Tuesday, March 31, 2009

Why Credit Default Swaps are Dangerous

From the Atlantic by Arnold Kling:

Felix Salmon says that credit default swaps are just like bonds. Charles Davi says they are just like futures and forwards (actually, they are most like options), which are derivatives that provide liquidity. But CDS are different from either of these.
The difference between credit default swaps and typical financial derivatives is the long-term nature of the commitment with CDS. On organized futures and options markets, it is essentially impossible to obtain a long-dated option. That is, if I want to buy an option that expires three years from now, I have no real chance of doing so. In most markets, such options are not traded at all. Even when there are option contracts that exist for more than six months ahead, trading volumes are slim, so that it is quite difficult to take a position of any size.

Long-dated options are only sold over-the-counter, with CDS being the main example. I believe that some currency swaps and interest-rate swaps sold over-the-counter also are long-dated. I suspect that those contracts are dangerous as well. If interest rates on Treasuries rise to double-digit rates in the next few years, then my guess is that some sellers of interest-rate swaps will blow up.

If you sell a long-dated option, then you need much more in terms of capital and loss reserves to cover your bet than is the case with options that expire over the next few months. Unless, of course, you are willing to take the risk of blowing up in a few years in order to get some nice profits in the near term. My guess is that if the writers of all forms of long-dated options were required to put up sufficient capital and loss reserves, the markets in those options would shrink considerably.

Speaking of capital, you need it in order to invest in bonds. But when you create a synthetic position in bonds by writing credit default swaps, you can do so without putting up capital. With bonds, investors who put debt or equity in your firm have a clear picture of what their risk and return profiles look like. With credit default swaps, you hide your leveraged bond position from regulators and investor.

There is nothing intrinsically opaque about credit default swaps. Regulators and accountants could require firms that are net sellers of credit default swaps to translate those positions into bond holdings and put these synthetic bonds on their balance sheets. My guess is that had such a policy been in place in 2000, the CDS market would not have taken off.

Comment from Derivative Dribble:

The collateral aka margin for a CDS is two ways, i.e., either party could end up posting, which means it is not like an option, but a forward contract. That said, the income of a protection seller is similar to that of a bond holder. So it's not an either or situation. The collateral operates like a forward contract but the economic exposure to the protection seller is very similar owning a bond.

The long-dated option issue you cite is largely dealt with through the use of collateral. CDS is a bilateral traded instrument, traded between sophisticated parties that want to get paid. To say they are dangerous is to say that at least one of those parties either doesn't want to get paid or doesn't know how to get paid.

Dinallo adds to watchdogs' calls for compulsory central clearing of CDS

In the Financial Times by Aline van Duyn and Joanna Chung:

Eric Dinallo, New York's insurance industry regulator, has added to calls by US regulators to make it compulsory for trades in the $28,000bn credit derivatives market to be cleared centrally.

Mr Dinallo said credit default swaps (CDS) - the most common type of credit derivative - were the major cause of the collapse of insurer AIG.

The damage caused was partly the result of a decision in 2000 to exempt CDS from state bucket shop laws, introduced after the 1907 financial crisis which prohibited betting on securities without some stake in the underlying asset.

"AIG Financial Products, the unit that sold almost $500bn of them [CDS], may therefore be viewed as the biggest bucket shop in history," he writes, adding that this experience meant regulators should once again revert to rules requiring capital to be held against insurance contracts such as credit derivatives, which pay out in the event of default.

"Credit default swaps must be regulated and sellers must be required to hold sufficient capital," Mr Dinallo writes.

"That will make credit default swaps more expensive, but it will also mean that the guarantee has real value."

Mr Dinallo, whose department regulates insurance arms of AIG but not its Financial Products division, said, in a subsequent interview, that making it compulsory for CDS to be cleared via a central clearing counterparty was one way to ensure there was sufficient capital behind the transactions. "This should be mandatory, unless a specific exception for a type of financial instrument is obtained," he said.

Concerns that defaults of a big counterparty in the derivatives market - such as AIG - would have a negative knock-on effect on other dealers linked through the privately traded CDS market has led regulators to push for clearing to eliminate such systemic risks.

The credit derivatives industry continues thus-far voluntary moves to transfer swathes of the CDS market to clearing houses.

Dealers will meet with the Federal Reserve in New York on Wednesday to discuss efforts to reduce CDS risks.

Industry participants have said mandatory clearing could be too expensive, potentially closing down the market for tailor-made risk-management contracts.

Mr Dinallo's comments echo those of Mary Shapiro, the new chairman of the Securities and Exchange Commission.

Last week, Ms Shapiro said in a Senate hearing that centralised clearing should not be voluntary.

"We do not have the authority right now to require that. We would strongly recommend that Congress require central clearing of CDS.

"I am not a big believer in voluntary regulation. And I think that this is an area where we need authority," Ms Shapiro said.

Fitch Reviews Asset-Backed Risk After Lehman Losses

Posted on Bloomberg by Neil Unmack:

Fitch Ratings is considering changes to the way it assesses counterparty risk in asset-backed bond deals to limit losses in the market roiled by the collapse of Lehman Brothers Holdings Inc.

The New York-based credit-rating firm will start seeking comment today from bankers, investors and regulators on proposals including requiring counterparties to put up more collateral against losses and preventing lower-rated institutions from taking on the role. Asset-backed bonds that don’t meet the resulting criteria may be downgraded.

“We don’t want to go out there and say ‘this is what you’ve got to do now,’” Stuart Jennings, a managing director at Fitch in London, said in an interview on March 27. “We need a dialogue with the market.”

Fitch downgraded 39 mortgage-backed bonds last year sold by Lehman’s Eurosail program where the investment bank was the counterparty, and in February cut Betula Funding 1 BV, a collateralized debt obligation that relied on failed Icelandic lender Landsbanki Islands hf. Standard & Poor’s is also reviewing counterparty risk in asset-backed bond deals amid the worst economic slump since the Great Depression.

Issuers of asset-backed securities enter into contracts with banks or insurers, known as counterparties, to hedge against potential losses caused by differences between the loans they package into debt and the bonds they sell to investors. These losses can result from differences in currencies and interest rates.

Injecting Collateral

Investors may suffer losses should a counterparty fail because they have to pay another bank to take on the role. Debtholders lost money after Lehman’s failure in September because the U.S. investment bank defaulted suddenly before a replacement could be found.

Fitch downgraded Betula Funding 1, which packaged buyout loans, by 12 steps last month to B, five levels below investment grade, because Landsbanki’s collapse exposed the transaction to currency and interest-rate movements.

The ratings company proposes counterparties set aside cash throughout the lifetime of an asset-backed bond to cover the potential cost of finding a replacement. Fitch currently requires counterparties post collateral if their rating is cut to below a certain level.

Government Support

Fitch’s alternative proposals include requiring counterparties carry the highest credit ratings or benefit from a certain level of government support. Such criteria would be less efficient at reducing risk than regularly posting collateral, and would limit the number of eligible counterparties, according to the ratings firm.

Another way of reducing risk may be for banks to set up a clearinghouse for counterparty agreements used in asset-backed deals, the ratings firm said.

Fitch will publish final requirements for asset-backed bonds after a one-month consultation period and give issuers of the securities time to reorganize deals to avoid downgrades.

Fitch will also review its criteria for counterparty risk in so-called covered bonds, which pool mortgages and other loans but differ from asset-backed debt in that the assets remain on the issuer’s balance sheet, Fitch said in a separate statement.

The covered bonds criteria will be “broadly consistent” with the asset-backed debt rules, the statement said.

S&P will “update the market once it’s finished” its own review of counterparty risk announced in October, said Mark Tierney, a London-based spokesman.

Thomas Lemmon, a New York-based spokesman for Moody’s Investors Service, wasn’t immediately available for comment.

Sunday, March 29, 2009

Big Bang Theory: Fixing Annuity Risk by Recouponing CDS

Posted on "A Credit Trader":

Pop-quiz! In which market can you actually lose money by being too right? Well, credit derivatives, where else? Read on for an explanation.

One of the recent Big Bang changes in the CDS market has been the recouponing of CDS to 100bp or 500bp. This change achieves two things: enhances fungibility and liquidity for clients and solves the vexing risky annuity issue that has brought much pain to dealers throughout the years.

Why Recoupon CDS?
To illustrate the basic motivation for the recouponing change consider a reference entity that has one bond outstanding and no loans. Trading the credit of this company is pretty easy: you’ve got a single security with a fixed coupon and an observable market price.

Now imagine that CDS starts trading on the name. Each day the spread moves you’ve got a different tradable product out there whether at 100bps or 150bps or 500bps or even upfront + 500bps running. So if a dealer does 10 bond trades, he’s either paying or receiving the coupon on the bond so the trades net out, nice and simple. However, if the same dealer does 10 CDS trades, it will likely have 10 trades all with different coupons and hence with different time decay, convexity and duration profiles, making risk management more difficult. Here, by the way, we are not even considering potentially different restructuring clauses, lookback credit event effective dates, roll dates and accrual periods.

Why not simply unwind previous trades, rather than put on new trades? Well, unwinding previous trades essentially means trading in off-market CDS which, as first time CDS participants quickly find out, carries an extra bid/offer cost – in fact, when quoting a level many dealers will explicitly ask you whether it’s for a new trade or an unwind of an existing position. The other problem is that only clients (i.e. buyside firms) can unwind CDS with dealers, not the other way around. In other words, dealers cannot exactly call up a client and ask them to unwind CDS trades just because it suits the dealer’s book.

So, if dealers charge extra for unwinding existing CDS positions, why don’t clients just put on new trades? The quick answer is that the practice guarantees continuous growth of the CDS book which will significantly stretch risk management/systems resources of small funds. The extra complexity comes not only from booking the trades, but also from calculating daily exposure and managing collateral on the positions. Also, by doing new trades, rather than unwinding existing positions, a fund will add counterparty risk, which it may need to manage by buying protection which adds even more trades to the book.

Enhanced Fungibility
Moving CDS to fixed coupons will make CDS trades more fungible and increase liquidity by making all trades “on-market”. This is all well and good and ensures that clients are happy as they will no longer be ripped off trying to unwind existing positions with dealers or suffering operational burden from the explosion of the trading book or having to manage dealer counterparty risk. These are all solid reasons for the recouponing. However, I would argue that the biggest beneficiary of the recouponing will be dealers as the change will eliminate the dreaded risky annuity risk which has been the bane of CDS risk management for a long time. What is risky annuity risk?

Risky Annuity Risk
To illustrate risky annuity risk, consider the following. Let’s say a dealer bought protection on a name at 100bp. The name subsequently widens and the dealer does a new trade selling protection at 300bp. From the looks of it, the trader should be happy as he is now flat the name and has booked a profit of 200bp running. Assuming $50mm notionals on each leg and a risky duration of 4.5, the trader is up $4.5mm on the trade (a simple present value calculation of 200bp for 5 years) – off to the bar with the lads!

A month goes by and the trader is focused on other things. A headline flashes across his bloomberg screen – the company in question has just filed for bankruptcy. Given that he is “flat” the name, he shouldn’t care. Yet he does – in fact, he has just lost $4.5mm. The problem, of course, is that the 200bp annuity he is receiving is risky to the survival of the company. If the reference entity suffers a credit event, both CDS are triggered and the coupon streams go away.

This is why it isn’t always fun being the dealer and making bid/offer on CDS. Clients can come back to the dealer and unwind existing trades (if at a higher cost than new on-market trades). Dealers do not have this luxury – and their books are spider webs of risky annuities with very significant jump-to-default risks that are essentially unhedgeable. The heads of credit desks did not have a happy time having to explain to CEO’s why they periodically lost tens of millions of dollars on credits that they were flat or even short. CEO’s quickly got up to speed with the fact that you can be short delta but long jump-to-default risk.

In fact, this was such a pressing problem that several dealers have attempted to create products to manage this risk. One of these products was an Annuity CDS which essentially turned a risky annuity into an upfront payment. However, since these products would never be as liquid as standard CDS and that they essentially solved a problem for dealers without offering any particularly compelling features to clients, they failed to take off.

Recouponing CDS is the right, if belated, step in the right direction for the market which should make both the buy and sellside a touch happier in these otherwise difficult times.

Saturday, March 28, 2009

Recoveries: Down and Out

Posted on "A Credit Trader":

Taken out to the woodshed and shot” is a phrase you often hear from CDS traders when one of their names blows up. The same can easily apply for recovery rates in the last few months across the credit markets.
High grade data: 2007 had 1 default and was taken out of the sample

High grade data: 2007 had 1 default and was taken out of the sample

This year’s trend is falling:


When Lehman Brothers went bust, its bonds were trading in the low 20s, which for a market used to 40% recoveries (and recovery marks in the 50s for Financials) was shockingly low. A saving grace was that the bonds were expected to trade up as typically happens, especially in cases when CDS notional outweights outstanding bond principal which was true in this case. FT estimated that CDS notional was $400bn vs. $127bn of the bonds. (It’s not clear what seniorities went into this estimate or whether FT took other deliverable obligations i.e. loans into account).


That bonds are expected to trade up post a credit event was a precedent largely formed around the Delphi credit event in late 2005 when bonds hit a local low exactly around the weekend bankruptcy filing and then traded up. This effect was believed to be due to buyers of protection seeking bonds to deliver into the credit event settlement. In reality, you could, theoretically, settle a credit event with a single bond (just passing the fax back and forth). The price action was also possibly due to the “buy the rumour, sell the fact” phenomenon, when the bankruptcy was priced in and the actual filing left the field open to distressed players who saw value in the assets.

What actually happened, unlike in the case of Delphi, was that Lehman bonds started falling in price. And they didn’t stop until the credit event auction held about a month later. The recovery at the auction was 8.625%.

Reasons for Falling Recoveries

Excessive subordination: A top heavy optimized capital structure of many companies that favored loans over bonds will cause senior unsecured recovery to fall dramatically.

Liquidation possibilities: Many consumer sensitive sectors have witnessed large declines in earnings that have left them with high leverage. Normally such firms would be valued as a going concern however those that started out the cycle with high leverage (such as the 2006 private equity vintage) may face difficulty obtaining DIP financing which increases the chance of their liquidation.

Supply: There is a strong correlation between default rates and recoveries which is likely a symptom of excessive leverage but also of large supply of distressed paper. With many investors still sitting on the sidelines, a flood of distressed debt will not find a strong bid.


Recovery Valuation

Default rates
To get a rough idea of market-wide recovery expectations, we can use the graph above. Current expectation of the default rate maps to a mid 20’s recovery, which is about 2 standard deviations below the historic average.

Recovery locks
A recovery lock is a tradeable product that allows investors to isolate and monetize their views on recoveries. It consists of two credit default swaps: one vanilla (i.e. floating recovery) and one with a fixed recovery. Depending on his view, the investor buys the protection on one and sells the protection on the other. Upon a credit event, both CDS are triggered and the resulting cashflow is the difference between the actual and fixed recoveries. You don’t have to wait for a default to make money on the trade, as a move in the recovery market will lead to P/L on the position.



Recovery locks tend to trade in distressed names at 5-10% bid/offer in the 5y tenor. Liquidity is increasing and markets are being made in 30+ names.

Recovery locks nicely dovetail into DDS or digital default swaps which pay out a fixed unit of $1 upon a credit event. There has been a consistent push to replace vanilla CDS by DDS whch will allow the market to essentially trade the probability of default rather than both probability of default and recovery. It will also make unwinds much more transparent as there will be no argument about which recovery to use. The problem with DDS is that the product is not a perfect hedge for a bond position as a recovery view will need to be made and translated into the notional of DDS.

CDS spreads and expected default rate
In the valuation of a CDS, there is a relationship between three variables: spread, default rate and recovery. Any two will give you a result for the third. Though normally, the traded spread and marked recoveries are used to come up with the expectation of default, the relationship can be used in the other direction given a fundamental view on the default rate and market traded spreads giving us the expected recovery.

Capital Structure Arbitrage
In some sectors, especially in Financials, CDS trades across the capital structure. We can use the fact that the probability of default is the same for senior unsecured and subordinated bonds, due to cross-default provisions, plus an estimate of the recovery of one of the CDS in one part of the capital structure to find the market expectation of the recovery of another part of the capital structure. This is the relationship:

Odds-and-ends: Jurisdiction, Sectors and Ratings

Europe has tended to have lower recoveries than US due to the fact that companies are normally liquidated rather than allowed to restructure as under the Chapter 11 process, though this has recently changed. The threat of liquidation means there is less of a premium for the probability the company comes out of bankruptcy. Also, a company that is more likely to be liquidated is going to try harder to milk its assets to the last drop to survive which will result in lower recovery.

Sectors have tended to have different historic recoveries with Utilities the highest (as these companies own hard assets) and Telecoms the lowest.


There is also a correlation between the rating of a company and its subsequent recovery as a slow bleed of a company’s assets is more likely to result in downgrades as well as lower recoveries.


Low recoveries is just another symptom of the excess leverage and stress in the credit markets. Equity tranches held by banks are likely to have been completely written down by now. The danger is that investors in the mezz and senior parts of the ABS/Corporate capital structures will take an actual hit (rather than an MTM hit) that will cause severe losses within pensions funds, insurance companies and municipalities.

Friday, March 27, 2009

US commercial banks lost $9.2bn on derivatives trades in Q4 08


The Office of the Comptroller of the Currency is an under-remarked institution, given its mandate:

The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises all national banks. It also supervises the federal branches and agencies of foreign banks. Headquartered in Washington, D.C., the OCC has four district offices plus an office in London to supervise the international activities of national banks.

The OCC also produces useful quarterly reports on the trading and derivatives activities of the banks it supervises - like this one, released on Friday, which details just how poorly commercial banks fared in the fourth quarter of last year:

U.S. commercial banks lost $9.2 billion trading in cash and derivative instruments in the fourth quarter of 2008 and for the year they reported trading losses of $836 million. The poor results in 2008 reflect continued turmoil in financial markets, particularly for credit instruments.

Other interesting factoids from the report include (emphasis FT Alphaville’s):

The notional value of derivatives held by U.S. commercial banks increased $24.5 trillion in the fourth quarter, or 14%, to $200.4 trillion, due to the migration of investment bank derivatives business into the commercial banking system

Derivative contracts remain concentrated in interest rate products, which comprise 82 per cent of total derivative notional values. The notional value of credit derivative contracts decreased by 2% during the quarter to $15.9 trillion. Credit default swaps are 98% of total credit derivatives.

Derivatives activity in the U.S. banking system is dominated by a small group of large financial institutions. Five large commercial banks represent 96% of the total industry notional amount and 81% of industry net current credit exposure

Foreign exchange trading revenues rose 32% to a record $4,093 million. Foreign exchange contracts continue to provide the most consistent source of trading revenues.

Credit trading continues to drive trading losses, as banks lost $9.0 billion in the fourth quarter, compared to $2.5 billion in third quarter gains. Banks had record losses trading both interest rate and equity contracts, losing $3,420 million and $1,229 million respectively.

Revenues from commodity trading activities fell 1% to $338 million.

There is also fascinating detail on credit risk and net current credit exposure, which increased by $364bn - or 84 per cent - in the fourth quarter to a record $800bn. Note, however, that gross credit exposure declined by almost 90 per cent from $7,100bn due to bilateral netting agreements.

OCC chart of credit exposure of US commercial banks

There’s quite a lot of chart porn in the report for those of you so inclined, but FT Alphaville thinks one of the best bits of the report is table one on page 22, which shows the notional amount of derivative contracts held by the top 24 commercial banks and trust companies as of Dec 31 2008, in $m.
And the top five, ranked by total derivatives, are:

JP Morgan Chase Bank NA - $87,362,762
Bank of America NA- $38,304,564
Citibank National ASSN - $31,887,869
Goldman Sachs Bank USA - $30,229,614

The fifth-ranked bank, HSBC Bank USA National ASSN, clocks in with a comparatively minor $3,713,075.

When ranked by holding companies, the ranking is as follows:

JP Morgan Chase & Co - $87,780,914
Bank of America Corporation - $39,081,848
Citigroup Inc - $33,424,365
Wells Fargo & Company - $$5,105,850
HSBC North America Holdings Inc - $3,660,305

And then there’s Table 7, reproduced below (click to enlarge):

OCC table of trading revenues (small)

Of the top five banks listed in that table, only one made money from trading cash instruments and credit derivatives.

No prizes for guessing that bank was Goldman Sachs.

Now, go download the report, not least because the OCC saved the best table for last.

Wednesday, March 25, 2009

One Way to Stop Bear Raids: Stricter Regulation for CDS

In the Wall Street Journal by George Soros:

In all the uproar over AIG, the most important lesson has been ignored. AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bonds ought to be allowed to buy them. Instituting this rule would tame a destructive force and cut the price of the swaps. It would also save the U.S. Treasury a lot of money by reducing the loss on AIG's outstanding positions without abrogating any contracts.

CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes them toxic is that such speculation can be self-validating.

Up until the crash of 2008, the prevailing view -- called the efficient market hypothesis -- was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don't deal with the current reality, but with the future -- a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. (I call this feedback mechanism "reflexivity.")

With the help of this new paradigm, the poisonous nature of CDS can be demonstrated in a three-step argument. The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.

The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.

AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.

The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.

Taking these three considerations together, it's clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination. And AIG failed to understand this.

Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. Under this rule -- which would require international agreement and federal legislation -- the buying pressure on CDS would greatly diminish, and all outstanding CDS would drop in price. As a collateral benefit, the U.S. Treasury would save a great deal of money on its exposure to AIG.

Commentary by A Credit Trader in italics below:

• AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. Perhaps I’m reading in too much into this sentence but to expect AIG to somehow have hedged or offset its CDS trades is akin to an insurance company kidnapping sick people who have bought life insurance and sticking them in incubators to prolong their life. AIG sold protection because it viewed selling CDS as an insurance business. The oft-uttered phrase that AIG was a hedge fund are missing the point that these trades were buy-and-hold; AIG was not in the business, unlike a hedge fund, of dynamically trading in the market.
• What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated. I like when the conclusion is stated upfront without any salient points.
• It [heavily regulating CDS] would also save the U.S. Treasury a lot of money by reducing the loss on AIG’s outstanding positions without abrogating any contracts. In fact, the US Treasury had three options in dealing with AIG’s trades: 1) take over AIG and have AIG’s counterparties face the government, 2) post enough cash to cover AIG’s collateral calls, 3) unwind AIG’s trades. It chose 3 which I think is the worst option as a) it locks in massive losses, b) it does so at the absolute wides of the market (spreads naturally blew out as soon as the market realized AIG was in big trouble), c) it commits the most amount of cash upfront.
• Since they [CDS] are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. CDS can be used as easily to go long risk as short risk. In fact, for each nefarious speculator betting on the demise of the poor company by buying protection, there is an avenging angel who is sitting on the other side of the trade and is a seller of protection. While, it is true that there can be heavy one-way flow in CDS on the back of strong protection buying or selling which will drive the market in one direction, the dealers obviously adjust the CDS levels up or down based on this flow at which they are happy to take the other side of the trade.
• Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. “Reflexivity” strikes again. I don’t think it has ever been news that the prices of assets affect investor psychology which will, in turn, have an effect on the prices of financial assets. This is certainly true of all other assets including CDS.
• Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. If the CDS product payoff profile is so skewed in favor of buyers of protection, why did credit spreads rally for many years until 2008. Also, if the average price of a high yield bond is in the 50s vs. an average historic recovery (yes recoveries in this cycle will be lower) of 40 – that suggests that the payoff profile is in favor of protection sellers, not buyers. Finally, gamma is on the side of protection sellers as well as duration increases as spreads rally – in other words, a protection buyer makes less marginal dollars for each basis point of widening in spreads since risky duration goes down. This can be seen via the Merton debt/equity model as well. Also, for distressed names, protection tends to be priced upfront which means that buying protection in expectation of a quick default is actually quite expensive.
• People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. I don’t understand what is wrong with this. If the risk of default increases, protection should be more expensive. That’s called a fair market.
• AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk. AIG was insuring mark-to-market risk rather than default risk which is where they went wrong.
• A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating. Lehman went bust largely because it could not raise short-term funding, not because of any CDS pressure. A rating downgrade caused the stock price to fall, making it difficult for Lehman to raise enough cash by issuing equity which caused rating agencies to downgrade it further, leading…. Also, Morgan Stanley CDS traded wider than Bear or Lehman and yet it miraculously survived. I guess reflexivity is only invoked when it works, kind of like those technical indicators.
• I believe that they [CDS] are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. What is wrong with speculation as such? Should we ban short-selling in stocks forever and ever? Metalgesellschaft lost a lot of money on commodities and Orange county on moves in interest rates. Let’s ban those as well. Also, reading this sentence suggests that CDS can only be by those who hold bonds. So, will sellers of protection be required to hold bonds as well. I’m sure this is not what Soros meant, just thought I’d be cheeky.

CDS Clearing Platforms, Make Some Strides

From Futures Industry by Joanne Morrison:

For months there has been extensive preparation, but yet no derivatives clearinghouse has begun clearing credit default swaps. And while there is widespread agreement that clearing is a way forward for this $27 trillion market, numerous obstacles continue to delay a robust launch. Lawmakers and regulators are vying for turf in both the U.S and Europe; the instruments to be cleared must be restructured and standardized; and some of the more complex instruments may never be suitable for clearing.

Even so, the migration to clearing is making progress. NYSE Liffe, the London-based futures exchange owned by NYSE Euronext, was the first to hit the marketplace. In December it began offering CDS index clearing through its Bclear service in conjunction with LCH.Clearnet. As of early February, however, the platform had not handled any contracts because of delays in firms connecting to the platform.

Three others are in varying stages of readiness. CME Group is close to completing the regulatory approval process for its CMDX platform, a joint venture with hedge fund Citadel. ICE Trust, a new clearinghouse created through IntercontinentalExchange’s acquisition of The Clearing Corp., is also waiting for regulatory approval, while Eurex says it is on track to begin clearing index-based contracts by the end of this quarter. (See “Financial Woes Change Landscape for Credit Derivatives” in Outlook 09.)

Central clearing is indeed something the major CDS dealers want to achieve and they have committed to doing so both in the U.S. and Europe. Most recently, a group of nine firms in a Feb. 17 letter to European Commissioner Charlie McCreevy vowed to clear certain European-based contracts on a system regulated there. The details of determining which contracts would have to be cleared this way are not finalized. The nine firms said they would “work to resolve” outstanding technical, regulatory, legal and practical issues by March 31 and committed to a July 31 deadline for clearing those contracts that are deemed eligible for clearing.

But before clearing can take off, major changes must be made in the underlying market. Industry experts say clearing will not gain any real traction until the major market participants agree to standardize contract design and trading practices. In another move toward that goal, the Depository Trust & Clearing Corp. in January said it would support all central clearing solutions with its trade information warehouse in a non-discriminatory way.

Efforts to standardize contracts are well under way. By early March, industry leaders expect to have made some significant changes in CDS contracts including establishing standardized coupons of 100 or 500 basis points; shifting to cash settlement from physical settlement; and changing effective dates to the trade date less 60 days. The industry is also working toward agreement on a standard auction process for settling trades and removing “restructuring events” as one of the triggers that require payment under the contract terms.

“Increasingly, now the whole industry has come to the same realization…that we really need to restructure the design of the product and make it so that it is more clearable, so that it can be netted and so that it can be more standardized,” Intercontinental­Ex­change chief executive officer Jeffery Sprecher said in early February.

“The timeline is predicated on our work to solve a range of structural issues that, once resolved, will create a new risk management framework, enabling the credit industry to grow,” said Sprecher, who made the comments during a conference call to discuss the exchange’s quarterly earning results.

Another factor is the operational challenge in establishing connections between the central counterparties and market participants. Although the large banks that dominate the credit derivatives market have futures divisions that are fully integrated into the clearing process, credit derivatives are typically handled by a different division of the bank. Exchange officials say that it could take several more months before dealers and banks have completed their preparations to connect their systems to the clearinghouses.

“We have to be able to interface with the community of users who will be active with us and that will be the next step,” said CME chief executive officer Craig Donohue in a conference call to investors on Feb. 3.

Pressure for a European Solution
Lawmakers and regulators on both sides of the Atlantic, frustrated by the slow progress, have threatened to take regulatory and legislative steps to ensure a migration to clearing for this bilateral market.

But the February commitment from leading CDS industry participants to clear qualifying contracts on a European platform by the end of July 2009 was welcomed by regulators in Europe. “This meets requests I made to the industry last October,” McCreevy said of the commitment made by the nine firms—Barclays Capital; Citigroup Global Markets; Credit Suisse; Deutsche Bank; Goldman Sachs; HSBC; JP Morgan Chase; Morgan Stanley and UBS.

One reason for the dealers’ willingness to make this commitment was to stave off the threat of increased capital charges. Pervenche Beres, chairwoman of the European Parliament’s committee on economic and monetary affairs, had drafted an amendment to the EU capital requirements directive that would impose higher capital charges on banks that do not clear CDS trades in Europe. Anthony Belchambers, chief executive of the U.K.’s Futures and Options Association, has raised concerns about this change to the capital rules. “Where does that leave the tailored transactions, which don’t lend themselves to a central clearing system,” he asked.

“We need to be careful with regulations with capital incentives. We want to make sure that they don’t have perverse implications for the markets,” warned Belchambers.

Regulatory Turf Battle in the U.S.
Concerns are also high in the U.S. where lawmakers are drafting laws that would vastly change how the OTC derivatives markets function.

“The failures of AIG, Lehman, Bear Stearns, and other institutions have shown us that it is time for some transparency in the market for credit derivatives,” House Agriculture Committee Chairman Collin Peterson (D-Minn.) said in early February.

The lawmaker’s bill, which passed the House Agriculture Committee and now must be considered by other House committees, would encourage the clearing of standardized CDS contracts as a way to reduce systemic risk. Representative Peterson is adamant that any CDS clearinghouse or trading system should be regulated by the Commodity Futures Trading Commission, or the Securities and Exchange Commission but not the Federal Reserve.

“I’m flat-out opposed to the Fed having a role in clearing or overseeing these products,” said Peterson in early February. “I share the concerns of those who think the Fed controls too much already. They are an unelected body that sets monetary policy, oversees its state member banks, oversees holding companies, and now they are printing money for the bailout. I am not surprised that the large banks are clamoring for the Fed to regulate derivative activity, given their cozy relationship with Fed members.”

Peterson’s view puts him in opposition to Representative Barney Frank (D-Mass.), the chairman of the House Financial Services Committee, and Tim Geithner, the new Treasury Secretary and former head of the Federal Reserve Bank of New York. Both Frank and Geithner believe the Fed should have a role in overseeing CDS clearing.

Yet another player in this game is the Securities and Exchange Commission. In late December the SEC granted exemptions allowing NYSE Liffe and LCH.Clearnet to offer CDS clearing through their Bclear service. The exemptions will expire in September, however, and they are subject to review under the agency’s new head, Mary Schapiro, who has told U.S. lawmakers repeatedly that standardized CDS contracts must be cleared through regulated clearinghouses. “I absolutely believe that credit default swaps need to come under the umbrella of federal regulation,” Schapiro told the Senate Banking Committee in January just days before being confirmed and sworn in to her post.

But efforts to better coordinate are being taken. U.S., U.K, and European regulators are in talks to jointly oversee the credit default swaps market and clearing in particular. “Representatives from regulatory agencies with direct authority over one or more of the existing or proposed credit-default swap central counterparties (CDS CCP) discussed today possible information sharing arrangements and other methods of cooperation within the regulatory community,” the Federal Reserve said in a Feb. 19 statement.

Support in the Marketplace
Despite the regulatory and technical logjams, industry experts are confident that clearing will indeed be part of the CDS picture.

Risk managers at both buy-side and sell-side firms are eager to see clearing adopted so that their firms are better positioned to value portfolios and hedge against counterparty defaults.

“I think what we are seeing right now is a fear bubble and it’s really driven in part by fear of counterparty default,” said Robert Park, chief executive officer of Fincad, a Vancouver-based firm that provides derivatives analytics and valuation models to more than 3,500 banks, funds and other institutions including JPMorgan Chase, Deutsche Bank, Alliance Bern­stein, Citadel Investments and Tudor Investment Corp.

“We’ve got this land grab rush going on between the various clearinghouse efforts and I think in general that’s a very positive move,” said Park predicting there would be one dominant clearinghouse in the U.S. and one in Europe.

Sophis, a software firm that specializes in portfolio and risk management solutions, recently conducted a survey of risk managers and derivatives traders. Half of the respondents indicated that at least 50% of their CDS trades will move from OTC to clearinghouses. “What we found was that across the board people were pretty convinced that something was going to be done from a standardization process whether it was going to be regulatory or operational,” said Eric Bernstein, chief operating officer at Sophis.

For NYSE Liffe, CDS is Just the First of Many
Duncan Niederauer, the chief executive of NYSE Euronext, sees the debate over CDS clearing as just one part of a larger recognition that the trading of all OTC derivatives needs to be reformed. Credit derivatives will be just the first type of OTC contracts that the exchange hopes to bring onto the London-based NYSE Liffe Bclear service. This service is provided in partnership with LCH.Clearnet.

“It’s clear to all of us that one of the repercussions of the financial crisis will be that many products that have been traded opaquely in relatively unregulated environments will be forced by regulators to migrate to more regulated transparent venues,” he said on Feb. 9. “CDS is only the first of what I expect will be many OTC derivatives that move toward an exchange clearing model and represent a key area of future growth for us.”

Niederauer acknowledged that the take-up for CDS clearing on NYSE Liffe has been “slow or non-existent,” but said a “slower ramping up was expected” due to the complexities of the product and the difficulties in getting members connected to the system.

He emphasized that NYSE Euronext’s approach to clearing CDS will not “disintermediate” the dealers active in this market, in that the clearing service is not linked to trade execution. Regarding the structure of the clearinghouse—a key concern for clearing firms—Neiderauer said index-based CDS will rely on the existing guarantee fund, but he hinted at a different approach with single-name contracts.

“Even where the CDS market experiences extreme swings in volatility with a default of a major investment bank in September, the indices remained relatively liquid,” he said. “We do not believe that this is the case with single names so a new guarantee fund may have to be established to support the clearing of that product. “

NYSE Liffe officials say that they are aiming to clear single name contracts later this year, but say a number of technical details and risk issues need to be resolved first.

“There are all sorts of complicating factors from a risk perspective” said Simon Grensted, managing director of business development at LCH.Clearnet. “The problem for single name contracts centers around pricing, liquidity and ‘jump to default’ risks. There are quite a large number of credit derivatives which are not that liquid, and there are some quite interesting challenges in the ones that are liquid. The cost of margining and clearing has to be economically viable for the user.”

NYSE Liffe also has structured its pricing scheme to attract volume. Fees are charged in proportion to the notional volume, with some fee caps set for larger trades. Each 1 million euros of notional value will be charged 10 euros, up to the following caps of 100 euros for proprietary business and 400 euros for client business.

NYSE Liffe is offering a 40% revenue scheme for early users of the system. Those firms who signed up prior to Jan 31 will be eligible to take part in the incentive scheme. Under that plan 20% of net revenue will be shared with partners based on submitted volume and 20% on cleared volume.

Eurex Promises User Say in Governance
Eurex has been less specific about its plans, but has emphasized that it wants to give market users control over how the clearing process operates. Credit derivatives will be cleared by a separate company under the governance of an independent board, and up to 90% of the board members will come from clearing firms, exchange officials said.

“From a regulator’s perspective, central clearing is increasingly recognized as a key element of market integrity,” said Uwe Schweickert, senior vice president at the Frankfurt-based Eurex.

Eurex plans to start with contracts linked to series 7, 8, 9, 10 and 11 of iTraxx Europe indexes. There is no timetable for clearing single-name contracts. While the goal is to roll out clearing by the end of March, the ultimate timing for the launch depends in part on what happens on the regulatory front, Eurex officials say.

Clearing members will have to provide a minimum contribution of 50 million euros. That contribution is dynamic dependent on the risk exposure of the clearing member, translating into 3% to 7% of margin requirement.

CME Awaits Regulatory Approval
The CME has received CFTC and Fed approval for the CMDX clearing platform that it is developing with Citadel, but as of early February the launch was still pending SEC approval.

“We are in advanced states of review by the SEC and continue to make progress there. We continue to work actively with market participants to demonstrate the advantages of our offering and have begun to work with those participants on operational readiness,” said CME’s Donohue.

Once all the approvals are in place, this system will be able to clear all credit default swaps, including single-name. On the first day of launch, CME says it will be set to cover 75% of the market, including more than 500 reference entities and 40,000 contracts. One important characteristic of the CME clearing solution is that credit derivatives contracts will be converted into a futures contract once they are cleared.

To help lure CDS participants, CME and Citadel will allow up to a 30% stake to be taken by those CDS market participants choosing to act as founding members. Transactions cleared through CME will be backed by its $7 billion default fund, the largest of any counterparty in the world.

Margin requirements will be based on the risk in a portfolio with a model the CME has developed and will be designed to cover a 1 to 5 day move. Firms wishing to clear on the CME platform must have adjusted net capital of $300 million and they must have set aside minimum Tier 1 capital of $300 million. The minimum membership requirement deposit is $5 million with an additional security deposit requirement.

ICE Stresses “Dialogue” with Dealers and Regulators
Meanwhile, ICE is working closely with the leading dealers to finalize its acquisition of The Clearing Corp. ICE’s Sprecher is adamant that the acquisition is conditioned upon regulatory approvals to run a clearinghouse. “We are very, very interested in acquiring The Clearing Corp. The reason it hasn’t happened yet is we are only interested in acquiring The Clearing Corporation if it has a license to be able to clear CDS trades, so its closing is tied to our final regulatory approvals,” Sprecher said in an investor call after releasing ICE’s latest earnings.

Sprecher explained that what is underway now is more than just a routine application process. “What’s happened is there’s been an interactive dialogue going on around the restructuring of the CDS industry and how some of these pieces come together. That ongoing dialogue involves many, many regulatory agencies [and] many, many market participants and our clearing and post-trade infrastructure is trying to get this put into place so that it can all be solved at the moment in time that this launches,” said Sprecher.

One key advantage to the ICE system is that the major CDS dealers are already linked into the system through Creditex, which is owned by ICE and has conducted 40 portfolio compressions together with Markit since August. Sprecher warns though that even a good platform is of no use without structural changes in the market. “I really feel like there’s a broad recognition in the market that the current product is broken… So while people are making money right now, there’s a general sense that it is not sustainable.”

Friday, March 20, 2009

Did CDS Cause Global Warming? – Confronting the Crisis Backlash

Posted on The Credit Trader:

Outside of penning diatribes against AIG bonuses, blaming CDS for the current crisis has been the most popular topic of late. Perhaps we can ascribe this to the fact that “credit” often goes alongside “crisis” in the press or the fact that AIG was caught with its pants down writing worthless protection, I’m not sure. In any case, I think it’s gone a touch too far.

For fear of becoming yet another CDS pundit, I will (try to) keep this brief and return as quickly as possible to interesting things in the credit markets like the current recovery regime as well as credit/equity relative value. (Please feel free to suggest topics in comments or via email).

Mind you I am not a leave-the-CDS-market-be zealot; I do think it needs changes. In particular, we need a way to deal with counterparty risk. We also need to standardize contracts to ensure liquidity and fungibility (this includes restructuring clauses, fixed coupons, hardwired cash settlements etc.). Both of these issues will be covered by the establishment of the CDS Clearinghouse.

Morgan Stanley

Morgan Stanley

Now let’s run through some things that have been mentioned in the press/blogs about CDS.

But CDS is outstanding is $55trn – that’s equivalent to world GDP! – Bill Gross

Yes and the outstanding notional of Interest Rate Swaps is over $300trn, should we ban that as well? The $55trn figure, of course, ignores both the netting of risk (according to ISDA, after offsetting exposures, the true risk is 3% of the headline $55trn number) as well as the recovery (historic average of 40%) .

Now, we can argue that $10mm notional in IRS is not equivalent to $10mm notional in CDS given the different nature of tail risks in the two products, though here I would point to some emerging market countries that have had short-dated rates north of 100% meaning the exposure on a IRS could actually be greated than in a CDS.

But CDS was designed to disperse risk. Now we realize that it was, in fact, concentrated – Gillian Tett

CDS was not designed to disperse risk, per se. Instead, It was designed to do two things:

  1. allow banks to get regulatory capital relief on their loan books letting them free up capital
  2. allow banks to more efficiently manage credit risk (without CDS, a bank would have to sell the loans to get rid of the exposure, which is something it would be loath to do as the reference entity is likely to discover this, putting the banking relationship at risk).

But CDS contract language is complex and credit event settlements may not work as advertised – Satyajit Das

First, CDS language is actually not that complex if you’ve read the ISDA. Second, if the language is “complex” then it’s because CDS deal with low-frequency and potentially large contingent liabilities which are important to get right. In fact, I would use the word rigorous rather than complex. As far as auction settlements, witness the 30+ smooth instances in the last three years, especially in the case of Lehman and the agencies.

On the second point, Das uses the example of the Delphi settlement writing “Delphi had 37% recovery when recovery was set by Fitch at 1-10%”. This is very misleading. The 37% recovery was a level where a) Delphi bonds were actually trading at the time of the settlement and b) where holders of bonds could be made whole against their protection positions (in any case the holder of bonds and CDS does not care where the auction recovery is settled since the P/L on the bond is offset by the CDS regardless of the actual recovery).

My guess is that the Fitch recovery numbers was a fundamental view of where the recovery would be on the bonds had Delphi gone through the workout process. This number really has no bearing on CDS (as CDS is not designed to hedge against the final workout price), especially if your view is that Delphi intends to come out of bankruptcy protection which tends to be the case with American companies.

But AIG failed because of CDS

This one is pretty hard to argue with. Yes AIG wrote massive amounts of protection on supersenior tranches of ABS CDOs. As spreads widened, it had to post increasing amounts of collateral. Further, a downgrade triggered ratings-based collateral triggers which quickly led to its demise.

Here I would argue that it wasn’t CDS, as such, that led to the failure of AIG. Rather it was the regulatory/ratings/trading environment of CDS.

First, AIG never had to post collateral when it entered the trades, something which led them to view the business as “free money” and likely caused them to sell more protection than they would have otherwise.

Second, collateral postings were not managed well as AIG had continuous disagreements / negotiations with its counterparties on the amounts to post. Presumably, if they were required to post collateral daily they would have acted sooner to unwind their positions.

Third, ratings-based triggers exacerbated the problem as such triggers are procyclical and subjective.

I would also argue that CDS should not be considered by insurance companies as a business opportunity. I and others have commented on the high correlations (both between individual bonds in the CDO as well as performance of CDO’s in an extreme event). I will just add two points that further draw a distinction between CDS and proper insurance policies.

  • First, the obvious difference between a CDS and a proper insurance policy, such as flood or fire insurance on a home, has to do with the fact that a CDS is synthetic while a home is “funded”. What that means is that I can write as much CDS as my heart desires (the outstanding principal of a bond has no bearing on how much CDS can be traded) while you can write only a single insurance policy on a home. This automatically limits the amount of exposure insurance companies can take on (ignoring further the reserves they need to hold against this policy).
  • Second, lets’s say you are a proud owner of a fire insurance policy on your home and one day you spot a man having a cigarette 30 feet from your home. Will you call your insurance company and demand collateral given the increased risk of fire? Probably not, but this is what happened in the case of CDS (yes I am simplifying, of course)

On the collateral side, clearly it was a mistake to let AIG and the monolines not post collateral. Establishing a clearinghouse will make sure this won’t happen in the future. However, apart from these two cases, margin requirements on CDS do exist and are followed rigorously. Hedge funds do post collateral to dealers when they trade CDS. It’s true that some hedge funds have to post minimal amounts, however those funds open up their books to dealers. In fact, in the case of Lehman, ISDA commented that 2/3 of the CDS exposure was collateralized.

But the CDS market is so opaque and unregulated

Tell that to the DTCC that have been documenting gross and net notional amounts of the vast majority of CDS trades since 2006.



But allowing AIG to fail would have caused AIG’s counterparties to fail as well, given the $100bn+ payouts

This is actually more subtle. First, the payments to AIG’s counterparties don’t accurately represent each party’s exposure to AIG. For example, if the government paid $13bn to Goldman, it does not mean that Goldman would have lost $13bn had this not happened. This is due to the following:

  • Some protection written by AIG is likely to have been collateralized. In fact, this is what Goldman has claimed.
  • Banks likely bought protection on AIG to protect themselves in case of AIG failure. A bankruptcy by AIG will have allowed the banks to monetize this protection.

The problem facing the banks had AIG failed has less to do with their $ exposure to AIG and more with their position exposure to AIG. For example, let’s say I buy $100mm of protection from AIG and then I buy protection on AIG to hedge against the case of AIG’s bankruptcy. Let’s say AIG does in fact go bust. In the ideal scenario the collateral plus the AIG hedges offset exactly my CDS MTM exposure against AIG, then the banks don’t actually lose money. However, the problem is that they are now long risk $100mm of protection (because their $100mm short risk position against AIG is now gone). What happens then is the market realizes that a dozen banks have massive long risk positions in much of the same trades that they will all now try to hedge at the same time. Spreads blow up and the banks lose.

Fianlly, I am ignoring such comments as Bear Stearns and Lehman collapsed because of CDS or that CDS can be used to drive companies into bankruptcy both of which probably don’t deserve discussing.

Wednesday, March 18, 2009

The Credit Ratings Game

By Patrick Bolton, Xavier Freixas, Joel Shapiro:

Abstract: The spectacular failure of top-rated structured finance products has brought renewed attention to the conflicts of interest of Credit Rating Agencies (CRAs). We model both the CRA conflict of understating credit risk to attract more business, and the issuer conflict of purchasing only the most favorable ratings (issuer shopping), and examine the effectiveness of a number of proposed regulatory solutions of CRAs.

We find that CRAs are more prone to inflate ratings when there is a larger fraction of naive investors in the market who take ratings at face value, or when CRA expected reputation costs are lower. To the extent that in booms the fraction of naive investors is higher, and the reputation risk for CRAs of getting caught understating credit risk is lower, our model predicts that CRAs are more likely to understate credit risk in booms than in recessions.

We also show that, due to issuer shopping, competition among CRAs in a duopoly is less efficient (conditional on the same equilibrium CRA rating policy) than having a monopoly CRA, in terms of both total ex-ante surplus and investor surplus. Allowing tranching decreases total surplus further. We argue that regulatory intervention requiring upfront payments for rating services (before CRAs propose a rating to the issuer) combined with mandatory disclosure of any rating produced by CRAs can substantially mitigate the conflicts of interest of both CRAs and issuers.

Tuesday, March 17, 2009

Deleveraging After Lehman--Evidence from Reduced Rehypothecation

IMF working paper by Singh, Manmohan | Aitken, James:

Rehypothecation is the practice that allows collateral posted by, say, a hedge fund to their prime broker to be used again as collateral by that prime broker for its own funding. In the United Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the customer’s assets. And moreover, there are no customer protection rules (such as in the United States under the Securities Act of 1933). The paper shows evidence that, following Lehman’s bankruptcy, the extent of rehypothecation has declined substantially, in part because investment firms fear losing collateral if their prime broker becomes insolvent. While less rehypothecation reduces counterparty risk in the system, it also reduces market liquidity.

Battle for credit derivatives clearing

In the Financial Times by Jeremy Grant:

Jeff Sprecher, chief executive of IntercontinentalExchange, has conquered months of tortuous negotiations to reach the point this week where the futures exchange can put its efforts to lead credit derivatives clearing into high gear.

However, the best laid plans are no guarantee that anything is going to work out in what is an entirely new initiative for the near-$30,000bn market for credit default swaps.

As Mr Sprecher told the Futures Industry Association’s annual conference in Florida last week: “We don’t know exactly what we will find when we get to the end of the thread we’ve started pulling here.”

ICE is far from alone in its uncertain push towards a clearing house for over-the-counter credit derivatives. Its rival futures exchange and OTC trading platform operator, Chicago-based CME Group, is also moving ahead with its initiative, having received the regulatory go-ahead on Friday.

US and European regulators have made centralised credit derivatives clearing a key part of their demands for a financial clean-up in the wake of the global financial crisis.

The battle shaping up in this area is only one part of a much bigger competition among banks, exchanges and other providers of services and infrastructure to the trading of all kinds of financial assets.

Regulators believe a centralised clearer for CDS markets should reduce risks to the wider financial system. A clearer stands between all parties who wish to trade and bears all the risk that a counterparty might be unable to pay its debts.

For the exchanges, a lot is riding on the project. Bread-and-butter trading revenues are down amid deteriorating equity and derivatives markets. They see clearing as a new source of revenues.

ICE spent $625m buying Creditex, a specialist broker central to its clearing effort, while the CME teamed up with hedge fund Citadel.

Yet in the US, no-one is clear who even regulates CDS clearing – ICE’s clearing business comes under the New York Fed, while the CME is overseen by the Commodity Futures Trading Commission, the futures regulator.

For the big dealer banks involved in the market, there are costs of hooking up with each at a time of severely constrained budgets. Some question the need for multiple providers, but acknowledge that the market, not regulators, will decide how many survive.

A further complication is the determination of European policymakers to have a separate clearer for the region, both to ensure risks are not concentrated in a single US clearer as well as to allow them to have a window on market activity.

But many argue such a demand is at odds with the global nature of the market.

David Clark, chairman of the Wholesale Market Brokers Association, which represents the interests in Europe of inter-dealer brokers, supports moves to increase clearing of all OTC products. But he says: “An American or Australian bank might trade in a CDS out of its London office with an underlying risk that is with a European borrower.”

Some – including the French central bank – insist European CDS clearing solutions be based specifically in the eurozone, effectively cutting London out of the picture. This is tricky for NYSE Liffe, the futures arm of NYSE Euronext, which has operated CDS clearing in the city since December.

Garry Jones, head of NYSE Liffe’s global derivatives, says: “The eurozone argument is a politically-driven process and we don’t think it has any merit.”

However, participants and the lead global trade body for the derivatives industry, the International Swaps and Derivatives Association, have agreed with the European Commission and exchanges to create a European CDS clearer by July.

For the two US-based exchanges, this means they will have to offer CDS clearing in Europe as well – which has big implications for their European rivals: NYSE Liffe, in conjunction with LCH.Clearnet, Europe’s largest independent clearer; and Eurex Clearing, part of Deutsche Börse.

LCH.Clearnet has no US CDS clearer, but last week opened a New York office to pursue opportunities. The Eurex CDS clearing offering will be ready by the end of this month, but Andreas Preuss, chief executive, declines to say whether Eurex will also have to make a push into the US.

He says: “We would never rule out anything. We are interested in providing a solution for the global market that is as powerful as it can be. We will certainly not accept a situation of competitive disadvantage.”

A further big complication is standardising contracts, which is necessary to make clearing truly viable. For CDSs based on the popular indices, this is relatively simple and these are the first being cleared. But contracts on individual companies are much more variegated.

Yet for all the focus on the CDS market, other OTC markets, such as interest rate and currencies, which are much larger than the credit markets in terms of notional volumes, could prove more promising in the long run.

Nasdaq OMX, the exchange group, is focusing on clearing interest rate swaps. It recently bought an 80 per cent stake in the International Derivatives Clearing Group, a new clearer that started up in December. LCH.Clearnet already clears such swaps.

Bob Greifeld, Nasdaq chief executive, says these are “a more enduring asset class in the ‘re-regulated’ world”.

But Craig Donohue, CME chief executive, compares the changes in clearing with the shift from floor-based to electronic, screen-based trading in derivatives on exchanges. “This is a secular shift that will take years to accomplish,” he says. “It is a marathon, not a sprint.”

Monday, March 16, 2009

Sovereign CDS: It’s not (just) the economy, stupid

Felix Salmon points us in the direction of this post, from A Credit Trader, discussing the recent blow-out of US CDS to above 100bps.

Conventional commentary will tell you that this means the market thinks the chance of a US default is increasing. The country’s economic fundamentals are deteriorating, making the cost of protecting against a default more expensive. Another line on the above is that US CDS is a stupid idea anyway since if America were to default, it’s unlikely that CDS will be honoured in the post-apocalyptic financial climate. In any case, here’s Credit Trader’s take-down:

… one shouldn’t look at CDS as a “default” trade. Though their pricing is clearly driven by the likelihood of default and the payout upon default, I can tell you that 99% of people buying CDS do not believe that the entity upon which they are buying protection will actually default. In this, they are similar to investors in stocks. People buy and sell stocks because they think the stock in question will increase or decrease in price. Same goes for CDS.This is a point that is (slowly) sinking into the wider market, as evidenced by a rather large piece of UBS research out this Monday morning.

The bank’s European Economics team, led by Stephen Deo, are examining the recent widening in the region’s sovereign spreads in a note entitled ‘How serious is Europe’s sovereign issue?’ Here’s the nut of the problem as UBS sees it (emphasis FT Alphaville’s):

When markets move, the pavlovian reaction of economists is to look for a fundamental explanation. This was our reaction as well. And indeed the sovereign spreads surged when it became clear that the deepening effects of the ongoing crisis would have damaging effects on the sustainability of public finances. We tried to explain the behaviour of spreads only by fundamental variables. We used fiscal variables such as level of debt, deficit, debt service, structural deficit, cyclical deficit, and many more. We also used macroeconomic data to gauge the performance of the underlying economy (GDP growth, unemployment rate, inflation, GDP volatility, GDP per cap, all types of leading and cyclical indicators, etc…). The results, frankly speaking, are appalling.

Instead, the bank began looking at the correlation between CDS spreads and risk aversion.

By contrast, we find a very high correlation between the behaviour of spreads during the last half year and the behaviour of risk aversion, which we proxy using the “UBS Global Risk Indicator”.

We thus conclude that the recent surge in sovereign spreads is not only a function of deteriorating fundamentals, but also a function of a widespread increase in risk aversion in all markets.

Following this idea, we fit a “UBS sovereign spread model” model that confirms that about two-thirds of the sovereign spread increase is due to risk aversion.

To wit, the charts below. They show the impact of S&P downgrades on European sovereigns’ spreads over Germany in 2002, 2004, 2008 and 2009.

Click to enlarge - UBS: Downgrade penalties

The de facto ‘penalty‘ for a downgrade increases from 5.2bps in January 2008 to 21.1bps in January 2009. So for the same increase in risk, i.e. one downgrade, the market is demanding a return four times larger than just a year ago. Something else has changed besides the economic fundamentals.

Looking a little bit more into the details, we actually find that 2008 is quite unique. In economists’ parlance, we call that a “regime shift“. Regime shift is an instance in which the behaviour of a market or a price changes. This is what happened with sovereigns.

The follow-through would be that as risk appetite increases, sovereign CDS spreads should start falling, regardless of the economic conditions. Of course, there’s a strong argument to be made that we are unlikely to get a decrease in risk aversion without a significant improvement in the economy, the two are considerably - perhaps intrinsically - intertwined, but the message on sovereign CDS should be fairly clear.

Put simply: It’s not (just) the economy, stupid.

Related links:
US CDS above 100bps: it’s a MAD MAD MAD MAD World!
- A Credit Trader
Credit protection madness
- Alea
The mystery meaning of sovereign CDS
- FT Alphaville

Saturday, March 14, 2009

US CDS above 100bps: it’s a MAD MAD MAD MAD World!

By A Credit Trader:

The recent widening in United States Credit Default Swap levels has gotten a lot of attention once it cleared the magic 100bps level intra-day.

As with any CDS-related news, you will get heated commentary in the blogosphere with a large perception of folks simply calling for all CDS trading to be banned. The general consensus appears to be “don’t the buyers of CDS realize that in the event of default by US, these contracts are not likely to be honored anyway?” This is Krugman’s line. Taleb chimes in with “It would be like buying insurance on the Titanic from someone on the Titanic”.


As with any heated commentary there’s bound to be a lot of misunderstanding of what this recent widening actually means and where it comes from. I’ll try to tackle this issue point by point below. For those of us with ADD (myself included) here’s a brief summary:

  • Traders don’t buy CDS because they think the name will default; they buy CDS because they think the spread will widen – I make this point in my AIG post. It follows that extrapolating any default information from wider CDS spreads can be misleading
  • An apples-to-apples comparison of US CDS spreads suggests that $-denominated US CDS (the standard contract that is quoted in the news is the €-denominated one) should be trading at half the level it is now, perhaps making the recent news a lot less exciting
  • The standard CDS contract is sufficiently complex so that the end-game buyers of CDS can be betting on something much more innocuous than a “default” such as a restructuring of privately negotiated tiny-size debt issuance
  • Sovereign CDS (US included) has actually lagged both rising financial as well as systemic risk and has only now caught up, making the recent move largely expected

CDS is not a “default” trade – it is a “spread” trade
The most important point to be made here, the same one I make in my AIG post, is that, one shouldn’t look at CDS as a “default” trade. Though their pricing is clearly driven by the likelihood of default and the payout upon default, I can tell you that 99% of people buying CDS do not believe that the entity upon which they are buying protection will actually default. In this, they are similar to investors in stocks. People buy and sell stocks because they think the stock in question will increase or decrease in price. Same goes for CDS.

I think the confusion largely stems from people viewing CDS akin to insurance. Though this is an easy analogy to make, it is, in fact, wrong. What motivates people when they buy fire insurance is that, in the unlikely case their house is consumed by a fire, they will get reimbursed. This is not what drives the CDS market.

There are two key differences between CDS and the insurance analogy:

  1. I don’t need to have a position in the entity’s bonds or loans in order to trade CDS on the same entity (while I do need to own the house I buy fire insurance on)
  2. As I mention above the vast majority of traders don’t trade CDS because of a view on default – they trade CDS because of their view on the level of CDS spreads expecting to lock in a MTM profit on the trade. Though you can probably save yourself some premium on fire insurance by installing sprinklers it’s clearly not as easy to do nor is it the primary motivation for fire insurance in the first place

Sovereign CDS is not a “fundamental” trade
I think one thing we can safely dismiss as the driver behind the widening of US CDS spreads, or in fact any sovereign spreads, in the market is any kind of fundamental view of where these spreads should be. The difficulty behind trading CDS on a fundamental default probability basis has to do with the fact that in order to put a number on an absolute default probability you need to have a firm view on: a) default likelihood, b) recovery upon default, c) devaluation of the local currency, to the extent that CDS you are trading is denominated in local currency.

Going through these in order

  • It is actually difficult to have a firm view on the absolute default probability of any sovereign, particular, the United States. The fact is that developed sovereign defaults are relatively rare (outside of Spain’s relatively orderly 6 defaults within 100 years starting in the 16th century). As far as United States, my best guess is that we would need to go back to the Civil War to find a proper case of a “default”, though even here you would have to stretch. This was when the Confederacy issued cotton-backed bonds to finance the war against the North. Once the South lost New Orleans (making it impossible for South’s creditors to take physical delivery of cotton) and began to run out of cash, it became clear that it was only a matter of time before the Confederacy defaulted. By the end of the war the Confederacy’s “greybacks” were worth 1 cent on the dollar. The North refused to honor the Confederacy’s debts and the rest is history. In the 20th century developed sovereign defaults are relatively rare, especially after the World War II.

European defaults/restructurings in the 20th century (Rogoff)

  • Getting a guage on expected recovery by a sovereign is not any easier. These range from the teens in Russia and Ivory Coast to 69% in Ukraine.


  • Though much of protection traded on sovereigns is in a currency other than the local currency (i.e. Brazil CDS is traded in USD not in BRL), for local currency trades one has to be aware of the likely devaluation of the local currency in case of default. Those of us old enough to remember will recall the Argy peso going from 1 to over 3 in its peg to the dollar. I touch upon this in the Quanto CDS but suffice it to say that buying protection on Germany in EUR rather than USD means that €CDS levels should trade around half of $CDS levels.

The Quanto CDS
Though people like to focus on the round 100bps number, what’s mising from this is the fact that US CDS is traded in euros and that in order to do a proper apples-to-apples comparison to US-traded corporates you would need to first translate the EUR spread to a USD equivalent spread. This translation is largely a function of how much the local currency will devalued in the case of default (ignoring the small impact of rate, fx and credit volatilities and correlations). So, if you think that the dollar will weaken by 50% relative to the Euro in the case of a US default then the fair USD-denominated US CDS spread should trade around 50bps.

Do sovereign CDS trade in currencies other than the standard contract currency? In fact they do and the biggest market is in Latin American CDS denominated in local currency. If you think CDS is an “obscure” market, then this is the ultra-obscure one. It is largely driven by sovereign issuance of US-denominated debt that they swap to their local currency (in order to remove the stain of “original sin” ie non-local-ccy issuance). Normally, they would just do a simple USD/local-ccy interest rate swap. However, the trick is to do a clean asset swap instead which is simply an interest rate swap that is credit-linked to themselves which can save the country upwards of 100bps on the swap. Corporates in Europe and Latin America tend to do this “self-reference” trick as well – though it is illegal in the US.

For Latin American CDS, this local currency discount can be anything from 25-60% on 5y CDS (it varies depending on the tenor and tends to be downward sloping).

The “non-default” default
The word “default” has been thrown around a little too easily lately with respect to CDS contracts. The concept of default is, generally speaking, a very loaded one that brings to mind long bread lines, a crippled banking system and runaway inflation. In the context of CDS, the concept of “default” is a very specific one. For this reason, CDS language talks about a “credit event” rather than a “default” and can include such actions as restructuring of debt, repudiation of debt, moratorium and accleration. In summary, the following issues need to be considered in the context of Sovereign CDS.

  • The nature of the “credit event”. For Western Europen sovereigns, for instance, these include a) Failure to Pay, b) Repudiation/Moratorium, c) Restructuring. Latin American sovereigns add to this list Obligation Acceleration which was a near possibility when Hugo Chavez declared his country’s pullout from the IMF. The point here is that something like a restructuring of debt can be much more benign than an outright default (i.e. a failure to pay). So, a CDS can often price in a less dire scenario than the likelihood of “default”.
  • Generally, anything counting as “Borrowed Money” can trigger a CDS credit event. This can often be a small privately negotiated loan rather than a large bond or loan trading in the market.

The Beta Issue
If you ask a Sovereign CDS trader why his names are wider today his likely response is “The index is blowing up, dude. Now do you have anything to do?” The simplest answer is that sovereign CDS is wider because everything is wider. And the simplest answer is often the right one.

Backstopping Financials
The move wider in sovereign CDS can be attributed to the expected covergence between sovereign and bank CDS spreads on the back of countries backstopping their financial systems. Countries have either bailed out certain institutions directly (Lloyd’s, RBS, ING, etc.) or have guaranteed bank deposits (Ireland, Germany,e tc.). While sovereign spreads have initially lagged the spreads of their financial systems, once it became clear that the sovereign was willing to underwrite the tail risk of their banks, it made sense for their spreads to converge. And if financial spreads refused to come down to the level of the sovereign, then sovereign levels would rise to the level of financial spreads. This was likely driven by two things: a) relative value trades of selling bank CDS and buying sovereign CDS betting on the convergence, b) continued buying of bank CDS as a hedge against bank paper. This led to sovereign CDS widening to the level of bank CDS rather than the other way around.
The Systemic Hedge
One way to understand the widening in sovereign spreads is by tieing sovereign risk to some other risk in the market that should be driven by the same views or needs. The typical buyer of sovereign CDS, apart from the marginal trader punting on Austrian eastern european exposure of the inability of Iceland to convince the world they’ve got things under control are the Investment Bank credit portfolio groups. These departments generally manage hundreds of billions of loan and derivative exposure across the bank. Their mandate is to protect the bank from an increase in non-performing loans. Normally, the counterparties to the loans do not trade in the market (either in CDS or stock) or are not liquid enough for the groups to go out and hedge in these assets. So, what they normally end up doing is buying systemic risk hedges in large size with the expectation that in the scenario a large portion of the bank’s loans goes bust, the world will be in such a state that their systemic hedges will offset the deterioration in the loan book. Though out-of-the-money S&P puts figure prominently in their hedges, in the world of credit we can look at a) super-senior spreads, b) financials spreads, c) sovereign spreads.

Assuming 40% recovery, the CDX super-senior tranche (30-100%) will be impaired after 40% of the CDX portfolio. Although it’s clearly difficult to envision the state of the world in this scenario, we can safely say the sovereign would be under pressure.
Why is U.S. Credit Risk News?
It is interesting that US credit risk is showing up on people’s radar at the moment when the “obscure” product like CDS is signaling it rather than the plain-vanilla Interest Rate Swap which trades in many multiples of volumes.

Sometime in early 2009, 30y interest rate swap yields rose above treasury yields. This price action suggested that the market viewed 30y Bank (AA) risk as safer than Treasury (AAA) risk. However, given the dire state of the Banks, this was clearly not the driver of the yield moves. What happened was that the exotics desks of the banks sold a huge amount of 2s/30s non-inversion notes to private bank investors that paid a high coupon as long as 30y swaps stayed above 2y swaps. The initial hedges done by these desks was to pay 30y swaps and receive 2y swaps. By the end of the year, rates had collapsed with 30y swaps falling more than 2y since the front end did not have as much room to rally. This meant the 2s/30s curve flattened massively causing the banks to partially unwind the hedges. In a period of poor liquidity every rates exotics desk was hitting 30y bids in size leading 30y swaps to rally beyond treasury yields.
So, though often painted as a credit risk issue, this episode was really a liquidity/technical problem.

Bring on the Technicals
Here, I briefly describe what, in addition to the above issues, could be the technical drivers of wider sovereign CDS, and US CDS in particular:

  • Credit-Linked Notes Unwinds. As we all know retail investors are the best negative gamma traders. They buy high and sell low. It is not impossible that there were investors who were looking to add a few basis points to their “risk-free” trade by adding US CDS risk. It is also possible that as the crisis deepened they grew less comfortable with the risks in the trade and unwound them, suggesting that the origination desks needed to buy back the US CDS protection they initially sold, pushing CDS wider
  • Liquidity in US CDS is not fantastic judging by two things: a) US dealers don’t trade it and b) the bid/offer spreads is 10bps or around 12% of the CDS spread. By comparison bid/offer spread in the CDX index (most liquid product in credit) is less than 1%. When you factor in these issues with the fact that in the current environment there are likely to be more buyers than sellers, you will see the CDS spreads widen to accommodate that

So, in summary, what do I make of US CDS widening? Well, not much apart from making it another cocktail conversation topic. Let’s revisit this issue once investors start discounting all their treasury holding by the US CDS spread… starting with China and their $1.7trn portfolio. Now that would give us something to talk about!