Category / CDS and Negative Basis
ISDA is consulting on a proposal to add another credit event… The proposed criteria for the credit event would be a government authority using a restructuring and resolution law to write down, expropriate, convert, exchange or transfer a financial institution’s debt obligations… the rules would allow written down bonds to be delivered into a CDS auction based on the outstanding principal balance before the bail-in occurred.
The FT has a timely article on the consequences of the EU’s ban on naked CDS:
Investors are buying protection on European banks on the basis that banks and sovereigns are so intimately linked that any increased risk of a sovereign default will increase the value of a bank CDS in a similar way to a sovereign CDS.
“The big downside of the ban is that it is likely to increase borrowing costs for financials,” said Michael Hampden-Turner, Citigroup credit strategist.
“It is hardly good for Spanish and Italian banks if the cost of borrowing is being squeezed up on the back of European regulation.”
Essentially then national champion banks are being used as proxies for the sovereign, with CDS buying (driven in part by CVA hedging) pushing out these banks’ credit spreads. The only way this loop will be broken will be if sovereigns either post collateral against their OTC derivatives (unlikely) or clear (somewhat more likely, but with its own problems).
From the new Basel consultative document BCBS 245:
Credit protection costs will be considered material when the risk weight on the exposure in the
absence of credit protection would otherwise be greater than 150% at the time the credit protection is bought…A bank must calculate the present value of material credit protection costs … if such costs have not been recognised in earnings … The present value should be treated as an exposure of the bank and be assigned a 1250% risk weight.
I don’t see that this really helps that much, as you can always mix in ‘good’ stuff to lower the risk weight below 150% and so be out of scope of the rule.
Today is a dark day.
His grief is for PAF2, an innovative regulatory arbitrage ahem I mean risk transfer deal whereby CS had their bonus pool write protection on a mezz tranche of derivatives receivables to get CVA capital relief. Or not. This deal probably wouldn’t have worked in most jurisdictions, and even in Switzerland it seems that its days are numbered. As IFRE tells us:
Credit Suisse may be forced to scrap or, at the very least, radically restructure [the deal]
The problem is that CS had to get protection on the senior to get relief, and no one really wanted to write that for what CS wanted to pay, so CS had to reduce the liquidity risk of the senior CDS by agreeing that if there was ever a payment on the senior, they would lend the counterparty the money to make it. So if the world goes to hell and CS lose a lot of money on counterparty credit risk – really* a lot of money – then they make a claim on the senior CDS which CS’s counterparty pays with money they have just borrowed from CS**. Um. Is that risk transfer?
As Matt says, Basel says no. Hence the problem.
Now, unlike Matt, I’m not sad, because this deal should never have worked. Regulatory arb that finds a clever way to transfer risk at the right price in order to exploit mis-designed rules is fair enough; reg arb that purports to transfer risk but doesn’t seems to me to be basically an arb not of the rules but of the regulator’s understanding of the trade. Unless, that is, they understood it but didn’t see the problem, in which case we have a bigger issue.
*Matt seems convinced that the senior attachment point was so high there was practically zero risk in the senior; I haven’t seen the trade details so I don’t know, but I will say that wrong way and concentrated sovereign risks can be significant in derivatives receivable securitisation structures, so one would want to be rather careful about the modelling before asserting something like that.
**And which, it appears, they can ‘pay back’ – in a very loose sense – by assigning the CDS back to CS.
What’s a credit event? It’s a difficult question. Dealbreaker is exercised on this, or more specifically on the issues with CDS protection holders getting paid on some unusual credit-event-like happenings:
This is a reasonable criticism. Certainly it seems odd that in something like the SNS Reaal bail in, sub CDS have not yet triggered (although they might today). Moreover, even if the CDS do trigger, because in SNS’s case the bonds have been expropriated, physically settled CDS holders may not have anything to deliver. Thus there are really two issues: the problem of what is and is not a credit event (a perennial issue in the CDS market); and the problem that even if there is a credit event, the things that the bond turned into (including, err, thin air) might not be deliverable. As Dealbreaker says
It may be “difficult to formulate contracts in an entirely watertight fashion,” but getting to a seaworthy concept doesn’t seem all that hard: essentially, define “Reference Obligation” to mean “(i) the Reference Obligation or (ii) whatever package of things the Reference Obligation poofed into in a Credit Event.”
The implementation date, as the Bond Vigilantes remind us, is 1st November, and boy is it having an impact on spreads:
This, from the FT, is deeply amusing:
Wall Street financial engineers have devised a new way to combat declining trading in the credit derivatives market – they are revamping an index to add financial instruments that do not exist… Markit, will cross a Rubicon and begin to include three companies in its North American high-yield CDX index for which no bank is offering a CDS.
Markit and derivatives traders hope the addition of CIT Group, Charter Communications and Calpine Corp will force banks to launch CDS on the three companies.
Now admittedly the chances of one of the three having a credit event before the banks get around to trading CDS on them are low – but it would be a real mess if it happened.
Back in May last year, I wrote:
Greek CDS typically trade under Old R restructuring. That fact could be become rather important soon. In Old R trades there is no limit on the maturity of the deliverable obligation, and no tranching in the auction post credit event. That in turn means the cheapest to deliver option may be quite valuable – there may be quite a large spread between short and long-dated bond prices post restructuring. Thus going into the event you can expect the CDS spread/bond spread relationship to be interesting. Everyone who entered into negative basis trades on Greece knew all this, right?
People are now waking up to this. FT alphaville for instance says today:
…Old R trades won’t have bucketed auctions even when the credit event in question is a restructuring.
So the question becomes whether anyone wrote CDS contracts with anything other than Old R trades on Greece. If there are MR or MMR trades there would have to be an auction with buckets.
Now, FT Alphaville didn’t think anyone had MR or MMR trades on Greece. Or, if they did, we thought it would be a booking error that would be cleared up.
But then, we saw this in a note from JP Morgan on February 24th (emphasis ours):
A problem might arise with the CDS contracts that have Mod R or Mod Mod R clauses. Western European sovereign CDS generally use the clause “Old Restructuring” (Old R). Under Old R, there are no maturity limits on deliverables, hence for the majority of the Greek CDS contracts currently in place there will be a single auction with bonds up to 30y maturity deliverable without multiple maturity buckets. But there is a small portion of Greek CDS contracts with Modified Modified Restructuring clauses (Mod Mod R), which means that for these contracts there will be several auctions for multiple maturity buckets. For the settlement of these CDS contracts, there might be bond deliverability shortage for shorter maturity buckets up to 10 years, where only international law bonds will be deliverable, creating some room for a squeeze in the auction process. But again, the universe of these CDS contracts (Mod Mod R) is rather small.
Now, that’s weird.
That was the first we’d ever heard of Greece CDS trades with MR or MMR. And we’re still thinking that someone at some point made a mistake.
Not necessarily. Restructuring is just a convention. You can negotiate whatever you want. Maybe someone needs restructuring to get capital relief*. Maybe they are doing a basket and they want the same restructuring choice on all the names in the basket. Maybe they just ticked the wrong box. But once you have agreed to, say, MMR, changing it to Old R is going to cost something. Pretty soon we’ll see if it was worth paying or not…
Now it is nearly the weekend, and I don’t plan on spending it thinking about CDS, so let me leave you with one of the more interesting google hits on ‘Old R’. Can anyone tell me what a single Oerlikon is and how it might help me in a bond auction?
*That, BTW, is why US corporates trade on XR – the FED does require restructuring as a credit event to give capital relief, while European regulators do. For extra amusement, read the letter from the insurers to ISDA over Xerox. It is in appendix one of this document, the choice sentence being ‘The current definition of Restructuring is clearly not workable if it is susceptible to the misinterpretation, as it apparently is in the minds of certain market participants, that there has been a Credit Event with respect to Xerox.’
I have been mean about Felix Salmon in the past, but this piece is really good.
The basic problem is this. If I have bought protection on 100 notional of a bond then I expect to be able to deliver whatever 100 notional of the bond turns into after the restructuring event, even if there is collective action and an exchange into new bonds. So if my 100 turns into 20 notional of new bonds which actually trade at 21 post exchange, I should be settled on the value of those 20 notional.
Felix points out that sovereign CDS documentation doesn’t track notionals, so I have to deliver 100 notional of new bonds, even if it was not a 1 for 1 swap. (Benton!)
Surely this is relatively easy to fix. All we need to say is that if 100 of old bonds turn into 20 notional of new bonds, an apple and two chocolate eclairs, I can deliver 20 new bonds, a pumpkin and two chocolate eclairs into the auction and get 100, or alternatively get cash settled on the current market value of 20 new bonds, a pumpkin and, yes, two chocolate eclairs. (For the avoidance of doubt, the chocolate eclairs are clearly the most valuable part of the package.)
In the mists of time, pretty much when dragons walked the earth, CDS referenced specific bonds.
What that meant was that if there was a credit event on that bond then you got to deliver that bond or were cash settled* on the value of that bond after the credit event. This meant that if you owned that bond and the CDS on it, you were hedged against the consequence of credit events (although obviously not against things that turned out not to be credit events**).
This was really good in that there was little basis risk between the CDS and the bond. But it was really bad in that it made CDS fairly illiquid. In this setting, a 1 year CDS on say the UK 4¾% Treasury Stock 2015 is not the same as one on the 4% Treasury Gilt 2016 despite the fact that both bonds are senior obligations of the UK government and both cross default. It would be really hard to imagine a credit event on the 4¾s of 2015 that wasn’t also a credit event on the 4s of 2016 – and vice versa – yet these two CDS are not in any way fungible. That reduces liquidity dramatically, and it means that dealers have to hedge each CDS with its underlying bond (or another CDS referencing the same bond). Well, either that or take basis risk anyway.
The market decided that it preferred some deliverability risk to illiquidity, so instead of trading CDS that referenced specific bonds, it began to trade CDS that referenced a specific obligator. You bought CDS on the UK (or more specifically on senior unsecured UK government obligations) rather than on a given bond. That single step dramatically increased liquidity, but it brought deliverability risk in cash settled CDS: you now no longer knew that the price the CDS settled at would reflect the value of the bond that you owned, as the settlement process was determined with respect to a basket of instruments.
Now all of this was long before the auction process was developed, and it was the key decision that meant that CDS were not as good a hedge as they used to be. The market chose to trade a product that hedged individual bonds less well in exchange for having a more liquid instrument. Now I am not going to take a position on whether that was a good choice or not, but I will say this. If you want a CDS that references a particular bond, and whose settlement amount is determined by the price of that bond after the credit event – or which allows you for sure to deliver a given bond – then buy one. Yes, it will cost you more than a standard CDS that is more liquid. It won’t have a readily observable price (although one might assume it would mostly trade in line with more liquid standard CDS). It will be hard to trade. But if you want a Ferrari, why are you buying a Ford?
*Of course, you want to be rather careful how a cash settlement amount on an illiquid bond is determined.
**Cf. restructuring. That is a different story, which also must be understood in any analysis of what CDS do and don’t do.
A pot pourri today:
Duffy, whose company is MF Global’s regulator and principal exchange
That’s right. The CME is both a shareholder owned for profit firm which makes money if its members trade more, and the regulator of those members. Gosh, isn’t it amazing something went wrong?
Update. In an exclusive (well, only shared with 594,861 youtube viewers), we have Duffy’s actual statement. Probably.
(I particularly like the line ‘my morals got me on my knees I’m begging please stop that rehypothecation’…)
right now, CVA desks are driving something like a quarter of the demand for sovereign CDS.
My guess is more like a third, but yeah, CVA desks are major players in the sovereign CDS market.
Doing this is in part a regulatory arbitrage for them such that more hedging means a lower capital requirement.
Not quite. It will, once Basel III is implemented, mean a lower capital requirement. And it isn’t regulatory arbitrage in the sense that this CDS does indeed somewhat hedge the position: it just doesn’t completely hedge it (because for instance the CDS might not trigger when you want it to).
To the extent that other market participants think that such CDS are now worth less because of politicians’ attempts at financially engineering around a credit event for Greece, that will cause spreads to move tighter, making the arb cheaper. Go Team Basel III!!
Yeah, the less the market believes that CDS hedge, the cheaper they are, and so the cheaper the CVA hedge is to put on.
We haven’t even mentioned the death spiral whereby sovereign CDS widen out and CVA desks are obliged to buy more, driving spreads higher… That’s one crowded trade all pointing in the same direction. Keep this in mind the next time spreads are widening out and politicians howl about the evil speculators that are exacerbating moves in the market (psst they may just be CVA desks following Basel regulations).
Exactly. CVA convexity is a big deal.
It’s also worth reiterating that nearly all sovereigns do not post collateral, but do demand it themselves — the dreaded one-way CSA. Banks have been trying to encourage sovereigns to start posting collateral so that they wouldn’t have to hedge against with CDS quite so much.
With the exception of a few minor countries (Portugal, for instance) they have not had much success. If sovereigns would agree to full two ways CSAs (zero threshold, daily collateral, cash only), then the CVA problem goes away. But, for now at least, they won’t, which is a shame as that is the only sensible way out of this mess.
It is with a heavy heart that I tackle this – but given recent events, the question of what risks purchased CDS protection on a bond hedges against cannot be ignored.
Here’s the issue. Suppose I buy a bond, and I buy CDS to maturity of the bond. Then if the bond defaults, the CDS pays out right?
Well, kinda. First clearly I have counterparty risk on my CDS provider. That can be managed with collateral, so assume I have enough of that too.
Second when do I get a payout on the CDS? The answer is ‘When the ISDA determinations committee votes that a credit event has happened’. Sadly we know from the example of Greece that some things that look a lot like default to the naive observer aren’t in fact credit events. Now certainly caveat emptor applies here: before buying a CDS I should have understood exactly what kind of thing it is. (See here for a nice discussion from FT alphaville on the evolution of CDS documentation.)
But now flip things around and suppose I am a regulator looking at this situation. Clearly the bank I am supervising can take a loss on a sovereign bond and does not get a corresponding CDS payment. I might reasonably argue that this means that the bank should not get full capital relief for the CDS. (Indeed, this principal has been established for the similar situation of corporate bond restructuring, which is why European regulators require CDS to have restructuring as a credit event before granting capital relief.)
Unfortunately, Basel is finding it difficult to do the right thing here. If it takes away the benefit of CDS hedges, especially sovereign CDS hedges, it will be the beleaguered large European banks who will suffer. And the Basel Committee will look like idiots; Basel III recently entrenched the role of CDS by making single name default swaps the main way of reducing capital charges on CVA risk. An about face on that issue would be embarrassing, so I think it is more likely than not that the Committee won’t be prudent. Which, frankly, is not a big surprise.
With a title like that, you know this is going to be technical. So I am going to assume you know what CVA is. The key point in hedging the credit spread sensitivity of the CVA is to note that you can calculate the sensitivity of the CVA to a small (1 basis point say) move in credit spreads and buy CDS with equal an opposite sensitivity. That way if the credit spread moves, the P/L in the CVA is offset by that in the CDS (ignoring gamma effects anyway) and hence you are hedged.
Unfortunately, you are not hedged on a jump to default, at least with standard single name CDS. This is because a portfolio of derivatives are not deliverable into the CDS, so you can’t just hand over the thing that generated the CVA and get its par value. (This is true even if the portfolio of derivatives has close out value exactly equal to the CDS notional you have bought – the point isn’t what it is worth; it is that it is not deliverable.)
Now you might argue that ISDA receiveables are pari passu with senior debt and hence a cash settled CDS should be fine. There are several problems here. First, the cash settlement amount depends on an auction, and that has its own dynamics. The amount fixed here may turn out to be rather different from the eventual senior debt recovery. Second, events of default on derivatives are often wider than those on senior debt, so you may be able to close out the derivatives before there is a senior default. This again gives rise to a basis risk between the derivatives recovery and the CDS recovery. Finally, because of the deliverability issue discussed above, some (many?) supervisors do not give credit for CDS bought against CVA in the default part of the counterparty credit risk calculation. (The Basel 2 piece not the Basel 3 CVA charge.) This means that CVA hedging does not reduce regulatory capital right now. Messy, that, isn’t it?
FT alphaville suggests that a consequence of the CFTC proposed rule whereby sovereigns (except the US, naturally) will have to post collateral to US swap dealers on OTC derivatives is that US swap dealers won’t do many trades with sovereigns. They are of course right. The large European, Asian and Latin American debt management offices will not post collateral at the whim of the Americans – or anyone else.
Should they (and indeed the US government) be obliged to post? Well, it depends. If they had to, they would have to find the money from somewhere, and that would increase their levels of debt. On the other hand, one way CSAs, whereby the dealers have to post collateral to the sovereign but not vice versa, are a liquidity drain on the banking system.
The clinch argument for me, though, is CVA. Uncollateralised derivatives create a big CVA. (See here or here for a description of CVA and how it arises.) Basel 3 will require banks to hedge their CVA well or take capital against it. Critically this includes CVA from sovereign transactions. The way you hedge CVA is to buy CDS. Thus when you see a picture like these two from the Alphaville post:
What should ask yourself is ‘how much of this increase in CDS trading is caused by CVA hedging?‘
The prior post suggests that there is only $4-30 Billion net notional of CDS on even the biggest countries. My guess is that the major swap dealers need a good deal more liquidity than that to hedge their collective CVA position without moving the market.
The Basel 3 CVA rules, then, are a huge shot in the foot for governments. (A 50mm shell in the foot, maybe.) By forcing banks to hedge their sovereign CVA, they have increased the demand for sovereign CDS. That drives out spreads, which in turn increases borrowing costs for governments. The problem could be largely solved if sovereigns would agree to post collateral – but they won’t.
This is data for the next post. It comprises the top twenty sovereigns by CDS net notional currently as reported to the DTCC.
| Reference | Market | Notional (USD EQ) | ||
|---|---|---|---|---|
| Entity | Sector | Type | Gross | Net |
| ITALY | Government | Sov | 283,927,804,667 | 26,010,413,830 |
| FRANCE | Government | Sov | 101,420,159,583 | 20,476,736,659 |
| SPAIN | Government | Sov | 164,190,071,870 | 19,015,765,467 |
| GERMANY | Government | Sov | 95,291,941,482 | 16,803,270,235 |
| BRAZIL | Government | Sov | 182,459,566,760 | 16,655,151,570 |
| UK | Government | Sov | 62,416,026,458 | 11,946,899,325 |
| MEXICO | Government | Sov | 124,849,244,575 | 9,066,035,683 |
| JAPAN | Government | Sov | 46,485,994,345 | 8,147,687,846 |
| BELGIUM | Government | Sov | 50,422,873,856 | 7,416,107,765 |
| PORTUGAL | Government | Sov | 72,288,708,568 | 6,581,678,265 |
| TURKEY | Government | Sov | 143,471,007,381 | 6,391,210,586 |
| AUSTRIA | Government | Sov | 52,070,136,066 | 6,270,933,248 |
| CHINA | Government | Sov | 38,814,484,174 | 5,916,508,330 |
| GREECE | Government | Sov | 78,523,946,314 | 5,342,770,919 |
| RUSSIA | Government | Sov | 100,719,048,627 | 4,611,451,808 |
| KOREA | Government | Sov | 53,928,043,655 | 4,326,483,915 |
| IRELAND | Government | Sov | 44,553,090,629 | 4,162,232,694 |
| USA | Government | Sov | 24,255,397,387 | 4,021,822,374 |
| HUNGARY | Government | Sov | 69,113,203,502 | 3,528,398,702 |
| AUSTRALIA | Government | Sov | 16,647,528,520 | 3,334,660,860 |
… typically trade under Old R restructuring. That fact could be become rather important soon. In Old R trades there is no limit on the maturity of the deliverable obligation, and no tranching in the auction post credit event. That in turn means the cheapest to deliver option may be quite valuable – there may be quite a large spread between short and long-dated bond prices post restructuring. Thus going into the event you can expect the CDS spread/bond spread relationship to be interesting. Everyone who entered into negative basis trades on Greece knew all this, right?
Update. Here are a few more links: more on negative basis trades on Greece and Barcap’s thoughts on how Greece will go (a soft restructuring which does not trigger CDS followed by a hard one a little while later that does).
Q: What’s a complex derivative?
A: One the respondent does not understand.
It seems like that is sometimes the answer anyway. Just because something is new, or new to the writer, does not necessarily mean it is complex, nor are old familiar things necessarily simple. As Merton demonstrated, for instance, common stock is far from common, being a derivative on the net asset value of a firm. That’s a complicated idea but the market has no problem with pricing equity.
Thus when FT Alphaville – normally it must be said the most reliable of sources – starts using terms like ‘OTC-squared’, one wonders if the thrill of the new has distorted judgment a little. Stripping away the hyperbole, there is a CDS options market. Primarily, this is a market on options on CDS on the CDX and iTraxx indices (and their tranches). This is very much like an OTC equity index market: you buy calls and puts on the index. You hedge with delta weighted amounts of the index. Um, that’s it.
FT alphaville discusses whether these CDX options should be cleared. Well, given that the CCPs are having problems offering clearing for any OTC options – including something as simple as plain vanilla index options on the S&P 500 – you would not have thought that it was a priority. Indeed, there are very good reasons that this is complex, including price discovery when the cleared option goes far away from the money (which it very well might).
So why pick on CDX options rather than, say, FX double barriers or capped callable floaters or globally floored cliquets on a custom stock basket? Because CDX options made a serious error for a derivative, an error few derivatives recover from. They are credit derivatives and thus, de facto, in some eyes at least, the spawn of satan. Exorcizo te, immundíssime spíritus, omnis derivativus credidi…
In depressing but entirely predictable news:
The [ECON] committee position would prohibit anyone from being involved in credit default swap (CDS) transactions if they do not already own sovereign debt linked to that CDS (“naked” CDS trading), or securities whose price depends heavily on the performance of the country,
But look at the wonderful stream of invective this has released from FT Alphaville:
perhaps they could ban the European Stabilisation Mechanism as well. Ban regulatory orders to make banks hold increasing amounts of sovereign debt. Ban the ridiculously low risk-weightings on that debt. Ban bailouts which leave countries with even more debt and make it even riskier to buy the bonds that have to shoulder that burden. Ban the ECB from not buying the bonds when everyone else sells. Actually, ban the ECB from buying as well, given how it sways the CDS market. Ban clearing houses for even daring to increase margins on risky bonds, to protect themselves and their members — which incidentally affects borrowing costs much more than CDS activity.
Ban Angela Merkel. Ban, ban, ban, until everyone gives up.
Then we’ll be fine.
Um, yes. But in the FT? Shouldn’t you be, dunno, a little less passionate in the pink ‘un? Still it is nice to see someone getting worked up at a vote in ECON who doesn’t live in Brussels. Sharon Bowles will be pleased.
William Cohen has done a nice piece of journalism for the New York Times on Goldman’s collateral calls vs. AIG. Unfortunately it is mixed in with a good deal of opinion, unjustified assertion, and spin. Let’s try to separate out the pieces.
The trades concerned was protection on various ABS written by AIG to Goldman. Goldman had the right to call collateral under certain circumstances, and this it did. I have edited Cohen’s text slightly to remove the invective:
On July 27, 2007, Goldman sent a $1.81 billion collateral call to A.I.G. Financial Products to make up for what Goldman thought represented the decline in the value of the securities [underlying the CDS written by AIG].
AIG disputed this call and Cohen reports that Goldman backed down:
During that time, Goldman reduced the collateral call to $1.6 billion, then to $1.2 billion and then to $600 million.
Apparently the two firms settled on $450M.
Things then quietened down between Goldman and A.I.G. Financial Products until Sept. 11, when Goldman asked for another $1.5 billion in collateral based on its marks. This was the beginning of the end. On Nov. 2, [AIG FP's] Cassano said, [Goldman's] Sherwood gave him a “heads up” that Goldman was increasing its collateral call to $2.8 billion, in addition to the $450 million it already had.
Various other banks who AIG had also written protection to also joined in at this point. This was close to the tipping point, and pretty soon multiple collateral calls had used up all of AIG’s available liquidity and more.
So, what do we know?
For me, it is difficult to see any malpractice from Goldman here. Goldman acted to protect itself, as it had every right to do. If AIG did not want to have to accept Goldman’s valuations, it could have negotiated a different valuation procedure for the trades. Instead it left itself open to massive liquidity risk by agreeing to the collateral arrangements that it did. AIG never considered the consequences were the underlyings to its trades to become illiquid, nor where it would find the collateral were the trades to go against them. I think that that is by far the worst of the behaviour seen here.
The auction results are out on the Anglo Irish credit event. Roughly: sub recovery 18%; senior 75%.
The sub is clearly about right. The senior, though, is interesting. Would you rather have 75% for sure now or run the risk of getting 50% or less later in some Irish restructuring? On the other hand, if you think that the rescue will work, then a 25% haircut on the senior is penal.
… is a great opportunity, in my view. Portugal 2y CDS at 375 over? Wave it in.
(Chart via Reuters.)
Spain and Italy look quite attractive too.
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.
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.
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.
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…
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.
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.
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.
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.
