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.

DTCC

DTCC

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.

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