales person) assured the fund, Paramax, that UBS’s collateral calls would not be based on aggressive marks. The court papers apparently claim he:

assured Paramax that mark-to-market risk was low… Paramax contends in the filing, it was informed … that “UBS set its marks on the basis of ‘subjective’ evaluations that permitted it to keep market fluctuations from impacting its marks.” … [the salesperson] was responsible for all marks on UBS’s super senior positions and that he could justify ‘subjective’ marks on the Paramax swap because of the unique and bespoke nature of the deal.”

Again, _if_ this is true, it has nothing to do with CDS. It could happen in any market. If it happened, it would be a dramatic failure of segregation of duties, but nothing about CDS makes this more or less likely.

Posted in: CDS and Negative Basis, Credit by David /
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FT alphaville has a post pointing out the results of an ISDA exercise on CDS written on the monolines. ISDA has investigated both CDS written on the monolines themselves, and on bonds wrapped by them, and come up with what is presumably close to a comprehensive list. At first sight the notionals are a little scary: $134B relating to MBIA for instance. But note that first many of these contracts will net, and secondly many are pay as you go CDS on the underlying ABS, and hence may not be triggered by the default of the insurer. I’m therefore not sure we can necessarily conclude as alphaville does that if there were a credit event (which may be something other than default, remember)

there’s no way they’d all get paid in the timely, efficient and full manner implied on the ISDA CDS tin

Rather I think the right reading is that ISDA is pointing out that if there is a credit event, there will be a lot of work to do for dealers in agreeing settlement prices not just of the monoline’s senior debt, but for the wrapped bonds. It is those bonds where there will be a wide range of prices (not least because many of them are illiquid) but at least if the dealers know what is out there, they will be prepared.

Posted in: CDS and Negative Basis 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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I am reminded of the terrible joke about the Lone Ranger and Tonto. They are surrounded by hostile Indians, their horses are dying, they have no cover, and their enemies have arrows pointed at them. The Lone Ranger turns to Tonto and says “What shall we do?” Tonto replies: “Who’s this ‘we’ white boy?”

The bond market is similarly one way at the moment. The FT comments on the spread widening in high grade debt here, while FT alphaville discusses the related turmoil in the CDS market here, the latter partly related to concerns over the stability of Bear, Stearns. Yet actual experienced defaults are low and even taking into account a severe recession, many high grade bonds represent excellent compensation for default risk. The problem is that they may be even better value tomorrow, given that some of that compensation is also for liquidity risk, and liquidity is terrible in many parts of the market right now. Until we can kick the ‘they will be even cheaper tomorrow’ mindset, spreads will remain wide.

Posted in: Bonds and CBs, CDS and Negative Basis, Markets by David /
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This is a valid question as we go into any restructuring of the bond insurers, and the answer is more complicated than it appears at first sight. Here are some of the issues.

Many corporate bonds pay interest and final principal – you get coupons for some period, then a return of principal.

A standard CDS on a corporate bond uses a notion of credit event which typically includes default, failure to pay and bankruptcy. If the bond displays a credit event, then the CDS protection buyer stops paying the premium on the CDS and has the right to receive recompense in a short period, perhaps 3 or 5 days. This recompense is either through the right to deliver a bond and receive par (physical settlement) or through the right to receive an estimate of par minus recovery as a cash payment (cash settlement). Some key features include rapid payment, the ability to go short – by purchasing cash settled CDS without owning the bond – and the derivatives (i.e. mark to market) nature of the instrument. Note too that the premium is risky in a standard CDS: if default happens, you stop paying it.

There are insurance policies which behave much like CDS. These are part of a wider class of insurance known as financial guarantee policies. The difference here is that they are legally insurance (and hence have a different legal, accounting, regulatory and tax framework). In particular this is not a mark to market instrument, and in most jurisdictions you have to be an insurance company to write insurance. Note also that insurance typically requires an insurable interest – I cannot profit from buying fire insurance on your house even if it burns down – so if you purchase a financial guarantee policy directly it might not allow you to go short.

The fact that there are two instruments, CDS and financial guarantee policies, which can act much the same way yet have very different accounting should be a matter of shame to the FASB and the IASC.

Another possibility for obtaining protection is a bond wrap. Bond wraps are part of a wider class of insurance policies known as financial guarantee policies. In a bond wrap the policy runs to maturity of the bond, you have to keep paying premium until that date (so the premium is not risky), and the policy writer agrees to make good the scheduled cashflows of the bond should the original bond issuer suffer a credit event. Thus here you get paid on the original schedule, and if there is a credit event you substitute the risk of the issuer for that of the policy writer. Most of the muni policies the monolines have written are in this form. The advantage from their perspective are not only insurance accounting, but also lack of cashflow stress: unlike a CDS you typically have plenty of time to find the cash to make the principal repayment.

With amortising securities the issues become more complex since there is the possibility of a principal and interest payment at each coupon date. You can write standard CDS on amortising securities, but it is also possible to write a pay as you go CDS. This imports bond wrap technology into derivatives, and gives the protection holder the right to demand payments on the original schedule from the CDS writer.

For corporate bonds, amortising or not, matters are fairly straightforward since the failure to receive any cashflow (or at least a material one) is an event of default. For ABS you might not want that feature though: in a typical credit card deal, for instance, there will be a certain level of delinquencies which all parties expect, and if you have a credit event which triggers cash settlement based on default, then many junior ABS would suffer that event in the first month. Moreover in many ABS the collateral prepays, so you do not know when you will get your principal back. This means that to define a CDS or financial guarantee you need to tease out the cashflows each security should get in a given month given the level of prepayments, see what cashflow it actually gets, and define protection based on the difference.

Matters get even more difficult when you have amortising collateral in a CDO but some of the tranches have bullet maturities. Remember too that in some cases the CDO issuance SPV can be technically unable to pay without the CDO collateral having lost value: this can happen in particular due to liquidity risk. Figuring out exactly who pays whom what when something bad happens in a CDO of ABS is sufficiently complex that standard documentation has not been available until recently. Most transactions historically used bespoke documentation, and figuring out exactly which risks were transferred was not a trivial business.

Finally, note that the legal final maturity of ABS is often well beyond the last cashflow date. For a mortgage deal, for instance, it might be 35 years. So a contract which only gives you the right to claim ultimate principal at legal final maturity is like buying protection on a long dated zero coupon bond.

My guess is that most but not all of the monoline’s structured finance business involved taking middle or upper tranche ABS and writing pay as you go style protection on it in the form of a financial guarantee. This has considerable accounting advantages over writing standard bullet CDS, as well as the advantages the monolines enjoy as a result of insurance rather than banking capital. Finally it means that the monolines have relatively little immediate cashflow stress even though their structured finance portfolio would be, on a mark to market basis, highly underwater. None of that means that there is no problem with their business — just that if this is going to be a train wreck, it will be a slow motion one.

In any event we do need to know the answer to this question as it determines the capital needs. If they have written CDS with collateral agreements then the monolines need enough capital to support the mark to market volatility of the trades. If they have just written insurance then they only need enough to support the ultimate realised losses on the portfolio. Those numbers are very different (and it impacts how right Bill Ackman is).

Some people have suggested that one of the villains of the current crisis is mark to market. I don’t agree: mark to market gives one view of the value of a portfolio; insurance accounting another. But certainly having a portfolio of similar risks subject to wildly differing accounting principles in the same legal entity is unhelpful.

Posted in: Accounting, CDS and Negative Basis, Insurance and Actuarial Practice, Monoline by David /
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Reuters reports that default correlation on the investment-grade Markit iTraxx Europe index reached new highs of 45 percent on Tuesday. Suppose you believe that this was too high: what could you do?

The effect of increasing default correlation is to move value up in a CDO. So if you believe the market spreads of the assets are right – or if you have no view on them – you can still take a view on default correlation by trading different parts of a CDO. For instance in the iTraxx if you believe that the implied default correlation is too high, then that implies that the CDS spread available for writing protection on the supersenior is too high and the CDS spread on the junior is too low. So you buy protection on the junior, sell protection on the supersenior, and make money if the market comes to believe you are right. Alternatively you could buy protection on junior and hedge by selling protection on the individual names (although that is quite a lot of trading for the iTraxx).

With that preliminary you can see why implied default correlation – the level the market demands for trading the index – is so high. Market participants are long risk on the supersenior and are trying to get out. Hence the cost of protection on the supersenior has ballooned out and thus implied default correlation is high. This does not mean that the market necessarily believes that companies are more correlated (or riskier): it just means that there are more buyers than sellers of protection on the senior tranches right now.

Update. FT alphaville has more background and a pretty graph of fair value CDS spread by tranche as a function of correlation here.

Posted in: CDS and Negative Basis, Markets, Securitisation and Tranching by David /
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The FT recently discussed negative basis trades. Here is the basic idea.

• A bank buys a bond, typically a long dated one.
• The bank buys a CDS or a financial guarantee policy to maturity of the bond from a counterparty, often a monoline.
• The bank would then hedge against the risk that the protection it had bought was ineffective often with another monoline.

This was profitable despite the multiple layers of protection since the credit spread of the bond was bigger than the cost of the first and second hedges combined. Remember a bond spread includes compensation for much more than the risk of default: it includes compensation for illiquidity, for the volatility of the value of the bond, and so on. The bank is basically monetising those premiums.

Most of these trades were done in the trading book so the banks concerned booked the PV of the difference between the credit spread of the bond and the cost of the protection up front.

With the monolines at AAA and monoline protection some tens of basis points, this approach was not a huge issue. But now monoline protection is hundreds of basis points and the AAA ratings might not be with us very long. Also, the bonds used were often either the supersenior tranches of CDOs or long dated inflation linked debt. The latter isn’t a problem: the former is, since the underlying credit quality of these bonds has gone South for the winter too. And negative basis trades are out there in size. The FT says:

Bob McKee, an analyst at Independent Strategy, a London research house, believes that up to $150bn worth of CDO business done by the monolines could be negative basis trades.

Doubtless there are some who will use these trades as another stick to beat the already bloodied body of structured finance. I would suggest the reality is somewhat different. The problem isn’t the trades themselves: it is the selective use of mark to market. Marking the trades up front is fine providing you do it properly. That means:

• Credit adjusting the pricing of all derivatives. The details are complex here but basically you PV the value of net cashflows from a counterparty back along their risky credit curve rather than along the Libor curve. This has the effect as a counterparties’ credit quality decreases of automatically marking down your trades.
• In particular valuing trades with realistic default correlation assumptions. In particular the only time that you need written protection on supersenior ABS is when the ABS market is in trouble – and that is just when the monolines are in trouble. Therefore the probability of joint default of the bond and the protection seller is not
  
  PD(bond defaults) x PD(monoline defaults)
  
  As it would be if they were independent. Instead it is something a lot closer to
  
  min(PD(bond defaults), PD(monoline defaults))
  
  Since the default correlation is so high. For the full negative basis trade it is reasonably close to
  
  min(PD(bond defaults), PD(monoline1 defaults), PD(monoline2 defaults))
  
  The real problem, then, is that some banks may have used naive default correlation assumptions in marking these trades and hence they are carrying them at an inflated value.
• Using realistic funding assumptions in valuing the position. I shudder to think about this, but it would not be massively surprising to discover that some of these trades were also valued under the assumption that the bank could fund the bond at Libor flat forever. That means in effect that the position has again be overvalued up front and will show a net carry loss over time.

Of course none of these issues would have seen the light of day without the declining credit quality of the monolines. But it does highlight the fact that those banks which have prudent P/L recognition and state of the art valuation policies are much better placed to withstand market turmoil than those who don’t.

Posted in: CDS and Negative Basis, Model risk, Monoline 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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Most OTC derivatives are done under ISDA documentation. Included in the typical package (master, confirm, definitions, schedule) is the CSA or credit support annex. This specifies what kinds of credit support, if any, each party to the contract has to give to the other. Commonly, for instance, the CSA might say (lawyerese for) ‘each of us will post collateral monthly to the other if the net value of the exposure is more than $10M. Acceptable collateral is cash or G4 government bonds, and the party has three days to post the collateral after it has been requested.’

Failure to adhere to the terms of a CSA is typically a default event for the contract, resulting in the whole amount becoming due and payable.

The FT has an interesting story here in regard of one of the smaller financial guarantee insurers, ACA. Apparently ACA has written protection on the senior tranches of CDOs in the form of credit default swaps where the CSAs specify collateral in the event that the tranches are downgraded:

Such provisions require ACA to post cash equivalent to the mark-to-market loss of the CDS contract pursuant to a ratings cut.

That collateral could be substantial if ACA’s CDOs have much subprime in them. Again according to the FT:

AAA rated subprime CDOs currently trade from the high single digits on junior tranches to 60% of face on super senior tranches.

If ACA can’t find the collateral then presumably the whole MTM of the contracts become due and payable. Given that

ACA has only USD 1.1bn in claims paying resources, according to research by Credit Suisse

At that point the holders of the wrapped tranches will really have a problem.

Posted in: CDS and Negative Basis, Monoline by David /
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…with monsters stalking the market it is nice to be long gamma. You have to call current CDS levels on the big 3 broker dealers is an opportunity to sell protection at nice wide levels too…

Posted in: CDS and Negative Basis, Markets by admin /
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I was reading Chris Patten’s musings on Hong Kong, East and West,–it’s not bad, but his unquestioning faith in free markets is a little naive,–when it occurred to me to wonder what a market with pegged CDS spreads would be like. Indulge me with this thought experiment. Patten points out quite rightly that one of the problems with China is a banking system rotting from the inside thanks to inappropriate lending at the wrong spread. This classic failure of managed economies typically causes a huge problems when the banking system needs to be recapitalised. OK. So how could this be avoided? Pass on some of the risk. But no one will buy these loans at anything like par given the spreads they were made at. But we know how to deal with an uncooperative market – fix the price. It worked in FX for many years – that was called Bretton Woods. So what would an economy look like when the government or its cronies dictated the ‘fair’ value CDS spread of local corporates? It might not be pretty, but it is an interesting question.

Posted in: CDS and Negative Basis by David /
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