Friday, January 30, 2009

Centralized Clearing for Credit Derivatives

By Viral V. Acarya, Robert Engle, Stephen Figlewski, Anthony Lynch and Marti Subrahmanyam (NYU Stern Business School Restoring Financial Stability White Paper Project):

Credit derivatives, mainly Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDOs), have been under great stress during the sub-prime financial crisis and have contributed significantly to its severity. In large part this is because these relatively new products are traded in bilateral transactions over-the-counter (OTC), unlike other major financial derivatives that are traded on exchanges. OTC contracts can be more flexible than standardized exchange-traded derivatives, but they suffer from greater counterparty and operational risks, as well as less transparency.

The Issues

  1. Transparency: The market for CDS provides a clear example of how lack of transparency makes risk assessment difficult. Following the bankruptcy of Lehman Brothers, about $400 billion of CDS were presented for settlement, but once all the offsetting bilateral trades—invisible to the outsider—were netted out, only about $6 billion ultimately changed hands. Evaluating and managing counterparty credit risk for CDS is a big problem with systemic implications. In March 2008, the Fed and the Treasury orchestrated a bailout of Bear Stearns because it was "too interconnected" to other financial firms through its extensive and complex network of bilateral OTC contracts to be allowed to fail. The serious consequences of letting a systemically important firm fail became all too apparent when Lehman Brothers had to file for bankruptcy and the credit markets responded by freezing up.
  2. Counterparty Risk: CDS and other OTC contracts deal with counterparty credit risk by setting (privately negotiated) collateral requirements for both parties to the deal. But the terms are not standardized and no account is taken of the risk externality by which credit enhancement for one deal affects the risk exposures of other market participants. The shortcomings of this arrangement, including the fact that the OTC environment offers almost no transparency regarding the counterparties' overall risk exposure, became clear in the case of AIG, which had accumulated a huge exposure to CDS, and had to be bailed out after a credit rating downgrade precipitated collateral calls that it could not meet.

Three Levels of Centralized Clearing

We feel that when an OTC derivatives market becomes large and important enough to have a significant impact on the overall financial system it needs to have centralized clearing in order to aggregate information on outstanding deals and risk exposures for the benefit of regulatory authorities and other market participants. Three different types of central clearing offer different levels of market integration and transparency.

  1. Deals Registry
    The most basic arrangement would be a Registry of deals in which counterparties report on trades they have set up bilaterally. A Registry could provide efficiency gains by both holding collateral for the counterparties and facilitating the transfers of funds among institutions.
  2. Clearing House as Central Counterparty
    A much stronger form of Clearing House would take on the role of counterparty and guarantor of all contracts, as does the clearinghouse for a futures or options exchange. Deals would still be set up in bilateral negotiation, but once registered with the Clearing House, the CDS would be broken into two separate contracts with the Clearing House in the middle. This kind of clearing facility would greatly reduce counterparty risk in the market, as long as it was adequately protected against default. An important element of that protection is that the Clearing House would set standardized margin requirements on all deals. This facility also has the valuable feature that it allows a firm to completely unwind a trade before maturity, because identical offsetting contracts made with different counterparties would cancel each other out when the Clearing House took the other side. We favor this form of centralized clearing over a pure OTC market structure or a registry for CDS and most other significant derivatives.
  3. Derivatives Exchange
    The most centralized form of market organization would be for trading to move to a formal exchange. An exchange offers the advantages of highly visible prices and volumes, broad market participation including retail traders, and elimination of counterparty risk through standardized margins and a contract guarantee supported by the capital of both a clearinghouse and independent market makers. One significant inconvenience of exchange trading is that contracts need to be standardized to permit large amount of trading in the same instrument. This would not be a big problem for CDS's, which are already quite standardized, but would be difficult for more individualized instruments, like CDO tranches. A second problem is that setting up and running an exchange is costly, so it is not suitable for thinly traded instruments.

Policy Recommendations

  1. A firm trading credit derivative contracts over-the-counter should be required to provide information to a central Registry on each deal they enter into. Information gathered in this way should be available to regulators and, potentially, to the public in a form that balances the need for counterparties to be able to evaluate each other's risk exposures against firms' proper concerns for keeping the details of their trading strategies confidential.
  2. When trading activity in a particular derivative expands to the point that the contract becomes systemically significant, it should move to centralized clearing with a clearinghouse that assumes the role of counterparty and guarantees every trade. This would greatly reduce counterparty risk and further improve market transparency, in addition to offering substantial efficiency gains in trading.
  3. Moving trading to a formal exchange may be appropriate for some actively traded and largely standardized derivative instruments, but the major gains from establishing a centralized clearing facility are obtained once there is a clearinghouse that assumes the role of counterparty and guarantees every trade. We therefore feel that the strongest public policy need in the area of OTC derivatives is to require centralized clearing for all systemically important derivatives.

Credit Swaps Overhaul Planned for March as Dealers Curb Risks

By Shannon D. Harrington on Bloomberg:

Dealers plan to overhaul credit- default swaps in March to curb risks in the $28 trillion market, making the derivatives more like bonds and creating a committee that will arbitrate disputes.

For the first time, the market will have a committee of dealers and investors making binding decisions that determine when buyers of the insurance-like derivatives can demand payment and could influence how much they get, industry leaders said yesterday at a conference in New York. Traders also will revamp the way the contracts are traded, requiring upfront payments to make them more like the actual bonds they’re linked to.

The changes are part of a broader effort to increase transparency, mitigate the risk of cascading failures and standardize the way bilateral contracts are traded and disputes are resolved. They’ll also allow dealers to process derivatives through a clearinghouse, heeding the call of regulators following the September failure of
Lehman Brothers Holdings Inc., one of the largest credit swaps dealers.

“You cannot run a clearinghouse without making sure the clearinghouse is always flat,”
Athanassios Diplas, global head of the counterparty portfolio management group at Deutsche Bank AG, said during a panel discussion at the conference, which was hosted by Markit Group Ltd., a data provider and owner of benchmark indexes in the privately traded market.

Credit-default swaps are derivatives based on bonds and loans that were created to protect debt holders against default. The contracts, now commonly used by traders to speculate on corporate creditworthiness, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Contracts typically are traded under a standard set of terms that determine, among other things, how they’re settled if the underlying borrower defaults.

Regulatory Pressure
The Federal Reserve Bank of New York increased pressure on the banks to make the changes following the September bankruptcy of Lehman. The overhaul is intended to coincide with a so-called roll in March, in which the market shifts to a new maturity date for contracts.

Regulators are prodding dealers including Deutsche Bank, JPMorgan Chase & Co., Barclays Plc and Morgan Stanley to move trading to a central clearinghouse that would back the trades, reducing the risk that the collapse of one dealer would trigger a wave of losses and cause others to fail.

Atlanta-based
Intercontinental Exchange Inc., Chicago-based CME Group Inc., Eurex AG and NYSE Euronext’s Liffe derivatives market are competing to clear credit-default swaps.

Protection Costs
In one of the most noticeable changes for traders, those who buy protection will pay an upfront fee depending on current market prices, and then a fixed $100,000 or $500,000 annual payment for every $10 million of protection purchased. Now, upfront payments are only required for riskier companies, and the annual payment, or coupon, on most contracts is determined by the daily market level.

The change will simplify trading, reduce large gaps between cash flows that can amplify losses, and make the derivatives more like the bonds they’re tied to, said
Jason Quinn head of U.S. high-grade derivatives trading at Barclays Capital in New York.

The industry committee will make binding decisions such as when a borrower has defaulted and protection buyers can demand payment. They’ll also resolve disputes over which bonds are covered by the contracts. Those decisions may affect the size of the payments protection sellers must make.

Few details were discussed on how members of the committee will be selected, though it will be balanced between dealers and investors, with members publicly disclosed.

“It only works if people believe in it,” said
James Hill, managing director in credit trading and structured credit products at Morgan Stanley.

J.P. Morgan’s CDS Analytical Engine Made Available as Open Source

From the ISDA press release:

The International Swaps and Derivatives Association, Inc. (ISDA) today announced that J.P. Morgan has transferred to ISDA its CDS Analytical Engine. The CDS analytical engine, originally developed by the Quantitative Research group at J.P. Morgan, is widely used in the industry to price CDS contracts. ISDA will make the analytical engine available as open source code, thereby increasing transparency around CDS pricing.

"J.P. Morgan has invested a lot of intellectual capital in this analytical engine. Its willingness to assign this to ISDA for us to make it available as open source to the entire industry demonstrates our collective commitment to the integrity of the CDS product," said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. "ISDA and its members are vigilant to public concerns around transparency. This is yet another measure of increased standardization in CDS."

What is it with politicians and CDS?

B

FT Alphaville does not believe credit default swaps are The Devil, but many politicians and a host of people who really should know better are convinced that the CDS market is the cause of all the world’s ills, and should be regulated out of existence - immediately.

Take the draft bill proposed by Collin Peterson, chairman of the agriculture committee of the US House of Representatives. His bill would require all CDS trades to be processed by a clearing house; more significantly, it would ban “naked” CDS trading - i.e. any trades in which protection buyers did not own the underlying bond referenced by the contract. Naked CDS trades account for about 80 per cent of the market.

This approximates to requiring anyone who is trading in the oil market to be prepared to take physical delivery of barrels of oil, or, as professor Mark Williams of Boston University put it to Bloomberg:

Saying you only can trade if you have the physical is like saying you only can write calls if you own the underlying. Imagine what impact that would have on our existing options market if such a ‘naked’ rule was mandated.

ISDA, the de-facto voice of the industy, is less than impressed, as per this terse statement:

“This bill would increase the cost and reduce the availability of essential risk management tools while failing to address the true causes of the credit crisis,” said Eraj Shirvani, ISDA Chairman and Head of European and Pacific Credit Sales and Trading at Credit Suisse.” Throughout the crisis, credit default swaps have remained available and liquid. They have been the only means of hedging credit exposures or expressing a view at a critical time for the industry. Impairing their use would be counterproductive to efforts to return the credit markets to a healthy, functioning state.”
Not even the lawyers like the proposal. Robert Claassen, who chairs the derivatives and structured products group at Paul Hastings in New York, finds it “difficult to understand where the House agricultural committee is coming from”:

To the extent the committee is concerned about speculation in CDS, they should consider giving the CFTC or the Federal Reserve Board the right to establish margin requirements for CDS exchange trades that are not ‘bona fide hedges’ or the like, similar to the rules governing futures contracts.

But an outright ban? While they are at it, why not prohibit the writing of any call option that isn’t a covered call? Or perhaps prohibit anyone from owning a house unless they intend to live there … the possibilities are endless!

The CDS market has become a whipping boy for politicians, policy makers and talking heads attempting to earn some populist credentials. Is it too much to ask that they also seek to understand the role of the markets they are so fond of vilifying?

Thursday, January 29, 2009

Credit Swaps Industry Says Limits Would Hamper Market

By Matthew Leising and Shannon D. Harrington on Bloomberg:

A draft of a bill aimed at reining in $28 trillion of credit-default swaps would hinder recovery of debt markets, according to academics and an industry group.

The proposal “would radically shrink” the market, said Scott MacDonald, head of research at Aladdin Capital Management in Stamford, Connecticut, which oversees $16.5 billion in assets. “While it’s important that there’s a drive to return to some degree of plain-vanilla in financial products, this would be considerable overkill.”

House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota circulated an updated draft bill yesterday that would ban credit-default swap trading unless investors owned the underlying bonds. The draft, distributed by e-mail from the committee, would also force U.S. trades in the $684 trillion over-the-counter derivatives markets to be processed by a clearinghouse. Hearings on the draft will be held next week.

U.S. regulators and politicians are stepping up pressure on banks to use clearinghouses and agree to increased oversight of the markets to improve transparency amid a credit crisis that began in 2007. Bad bets on credit-default swaps led to the collapse and government rescue of American International Group Inc. in September.

Credit-default swaps “have been the only means of hedging credit exposures or expressing a view at a critical time for the industry,” Eraj Shirvani, chairman of the International Swaps and Derivatives Association and the London-based head of European and Pacific credit sales and trading at Credit Suisse Group AG, said in a statement. “Impairing their use would be counterproductive to efforts to return the credit markets to a healthy, functioning state.”

Market Ballooned
Total credit-default swaps outstanding ballooned almost 100-fold within seven years to top $62 trillion of contracts by the end of 2007, according to estimates from the New York-based ISDA, which represents dealers, hedge funds and other investors in the privately negotiated derivatives industry.

While created initially as a way for banks to hedge their risk from loans, the derivatives became a popular vehicle for hedge funds, insurance companies and other asset managers as a way to speculate on debt because they were often easier and cheaper to trade than actual bonds.

Secondary trading on bonds diminished after industry regulators forced transactions to be publicly disclosed on a computer system called Trace, which proved unpopular with dealers.

Bondholder Protection
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Peterson’s plan “is anti-derivative,” said Mark Williams, a finance professor at Boston University. “Saying you only can trade if you have the physical is like saying you only can write calls if you own the underlying. Imagine what impact that would have on our existing options market if such a ‘naked’ rule was mandated.”

As much as 80 percent of the credit-default swap market is traded by investors who don’t own the underlying bonds, according to Eric Dinallo, superintendent of the New York Department of Insurance. Dinallo in September proposed regulating the part of the market in which investors own the bonds. He shelved the proposal two months later because of progress by federal regulators on broader oversight of the market.

‘Kill’ the Market
Hearings will be held on Feb. 3 and 4, after which the Agriculture Committee may make changes to its language. Peterson hopes to have the bill passed out of committee before the President’s Day holiday in the U.S. on Feb. 16, he said yesterday, before it would go to the House.

“This is a bad idea,” said Robert Webb, a finance professor at the University of Virginia and a former CME trader. “It is reminiscent of the opposition in the 19th Century to futures trading in the belief that speculators were controlling the market and driving agricultural prices down.”

The draft bill is a “negotiating tactic” and is unlikely to become law, said Andrea Cicione, a credit strategist at BNP Paribas SA in London. “Going to extremes isn’t a good thing and it doesn’t make much sense,” he said. “The corporate market has worked well and shown itself to be quite resilient.”

Clearinghouse
European Union Financial Services Commissioner Charlie McCreevy said today he wouldn’t support a ban on trading credit- default swaps without owning the underlying bonds. Speaking in an interview at the World Economic Forum in Davos, Switzerland, McCreevy also said he favored creating a clearinghouse for OTC derivatives.

Forcing interest-rate swaps and credit-default swaps through a clearinghouse, which would establish prices for the privately traded contracts, may reduce how much banks are able to make from them.

As much as 40 percent of profit at Goldman Sachs Group Inc. and Morgan Stanley comes from OTC derivatives trading, according to CreditSights Inc. Estimating the new income that exchanges such as CME Group Inc. could earn from processing the OTC trades is difficult because clearing fees and volumes aren’t known yet, said Bruce Weber, a finance professor at the London Business School.

JPMorgan Chase & Co. held $87.7 trillion of derivatives as of Sept. 30, more than twice as much as the next largest holder, Bank of America Corp., which had $38.7 trillion, according to data from the Office of the Comptroller of the Currency. Of the holdings at New York-based JPMorgan, 96 percent were in the OTC market, compared with 94 percent for Bank of America.
JPMorgan, Bank of America

The largest positions at JPMorgan and Bank of America, based in Charlotte, North Carolina, were in interest-rate swaps. Banks enter into interest-rate swaps with clients such as cities or hospitals that sold bonds and seek protection against adverse moves in interest rates. They also hedge their exposure to rates in the inter-dealer market.

The OCC data only included U.S. commercial banks, so Morgan Stanley and Goldman Sachs Group Inc. weren’t listed at the time. Both New York-based investment banks converted to banks regulated by the Federal Reserve on Sept. 21.

A provision in Peterson’s bill, which will be discussed in hearings next week, allows for the U.S. Commodity Futures Trading Commission to exempt certain OTC contracts that are too customized or don’t trade frequently enough to be cleared.

Added Stability
Funded by its members, a clearinghouse adds stability to markets by becoming the buyer to every seller and the seller to every buyer.

The standardization necessary to process a contract in a clearinghouse may harm the market and drive the trading overseas, Weber said.

“It’s a big deal because the OTC market has developed almost as an alternative to the exchange market with its clearinghouses,” he said. “It would be advantageous for places like London, Hong Kong or Singapore where OTC trading wouldn’t have that kind of restriction.”

Weber said that if price transparency is what Peterson wants, it can be achieved in other ways, such as putting OTC derivative prices on a system such as the Trace bond-price reporting system of the Financial Industry Regulatory Authority.

Peterson’s draft bill would also authorize a study by the CFTC to determine if OTC trading influences prices on exchange- traded contracts such as oil. If the commission found such an influence it would be authorized to set limits on the size of positions held by OTC traders.

U.S. Draft Law Would Ban Most Trading in Credit Swaps

By Matthew Leising at Bloomberg.com:

Draft legislation that would change how over-the-counter derivatives are regulated might prohibit most trading in the $29 trillion credit-default swap market.

House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota circulated an updated draft bill yesterday that would ban credit-default swap trading unless investors owned the underlying bonds. The document, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the $684 trillion over-the-counter derivatives market to be processed by a clearinghouse.

“This would basically kill the single-name CDS market,” said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California. “Given the small size of many issuers’ bonds outstanding, this would make it practically impossible for the CDS market to exist.”

U.S. regulators and politicians are stepping up pressure on banks to use clearinghouses and agree to increased oversight of the OTC markets to improve transparency amid the credit crisis. Bad bets on credit-default swaps led to the U.S. takeover of American International Group Inc. in September.

80 Percent
As much as 80 percent of the credit-default swap market is traded by investors who don’t own the underlying bonds, according to Eric Dinallo, superintendent of the New York Department of Insurance. Dinallo last year proposed outlawing so-called “naked” credit-default swap trading. He shelved the proposal in November because of progress by federal regulators on broader oversight of the market.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Proposals that would impair the credit-default swaps market “are likely to prove counterproductive to efforts to promote lending and return the credit markets to a healthy, functioning state,” said Greg Zerzan, the counsel and head of global regulatory policy at the International Swaps and Derivatives Association, which represents participants in the privately negotiated derivatives industry.

“This is a bad idea,” said Robert Webb, a finance professor at the University of Virginia and a former CME trader. “It is reminiscent of the opposition in the 19th Century to futures trading in the belief that speculators were controlling the market and driving agricultural prices down.”
European Reaction

European Union Financial Services Commissioner Charlie McCreevy said today he wouldn’t support a ban on trading credit- default swaps without owning the underlying bonds. Speaking in an interview at the World Economic Forum in Davos, Switzerland, McCreevy also said he favored creating a clearinghouse for OTC derivatives.

The proposal “looks more like overregulation than better regulation, which is what the market needs,” Aaron Low, a principal and fixed-income strategist at hedge fund Lumen Advisers LLC in Singapore, said in an e-mail. “It will effectively reduce liquidity and price transparency.”

Forcing interest-rate swaps and credit-default swaps through a clearinghouse, which would establish prices for the privately traded contracts, may reduce how much banks are able to make from them.

As much as 40 percent of profit at Goldman Sachs Group Inc. and Morgan Stanley comes from OTC derivatives trading, according to CreditSights Inc. Estimating the new income that exchanges such as CME Group Inc. could earn from processing the OTC trades is difficult because clearing fees and volumes aren’t known yet, said Bruce Weber, a finance professor at the London Business School.

JPMorgan’s Holdings
JPMorgan Chase & Co. held $87.7 trillion of derivatives as of Sept. 30, more than twice as much as the next largest holder, Bank of America Corp., which had $38.7 trillion, according to data from the Office of the Comptroller of the Currency. Of the holdings at New York-based JPMorgan, 96 percent were in the OTC market, compared with 94 percent for Bank of America.

The largest positions at JPMorgan and Bank of America, based in Charlotte, North Carolina, were in interest-rate swaps. Banks enter into interest-rate swaps with clients such as cities or hospitals that sold bonds and seek protection against adverse moves in interest rates. They also hedge their exposure to rates in the inter-dealer market.

The OCC data only included U.S. commercial banks, so Morgan Stanley and Goldman Sachs Group Inc. weren’t listed at the time. Both New York-based investment banks converted to banks regulated by the Federal Reserve on Sept. 21.

Provision for Exemption
A provision in Peterson’s bill, which will be discussed in hearings next week, allows for the U.S. Commodity Futures Trading Commission to exempt certain OTC contracts that are too customized or don’t trade frequently enough to be cleared.

Funded by its members, a clearinghouse adds stability to markets by becoming the buyer to every seller and the seller to every buyer.

The standardization necessary to process a contract in a clearinghouse may harm the market and drive the trading overseas, Weber said.

“It’s a big deal because the OTC market has developed almost as an alternative to the exchange market with its clearinghouses,” he said. “It would be advantageous for places like London, Hong Kong or Singapore where OTC trading wouldn’t have that kind of restriction.”

Weber said that if price transparency is what Chairman Peterson wants, it can be achieved in other ways, such as putting OTC derivative prices on a system such as Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Peterson’s draft bill would also authorize a study by the CFTC to determine if OTC trading influences prices on exchange- traded contracts such as oil. If the commission found such an influence it would be authorized to set limits on the size of positions held by OTC traders.

A Short Introduction to Correlation Markets

ByPierre Collin-Dufresne

Abstract: This short note gives a short overview of correlation markets and was prepared for the "Roundtable Discussion on Default Risk Correlation Models" given at the inaugural SoFiE-Conference in June 2008.

Credit Default Swaps and the Stability of the Banking Sector

By Ulrike Neyer and Frank Heyde

Abstract: This paper considers credit default swaps (CDS) used for the transfer of credit risk within the banking sector. The banks' motive to conclude these CDS contracts is to improve the diversification of their credit risks. It is shown that these CDS reduce the stability of the banking sector in a recession. In a boom or in times characterized by a moderate economic up - or downturn, they can reduce this stability. The crucial points for these negative impacts to occur are firstly, that banks are induced to increase their investment into an illiquid, risky credit portfolio and secondly, that these CDS create a possible channel of contagion.

Wednesday, January 28, 2009

Everything You Wanted to Know about Credit Default Swaps--but Were Never Told

By Peter J. Wallison in the RGE Monitor:

Credit default swaps (CDSs) have been identified in media accounts and by various commentators as sources of risk for the institutions that use them, as potential contributors to systemic risk, and as the underlying reason for the bailouts of Bear Stearns and AIG. These assessments are seriously wide of the mark. They seem to reflect a misunderstanding of how CDSs work and how they contribute to risk management by banks and other intermediaries. In addition, the vigorous market that currently exists for CDSs is a significant source of market-based judgments on the credit conditions of large numbers of companies--information that is not publicly available anywhere else. Although the CDS market can be improved, excessive restrictions on it would create considerably more risk than it would eliminate.

Japan’s CDS spreads wider than west

By Lindsay Whipp in the Financial Times:

Japan’s credit default swaps, which have traditionally experienced tighter spreads than their US and European counterparts, are trading wider and do not look to be narrowing soon.

The iTraxx Japan index usually moves in line with the US’s CDX IG and iTraxx Euro Main but, since late last year, it has been consistently trading wider than the US and Europe.

The iTraxx Japan’s closing price on Tuesday was 322 basis points compared with Monday’s close for the CDX IG of 208.5bp and the iTraxx Euro Main’s 165.5bp, according to UBS figures.

Part of the reason is that Japan’s CDS market is not deep or well developed compared with its counterparts.

Unlike in other more developed markets, Japanese banks rarely use CDS for hedging purposes because the spreads are wider than their net interest margins from loans, making them too costly to purchase, according to Fumihito Gotoh, head of credit research for Japan at UBS.

Japan’s corporate bond market is small compared with the US and Europe as companies have often looked to their banks directly for loans rather than tapping capital markets.

Volumes of CDS outstanding on Japan itself and on Japan Tobacco are much smaller than those for J.Sainsbury and also for Halyk Bank of Kazakhstan, according to DTCC trade data warehouse.

This leaves overseas investors such as hedge funds as the main operators in Japan’s CDS market. As many of these have faced redemptions or are repatriating funds, market volume has thinned further and increased volatility.

“Many overseas investors have suffered from the credit crunch and are viewing Japan from the same perspective that they are viewing their home countries, where there are expectations for a sharp rise in defaults,” said Mr Gotoh.

Bankruptcies in Japan are rising and the level of publicly listed companies filing for court protection in November hit the highest since the end of second world war.

But many of these companies have been relatively new businesses from the real estate sector and do not have CDS in the iTraxx Japan index.

So, while this increase in bankruptcies may have had some impact on the index, “it can’t explain everything”, Mr Gotoh said.

The outlook does not look particularly bright either. “There probably won’t be much significant tightening for the first half of 2009 as we are expecting poor macro indicators,” Mr Gotoh said.

“If the US government contains the problem, institutions are more willing to provide money for the economy that could be a strong driver to lower the spread.”

The dysfunctional nature of Japan’s CDS market does not seem to be reflected in its corporate bond market.

Mr Gotoh estimates that A-rated Japanese companies are raising funds in the domestic corporate bond market at about 100bp above Libor. In the US and Europe, such companies need to spend about 400bp-500bp above Libor.

But Japan’s smaller and lower-rated companies are finding it harder to access funds in the credit turmoil.


Monday, January 26, 2009

The Price of Protection: Derivatives, Default Risk, and Margining

By Rajna Gibson Brandon (University of Geneva - Graduate School of Business (HEC-Geneva); Swiss Finance Institute) and (Carsten Murawski University of Melbourne - Department of Finance)

Abstract: By attaching collateral to a derivatives contract, margining supposedly reduces default risk. In this paper, we first develop a set of testable hypotheses about the effects of margining on banks' welfare, trading volume, and default risk in the context of a stylized banking sector equilibrium model. Subsequently, we test these hypotheses with a market simulation model. Capturing some of the main characteristics of derivatives markets, we identify stress situations in which margining has an ambiguous impact on banks' welfare, increases banks' default risk while reducing their aggregate trading volume. This is the case, in particular, when margin rates are high and collateral is scarce.

Download paper here.

Sunday, January 25, 2009

CDS Demonization Watch, Gretchen Morgenson Edition

By Felix Salmon at Portfolio.com:

In the wake of making my proposal below (which I'm entirely serious about, by the way), I'm forced to agree with Gretchen Morgenson about this:

Credit-default swaps clearly played a role in this debacle, and it is crucial that they are part of the solution.

That's about all I agree with her on, however. Consider this:

Sellers of C.D.S.'s spent years raking in premiums while underestimating or simply ignoring the possibility of rising defaults...
The fear that already-hobbled financial companies may have to pay off huge amounts on C.D.S. arrangements hangs like a cloud over the markets.
C.D.S.'s have already figured prominently in taxpayer bailouts. The $150 billion rescue of the American International Group, for example, came about because of swaps the insurer had written on mortgage securities. And the $100 billion taxpayer backstop handed to Bank of America on Jan. 16 had a good bit to do with soured credit-default swaps that the bank inherited when it acquired Merrill Lynch.

To read this, you'd think for all the world that the problem in the CDS market is that the big banks have written lots of credit protection, and that they're liable to make huge payouts if and when companies start defaulting.

But the losses at AIG came overwhelmingly because the insurer was selling default protection to banks on their super-senior CDOs. In other words, AIG was bailed out largely because if it hadn't been, many of the world's largest banks would have found themselves to be insolvent overnight. The banks were the prudent ones, insuring themselves against loss with the world's largest insurer; it was AIG which wrote more insurance than it could realistically handle.

And yes, Merrill Lynch lost money on the CDS basis trade. But that trade, again, involves buying credit protection, not selling it. The problem was that not that the CDSs had soured, so much as that the CDSs hadn't soured enough.

Morgenson writes, from atop her high horse:

Obviously, something must be done to eliminate the possibility that taxpayers will wind up paying off entities that essentially bet against the American economy.

She's talking here about people who bought credit protection. And the entities which bought the most credit protection -- on their loan books, on their CDOs, and for their basis trades -- are America's biggest banks. The net sellers of credit protection, by contrast, apart from AIG and the monolines, were generally hedge funds.

So Morgenson is essentially asking the beleaguered banking sector to bail out the hedge funds it bought protection from. Which makes no sense to me.

Morgenson then pushes a proposal from Chris Whalen that the CDS market on certain financial institutions be shut down entirely:

"It is absurd for the government to allow private speculators to profit by trading against public-guaranteed liabilities of banks," Mr. Whalen said.

Again, this doesn't make a lot of sense. If the liabilities are guaranteed by the government, then speculators aren't going to profit by trading against them, since the entities in question won't default. Sure, there might be some short-term mark-to-market profits if the CDS spreads widen out. But over the medium term, if the guarantee is real, then the government knows that all those speculators who are long protection are going to end up losing all their insurance premiums, with nothing to show for them.

Morgenson also seems to support a proposal from Sylvain Raynes which bears more than a family resemblance to the bright idea which Ben Stein came up with in October. Essentially, all CDS contracts would be unwound -- leaving the banks which hedged their loan portfolios in the nasty position of having much more credit risk on their books than they ever counted on. Raynes's proposal is basically a forced transfer of credit risk from the people who did want it to the people who didn't want it: how that makes any sense at all I have no idea.

It may or may not be true that we would have avoided much of this crisis had credit default swaps never been invented. I suspect it's not true, and that the CDS market, in allowing people to short the credit market, actually helped at the margin to stop the credit bubble from expanding. But even if it is true, that doesn't mean that the solution is to ban or unwind the CDS market which now exists. It was foolish to sell protection too cheaply on risky debt; it was sensible to buy that protection when it was cheap. So let's not punish the sensible people and bail out the foolish ones by abrogating those contracts.

Was Merrill Casualty #3 of The Basis Trade After DB Prop and Citadel

By Tyler Durden at Zero Hedge:

In a bet gone very bad, that if true would make Jerome Kerviel's $5 billion loss at Soc Gen seem like amateur hour, the WSJ reports ($$$ link with hat tip to portfolio.com) that the main reason for Merrill's massive $15 billion Q4 loss was due to some very large basis trades gone horribly wrong. We wrote briefly about the basis trade here but now with attention turning more firmly to this topic, it is worth revisiting.

Before we get back to what potentially could be the culprit for over $30 billion in prop trading and hedge fund losses last quarter in all of Wall Street, let's reexamine the basics. As we mentioned previously, at its core, a basis trade is a hedged position where an account buys a bond (let's say with a 5 year maturity) and hedges it with a matched-maturity (or comparable duration) Credit Default Swap. In this way, the account is completely insured from default risk on the bond purchased since if the underlying company that issued the bond were to file for bankruptcy, the account would lose the principal value on the bond but would pick up the recovery from the CDS, ending up with a 0 net gain/loss at the time of default event (CDS settlements can be physical or cash as defined by the CDS OTC-clearing authority ISDA, we will write more about this at a later date).

When an account buys the bond, one also receives the cash flows associated with the coupon on the bond; when hedged in a basis trade, as CDS has a "negative coupon", or the quarterly payment associated with paying for the "insurance", the net recurring cash out/inflow to the account is known as the "basis." In the good old days, the basis would be usually positive, meaning that to hedge a position perfectly, there would be some, usually very minor quarterly cash outflow, usually to the tune of 5-10 bps on the entire notional exposure. Again, in the good old days, a "negative basis" was rare to find - these are positions that for whatever technical or fundamental reasons, would be net cash positive. In other words, an account would have no default risk thru the bond's maturity, and would be compensated to have it put on the books. It would be rare to find negative bases of -10 bps, so hedge funds and prop desks would immediately snap these up as they became available in the market and usually lever them up dramatically, sometimes to the tune of 100-to-1, using a gullible Prime Broker or other synthetic instruments, and end up with anywhere from a 5% to 10% risk free annuity for years.

Another basis trade 101: When looking at the basis of a bond and match-maturity CDS, the most relevant bond metric is its Z-spread, or the spread to Libor, not the more traditional spread to comparable treasury. When comping bonds and CDS, one cares mostly about the bond's Z-spread as that gives the most appropriate reference of whether the bond trades rich or cheap vis-a-vis a CDS. This is because a CDS spread is also relative to the appropriate metric on the Libor curve, not relative to Treasuries.

So back to the basis: the problem with the whole "risk free" concept is that it made one major assumption - that liquidity would be essentially infinite. As the Bear Stearns implosion and the Lehman bankruptcy showed, this is one assumption that would be promptly crushed, and would lead to dramatic aberrations in the basis trade. One major issue was the availability of CDS, or rather lack thereof, to hedge cash bond positions. As prime brokers rushed to conserve liquidity, they made it virtually impossible for accounts to take advantage of dropping bond prices, and increasing Z spreads. They did this by exponentially increasing funding costs on CDS: traditionally the margin requirements on CDS would be in the sub 1% range; after Lehman some counterparties raised the margin requirements as high as 20%, and others even asked for the whole margin to be paid up front. On a $10 million CDS position, which traditionally would only have cash outflows every quarter to fund the quarterly insurance payment, all of a sudden accounts would have to pony up to $2 million in margin just to put a trade on (or keep it on, leading to many basis forced unwinds). Of course, this made it prohibitive for many but the largest hedge funds to participate in the heretofore extremely liquid CDS market, thereby creating phenomenal dislocations and the great arbitrage of negative basis trades that would create 5%-10% and on rare occasions even 15% unlevered returns!

As this can be a handful to swallow at first, we have presented this graphically. We chose to demonstrate the negative basis trade currently available in CIT Group's 5.0% Notes due 2/2014, which we match with CIT 5 year CDS due March 20, 2014. On the graphic below, it is evident that the basis had been gravitating around zero for a while, initially starting off as positive around the time JPM was taking over Bear, then was roughly 0 for several months, but then became dramatically negative the day after Lehman filed. In fact the spread went from 0 to almost 1,500 bps (or 15%) almost overnight! And in the subsequent liquidity constrained market, the basis spread has fluctuated all over, and is currently roughly -500 bps.



This is just one example: most high yield and cross over names currently represent negative basis opportunities: some interesting outliers include Marriott Hotels, Home Depot, Temple-Inland and Omnicom, all of which are BBB- (or higher rated) credits yet present negative basis opportunities of 300 bps and wider. We would be very cautious with blindly purchasing these bases, as the liquidity premium in the market will likely be a key concern for along time, and as long as that is the case, there is no reason why the basis trade should collapse. In fact, if there are any more risk flaring episodes and liquidity becomes even more valuable, these spreads are likely to blow out to even wider levels.

So back to our original topic. How could Merrill lose $15 billion on basis trades? And not just Merrill: Boaz Weinstein's group at Deustche Bank lost over $1 billion on this same trade, and basis trades are the main reason why Citadel has lost over 50% in 2008. Anecdotally, basis trades on CDOs are the reason why AIG, and most of the U.S. insurance industry is in its current deplorable state.

How would one go about estimating the P&L impact to these asset managers? It is not difficult: as the basis explosion resulted in a mismatch of DV01, or dollar equivalent change in 1 bps point in both bonds and CDS, or, netted out via the basis trade itself, one can calculate what the adverse MTM impact was on any notional position. If we take the CIT example above, and we assume that Merill had a $10 billion notional basis position in the name (this is an oversimplification but it was probably true for their overall basis portfolio), and the spread blew out from 0 to 1,500 bps around the time of the Lehman events, Merrill would have experienced a roughly $6 billion hit on the position (an average DV01 of $4MM), which implies that a $15 billion loss could have been created as simply as experiencing a blow up on $25 billion on basis trades. And this assumes no leverage which is naive for the prop desk model: if ML had leveraged its prexisting basis trades even 10x, the total basis trade notional needed to create this loss would have been only $2.5 billion. Is it inconceivable that ML had $25 billion in basis trades? Not at all - after all they were a preeminent CDS trading powerhouse and had one of the most active basis trade prop desks.

This is merely another amusing anecdote of what happens when you have a very popular trade in which everyone had piled in, from hedge funds to prop desks to insurance companies, and one of the assumptions that had been taken for granted disappears i.e., liquidity. The outcomes are only now starting to emerge: so far they have cost the jobs of John Thain (while we are amused by his office decoration choices, if he had not lost $15 billion in Q4, we are confident he would still have his job), "prodigy trader" Boaz Weinstein, and soon possibly Ken Griffin. It seems nobody ever learns from the Black Swan parable even though Nasim Taleb has been pounding the table on this for over 2 years now. Just as the Volkswagen short squeeze caused Adolf Merkle his life, and many hedge fund managers their jobs, every time you encounter this type of overhyped, "hedge fund hotel"-type trade, you will inevitably see casualties.

We at Zero Hedge would venture to surmise that the current bubbly purchasing of Treasuries and corporate loans will be the cause for the next 2 black swan events. We do not know in what form yet (by definition), but would caution all investors from getting involved at this point.

How to Resolve the CDS Basis Trade Blowup

By Felix Salmon at Portfolio.com:

Tyler at Zero Hedge has a wonderful post on the CDS basis trade today, which is a must-read for anybody who's interested in what happened to the CDS basis in the fourth quarter of last year or how Merrill Lynch could have lost so much money in December.

Tyler explains that while the CDS basis was positive during most of the Great Moderation -- it cost slightly more to insure a bond against default than you were receiving in coupon payments -- the basis on many names has become very large and negative over the months since Lehman Brothers collapsed.

Now a negative basis violates, in theory, the no-arbitrage rule: it means you can buy a bond, fully insure it, and lock in risk-free profits just by holding both the bond and the CDS to maturity.

But after Lehman and AIG blew up, that arbitrage trade became hard to put on, because prime brokers started asking for collateral from the buyers of credit protection:

Traditionally the margin requirements on CDS would be in the sub 1% range; after Lehman some counterparties raised the margin requirements as high as 20%, and others even asked for the whole margin to be paid up front. On a $10 million CDS position, which traditionally would only have cash outflows every quarter to fund the quarterly insurance payment, all of a sudden accounts would have to pony up to $2 million in margin just to put a trade on (or keep it on, leading to many basis forced unwinds).

This is truly a strange world: it's rare to ask people to put cash up front for the privilege of being able to pay an insurance premium every quarter. But as a result, the negative basis hasn't been arbitraged away, and the mark-to-market losses on anybody playing the CDS basis trade can be enormous -- yes, bigger even than the losses that Jerome Kerviel managed to rack up at SocGen.

A $15 billion loss could have been created as simply as experiencing a blow up on $25 billion on basis trades. And this assumes no leverage which is naive for the prop desk model: if ML had leveraged its pre-existing basis trades even 10x, the total basis trade notional needed to create this loss would have been only $2.5 billion. Is it inconceivable that ML had $25 billion in basis trades? Not at all - after all they were a preeminent CDS trading powerhouse and had one of the most active basis trade prop desks.

It seems to me that this is one area where government funds could be put to very good use -- and be guaranteed to make a profit. The government starts buying up lots of corporate bonds where there's a negative CDS basis -- Tyler cites CIT, Marriott Hotels, Home Depot, Temple-Inland and Omnicom as examples of credits where the basis is 300bp or more -- and then buys CDS protection on those bonds; it then promises to hold both the bonds and the CDS to maturity. Naturally, the government would buy the CDS protection on the new CDS exchange which it's trying to get the market to set up.

The result would be good for credit spreads, as bond prices would rise. It would be good for price discovery, as the confusion generated by the huge difference between bond and CDS prices would largely go away. It would lock in significant profits for the government. And it would get the new CDS exchange off to a flying start. What's not to love?

Friday, January 23, 2009

Moody's Corporate synthetic CDO assumptions updated

New York, January 15, 2009 -- Moody's Investors Service announced today that it has revised and updated certain key assumptions that it uses to rate and monitor corporate synthetic CDOs, a type of collateralized debt obligation backed by a pool of credit default swaps referencing corporate credits.

Moody's is revising its assumptions to reflect the expected stress of the global recession and tightened credit conditions on corporate default rates, which are likely to be more variable and extreme than those in other recent historical downturns. Specifically, the changes announced today include: (1) a 30% increase in the assumed likelihood of default for all corporate credits in synthetic CDOs, and (2) an increase in the degree to which ratings are adjusted according to other credit indicators such as rating Reviews and Outlooks. Moody's also announced an increase in the default correlation it applies to corporate portfolios as generated through a combination of higher default rates and an increase in investment grade and financial sector asset correlations.

Moody's will immediately start reassessing all of its outstanding corporate synthetic CDO ratings across 900 transactions in the U.S., Europe and Asia using these updated assumptions. Rating actions will be released continuously as individual analyses are completed. A summary of all rating actions will be published once all ratings in this sector have been reviewed.

Based on initial assessment, Moody's expects to lower the ratings of a large majority of corporate synthetic CDO tranches by three to seven notches on average. The actual magnitude of the downgrades will depend on transaction specific characteristics such as tranche subordination, vintage and portfolio composition.

Default Probability

Moody's is increasing its default probability assumptions for financial and non-financial corporate credits in the reference pools of synthetic CDOs by a factor of 30% across all rating categories. Historically, corporate default rates within a given rating category have varied greatly across the economic cycle. As in similar points in previous credit cycles, corporate default rates are likely to be elevated well above their historical long-term averages for at least the next two years; furthermore, Moody's expects that the current negative cycle will be worse than the previous cycles. Moody's will closely follow any changes in future corporate default rate expectations and macroeconomic outlooks and make necessary adjustments to this stress factor accordingly.

Given highly volatile credit conditions, Moody's will further extend its quantitative modeling practice of anticipating possible future corporate rating actions by treating ratings on "Review for Possible Downgrade" in the reference pool as if they are two notches lower and those with a "Negative Outlook" as if they are one notch lower. The prior practice was to adjust the rating down one notch for review and no notches for outlook. Ratings on "Review for Possible Upgrade" will continue to be treated as if they are one notch higher.

The revised default probability assumptions will also be incorporated into Moody's CLO rating methodology; those changes will be announced shortly.

Correlations

Globalization and the increasing complexity and interdependence of credit markets have led to a substantial increase in the extent to which stress in one sector can impact another. In addition, the severe market environment at present is putting pressure on many regions and industries together. Both factors have led to a sharp increase in observed default correlation among corporate credits.

Moody's explains that default correlation in its synthetic CDO rating analysis is derived through a combination of asset correlation and default rates. While increasing default probabilities generates higher default correlations across all rating categories, Moody's is also raising asset correlation assumptions in the investment-grade rating categories and in the financial sector in order to generate default correlations in line with its current observations. Accordingly, asset correlation assumptions have been updated as follows:

• Increased inter-industry asset correlations of investment-grade corporate credits from 3% to as high as 8%. Moody's calculates overall asset correlations using a tree structure that adds component percentages according to risk or asset classification and assigns each asset into one of the branches on the tree.

• Reclassified corporate credits according to a new industry classification code. The new code incorporates Moody's latest view on the industry characteristics of rated companies.

• Merged four industries -- Banking, Finance, Insurance and Real Estate -- into one. This reflects much stronger connections between companies in these industries as demonstrated by the recent financial crisis.

• Increased the number of global industries from 3 to 12 and reduced the number of local industries from 15 to 5. An industry that is global tends to have higher correlation between companies in different regions.

• Increased intra-industry asset correlations. For instance, the asset correlation assumption for a pair of A2-rated corporate credits that are in different regions, but are in a global industry rose from 9% to 20%.

• Portfolios with more than 8% concentration in a single industry are subject to an additive asset correlation penalty of up to 30%. The prior trigger was at 20% concentration with an additional asset correlation penalty of up to 15%.

Moody's will release its updated synthetic CDO rating model, CDOROMv2.5, this month, along with an updated user guide, which will incorporate and explain in detail the new modeling parameters.

Moody's rates and monitors corporate synthetic CDOs using the methodology as summarized in Moody's Rating Methodology Report, "Moody's Approach to Rating Corporate Synthetic Obligations." This announcement updates some of the key parameters of the existing methodology as described in this report. Moody's emphasizes that in addition to the quantitative factors discussed in this announcement and in the methodology report, qualitative factors are part of rating committee considerations. The qualitative factors include the strength of the counterparty and collateral agreements, the legal environment, documentation features, and the potential for selection bias in the portfolio. All information available to rating committees, including macroeconomic forecasts, input from other Moody's analytical groups, market factors, and judgments regarding the nature and severity of credit stress on these transactions may be used to make a final rating decision.

Long-term sukuk outlook promising after weak 2008

The value of sukuk issuance dropped by more than 56% in 2008 and S&P doesn't expect the market to revive before the second half of 2009. However, several structural factors indicate longer-term growth should be rapid. The market for Islamic bonds, or sukuk, declined sharply in 2008 as a result of global market turmoil, drying up of liquidity, widening of credit spreads, and a wait-and-see attitude among investors. Although difficult to measure, part of this decline could also have been due to comments about the Shar'iah compliance of some sukuk by the Accounting and Auditing Organisation for Islamic Financial Institutions.

Standard & Poor's considers that long-term prospects for the sukuk market remain strong, however. Although volumes dropped dramatically in 2008 (down more than 56%), the market attracted about the same number of issuers as the year before. Conservative estimates of the pipeline of sukuk that have been talked about or announced are in excess of $45 billion. Several factors support sustainable growth of this market, including the increasing popularity of Shar'iah-compliant products; government openness to Islamic finance; massive investment and financing needs in the Gulf; and issuers' desire to tap investors from the Middle East and Muslim Asia. Issuers from more than 20 countries have expressed interest in issuing, or announced their intention to issue sukuk, and Standard & Poor's anticipates that several new sovereigns will enter the market.

To date, Standard & Poor's has rated 27 sukuk (or sukuk programmes), the bulk of which are ijara (lease financing), or musharaka (venture capital financing). (Please see our "Glossary Of Islamic Finance Terms," published January 7, 2008, on RatingsDirect.)

Credit spreads on sukuk have followed the same trend as for conventional bonds, with a sharp widening in the past 12 months. Meanwhile, the average size of the sukuk issued last year declined significantly, partly due to the lower appetite of investors. At the same time, the US dollar lost its place as the currency of choice for sukuk, with only about 10% of issues raised in this currency. Standard & Poor's expects the sukuk market to continue being skewed toward issuances in local currencies, at least in the foreseeable future.

Growth to resume once markets normalise

The sukuk market experienced a dreadful year in 2008, largely as a result of deteriorating global market conditions. For instance, the Gulf Cooperation Council (GCC) countries, one of the two key markets for Islamic finance, experienced a major shift in liquidity flows. The liquidity inflow into the Gulf - mainly into the United Arab Emirates (UAE) and Saudi Arabia - started to reverse from the second half of 2008 when investors betting on the revaluation of the domestic currencies left these markets. This led to a significant downturn in local and regional debt and equity markets, including the sukuk market.

Overall, total sukuk issued globally dropped to $14.9 billion in 2008 from $34.3 billion in 2007. More than 45% of sukuk issued in 2008 were ijara, most probably as a direct consequence of the debate about Shar'iah compliance among some scholars.

Appetite for sukuk declined dramatically, along with that for international debt issuances, loan syndications, and other wholesale debt. We expect the sukuk market to revive only in the second half of 2009 or early 2010 - if and when financial market conditions start to improve. This delay is despite the fact that the pipeline for sukuk issuance remains healthy and the market is attracting interest from an increasing number of issuers in both Muslim and non-Muslim countries. Several structural factors indicate that growth in the longer term should be rapid:

• On the demand side, investors from the Middle East and Muslim Asia are increasingly seeking to invest in products that are compliant with their religious beliefs. In addition, wealth accumulated when oil prices were high in the past few years means that their financial flexibility is still strong.

• On the supply side, massive infrastructure projects in the Gulf require a huge amount of financing. Conventional borrowers are also seeking to diversify their investor base. They want to attract funding from investors as the crisis continues to widen and access to wholesale funding sources remains constrained.

• The openness among governments and regulators to Islamic finance is increasing around the world. We observe this trend not only in Muslim countries but also in non-Muslim countries such as the United Kingdom, which is the European country most supportive of Islamic finance.

• Financial institutions are seeking to better balance their funding, especially in the Gulf where short-term funding sources typically dominate and maturities are increasing on the asset side.

Last year clearly showed that the sukuk market is connected to global debt markets. Islamic finance is one component of global finance and is exposed to the ups and downs of international funding markets. Therefore, we expect the revival of the sukuk market to start more or less at the same time as that of the conventional capital markets.



Club of sukuk issuers is widening

One of the few positive developments for the sukuk market in 2008 has been its continuous geographic diversification. It is attracting issuers from an increasing number of countries and this trend is set to continue. Issuers from more than 20 countries have announced their intention to issue sukuk, or expressed an interest in doing so.

Therefore, Standard & Poor's expects the market to continue globalising. We expect more sovereign issuers to join the club in 2009 and understand that the Singapore, Indonesia, Kazakhstan and Qatar, among others, have plans to issue sukuk. Sovereign issuance should support the construction of a yield curve and introduce benchmarks for private issuers in these countries, boosting the growth of the sukuk market.



Malaysian and UAE-based issuers continue to drive the sukuk market, with more than 70% of total issuance coming from these two countries in 2008. Authorities' support for Islamic finance and openness to foreign investors are the key elements behind these figures. Other GCC and Asian countries are set to increase their contribution to the growth of the market in the future, thanks to huge financing and investment needs in the GCC, as well as sovereign issuance and support for Islamic finance development.

The largest sukuk in 2008 was issued out of Saudi Arabia by Saudi Basic Industries Corp. (SABIC) for a total amount of 5 billion Saudi Arabian riyal ($1.3 billion). The structure of this sukuk was very innovative. Under an asset transfer agreement, SABIC transferred certain rights and obligations for specific marketing agreements to SABIC Sukuk LLC, a 100% subsidiary. These represent SABIC Sukuk LLC's underlying assets, and it will hold them as a custodian for the benefit of the sukuk holders. The sukuk assets should generate the necessary cash flows to cover periodic payments to the sukuk holders. SABIC will be required to purchase the sukuk from the holders when they exercise their right to redeem their bonds. Therefore, we have equalised the ratings on the sukuk with those for SABIC.

Other large sukuk, denominated in local currencies, were issued out of the UAE, by Aldar Properties PJSC, Nakheel PJSC, Dubai Electricity and Water Authority, and Sorouh Abu Dhabi Real Estate. The sukuk issued by Sorouh (Sun Finance Ltd. Class A, B, and C) was the first sukuk with no credit enhancement that we have rated. We believe that the potential for asset-backed sukuk continues to be strong despite the currently weak investor interest in structured products.

US dollar no longer the currency of choice

The US dollar lost its leadership position with regard to sukuk issuance in 2008, with only about 10% of issuance in this currency. The credit crisis meant that sukuk issuers had to attract domestic investors instead of international investors and as a result issuers deserted international markets and concentrated on local markets where liquidity was more abundant and the appetite for Shar'iah-compliant instruments stronger.

In addition, investors betting that some GCC governments would de-peg their currencies from the dollar converted their funds into local currencies and placed them in local and regional debt and capital markets. In the end, the governments did not de-peg their currencies, however, and currently five out of the six GCC currencies are pegged to the US dollar. Standard & Poor's expects the sukuk market to continue being skewed toward issuance in local currencies for the foreseeable future, with only a limited portion being issued in dollars. Some of the sovereign sukuk to be issued in 2009 or 2010 will be both in local and foreign currencies (mainly dollars). Once market conditions return to normal, dollar-denominated sukuk will regain a stronger position, however.



Our role is to provide market participants with independent and objective opinions about the creditworthiness of issuers and issues - including those involving sukuk. We don't comment on the Shar'iah-compliance of a particular issue or issuer. Our ratings don't constitute a recommendation to sell, buy, or hold a particular security - whether it is Shar'iah-compliant or not. Instead, our ratings help investors to make informed decisions and issuers to access debt markets and benchmark their creditworthiness against that of their peers.

Thursday, January 22, 2009

Shari’ah compliance was a factor in the 2008 downturn of sukuk issuance

From Arabian Business.com:

Global sukuk issuance slumped by more than 50 percent in 2008, which is largely attributable to the international financial crisis.

But Moody’s said that debates over the Shari’ah compliance of some Sukuk structures, ignited by the Accounting Auditing Organisation for Islamic Financial Institutions (AAOIFI), also had a part to play in the slowdown.

"Early in 2008, the AAOIFI recommended that Islamic finance market participants should refrain from issuing sukuk structures that have a purchase undertaking or a guarantee from the sukuk issuer to repurchase at a specific price at a future date,” said Faisal Hijazi, Moody’s business development manager for Islamic finance.

“This is because AAOIFI believed that this structural mechanism is not compliant with a fundamental principle of Shari’ah, namely profit and risk-sharing,” he explained.

Ijarah sukuk, a form of capital leasing, became the dominant Sukuk structure in terms of issuance volumes in 2008, replacing Mudarabah, which was the dominant structure in 2007, Moody’s said.

A recent report by Kuwait Financial Centre (Markaz) revealed that while both conventional and sukuk markets plunged in the GCC in 2008, sukuk actually managed to grow its market share.

Sukuk’s market share grew to 45 percent of total the value issued by GCC bond markets, from 40 percent in 2007.

S&P Launches CDS Indices Designed to Reflect the Performance of the U.S. CDS Market

From S&P (hat tip to Alea):

Continuing to provide index solutions that better meet the changing needs of the investing public, Standard & Poor’s Index Services today announced the launch of the S&P CDS U.S. Indices. The Indices are designed to measure the performance of the approximately $29 trillion (notional) Credit Derivatives Market.
“With the launch of the S&P CDS U.S. Indices, Standard & Poor’s is responding to the market’s need for transparent and objectively run credit default swap indices,” says James Rieger, Vice President of Fixed Income Indices at Standard & Poor’s Index Services. “Working closely with market participants, Standard & Poor’s designed the Indices to track the most liquid credit default swaps and be efficient enough to support investment products such as index funds, index portfolios, and derivatives.”

Standard & Poor’s is launching three U.S. based CDS indices:

• The S&P 100 CDS Index initially consists of the 80-90 members of the S&P 1002 that have CDS with sufficient liquidity. The weight of each constituent in the S&P 100 CDS Index is based upon its weight in the S&P 100.
• The S&P CDS U.S. Investment Grade (IG) Index consists of 100 equally weighted investment grade U.S. corporate credits which meet certain liquidity criteria
• The S&P CDS U.S. High Yield (HY) Index consists of 80 equally weighted high yield U.S. corporate credits which meet certain liquidity criteria

Each CDS Index will offer three calculations that reflect the performance of a basket of single name credit default swaps. The first type of calculation, consistent with industry standards, removes a reference obligation from the index upon a credit event. The second type (S&P CDS Event Inclusive Indices) will augment its calculation of the performance of the CDS indices by incorporating the effect of credit events and corporate actions on the affected issues. The third type (S&P CDS Rolling Indices) will calculate the performance of each CDS basket on a continuous basis.

“The S&P 100 CDS Index is the first index to track the performance of the reference entities of an equity index,” continues Rieger. “With this first-of-its-type index, Standard & Poor’s is providing market participants with a view of the relationship between the equity market and the CDS market for the S&P 100 constituents.”

Standard & Poor’s is using CMA DataVision, the credit information specialist, as its primary source of pricing for the Indices.

More at Bloomberg: S&P Starts Three Default Swap Indexes a Year Later Than Planned

Tuesday, January 20, 2009

To Stabilize Global Banks, First Tame Credit Default Swaps

By Christopher Whalen at the Institutional Risk Analyst:

As readers of The IRA know full well, the Fed of New York and the Depository Trust & Clearing Corp have been working for years to address the bank office issues facing CDS, this all the while declaring that there is nothing basically wrong with the CDS market. Strange, then, that as part of the process of rationalizing CDS contracts, nearly half of the outstanding contracts have been torn up in the past year! This is because, dear friends, when it comes to CDS, clearing is the least of our problems.

The tension with CDS regarding the money centers in particular and banks generally comes from several basic flaws in the ISDA model for these instruments, including the lack of a central counterparty and the issues that arise from this archaic, bilateral market structure. Most crucially, because the Fed still refuses to enforce any type of credit margin discipline over the CDS markets by raising collateral requirements to realistic levels, the short-selling pressure of C and other wounded money centers is magnified many times above the true pool of investors with hedging needs. Yesterday's trading in US bank names is a case in point.

Unlike a centralized exchange where an impartial counterparty holds the cash, the bilateral relationships in the CDS market lead to gross under-collateralization of CDS trades which are, in turn, governed by separate collateral security agreements. This leads to what one participant calls "a dirty float," where counterparties keep minimal collateral with one another and thus nobody is sure whether their contracts are money good. It is thus possible to run short positions against banks or other names and have virtually no collateral backing these trades, both for dealers and their customers. Why should the citizens of the industrial nations tolerate the existence of this unsafe and unsound market for another moment longer?

By failing to enforce margin limits on CDS leverage while investing new capital in C, BAC and other large banks via the TARP, the Fed and Treasury are essentially trying to fill up a bucket with a hole in the bottom. Providing new capital to wounded banks is pointless if you are going to allow the remaining street dealers to short bank stocks with impunity and virtually no collateral. To fix the systemic risk issues with the CDS market permanently and also provide a much need additional buttress to the bank rescue efforts by the Fed and Treasury, here is what we would suggest.

First, the Fed and Treasury should prohibit the writing of new CDS on any financial institutions that is participating in the TARP. Instead, the Fed and Treasury should interpose themselves as counterparties for these names, writing CDS for any and all counterparties and capturing the revenue for the US Treasury. This change can be accomplished unilaterally, without notice or Congressional authority, pursuant to the safety and soundness provisions of 12CFR. After all, since the government is already effectively backing the liabilities of these insolvent firms, the taxpayer has first claim on any insurance premiums written against such public support. It is absurd for the government to allow private speculators to profit by trading against public-guaranteed liabilities of banks that participate in the TARP. Unfortunately, Chairman Bernanke and his colleagues at the Fed are still not willing (or able politically) to enforce prudential rules on the CDS casino.

Second, the Fed and Treasury, via legislation if necessary, should propose changes to the legal configuration of the CDS contract that will take it away from the OTC FX/interest rate model used by ISDA over the past decade or more. Regulators should require that CDS contracts be exchange traded, but with collateral and delivery requirements that mirror not the cash settlement world of OTC FX and interest rate OTC contacts, but instead based on the basic model of the exchange traded world of physical commodities, but priced based upon the risk measures used in the insurance industry.

While it is entirely appropriate for exchange traded instruments like the S&P 500, Eurodollar futures, or OTC interest rate swap and currency contracts to settle in cash, allowing cash settlement in CDS has opened a Pandora's Box for bank managers and investors, who must manage both the market and credit risk of dealing in these contracts as de facto central counterparty, while at the same time being attacked by their clients who are shorting the bank's equity and debt! Remember, a speculator must only agree to pay for CDS based upon the short-term yields on the underlying bonds -- a price that does not even begin to approximate the true cost of funding a short put position in the underlying basis upon default.

When traders use CDS to build short positions on C, BAC and JPM as part of equity volatility trades and similar short-term strategies, they are increasing the cost of the TARP bailout to the taxpayer while at the same time adding to the overall instability of the financial system. As we've said before, if there were nothing wrong with the basic model for CDS, then there would be no need for the industry to have torn up $30 trillion in notional amount of contracts during the past year!

The basic model for a CDS contract does not really fit the needs of investors or the real economy, who are in the most simplistic terms looking for a practical way to hedge an illiquid corporate bond. Unfortunately, most corporate bonds cannot be borrowed in the securities lending market, WHICH MEANS THAT THERE IS NO TRUE CASH BASIS FOR SINGLE NAME CDS. Faced with this issue, the happy squirrels at ISDA came up with cash settlement as a way to ensure the astronomical growth of CDS - never realizing that in so doing, they were also magnifying the overall level of risk in the global financial system many times over and above the actual "basis," represented by the bonds specified in each CDS contract.

CDS are a great tool for playing/managing volatility in time of low or no defaults. In the period 2002-2007, when the CDS market was growing many times faster than the underlying real economy and corporate default rates were virtually zero due to the plenitude of credit, using CDS to trade volatility produced huge paper profits to dealers. But now that all types of default rates are rising and credit spreads are widening, the cost to the system of a CDS contract -- which requires the seller to fund the par value of the underlying security, less recovery value -- is a dead weight around the neck of the global financial system.

As we've noted before, CDS contacts are high-beta risk, that is, highly correlated with the broad financial markets. Unlike natural disasters and other low-beat risks, where the frequency of events is relatively low and uncorrelated to the financial markets, in CDS the high degree of market correlation ensures that most or all of a portfolio of single-name CDS contracts will deteriorate when economic conditions turn negative. There is no way to hedge such risk because it is entirely correlated to the broad market -- unless you happen to be a conservative P&C underwriter! The yield spread on a bond represents the current cost of renting money for a year, but it does not begin to describe the cost of refunding the entire security upon default!

What a shame the folks at American International Group (NYSE:AIG) forgot the centuries of experience that the insurance industry has with managing different types of risk. The widening sinkhole around AIG provides a case in point of what happens when a low-beta and high-beta portfolio are mixed without adequate capital and, more important, an understanding of the full downside funding risk. Recall that in the traditional, low beta world of P&C insurance, the assumption is that most coverage will never result in claims. In a broad portfolio of single-name CDS during a recession, by comparison, the assumption must be just the opposite.

As corporate defaults rise and recovery rates fall, the net funding required to perform on single name CDS must approach 100% of par. In such an event, the exercise of extant CDS contracts could theoretically consume all of the capital in the global banking system, several times over. How is this good public policy? Indeed, viewed from an actuarial perspective, the world of CDS makes no sense at all. In order for premiums to be high enough to make a high-beta portfolio of CDS contracts profitable in an economic sense, a new pricing methodology based upon true, medium-term default risk need be developed - but such a framework would be very expensive and might not be practical to implement.

So what is the solution? So us, the Fed and Treasury must immediately force the CDS market onto exchanges and go back to the pre-Delphi bankruptcy model to require physical delivery of the underlying bonds in order for purchasers of protection to collect their insurance payments. The Fed should also reinstate higher margin requirement for all securities and include CDS in a newly reformed margin regime. On single name CDS, the margin requirements for sellers of protection should approximate roughly 50% of the amount of the net exposure, roughly half the estimated recovery value less par. By imposing this Draconian requirement, the doubts as to funding of CDS and the related market fear, will disappear. Admittedly, these changes will have the effect of driving most or all of the speculative players out of the CDS market and make it a hedge-only market, but frankly there are many more liquid alternatives for traders, including exchange traded futures and options, to use to support volatility strategies, including short-sales of bank stocks. Allowing cash settlement CDS contracts to continue to exist and trade in their current form seems to be contrary to all of the efforts currently underway to stabilize the global financial system.

Unless and until Chairman Bernanke and the other regulator are willing to tame the CDS tiger, there will be no success in bringing stability to the US banking system or foreign banking markets. And the longer Bernanke & Co refuse to say an emphatic "no" to Goldman Sachs (NYSE:GS), JPMorganChase (NYSE:JPM) and the other CDS dealers, the financial crisis affecting global banking institutions will continue to worsen. Making this change may force GS and other dealers into mergers or liquidations, but such is the cost of reform. The US economy can live without the major Sell Side dealer firms, but we cannot survive without commercial banks, insurance companies and commercial companies, all of which are targets for the CDS Mafia and the unlimited leverage that they use as weapons against us all to generate speculative gains. We have the power to fix this aspect of the financial crisis immediately, but do our leaders have the courage and the vision to close down this reckless, speculative market before it destroys what remains of our economy?