Tuesday, March 18, 2008

Revisiting The CDS Menace

As readers of this blog know, I have written extensively about credit default swaps (CDS) and the risks involved. I explored several aspects, from the theoretical (CDS Factors in Equity Valuation, a four part series), to the more practical (CDS: Phantom Menace).

Today, I am revisiting the CDS subject because of a reader's comment to last Saturday's post. He/she said: "I am unwinding every ITM CDS* on Monday with all my counterparties". There is a ton of trouble brewing within that one simple, declarative sentence.

I assume the commenter is a CDS dealer/market maker, likely running a square book, i.e. not exposed to credit risk on a net basis. But he/she is exposed to counterparty risk and by unwinding positions he/she wants to minimize that as much as possible. After Bear Stearns' implosion, I totally understand and I bet dozens of other institutions are thinking along the same lines.

As with all insurance contracts, the ultimate risk in CDS is counterparty risk, i.e. when time comes to collect on the insurance (or the premiums, for that matter) the other side won't pay up. Since these derivative instruments trade 100% over the counter, there is no central clearer in between to guarantee payment. And this is where notional amounts come into the picture.

The conventional view on CDS is that enormous notional amounts should not concern us because they mostly cancel out between counterparties, greatly reducing the net market exposure. The Bank for International Settlements puts CDS notional amounts at $42 trillion, but with a gross market value of $721 billion (BIS data as of June 2007 - pdf). The International Swaps and Derivatives Association provides a slightly higher figure for notional amounts, at $45 trillion (ISDA data as of June 2007 -pdf).

But if one or more counterparties were to fail, they would set off a series of dominoes which could easily result in a daisy chain. Netting would then become a matter for the bankruptcy courts, taking years to resolve. Not exactly a favorable outcome when market volatility is measured in minutes.

One more aspect to explore is CDS pricing. Amounts outstanding exploded upwards during the last three years, i.e. when credit spreads were at historical lows. The chart below shows the notional amounts of CDS outstanding versus the yield spread between BAA corporate bonds and the 10-year treasury bond (click to enlarge).

CDS Amounts Outstanding and Corporate Yield Spreads (Data: ISDA, FRB)

We see that while credit spreads stayed at a low 150-170 bp, CDS amounts boomed from $8 trillion to $45 trillion. In other words, the vast majority of credit insurance was sold at very low prices. Credit spreads have now spiked to 350 bp and the CDX index for North American corporate CDS is at 185 bp, coming from a low in the 20's last June.

This means that marking all those CDS to market is currently resulting in very large valuation losses for those that sold the insurance. This further exacerbates the counterparty risk problem, particularly with those that made a habit of collecting such pennies in front of steamrollers, e.g. hedge funds. And this, even before credit events have begun in earnest, during what many are already describing as the worst crisis since WWII.

We may be in for very unpleasant surprises when those who sold insurance on the cheap are called upon to pay. Let me put it this way: if the large, professional credit monolines (MBIA, AMBAC, etc.) were not adequately reserved, what are the chances that Joe's Greasy Spoon and Hedge is?

(*) ITM = in the money.


  1. After Bear Stearns' implosion,...

    Uhh, BSC was rescued, it didn't 'implode':

    After Bear Stearns Rescue, Who's Next?

    Or hadn't you heard?

  2. Well, they take T-bill as a collateral when they buy CDS from hedge funds. Of course, they don't provide anything when they sell the CDS. No worry.

  3. Re: CDS collateral

    I wonder how many CDS sellers are actually posting the sharply higher collateral required, as implied by the recent run-up in credit spreads.

    Typically, for CDS sellers the margin leverage vs. potential liability (i.e. notional amount adjusted for recovery) is in the 100-200x range.

  4. Dear Hellasious,

    Many thanks for all these insightful (and quite worrying) posts. I was wondering if you could quickly comment on the following two graphs:

    It doesn't look good to me....

    Kind regards,

  5. Dear serge,

    The charts you point out are indicative of the wider situation: the Fed is becoming lender of last resort to the financial system.

    The first shows the effects of the TAF and the second one is related to it: banks have replaced much cheaper TAF funds for funds previously borrowed from the interbank market.


  6. Very interesting post: you point us in the right direction now that BSC is gone, ops, has been rescued...
    Thank you

    PS. We still have this funny FED meeting today... I definitely won't need to go to the movies: Washington is providing the entertainment tonight ;)

  7. I am shocked, shocked:

    Bear Stearns’s stunning downfall and subsequent sale to JPMorgan Chase on Sunday was orchestrated by some of the most powerful people on Wall Street and in Washington. It will go down either as a heroic rescue of the financial system or grand theft, Wall Street style. Maybe it was a bit of both…Make no mistake: this was one of the greatest corporate euthanizations of all time. And Wall Street played its own gleeful role in it…The run on Bear began around midday on Wednesday, when a series of banks and hedge funds started a whisper campaign against the firm. The firm was doomed, they said. It was almost broke. But some of the money managers were clearly talking their book. They were obviously shorting Bear’s stock, betting it would decline…How do I know? Because I was on the receiving end of a handful of phone calls from the Gang of Wall Street Whisperers. All of them offered a variation on the same theme: Bear Stearns is toast; no one is trading with the firm; clients are pulling their money out.

  8. Hank Paulson on CBS Early Show this AM must have blinked 100 times and stammered about 20 for a 2-3 minute segment. Why can't they get one of those psychologists to interpret his facial movements like they do other criminals.

    Brant, Atlanta, GA

  9. Uhh, BSC was rescued, it didn't 'implode':

    Sure, and she can't be a pig, she's wearing lipstick.

  10. Question: Assuming things play out as speculated, and the known world comes crashing down around us when counterparty exposure starts to rear its ugly head, what trade do you put on to benefit? Doesn't seem as simple as shorting the ABX, is it?

  11. IMHO, ABX and CMBX are already yesterday's news. The credit crunch is moving to other pastures at present.

  12. Dear eh,

    Thanks for the "shocked" article from NYT. Another note: Morgan was Bear's clearing bank and probably owed a ton of money from financing Bear's inventory of securities. Taking them over and passing $30 billion of the toxic portfolio to the Fed was also in their best interest, too.

    Had Bear gone formally bankrupt Morgan would have thus been on the hook, too.

    This is what I THINK, by the way, not what I know for a fact.

  13. Definitely agree ABX is old news, it was the popular vehicle to play subprime concerns prior to that blowing up. I was wondering what you thought might be a method for expressing a view that counterparty exposure in derivatives might be the next blowup.

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  15. The speed of the unwind for financial companies shows that they can't make it to the exits before the ax falls. This is the lesson that I have taken from watching on the sidelines this past 9 months!. This may be true in the equity and commodity markets as well, speed kills as they say so be careful and protect yourself!

  16. Since we're losing, let's change the rules.

  17. Re: changing the rules

    What the AIG gentleman is not telling anyone is that we got into this mess in large part because a whole slew of CDOs and other structured finance products WERE NOT marked to market.

    I don't mean they were not properly valued vs. risk, though this was obviously also the case. I mean there was no active market to price them against on an ongoing basis.

    Do you know how most people marked them? They called up the IB that issued them and asked/suggested, "Where do you say those puppies are at today, just for closing the quarter's books? Around par fifty (100.50), would you say? Thanks, see ya soon..."

  18. @eh... great Cramer vid

    @Hell, I read foreign buyers of Treasuries as % of purchasers is at a low.

    Do you see treasuries eventually being one of the dominos? Or do you think that if it will happen, it is a long way off, say when Social Security becomes cash flow negative in 10 years?
    Obviously a lot of people are scared and parking their money in T-bills right now.

    @Dink... Naked Capitalism posted an interesting read on the current market environments viewed thru The Prisoner's dimmena framework we discussed earlier. I thought you might find the post as well as a comment I left interesting. :)

  19. I enjoyed your thinking on how the existence of CDS may influence equity valuation -- thought provoking. However, I still can't get over to your conclusion.

    As you rightly point out, CDS are side-bets. How does the existence of CDS change the fundamental exposures of a real equity holder? "Phantom" equity does not receive dividends so does not dilute equity holders in viable companies. In a default situation, real equity holders are still at the end of the line but CDS hasn't altered that fact.

    Your assumption that b/c risk has been created in the CDS market, it has necessarily been transfered from the equity holders seems unfounded. In a default situation, an equity holder's economic situation is unchanged despite many side-bets existing in the CDS market. Thus, more aggregate "equity-like" risk in the system does not equal less (or more) risk for an equity holder of a specific firm. One exception would seem to be your 'worth more dead than alive' scenario where insurance policy owners stand more to gain in a default scenario and therefore manipulate the stock.

  20. * So 45 trillion notational, but most will cancel out... if some team of forensic lawyers/CPAs spend their entire lifetimes dedicated to sorting out the rat's nest of contracts.

    * I read an interesting analogy somewhere that gave me a conceptual framework: Imagine a casino where a hundred gamblers are playing with 10k each. Then imagine a casino on the floor above that one where there are richer gamblers watching the first casino with spy cams and making bets on their performance. Then keep adding new floors of casinos. Statistical nightmare.

    *Thai- very interesting (both Lune's article and your response)! I've been pondering the trust concept. It seems those that "defect" in Tit For Tat are the ones causing all of society's ills. But then I guess that's a presumptive perspective because under a tyranny a rebel defector would be a good guy. Honesty is only possible in a tolerant society I suppose.

  21. H--

    The cds counterparty issue has been flagged for some time. Now that CDS prices have blown out, why haven't we seen the hedge fund implosions? I know there are a number of funds that have folded or stopped redemptions, but its not been a mass counterparty-risk inducing episode.

    So why hasn't it happened yet?

  22. When giving the CDS data, it might be worth noting (assuming that my memory is correct) that close to one quarter of that notional value is now the property of JPMorgan Chase.

  23. H:

    Just curious: Given that you seem to believe the CDS situation is critical, how do you square that with yesterday's post "Let financial markets sort themselves out, but with rock solid backing for bank depositors, pension funds and public institutions."

    Is it possible to let the CDS market run its course -- presumably wiping out a big chunk of the IB and hedge fund community -- and protect the innocent?

  24. To david pearson:

    "So why hasn't it happened yet?"

    Oh, but it has. Those institutions that sold mortgage-related CDS are dead or dying, from the monoline insurers to dedicated funds like SIVs that bought synthetic CDOs. All a result of sharply higher actual loan defaults.

    On the corporate CDS front, bond defaults are still very low so no out and out panic yet, even if CDX spreads have gone up sharply in anticipation.

    And perhaps some hedgies are kept on life support so that IBs (prime brokers) do not to have to write off the loans on their books.

  25. To st:

    "Is it possible to let the CDS market run its course -- presumably wiping out a big chunk of the IB and hedge fund community -- and protect the innocent?"

    Yes, absolutely. The financial community is not the whole of the US, you know. Wealth there is extremely concentrated - if some of it gets wiped out 99% of the population won't exactly cry in their milk, as long as their savings are protected via the FDIC and PBGC.

  26. Dink,

    You need to recognize that fundamentally you are constantly lying to yourself, we all are. Your (mine, everyone's) brain is designed to hide this fact from you.

    This was in fact Freud's greatest insight (remember the whole Id/superego thing?) and became the kernel of what later has become evolutionary psychology.

    Read peoples comments on these blog with a different lens and you will see a lot of self delusion-- statements where the conclusion has to apply to the author as well but the author is deluded into thinking it does not.

    Yesterday's pigs at the trough is a classic example. The implication that others are pigs but the authors are not is of course absurd (no personal attacks on anyone intended). We all share this planet together. One person has no more claim over how it is managed/divided than another-- unless of course they (sadly) have force of arms.

    Functional MRI studies asking questions designed to elicit inherent internal paradoxes are clearly proving this-- we may use them as 'lie detectors' one day-- depends how 'big brother' society becomes.

    Science Wars are another example.

  27. H:

    I'm not sure letting pensions go to the PBGC counts as protecting the innocent by most people's standards. If I recall from some of the airlines examples, the PBGC insurance maxs out at about 50K per annum.

    An appropriate limit for a government program, but nothing like the caliber of FDIC insurance -- especially given that anyone with deposits over 100K likely knows the limit and is splitting their accounts.

  28. I thought that the PBGC was allowed (that is, instructed) to invest in CDOs about half past February?

  29. In fact I did not get to unwind anything really. Nobody would deal. Lots of stalling.

    Risk Mgmt told us no trading with Lehman yesterday. Have not heard bank from them yet. Maybe they have to wait for the closing price to update their KMV model. Ha!

    Amazing days. The Fed saves us all (everyone but the underwater home owner).

    God bless the people at Bear. What a way to end a career.

  30. hellasious, you're comment about the financial community being concentrated - if you've already addressed this, then please forgive me and point me to it.

    Are the pension funds involved in much of any of this mess? It's hard to believe they own much of this more complicated stuff....their boards and such are so hard to get through. I'm formulating a picture where a lot of the toxic waste catapulted through wall street and straight into hedge funds (who are so brilliant and easy to talk to and 'get it' ;).

    i suspect that some of the bigger pension funds are invested in hedge funds, but you see where i'm going with this.

    are they as exposed?


  31. Hello Hellasious,

    just a Machiavillian idea:

    If you were this Lewis guy I would try the following: Unite with some other big BSC holder around a bridge table, buy up stock till you are far above 50%.
    At the same time buy CDS protection on BSC which is now cheaper again.
    Then block the deal.
    Either JPM pays you really more for stock or lawsuit settlement or you let the world explode and cash in CDS (preferably from somebody left standing, Goldman or JPM self, how ironic)

    How do you think the powers that be would react to a strategy like that?

  32. "But if one or more counterparties were to fail, they would set off a series of dominoes which could easily result in a daisy chain. Netting would then become a matter for the bankruptcy courts, taking years to resolve. Not exactly a favorable outcome when market volatility is measured in minutes."

    Exactly. This week we have got alot closer to a resoluion of the discussions in earlier posts on this matter between Hell and CDS Trader (CDS Trader being in the camp that the CDS market is not a problem as most players in the CDS Market will net out, profits will be matched by losess - CDS Trader, I apologise if I summarised your position a bit too simply).

    The key problem, as Hell says, is that in the short term people will be 'unnetted' for want of another term. So I think CDS Trader is going to lose this one.

    I do notice that CDS Trader is absent so far in this comment section today....busy trying to stay netted perhaps?

  33. The FED will just hook'em up and let them borrow their way to prosperity. Any thing goes this is a crisis dang it.

    Actually this whole damn mess is totally disgusting.

  34. Hubert-

    I don't think the deal can be blocked. $2/share in the takeover or $0/share in the implosion.


    So the fMRI will be able to alert us when we're lying to ourselves? Its powers could be used for good (psychologists, teachers, parents) assuming humans don't go insane with their self-perceptions shattered.

    In the book "Blink" the author tells of two researchers (I think at UC San Francisco) who've mapped every facial expression down to the smallest muscle. It appears facial expressions are universal. These two worked with a U Washington professor who was videotaping couple's conversations in a lab. Together they had a 95% success rate in determining whether the couples would still be married in 15 years. A better % than seasoned marriage counselors were guessing. This analysis could be cheaper than the fMRI.

    The use of force is sad; one would hope everyone would be reasonable enough not to do anything that would require others to use force. But as Neal once said (Neal was to me as Moe was to Hell I think) "You gotta control your crazies" (we were discussing the Saudia Arabia gov's responsibility in controlling its extremist population).

  35. I disagree that CDS and debt are bygone issues. It looks like the U.S. Administration is pushing for relaxed capital requirements for Fannie and Freddie Mac.

    There's a whole lot of buzzwords in there and I don't know what all of them mean.

    That doesn't stop me from rushing to the conclusion that general leverage conditions haven't changed one bit. The worst debt is being nationalized and never marked to market via term auction facilities.

    Any feedback would be welcome.

  36. Bad url. copy+paste these two bits together.


  37. When you have to publicly sell chicken shit sandwiches as wholesome chicken sandwiches as Stammerin' Hanky Panky Paulson does over and over again, blinking and, well, stammering are common.

  38. Speaking of Risk Management, one of my "clients"
    works for Citizens-owned by RBS- in Risk Management and he has Lehman as the next one to fall. And FWIW, months ago he picked Bear to be the first to go down.

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