Category / Credit

Did someone just leave the door ajar? August 7, 2012 at 6:58 am

From BCBS 228, Basel III counterparty credit risk – Frequently asked questions :

How should purchased credit derivative protection against a banking book exposure that is subject to the double default framework or the substitution approach be treated in the context of the CVA capital charge?

Purchased credit derivative protection against a banking book exposure that is subject to the double default framework or the substitution approach and where the banking book exposure itself is not subject to the CVA charge, will also not enter the CVA charge. This purchased credit derivative protection may not be recognised as hedge for any other exposure.

So, let’s get this right. You have a banking booking position, oh say some RMBS, just to pick a random example. You buy CDS on it from oh, say MBIA. MBIA’s credit spread goes to the moon during a crisis, but there is no CVA charge just because it is in the banking book? (There will be a higher default risk charge, of course, but that isn’t the point.) Interesting…

Swap pricing in the face of regulatory uncertainty July 6, 2012 at 10:43 am

There’s a problem in corporate swaps. It’s this.

  • Basel 3 has a capital charge for CVA risk.
  • This charge increases the price that some corporates will have to pay for their swaps, given their current credit support arrangement.
  • The EU may or may not grant an exemption from this charge for many corporates. It’s a political issue, and impossible to call.
  • So given you don’t know if you will have to pay the charge or not, do you price it in?

Risk magazine amusingly tells us:

Three banks that spoke to Risk for this article all claimed to be assuming there would be no exemption. They also said rival dealers are doing the opposite.

You might say ‘of course they would say that’. But there is a problem here, and it isn’t going to be resolved any time soon.

Bond bids bounded July 2, 2012 at 7:36 am

Via Alea, I found an interesting article in Euromoney about a presentation by JPMorgan’s Michael Ridley. He was discussing the parlous state of secondary bond market liquidity in Europe is one of the most worrying by-products of the region’s bank-funding crisis. Primary volumes in the first quarter were excellent, but secondary volumes remain low. Apparently bonds are often cheaper in the primary market than in the secondary market, and the challenging market liquidity situation is not improving.

The volume figures quoted in the article are rather scary:

Explaining that the US bank traded 5,000 names last year, Ridley noted that of the top 1,000 bonds, just eight traded more than three times a day. Twenty-six traded twice a day, 134 once a day and 832 traded just three times a week. Ridley added that 145,000 bonds on the bank’s books did not trade at all in 2011.

If you buy a corporate bond in the primary market, you should plan on a worst case holding period of ‘until maturity’.

Lisa in one sentence June 20, 2012 at 8:50 am

Lisa Pollack has a long and good post on FT Alphaville which can be summarized thusly:

So, Mr. Regulator, given you had full reporting of JPMorgan’s synthetic credit trades in the DTCC warehouse, and it was blatantly obvious from that that they had a whale of a position, why didn’t you do anything about it?

Floating carcus ahoy May 11, 2012 at 9:20 am

When Magellan emerged from the strait that bears his name into the Pacific ocean, he thought that he was only a few days sailing from Portugal and home. Good try, but no cigar. A similar navigational issue seems to be plaguing folks over last night’s $2B JPMorgan loss. Here are some things we can, and cannot conclude from this ‘egregious’ loss.

Update. FT alphaville makes a similar point about the difficulty of identifying a ‘good’ hedge here.

Interconnected and proud April 27, 2012 at 4:18 pm

According to Bloomberg, The largest U.S. banks, including JPMorgan Chase & Co. (JPM) and Goldman Sachs Group Inc. (GS), told the Federal Reserve that a limit on their credit exposure is unnecessary and “fundamentally flawed.”

They are of course wrong. The FED’s single counterparty credit limit (10 percent of capital for credit risk between a company considered systemically important and any counterparty when each has more than $500 billion in total assets) is a sensible move to address interconnectedness. Why is it that few challenge the proposition that the derivatives market – where exposures are typically collateralised every day – is too interconnected, but when it comes to direct interbank credit, no one cares that one SIFI owes another billions?

Accounting for credit risk before the crisis – a case of a gateway drug? April 20, 2012 at 8:48 pm

(Crossposted from FT Alphaville.)

“The question is,” said Alice, “whether you can make words mean so many different things.”

In a recent Alphaville post, I made the claim that if the monolines had been required to mark the credit risk that they had taken to market, they would not have played such a prominent role in the financial crisis. Here I want to provide some support for that claim.

There will be several threads to this narrative. We begin with credit spreads.

What’s in a credit spread?

A credit spread is the compensation the taker of credit risk receives for risk. It is well-known that this includes more than just compensation for default risk. Citi research, for instance, produced this illustration recently, showing the default and non-default components of generic BBB credit spreads over time:

Components of the credit spread

They use the term ‘risk premium’ for the non-default component: in reality this component is a mix of compensation for liquidity risk, funding risk, and other factors.

Notice how this non-default component varies over time. What this means is that a holder of credit risk who is marking to market suffers some P&L volatility that is unrelated to default risk (as well as some that is).

The consequences of marking credit to market

If you have to mark a credit risk position to market, then:

  • You have to fund losses caused by credit spread volatility;
  • You have to support the risk of credit spread volatility with some equity; and
  • The risk of the position includes the risk of movements in the non-default component in the credit spread.

A non-mark-to-market holder of the same risk does not have these issues. Depending on their precise accounting standard they may have earnings volatility resulting from changes in perceptions of default, but they won’t have volatility resulting from non-default factors, and thus they don’t need as much equity to support the same position. The need for less equity means that a non-MTM credit risk taker will require a lower return than one who has to mark-to-market.

The history of historic cost

Long ago, the existence of multiple ways of accounting for financial instruments made sense. There were liquid (or at least semi-liquid) securities, and these were marked; there were totally illiquid loans, and these were accounted for based on historic cost (with a reserve being taken if the loan was judged to be impaired). Banks had a buy-and-hold strategy in the loan book, so recognising P&L on an historic cost basis made sense, while marking to market was natural for the flow-based trading book. Insurance companies had approaches* that were similar to historic cost: essentially they recognised premiums as they were paid, and reserved for claims that had been incurred but not yet presented.

Over the 1990s, these boundaries became blurred. Credit default swaps and securitisation liquidified banking book credit risk, and some institutions adopted originate-to-distribute strategies, while others were able to take credit risk in unfunded form by writing credit protection.

This meant that an arbitrage became available whereby the same risk could be taken by both mark-to-market players (by buying a trading book security) and non-MTM players (by writing credit protection which did not have to be marked or making a loan).

So how exactly did you take unfunded credit risk without having to mark it?

Several methods were developed to allow insurance companies to take unfunded credit risk without having to mark it to market.

  • In the transformer approach, the insurance company would write a contract of insurance to a SPV which then wrote a CDS. Provided that neither the insurer nor the CDS buyer consolidated the SPV, this provided a compound contract that at one end looked like and was accounted for as insurance, and at the other end looked like and was accounted for as a credit default swap.
  • In the wrap approach, the insurance company provided a financial guarantee contract on a bond. If the guarantor was AAA-rated (which the large monolines were pre-crisis), this essentially split the bond into a funding component provided by the buyer of the wrapped bond and a risk component, provided by the insurer.

Insurance companies took credit risk in other ways, too, of course, including some mark-to-market ones; we will come back to this shortly.

Why was taking credit risk in unfunded non-MTM form attractive to some insurers?

The insurance business model is, roughly: take risk by writing insurance, receive premiums, invest the premiums, and pay claims when presented. It works well when the value of invested premiums is larger than that of the presented claims. Given this model, some insurers found credit risk attractive: due to the non-default components of the credit spread, it seemed as if they could get paid more to take credit risk than defaults would cost them, and the structuring technology described above allowed them to do this without having to worry about intermediate earnings volatility caused by having to mark to market. The only question in this business model was ‘do you expect ultimate default losses to bigger or smaller than the value of invested premiums?’

Insurance risk models vary significantly from firm to firm, but what they share is a desire to estimate the capital required to support the risk of unexpectedly large claims. In other words, they assumed that the key risk was the risk of bigger-than-expected claims; something that is perfectly reasonable given the insurance accounting model.

Credit risk taking, then, was potentially attractive to insurers for three reasons:

  • It could be made to look like a business model they were familiar with (take premiums, invest them, pay claims);
  • It could be accounted for as insurance; and
  • The capital required to support some forms of credit risk taking, such as writing protection on asset backed securities, was rather small according to their models.

Was insurance accounting a gateway drug?

It is certainly not that case that most credit risk taken by insurers pre-crisis was non-MTM. AIG, for instance, used fair value accounting on most of the contracts it wrote. However I believe that the availability of the non-MTM model in the early 2000s acted as a kind of ‘gateway drug’, getting some insurers into credit risk taking. Without it, the capital required to support credit risk taking would have been higher, and thus the business would have seemed less attractive. Moreover, the earnings volatility potentially created by having to mark to market** would have at least have given pause for thought at a much earlier stage.

To be fair to insurance accounting standards setters, it is hard to see what they could have done differently. Financial guarantee accounting makes some kind of sense where the guarantor is writing a wrap on an entire municipal bond, and there are no reasonable proxies available. The transformer structure, where a transaction is accounted for as insurance at one end and marked to market as CDS at the other, is less defensible. Arguably, though, the transformer SPV is a major part of the issue, and the rules governing when such things are consolidated have been tightened up (as have the details of financial guarantee accounting). One does wonder, though, what the relevant supervisors had in mind given their evident comfort with the types of practice described here.

Conservation of P&L volatility

Many laws in physics say that in any interaction, some property such as momentum or charge is conserved: the total amount of it in the system remains the same. In a certain sense, moving credit risk from an MTM to a non-MTM player violates conservation of risk. A non-MTM party sees less risk in the deal than an MTM party as the volatility of the non-default-related component of the spread has disappeared. Early 2000s structures such as the one we have described facilitated this, and thus allowed the non-default component of the spread to be monetized.

The introduction of CVA made this situation somewhat better. Non-MTM parties do not get the full benefit of their accounting if they have to post collateral based on the mark of the position – at very least they have to fund the collateral, and that is a drain on their liquidity. So many of monoline trades were done without collateral agreements. This in turn meant that once CVA charges were imposed, some of the volatility of the non-default component of the credit spread reappeared as CVA volatility. This risk hadn’t disappeared after all. Perhaps that is the real lesson: if your trade seems to make risk disappear, there’s something wrong with it.

*Obviously a one sentence account glosses over many complexities and jurisdictional differences.

**Of course, being able to use a model to mark means that much of this volatility can be avoided, at least while the asset credit protection has been written on is not obviously impaired.

That spread is rich March 28, 2012 at 6:12 am

No, not an advertisement for the new chocolate Philadelphia, but rather a comment on the ratio of the default to non-default component of credit spreads. The following is from Citi investment research, via FT alphaville:

Components of the credit spread

Now, note that tihs isn’t quite as straightforward as it looks: we are comparing current default rates with compensation for future risk, so it isn’t entirely clear that credit spreads are rich – if defaults in the future are much higher, then they might not be. Still, it does look as if now might be a good time to take (a diversified pool of) corporate credit risk.

CVA securitization February 23, 2012 at 9:33 am

When the RMMG (as it then was) issued the CVA capital rules in Basel 3, I said that they would lead to a number of capital arbitrage deals. Street talk was that the Swiss were first off the blocks; now we learn from Euroweek (HT FT Alphaville) of a deal by RBS:

Royal Bank of Scotland is in the market with a highly innovative capital relief trade, dubbed Score 2011-1, securitising a $2bn book of credit counterparty risk.

There are some challenges to getting both default risk and CVA charge capital relief in a securitization structure, but they aren’t insurmountable. I predict 2012 will see a goodly number more such deals.

The problem with assessing bond return distributions February 1, 2012 at 1:24 pm

Yesterday we saw that one good way of visualizing bond returns is to look separate at the survival probability and the distributions of returns given default (also known as the LGD distribution).

(A minor technical point – in the prior post I used normal LGD distributions, whereas in fact something like a beta distribution might be more suitable.)

We noted too that once we look at the distribution, subtler differences between bonds than just probability of default are obvious. Another example of this is how much uncertainty in recovery there is. Consider this example:

Visualizing bonds 5

These two bonds have the same PD, the same average recovery and hence the same expected loss. But one has more uncertainty in recovery than the other, and hence can reasonably be called riskier.

Now, a plain vanilla tranched security supported by a diverse pool of collateral assets might well have quite a benign return distribution. Losses come from the bottom up, and if the loss distribution of the collateral is fat tailed, and our tranche is not the bottom of the stack, then we might well find something roughly like this (although of course the precise form is subject to considerable debate):

Visualizing bonds 6

In other words, even if you do get a loss, it will likely not be large. The problem though is that this assumption is rather sensitive both to the collateral loss distribution, and to the structure of the securitization. Something like this is entirely possible too:

Visualizing bonds 7

Now, remember first that it is really hard to know what the real loss distribution is – there is a lot of model risk – and second, its shape really effects the expected loss. For instance, for the first tranched ABS above, the expected loss (EL) is only 0.25%, whereas the EL for the second bond is 0.65%. Assessing the real world return distribution of these securities is difficult.

This brings us nicely to informationally insensitive assets. What people want is something with PD = 0 (and so EL = 0). There isn’t any such thing. What is available are assets with small PDs, and unknown loss distributions. Sovereign recoveries are typically low and uncertain: 30 to 40 isn’t a bad guess for an average. AAA ABS, on the other hand, can be structured to have whatever loss distribution the issuer wants. What we learn from this is that it is a serious error looking just at PD or EL in assessing credit quality; you need to get several different views of what the whole return distribution might be like. Moreover, a crisis in the securitized funding markets is caused not just by a reassessment of PDs, but also by a realization that the loss distribution is likely to be more like the third graph above than the second.

Visualizing high quality bond returns January 31, 2012 at 5:46 pm

I have been musing for a while on how best to give insight into the returns of fairly safe instruments, like an asset swapped government or investment grade corporate bond. Here’s what I have come up with.

The first thing you need is to understand what the probability of default is. Now, in a precise sense this number is meaningless in that ‘probability’ implies that we have some (ideally large) population of things that we are sampling, and they are IID. This isn’t true with a typical bond – either it defaults or it doesn’t, and no two bond issuers have exactly the same return distribution. Still, let’s pretend that probability of default makes sense. For high quality bonds, survival probabilities (i.e. 1 – PD) are close to one, so showing full return distribution won’t tell us much; instead then let’s zoom in to the 90% to 100% area. Our first visual aid then is survival probability, graphed between 90% and 100%.

The second thing we want to know is how much we get back if default happens: the recovery. Again, we can’t know this, nor does it really make sense to talk about a distribution of recoveries. We have Knightian uncertainty rather than risk. However, if we make the (false) assumption that recoveries for similar types of issuer are similar, then one could (mis-) represent unknown recovery as a distribution of possible returns, which we can also separately picture.

A typical high grade corporate bond with PD = 1% and average recovery 45% would then look like this:

Visualizing bonds 1

(By keeping the ‘doesn’t default’ part separate from the ‘does default’ we can at least see what is going on in the latter.)

Now consider a higher quality corporate bond, with PD = 0.5% but still with average recovery 45% and the same uncertainty in recovery. Comparing the two bonds, we would have

Visualizing bonds 2

Here we can clearly see that the second bond is safer: it is less likely to default, and the average recovery is the same. Thus for the first bond, the expected loss (EL) is 0.55% (1% PD with 45% average recovery), while for the second it is 0.275% (0.5% PD, same recovery).

Now let’s turn to a typical high grade ABS. Here credit enhancement typically means that the PD is low, but if the credit enhancement doesn’t work, then the losses can be quite large. Recoveries, in other words, are often lower when ABS don’t pay in full*. Thus we might have the following comparison:

Visualizing bonds 3

This shows that the ABS has the same PD as the corporate bond but if it defaults, you are likely to get less back. Intuitively, it is riskier, and indeed its EL is 0.72%, higher than the 0.55% for the corporate bond.

Now let’s look at an ABS with the same EL as the corporate bond, but with ABS-style low recoveries. It’s PD is 0.764% or in pictures:

Visualizing bonds 4

Which of these bonds is riskier? The corporate bond is more likely to default, but if it defaults, the expected recovery is higher. The two bonds have the same EL. Riskiness isn’t easy to call; it really depends on your tolerance for large losses vs. your desire for 100% capital return. Depending on your rating system, you could justify rating either bond a notch over the other – and all that that demonstrates is how hard it is to compare things with multidimensional properties on a single linear scale.

In the next post we will use this tool to discuss ABS structuring and the recurrent topic of informationally insensitive assets.

*This is not necessarily true, but it is common especially in structures where reserve accounts are used. We will say more about this tomorrow.

Capital for risk… or not December 14, 2011 at 7:44 am

Today I want to look at another aspect of the RBS failure: regulatory change since the crisis, and how it measures up given what we know about RBS. As before, the FSA report into the failure of RBS will provide our material.

The causes of losses at RBS

What caused big losses at RBS? At the grossest possible level, 3 things, in order of significance:

  1. Bad Loans
  2. Buying ABN
  3. Bad Trading Book assets

As FSA says:

“Between 2007 and 2010, RBS made net accounting losses of £30.7bn. This reflected £50.0bn of income net of tax and other expenses, offset by three main categories of loss.

  • Losses of £32.5bn on loans and advances in RBS’s banking book, across a wide range of sectors and geographies…
  • Goodwill write-offs of £30.5bn, of which £22.0bn resulted from the acquisition of ABN AMRO…
  • £17.7bn on credit trading, arising from assets acquired both as a result of organic growth and as part of the ABN AMRO acquisition.”

(Page 120)

Just to ram the point home, here is a summary of RBS’s losses due to impairment charges in its banking book:

RBS Banking Book Losses

Regulatory change

FSA acknowledges that it has to do more about big strategic acquisitions like RBS buying ABN:

“Supervision has since modified its current approach to acquisitions to ensure that it is considerably more intrusive and challenging in its handling of major takeovers… The Review Team recommends that the FSA formalise its more intensive approach to major corporate transactions involving high impact regulated firms, by producing guidelines.” (Page 187)

Big changes have already happened in the capital regime for the trading book, and more are planned:

“A fundamental review of the market risk capital regime (including reliance on VaR measures) was required. This was recommended by the Turner Review, and is being undertaken by the Basel Committee. In the meantime, the Basel Committee has agreed a package of measures, including stressed VaR and enhancements to the capture of credit risk within the trading book, which is being implemented in the European Union.” (Page 93)

(If you are connoisseur of this kind of thing, you will recognise that ‘in the European Union’ as a dig at the FED.)

So, to summarise, FSA thinks that the pre-crisis regime for the causes of the second and third largest category of losses at RBS should be improved. What about the top cause? What about loans in the banking book? After all, both corporate property lending and corporate other (primarily ordinary corporate loans and loan committments) both caused bigger losses than all the trading book put together. Where’s the acknowledgement that the Basel II regime for the banking book was inadequate?

The closest we get is this:

“But it is now clear that the Basel II capital regime, introduced on the eve of the financial crisis, failed entirely to identify and address the issue of inadequate overall capital resources. As a result, the devotion of significant FSA resources to Basel II implementation failed to make any significant contribution to making RBS or any other major bank more robust in the face of the financial crisis.” (Page 270)

Now of course Basel III and the associated G-SIFI reforms have increased the total capital requirement for a bank like RBS from a 2% common equity tier 1 ratio to 9.5% or more. There are the liquidity reforms too: these represent potentially the most significant and most overdue changes in bank regulation in three decades. But still, I think a much more explicit acknowledgement that the Basel II regime for the banking book was inadequate is required. The trading book gets a lot of regulatory attention, yet it actually wasn’t the cause of the biggest issues at many banks including RBS. At least the FSA report gives us some data here. Doing something about the Basel II banking book capital regime, though, is another matter.

Update. Lest you think that RBS had an unusually poor loan book, here is how it compares to its peers:

RBS Banking Book vs UK peer group

The easy fix would be to increase the default correlations in the Basel II IRB formula, then recalibrate the common equity tier 1 ratio so that the changes are broadly neutral across the financial system. That would advantage large diversified banks less versus smaller, less systemic rivals, something that is surely systemically advantageous.

Linkfest November 17, 2011 at 8:38 am

I am out of town so this will be brief, but there are a lot of good things around today:

  • Zoltan Pozsar has a nice paper on VoxEU, ‘Can shadow banking be addressed without the balance sheet of the sovereign?’. One of his main points, which we have made before, is that the demand for safe assets was an important contributor towards the crisis. As he says, Seeing the shadow banking system from the perspective of the safe asset demands of institutional cash investors is crucial for drafting the right policies for shadow banking.
  • A lovely piece from FT alphaville on the interaction between CVA hedging and sovereign CDS. Amusingly, they use data from the EBA stress tests to show how big this problem is for European banks.
  • Another good piece from Alphaville (these guys are on fire this week) about the impact of the IRC on European sovereign bond prices. They kindly refer back to an old point of mine about the IRC creating pressure to move bonds to the banking book, as ask

    All the other factors now driving the crisis speak against holding sovereign debt in banking books as well, increasingly. No?

    They are of course right about that. But if the TB/BB boundary is flexible, in other words you can just move sovereign bonds that you had in the TB into the BB with no impact on strategy and a big saving on capital, why wouldn’t you. A great question in this context is where is sovereign bond repo booked: TB or BB.

  • Finally, a Dealbook piece by Jesse Eisinger that quotes me as saying that ‘I’m pretty certain that clearing is being imposed without anyone actually knowing whether it actually reduces counterparty risk or not.’ Just to be clear, what I mean by that specifically is that the problem of whether the multilateral netting benefits of clearing (clearable OTC trades with A and B are now both with the CCP, resulting in risk reduction) outweigh the disadvantage of splitting netting sets (trades with A are split into clearable ones, now with the CCP, and unclearable ones, now still with A) is still open. So far as I know, there is no study of this that makes remotely plausible assumptions about the multiplicity of CCPs for multi-currency, multi-asset portfolios.

Were the markets bamboozled by the Euro? November 15, 2011 at 6:28 am

This picture is from Pictet (via the ever helpful FT alphaville):

Eurozone bond spreads before and after union

Alphaville’s question is, given this, was Union sensible? I think it clearly was; on a weighted average spread basis, the EZ countries are still doing better than they were prior to the Euro, and even if they weren’t, those eight or nine years of low spreads were worth having (or at least they would have been if the money had been spent sensibly). In any event, what interests me more is why spreads were so low for so long. It seems to me that there are three (not necessarily mutually exclusive) possibilities:

  • Despite having thousands of smart people looking at these things, the markets were wrong about what the bond spreads of Eurozone countries should be. They have now woken up.
  • The markets have over-reacted to current events, and spreads are now well above where ‘fundamentals’ would suggest they ‘should be’ (whatever that means).
  • The markets are right, and the spread changes have been in response to new information, specifically the discovery that leading EZ politicans are unwilling or unable to backstop the periphery.

I’m not sure where I come out on this yet…

On the risks of synthetic structures September 9, 2011 at 12:41 pm

Ever since synthetic CDO became for many a long way of saying trash, investors have been nervous about synthetic structures. The recent kerfuffle about ETFs is one example of this. Let me do a little fact from fiction separation here.

In a synthetic structure someone wants to take exposure to some asset class and someone is providing it. For instance a fund may wish to track the FTSE 100 without the tedious and expensive business of owning the component shares. Therefore it enters into a swap where it receives the total return on the index and pays some financing rate. So far, so straightforward.

An major division in synthetic structures is between those where the exposure provider owns the underlying asset and those where they don’t. In the simplest and safest version of the structure, the exposure provider owns exactly the asset they are providing exposure to, and they pledge this asset as collateral against the swap. (Typically this happens when the exposure provider has advantages that the exposure taker does not, such as better market access or an advantageous tax position with regard to returns on the asset.) Here the worst that can happen in the event of failure of the exposure provider is that the exposure taker seizes the asset. Providing that they can legally own the asset, this is highly likely to involve little or no loss: counterparty risk is minimal.

In any other version of the structure, there is are more risks. These can include the exposure provider having difficulty in providing the promised return because they don’t own the asset, and counterparty risk, especially if the structure is leveraged and/or the collateral posted against the swap does not cover the exposure. Morningstar has a good discussion of the issues for ETFs here. (Another risk arises if the return the swap provides is not precisely the one the exposure taker wants, but we won’t discuss that.)

Why were synthetic CDOs so dangerous? Well part of the answer at least is that the exposure provider often did not own the asset. Indeed, sometimes the structure was created because the exposure provider wanted to be short. This was (probably) the case for Goldman’s famous Abacus deal, for instance.

One particular issue here is that if the exposure provider owns the asset, then the derivative has not changed the market for the underlying. Instead of the exposure taker buying the asset (and hence presumably increasing its price), the exposure provider buys it instead. The market in the underlying is unaffected. However if the exposure provider is short synthetically – through providing exposure but not hedging that obligation – then the existence of the derivative has changed the market in the underlying.

An extreme example of this is where there is more exposure written than there is underlying available and this fact is not evident to market participants. For instance, suppose I sell physically settled CDS protection on more notional of a corporate bond than has been issued. Clearly if there is a credit event the CDS buyers will not be able to find enough bonds to deliver to me, and the market in the bonds will be disrupted. The Amherst trade is a great example of this.

Personally I think that one of the great advantages of trade repositaries is that they could be used to ensure that a false market in the underlying does not develop. If market participants knew what was going on synthetically just as they know (thanks to exchange reporting) what is going on in the cash market, then prices will better reflect the real supply and demand in the market. A real systemic risk of synthetic structures is that they can be used by people to hide what they are doing: now that the technology exists to eliminate this loophole, it should be used.

Prices are not a reliable measure of default risk May 4, 2011 at 10:51 am

You know it is true because a judge says so.

In the case of Barclays vs. CRSM, regarding claims of CDO-squared mis-selling, Mr. Justice Hamblen made some interesting and, in my view, wholly accurate statements, viz:

302…the valuation figure … was not … an estimation of long term default risk.


371… (4) It was reasonable to take the view that credit spreads and an implied probability of default derived from the pricing model did not provide a reliable measure of the real world probability of default.

This is something that we have been discussing for a while: credit spreads contain more than compensation for default risk alone, and thus PDs estimated from credit spreadsd are not accurate real world estimates. It is really nice to see this turning up in a legal judgement.

See here for further comment from Eversheds on the case, or here for Herbert Smith.

Does your cabal look big in this? December 14, 2010 at 10:53 am

The NYT has a histrionic article on clearing which both Craig Pirrong and John Carney do a good job of replying to. I particularly like the title of Carney’s piece: What if We Need a Secret Banking Elite to Rule Derivatives Trading?

Here’s the issue. Central counterparties for OTC derivatives have to decide who they can deal with. If they deal with only the strongest, most robust firms, then clearly they run less risk, and hence they can take less margin (or other protection). They will still need some margin, of course, but they can place at least some confidence in the strength of the person they are dealing with*. However if they deal with many more firms, including lower quality ones, then the failure of a clearing member becomes more likely, and they will need more protection.

There are three policy choices here, none of them particularly appealing.

First, a CCP could charge variable amounts depending on the credit quality of its counterparty. If they did this then BB-rated CCP users would pay a lot more margin than AA-rated ones. This approach would have the advantage of making membership of the CCP available to a wide range of parties, but the costs would be very considerable especially for lower quality firms. This is partly because a CCP would have not other business (such as lending or corporate finance) which it could use to generate returns to cross subsidise derivatives; moreover, unlike a dealer, it would only take the very highest quality collateral. In practice then these constraints might well be enough to dissuade lower quality counterparties from using central clearing.

Second, a CCP could charge everyone the same high level of margin as would be needed for the lowest quality counterparty. This would be fair, but would impose much higher costs on the system than are needed. The resulting liquidity drain would be terrifying.

Third, a CCP could charge a lower level of margin, but make up for that by charging higher default fund contributions. This would result in the higher quality counterparties subsidising the lower quality ones: worse, there would be an incentive to be a less safe derivatives trader. So that doesn’t really work out well either.

This leaves us with the current situation: limited membership of CCPs with the limitation determined by credit quality (amongst other things: the ability to participate in default management is important too). Those who do not qualify can use central clearing but only as the client of a clearing member. The resulting structure might not be ideal, but it is a lot better than opening up direct membership of CCPs to lower quality counterparties.

*The problem for a CCP typically isn’t the default of one clearing member, it is a wave of defaults in what would necessarily be a stressed market. What you want is not that the unconditional probability of default of a CCP clearing member is low, but that the PD conditional on the market being in turmoil is low and reasonably uncorrelated with that of other CMs. Bank resolution regimes and higher capital requirements aim to ensure precisely this.

Seniority destruction through resolution and covering November 14, 2010 at 6:06 am

The Bond Vigilantes point out that in the new post-Basel III world, bank capital structure may well get a lot simpler:

deposits, covered bonds, senior notes, CoCo’s and equity

The covered bonds will be needed to meet funding requirements, but of course this process removes assets which would otherwise be available to meet senior creditors. As the vigilantes point out, if bank resolution regimes make senior creditors share the pain, then this will have the effect of making bank senior debt a good deal less attractive:

If you imagine a situation (shouldn’t be too hard) where a bank gets into difficulty, its CoCo’s are triggered but still falls into bankruptcy. The equity will be wiped out leaving a senior debt holder not only at the bottom of the pile in a liquidation, but also with a claim over fewer assets than they historically would have had, since most of the mortgages would have been pledged to the covered bond pools.

Know your counterparty (if you can) October 18, 2010 at 11:00 am

More from Caballero:

In Caballero and Simsek (2009a, b), we capture the idea of a sudden rise in complexity followed by widespread panic in the financial sector. In our model, banks normally collect basic information about their direct trading partners, which serves to assure them of the soundness of these relationships. However, when acute financial distress emerges in parts of the financial network, it is not enough to be informed about these direct trading partners, but it also becomes important for the banks to learn about the health of the partners of their trading partners to assess the chances of an indirect hit. As conditions continue to deteriorate, banks must learn about the health of the trading partners of the trading partners of their trading partners, and so on. At some point, the cost of information gathering becomes too large and the banks, now facing enormous uncertainty, choose to withdraw from loan commitments and illiquid positions.

This is an interesting model. It also clearly relates to the ‘do I believe the financials’ question whereby in good times publically available information is sufficient to give confidence but in a crisis the potential for losses to be hidden (thanks for instance to the potentially judgemental nature of loan loss reserves) gives rise to uncertainty and hence a withdrawal from the market. Aversion to (Knightian) uncertainty clearly has a key role in explaining flights from risk.

Sovereign default does not imply bank default September 17, 2010 at 6:26 pm

A careless journalist says:

If you’re a bank and the country you’re based in goes bust, then you’re going to go bust too.

Nope. Or, more precisely, if a sovereign defaults on foreign currency debt, then banks incorporated in that country do not have to default on their foreign currency debt too, and even more importantly they certainly don’t have to default on their local currency debt. If banks only have local currency debt, they may well be fine – especially if they have foreign currency assets which will likely appreciate vs. their debt, and if the central bank makes lots of liquidity available in local currency, which it might.

If the banks have foreign currency debt too, their default depends on their ability to service it (given any government action): if they have foreign currency assets too, and not too much funding liquidity risk, they might survive.

For all of these reasons, by the way, there is a case for some banks with substantial foreign asset bases to be rated through their sovereign of incorporation.