Thursday, December 6, 2007

CDS Factors In Equity Valuation - Part D

This is the fourth in a series. Parts A, B and C were posted on Sep. 10 - 12 and Dec. 3, respectively.

I wish to express my appreciation for all comments and suggestions made by readers of the first three parts; they were invaluable.
______________________________________________________________

Part D: The Equity Risk Premium as Insurance Premium

It was shown previously that Credit Default Swaps are in fact insurance contracts and not bona fide swaps. Taking this insurance characteristic further, let's view the entire CDS market as a large insurance company (CDS Inc.) underwriting credit default insurance on the following entities:
  • Global Governments
  • Global Structured Finance
  • Global Corporations
We need to dispense with the first two, since we are examining the effects of such insurance on equities, i.e. the corporate sector. Before we can do so, we must estimate what portion of the total CDS business is attributed solely to the corporate sector. (If you don't care for the gory details, I estimate it as 80% - now go to Step 3).

Step 1

We can safely assume that central government credit represents only a small portion of the default insurance business. The largest government debt issuers in the world (US, UK, Germany, France, etc.) are themselves rated AAA and serve as risk-free benchmarks. The sole exception is Japan, which carries a AA- rating; it is highly unlikely, however, that hedgers and speculators are much interested in underwriting or purchasing CDS on Japanese government bonds (JGBs), given the extremely low nominal interest rates (e.g. the 10-year JGB is currently at 1.56%). The rest of the world's governments simply do not issue so much debt as to make a difference. In sum, I estimate that no more than 5% of CDS notional outstanding is against central government credits.

This leaves regional/municipal debt. In the US, by far the largest issuer of such bonds, this market is estimated at $1.7 trillion, spread among 50.000 separate entities that issue bonds (SIFMA). This is a market where credit insurance has been dominated by the monoline insurers (MBIA, AMBAC, FGIC, etc.), long before the advent of CDS. It is pretty much an end-user investor market, meaning that there isn't all that much speculation going on. With the exception of a few large issuers such as the States of NY, NJ, California and Florida the market is highly fragmented. This, in effect, limits the use of CDS to mostly hedging purposes and it is unlikely that notional CDS outstanding exceeds the face value of muni bonds, or approx. $2 trillion - if that much. This represents less than 5% of global CDS, bringing the total for all government-related credits to ~10%.

Step 2

Next is structured finance, i.e. credit insurance written against CDOs, CLOs, etc. The total size of the asset-backed market is ~$2.6 trillion, with new bond issuance particularly heavy during the last 2-3 years. For credit insurance, this was also a hedging-related activity until rather recently, when speculation on the sub-prime MBS market created significant short selling interest, particularly against the ABX and CMBX indices. There is no way of knowing with any degree of certainty what multiple of face value is covered by CDS - but we do know that banks have been taking large, multi-billion losses on their portfolios of such paper, so it cannot be very large. Goldman is apparently an exception and so are some hedge funds who called this market right and benefited accordingly. I will go ahead and guesstimate the amount at ~$5 trillion, or another 10% of notional CDS.

Step 3

This brings the total for the first two sectors to 20% of CDS notional, or $9.1 trillion, leaving 80%, or over $35 trillion, as CDSs written against global corporate names. The US Office of the Comptroller of the Currency in its latest survey found that US banks' positions in credit derivatives ($12 trillion) were broken down as follows: 73% investment grade - 27% sub-investment grade (chart below). It can safely be assumed that this split is pretty much the same across the entire CDS market.


Let's revert now to the original premise, that CDS Inc. is one very large insurance company writing all this coverage, 80% of which is insuring the credit, or business risk, of Global Corporations, Inc. We know that current credit spreads for investment grade corporations are approx. 80 bp (CDX IG) and for sub-investment grade approx. 450 bp (CDX HY). The weighted average for the market is thus 170 bp, or 1.70%. However, this is likely too high because we must subtract the far less risky government credits and GSEs included in the 73/27 split given by OCC. With all the estimating going on everywhere, I will reduce this rather arbitrarily to 150 bp, as representative of the entire "book" of corporate CDSs.

If you are still with me...bravo. There isn't much more left to go.

Step 4

So, the annual GROSS insurance premiums changing hands for the entire corporate CDS market is 1.50% of $35 trillion, or $437.5 billion per year. Think of this as the annual premium paid on a contract to cover the risk of holding Global Corporations Inc. securities. The present value of such a contract for 5 years, discounted at 4.40% (the 30-year Treasury rate) is $2.3 trillion. If we view the CDS market as perpetual, then the present value rises to $10.5 trillion.

It is thus possible to argue that these sums represent the amount of risk that has been shifted from the global cash equity market onto the CDS market, thus making stocks appear less risky, or cheaper. Equivalently, we could say that total capitalization and P/Es for global markets are being understated by the equivalent amount. At the end of June, the total market cap of all major stock markets (i.e. stocks of corporations that are most likely to be covered by CDS) was approx. $47 trillion, therefore CDSs created an over-valuation of anywhere between 5% and 22% for stocks. While theoretically we could choose the 5% that represents the expiration of CDS insurance within 5 years, in practical terms it's more proper to view CDS as a perpetual market, adjusting instead for amounts outstanding.

The bottom line is that global shares may now be approx. 22% overvalued, due to the effects of the CDS market alone.

Again I will close by saying, please do take as many shots at this as you see fit. Comments can only help.
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P.S. Correlation between S&P 500 and US credit spreads


30 comments:

Anonymous said...

The American Securitization Forum wrote the rate freeze presented to the public by the President of the United States of America.

I found it on their website americansecuritization.com.

It would appear that some of the firms that sold a lot of the bad debt, are members of the industry group that authored the plan with which they will try to bail themselves out.

Members include Countrywide Home Loans, Ameriquest Mortgage Company, Capital One, Citi Global Markets Inc., Fannie Mae, Freddie Mac, GMAC, JPMorgan Chase, Thornburg Mortgage, Inc., Washington Mutual Bank, MetLife

DBRS, Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s

ABN AMRO, Inc., Banc of America Securities LLC, Barclays Capital Inc., Bear, Stearns & Co. Inc., Countrywide Securities, Credit Suisse, Deutsche Bank Securities Inc., Goldman, Sachs & Co., HSBC Securities (USA) Inc., Lehman Brothers Inc., Merrill Lynch & Co., Morgan Stanley, UBS Investment Bank, PIMCO,

Should Secretary Paulson have disclosed the conflict of interest?

Who is going to profit from the rate freeze modifications?

Who is going to look good if it works, but very bad if it doesn't?


It looks like the executive summary of Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, says they’re not going to check homeowner income, and will be allowed to modify loans even if they don't make contact with the homeowner.


wow


Who’s stocks went up after the announcement?


Notables
CHAIR Greg MedcrafT, Managing Director, Global Head of Securitization,
Societe Generale Corporate & Investment Banking DEputy CHAIR DianE W old, Managing Director, HEAD OF Investment Banking, GMAC-ResCap
SECRETARY Sanjeev Handa, Head of global public markets, TIAA -CREF
TREASURER nelson soares, managing director, HEAD OF U.S. SECURITIZATION BANKIN G GROUP, LEHMAN BROTHERS
EXECUTIVE VICE PRESIDENT JASON H.P. KRAVITT , SENIOR PARTNER , SECURITIZATION PRACTICE , MAYER BROWN, ROWE & MAY LP
EXECUT IVE VICE PRESIDENT LAWRENCE RUBENSTEIN , GENERAL COUNSEL , WELLS FAR GO ASSET SECURITIES CORPORATION

Kicker said...

Great post...

I think a good back-of-the-envelope check would be to look at the price/EBITDA ratios prior to the LBO boom and after.

It was the CDS market that was responsible for compressing corporate yield spreads (IMHO). The low yield spreads jump started the corporate buy-out boom. The corporate buy-out boom is what boosted equities.

Another thing you may want to look into is how the CDS market may have lead to the explosion in the size of the ABCP market. Cheap CDS credit enhancement was used instead of additional equity. Conduits were free to lever up their balance sheets.

Look at how closely tied CDS premiums to the size of the ABCP market:

http://www.federalreserve.gov/pubs/bulletin/2007/articles/bankprofit/chart/cds_dfault_prem_17.gif

http://www.federalreserve.gov/releases/cp/outstanding.gif

And of course, the high leverage attracted the under-capitalized sub-prime and alt-a wholesale lenders. Which made more money available to the home buyers and was partially responsible for the housing bubble.

Kicker said...

Looks like the links got cut:

CDS premium

ABCP

Anonymous said...

Where you lose me is in making the leap to equating corporate equity and debt. A company's capital structure has two components (equity and debt) that usually have different costs and different recovery prospects. (Debt stands ahead of equity in a bankruptcy.)

I can buy what you're saying if debt and equity were equal. But they're not, especially as they relate to the company's weighted average cost of capital (WACC), which is the discount rate used in discounted cash flow valuation of companies.

Let's take a simple example. Company A has a WACC of 10%, which represents equal parts equity at a cost of 8% and debt at 12%. The CDS on this company will mirror the 12% debt cost, not the 10% WACC.

The higher the WACC (discount rate), the less the company is worth. If this company had all debt, it would be worth less than with 50% debt/50% equity or 100% equity.

I think you're on the right track, but you have to do a better job briding between the different characteristics of equity and debt.

Right now, investors are greatly overvaluing equity and undervaluing debt, and this is especially true in the smallest, weakest companies (those with the highest cost of capital). But I'm not sure your explanation explains why.

Mane The Mean said...

Hellasious,

what is your take on the interest rate freeze mandated by Bush et al?

Are they panicking? I assume that the mandate does not matter that much, but destroys some trust, of which there is not much left anyway.

eh said...

The largest government debt issuers in the world (US, UK, Germany, France, etc.) are themselves rated AAA and serve as risk-free benchmarks.

Maybe so, but if you think about the purchasing power of money, and given things like the fall in the dollar index and the rise in oil prices, I would imagine that a great many holders of dollar denominated debt now wish they had some sort of insurance against the fall in purchasing power they have suffered.

Hellasious said...

To Anon.

"Where you lose me is in making the leap to equating corporate equity and debt."

I do not.

The direct correlation is between credit risk and equity risk, not between debt and equity in the capital structure of a corporation.

Regards

Hellasious said...

To mane:

I think it's not meant to help the average borrower, but the average lender. Keeps the poor suckers in the house and chained to their mortgage forever, despite the fact they are already "upside down".

Instead they could walk away, rent at half the cost and stop losing money on a constant basis, as house prices continue weakening.

It's part of the hamster picture..

Regards

Mane The Mean said...

I think the poor suckers should sell their houses at once, almost at any price. Then they could pay off most of their mortgages, and most likely could serve the rest from their regular income.

Otherwise their position will only worse by the day.

Is there something in the new rules by Mr. Bush, which prevents this?

Anonymous said...

>I do not.

The direct correlation is between credit risk and equity risk, not between debt and equity in the capital structure of a corporation.


But credit risk and equity risk are different.

Equity risk is higher in almost all cases. Consider three high-risk cases:

1. equity holders lose 50%, debt holders lose nothing.

2. equity holders lose 100%, debt holder lose 50% in a debt restructuring.

3. company goes bankrupt, both equity and debt holders lose 100%.

Only in the third case are equity and debt risk correlated.

There's a whole industry that holds the riskiest corporate debt and simultaneously shorts the equity as a hedge, virtually hoping that the company hits the skids but doesn't go bust. It's called private investment in public equity (PIPEs).

Hellasious said...

Correlation does not mean 1:1...It means they vary in similar fashion (this is a simplistic explanation, but...).

Think of two sinusoidal functions with different amplitudes running concurrently. One may go up +1 and the other only +0.5, but they both go up at the same time.

Regards

david pearson said...

Hellacious,

Any thoughts on the Credit Suisse/Adams Square synthetic CDO liquidation? It appears Credit Suisse had to pay out on the super senior swap, and I wonder how many more of these are out there?

Anonymous said...

WACC

"If this company had all debt, it would be worth less than with 50% debt/50% equity or 100% equity"

Wrong. Debt is accounted for after tax and is always cheaper ,even before tax, than equity.

Anonymous said...

"The direct correlation is between credit risk and equity risk, not between debt and equity in the capital structure of a corporation."

Even in bankruptcy the bond holders get paid first and most bankruptcies do not go the way of Enron or Worldcom.

Anonymous said...

"Correlation does not mean 1:1...It means they vary in similar fashion (this is a simplistic explanation, but...).

Think of two sinusoidal functions with different amplitudes running concurrently. One may go up +1 and the other only +0.5, but they both go up at the same time."

Not if the correlation coefficient is 0.

In the world of finance, correlation is a statistical measure of how two instruments move in relation to each other.

Shawn said...

Greenie,

< but what you are effectively saying is that oil is priced in dollar means US is strong. If oil get priced in euros, that would also mean strength of US diminished. Therefore it is harmful. >

No, others and I are not argueing if Dollar is going to be strong or not, because that may involve many other factors.

Let's revisit the most fundamental reason of Asia Currency Crisis 1997, as I lived through it daily.

Fundamentally, it was because many weak Asia countries had little foreign currency reserve for them to exchange for foreign goods. They ahd minimal Australia$, Canada$, Euro$, etc to deal with those daily import/export need in those countries.

This was why there was a run in the Asian currency when people woke up to it, because fundamentally Thailand/Hong Kong/etc cannot print USD$, Australia$, Canada$ to satiisfy the import from those countries.

Now if Oil is priced in Euro and never in USD, I argued that USA would now be in a big hole to try to save foreign currency (in Euro, or whatever foreign currency to convert to Euro) to pay for oil.

Now, how would that do to the currency strength, that will be a different topic. But USA CANNOT print Canada$, Australia$, Euro$.

The corner arguement of Mish, if I remember correctly, is that he think currency can be traded daily and freely with a click on the computer screen, and FOREX market is a daily Trillion dollar market.

Hellasious said...

To David Pearson,

Go to SIFMA's data:

http://www.sifma.org/research/
pdf/SIFMA_CDOIssuanceData2007.pdf

Issuance was heavy for synthetic CDOs in 2004-06 (total ~$190 billion, NOT including the unfunded tranches).

There was plenty of synthetic issuance even in 1Q07, but then it fell right off the cliff: -90%.

So...there's more where Adams Square came from.

Regards

the cds trader said...

I'd say all your numbers are pretty close, as yes sovereigns are a pretty small part of the CDS market (I'd say 1%).

BUT...I think the part "It is thus possible to argue that these sums represent the amount of risk that has been shifted from the global cash equity market onto the CDS market" is a leap to far...equating debt to equity is not that simple.

I think it's not right partly because the market size of those trading directly CDS versus equity is TINY relative to the size of each market (I'd be amazed if it accounted for more than 0.1% of equity volumes for example).

Yes, increased CDS trading may allow efficient transfer of risk, and allow MORE and CHEAPER issuance of debt for companies, allowing them to leverage, but you DEFINITELY cannot take the notional amount of CDS contracts (or CDS premium) and say that number represents anything. As I mentioned against one of your other CDS posts, notional values are misleading in that many of the trades will cancel out among counterparties.

Keep up the good work though!

Hellasious said...

Dear CDS trader,

Just because the CDS instrument originated from within the credit (debt) dept. doesn't mean it's a bond-type instrument.

As you very accurately put it, CDS are risk transfer instruments - but what type of risk? Certainly not yield curve risk. When we trade corporate CDS we trade creditworthiness risk = business risk = equity risk.

Just because there are few who trade the equity-corp. CDS correlation doesn't mean that it doesn't exist. If you have access to a B'berg run a COMP chart between any corp. credit index you like and S&P. (I will put one up ASAP).

If you are a dealer and you run a matched book, you can view YOUR risk as canceled out. This doesn't mean the OVERALL market is running flat. CDS is not a zero sum game. No insurance market can be.

I totally agree that $45 trillion in CDS notional does not mean that there is a "bet" of that size out there - you and I understand this. But the larger the notional the larger the systemic risk, no question.

Let me just ask this: what would happen to the CDS market if Morgan or any other major player said it has to take a $50 billion hit to their earnings - for whatever reason?

Would you then worry about counter-party risk? Would you pull up your book and look at every single position you have with Morgan - matched or not? What would that mean for the importance of notional, then?

All the best and thanks for commenting. It really, really helps.

Greenie said...


This was why there was a run in the Asian currency when people woke up to it, because fundamentally Thailand/Hong Kong/etc cannot print USD$, Australia$, Canada$ to satiisfy the import from those countries.

Now if Oil is priced in Euro and never in USD, I argued that USA would now be in a big hole to try to save foreign currency (in Euro, or whatever foreign currency to convert to Euro) to pay for oil.


Your comparison is not valid. Asian countries tried to peg their currency to a fixed exchange rate that was too high for their economic conditions. Their economic conditions were deteriorating, because the construction boom made by Japanese money ran its course. However, the countries tried to maintain their currency peg. To do that, they were bleeding dollars and nearly ran out of reserves. The market was not ready to exchange their dollars for pegged Thai baht, and so they had to readjust to what was reasonable.

In the current situation, US dollar is freely traded, Euro is freely traded and oil is freely traded. There is no government force trying to hold any of them to non-market value. So, the situation is not similar.

I realize where your confusion comes from. You think US government prints US dollar. I am also guessing that you think inflation will be the order of the day and dollar will collapse. Maybe you need to get a better understanding of our debt based monetary system. Nobody prints any money, and if any country does, it is finished.

BTW, I am from Asia too and been through the currency crisis.

s said...

Anonymous said...
WACC

"If this company had all debt, it would be worth less than with 50% debt/50% equity or 100% equity"

Wrong. Debt is accounted for after tax and is always cheaper ,even before tax, than equity.


Actually, this is a simplistic argument. The "WACC" on such a company would reflect a substantial risk premium to relfect the leveraged psoition which would likley make it worth less than a more "optimal" capital structure.

As for the "if anyone prints money they are done" comment, now that is juts wrong. If anyone prints money transparently their currency is done. But why print money when you can synthetically create it via dervatives: saves you money on the ink.

Shawn said...

greenie,

< Asian countries tried to peg their currency to a fixed exchange rate ... their economic conditions were deteriorating ... >

Well, that is a complete news to me.

As far as I remembered, and vividly, the Asian currency were traded freely. At least that was my daily news for South East Asia of Thailand/Malaysia/Indonesia.

There was no pegging of currency. That happened only after the financial crisis.

These countries, if I remembered correctly, were enjoying strong economic boom (now I am not to argue if this is similar to NASDAQ 2000 before bubble burst that economic situations were "hiddnely" getting worse).

Not only were their economic growth were strong, but there were talks as if South East Asia would become the previous version of Asian 4 Tigers or Dragons -- Singapore/Taiwan/Seoul/Hong Kong.

But here lie the problem that trigger the whole thing -- these countries were running trade deficit due to strong consumerism growth, and their foreign reserves were low.

Once the Asian crisis hit, and you see everything went in Complete Reverse:

1) No more free forex trading, as currency was begin to be pegged. Repeat, I did not hear about Currency-Peg thing ever until after the crisis started and asian currency was dropping everyday, causing import/export business to collapse due to unknow future price point.

2) Internal consumerism collapse, and was replaced by export orientation. This lead to 3rd point

3) Massive accumulation of foreign reserves.

I remembered one piece of news that got flashed most often after the crisis -- the pont (3) above. The officials of various countries try to convince their citizens out of panic mode by stating that country XXX now have increasingly foreign reserve to support 3/4/5/6/7/8/9 months of import.

So contrary to your statement, I lived and saw currency-peg as a new thing for these countries after crisis, not before crisis.

And, their economic situations were booming as far as I lived it. Except they were running deficit that drawn down their foreign reserves that nobody was paying attention to.

That was what caused the crisis, once George Soros seized the opportunity and triggered it.

USA print money -- I mean to say USA government cannot just borrowed money Endlesslu to pay for oil through FED credit window, that they have to do start accumulate foreign reserve to pay for it.

Yes, dollar can still trade freely, but now you get back to Asian crisis mode -- remember why you need foreign currency to do your import/export thing??

Contrary to your werid assumption on my position, I think deflation will come due to the massive debt credit problem.

< I am also guessing that you think inflation will be the order of the day and dollar will collapse. Maybe you need to get a better understanding of ...>

Don't over estimate your intelligence by making assumptions over other position.

Shawn said...

greenie,

< Their economic conditions were deteriorating >

Well, if I recalled correctly, many stock market index were near record highs.

I recalled reading banks in Hong Kong offered 0% deposit rate. Also, the banks would Charge service fees if you deposit money in the banks. So essentially if you were in HK, then putting money into a bank will cost you negative returns.

Credit were loose, times were good.

Greenie said...


Well, that is a complete news to me.


Check here:

http://en.wikipedia.org/wiki/Asian_financial_crisis

or here:
http://news.bbc.co.uk/2/hi/asia-pacific/6260720.stm

and here is some info on Hong Kong:
http://www.financeasia.com/print.aspx?CIID=97063

Greenie said...


But here lie the problem that trigger the whole thing -- these countries were running trade deficit due to strong consumerism growth, and their foreign reserves were low.


Again, your comparisons are not valid. You cannot compare the current situation of US with four bubbly small Asian countries running trade deficit. A better comparison is UK (i.e. British Empire) from 1880-1930s, when British pound was the reserve currency around the world, and Britain was running trade deficit.

The difference between US at present and those small Asian countries of 1998 is that US dollar is the global reserve currency accepted by all central banks in the world. That is where all the power of US comes from. It is not from pricing of oil in dollar or anything like that.

When US dollar loses that status (i.e. final collapse of Bretton Woods era), then US becomes equivalent to any other country in the world....and all your expectations will materialize. Until then, stick to Mish. He knows his stuff :)


One more time: horse = US dollar is reserve currency, cart = oil is priced in dollar. Hope this help.

P. S. I expect end of dollar reserve era within another 8-10 years. The process has already started.

Greenie said...

Sorry Hellasious for stealing your thread.

Juan said...

Hellasious,

Thanks for pointing out the (dialectical) contradiction/relation between systemic and micro. Neoclassical econ with its ingrained methodological individualism often prevents people from seeing the macro as anymore than aggregation, so falls into fallacies of composition and analytic failures.

Greenie,

You note that '[Asian] economic conditions were deteriorating [prior to financial crisis]' and, you know, I've long found it interesting how infrequently this has, at least in the U.S.. been included within analysis, as though it was strictly financial.

Please correct if in error but didn't weakening first evidence itself as falling profits (not earnings) in S. Korea, more or less late 1995 - early 1996?

Al_Tannr said...

I would appreciate more information on what HellasIOUs called a "matched book." CDS Trader also wrote about low net exposure, even zero for certain cases.

How is a "matched book" similar to and/or different from a stock fund which fully hedges using equal long and short positions? Are the CDS positions which are "matched" distributed over different underlying instruments? Or, are they matched against holding/writing a CDS index?

Several times over the last few months, some of the most shorted housing-related stocks moved up strongly while the general market drifted down. One explanation was that long/short funds were having to cover their short positions. Do CDS holders have to actively manage their positions to maintain minimal risk? If so, are there potential market dislocations which could make this difficult to do during the day?

Thank you for this excellent blog. Alan

the cds trader said...

re: Hellasious "Let me just ask this: what would happen to the CDS market if Morgan or any other major player said it has to take a $50 billion hit to their earnings - for whatever reason?

Would you then worry about counter-party risk? Would you pull up your book and look at every single position you have with Morgan - matched or not? What would that mean for the importance of notional, then?"


jesus i'd probably cr*p myself if i had to try and hedge all my positions to JP, that would take some work!! :)



and re: al-tannr:

a matched book for a CDS dealer would usually mean in the first instance that my "market risk" is pretty much flat, such that if the overall market moved 1 basis point (1bp) either way, I wouldn't make or lose anything...although in reality you can never hedge back to zero, as you'll have a number of trades of different maturities and prices you entered into these trades will pretty much all be slightly different.

in the second order, you can look at each credit (company) and try and get the risk as close to zero for that also. but it really is a b*tch to get rid of every little bit of residual risk.

Anonymous said...

My apologies if this question has been answered previously, but does anyone have a sense as to the size of the long correlation book? My thought is that if any of these central bank pseudo-bailouts are successful in finding an exit for senior credit-holders, those long correlation will get absolutely hammered.

I hope this makes any sense. Thanks and thanks for this excellent blog!
Rich