Si leo esta ayer amigo...
Carranza this will curl your hair (below).
What would we all do without Mr. Das? He is a city on a hill perched above a reeking swamp, which seems to currently characterize our world-wide banking system, or much of it.
Oh, appalaud our mainstream newspapers. Fortunately, perhaps, for all of us they have never really taken up this story: ie. the debacle of the CDS. If they did I suppose doubt and uncertainty would fill our days .
And ... if they did we would miss...
El baile de los cucharachas.
Credit Default Swaps: Problem Child of the Global Financial Crisis
by Satyajit Das April 13, 2009
Credit default swaps (CDS) are complex and powerful financial instruments that frequently have unforeseen consequences for market participants and the financial system. As former New York Federal Reserve President Gerald Corrigan told policymakers and financiers on 16 May, 2007: "Anyone who thinks they understand this stuff is living in la-la land." Recent events highlight the continuing problems.
The CDS contract is triggered by a "credit event;" broadly, this equates to default by the reference entity. CDS contracts on Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac") were triggered as a result of the "conservatorship."
This may seem odd given the government actions were specifically designed to allow Fannie and Freddie to continue fully honoring their obligations. However, "conservatorship" is specifically included within the definition of "bankruptcy" in the CDS contract, resulting in a "technical" triggering of the contracts. This necessitated settlement of around $500 billion in CDS contracts with losses totaling $25 to $40 billion.
The triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default.
The CDS market is also complicating restructuring of distressed loans as all lenders do not have the same interest in ensuring the survival of the firm. Different legal forms of economically similar actions can lead to entirely different outcomes under the CDS contract, complicating significantly the effects of the contract and its efficacy as a hedge.
Observing protocols
In recent years, practical restrictions on settling CDS contracts has forced the use of "protocols" – in which any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller makes a payment to the buyer of protection to cover the loss suffered by the protection-buyer based on the market price of defaulted bonds established through an "auction" system.
Recent cases highlight some of the issues in respect of the protocol and auction mechanism. The auction prices in the settlement of CDS on Fannie and Freddie (paid by sellers of protection) were as follows:
Fannie Mae – around 8.49% for senior debt and 0.01% for subordinated debt.
Freddie Mac – around 6% for senior debt and 2 % for subordinated debt.
Holders of subordinated debt rank behind senior debt holders and would generally be expected to suffer larger losses in bankruptcy. The lower payout on the subordinated debt probably resulted from subordinated-protection-buyers suffering in a short squeeze, resulting in their contracts expiring virtually worthless. The differences in the payouts between the two entities are also puzzling given the fact that they are both under identical "conservatorship" arrangements and the ultimate risk in both cases is the U.S. government.
In other CDS settlements in 2008 and 2009, the payouts required from sellers of protection have been highly variable and large relative to historical default loss statistics. This may reflect poor economic conditions but are more likely driven by technical issues related to the CDS market. Skewed payouts do not assist confidence in CDS contracts as a mechanism for hedging
It's only a flesh wound!
The derivative industry's indefatigable support of the market centers on the fact that all the CDS contracts related to the high profile defaults in 2008 settled and the overall net settlement amounts were small. Strictly speaking, this is correct. Closer scrutiny suggests caution.
In practice, there are actually two settlements – the "real" settlement in which genuine hedgers and investors deliver bonds under the physical settlement rules (i.e. those who actually own bonds or loans and were hedging), and the parallel universe in which dealers and large hedge funds settle via the auction. Dealers tend to have small net positions (large sold and bought protection but overall reasonably matched).
Take the case of Lehman Brothers. Its net settlement figure of $6 billion is frequently quoted, but that refers to the second process. Real CDS losses from Lehman CDS were higher, probably around $300 billion to $400 billion. Some banks and investors that had sold protection on Lehman did not participate in the auction. They chose to take delivery of defaulted Lehman debt, resulting in losses of almost the entire face value. For example, one German Landesbank reportedly took delivery of $1 billion of Lehman bonds that were worth $30 million at current market values.
There were no failures in settlement of the CDS contracts because, in part, some sellers of protection (such as banks and some insurers) were supported by governments concerned about systemic failure of the financial system. Other sellers of protection had to bear losses, reducing the capital available to meet future claims. Whether the sellers are in a position to meet potential losses if default rates rise as expected remains unknown. As a former U.S. Sen. Everett Dirksen once noted: "A billion here, a billion there, and pretty soon you're talking about real money."
CDS contracts did, in all probability, amplify losses in the credit market in recent defaults. For example, when Lehman Brothers defaulted, the firm had around $600 billion in debt. This would have been the maximum loss to creditors in the case of default. According to market estimates, there were CDS contracts of around $400 billion to $500 billion where Lehmans was the reference entity. The outstanding volume of CDS contracts is not known with certainty, reflecting the lack of transparency about trading in the OTC market.
If used for hedging, the CDS contracts would merely have resulted in the losses to creditors being transferred to the sellers of protection leaving the total loss unchanged. Market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250 billion to $350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200 billion to $300 billion) are in addition to the $600 billion.
"I" or Innovation Dysfunction
Financial innovation can offer economic benefits. A number of major benefits of CDS contracts are often cited by acolytes and fans, generally those promoting the product.
The first is that CDS contracts help complete markets, enhancing investment and borrowing opportunities, reducing transaction costs and allowing risk transfer. CDS contracts, where used for hedging, offer these advantages. However, when CDS are not used for hedging, it is not clear how this assists in capital formation and enhancing efficiency of markets.
CDS contracts, also, are claimed to improve market liquidity. It is generally assumed that speculative interest assists in enhancing liquidity and lowering trading costs. But when the liquidity comes from leveraged investors, the additional systemic risk from the activity of these entities has to be balanced against potential benefits. The current financial crisis highlights these tradeoffs.
CDS contracts also, it is claimed, improve the efficiency of credit pricing. It is not clear whether this is actually the case in practice. Pricing of CDS contracts frequently does not accord with reasonable expected risk of default. The CDS prices, in practice, incorporate substantial liquidity premiums, compensation for volatility of credit spreads and other factors.
CDS pricing also frequently does not align with pricing of other traded credit instruments such as bonds or loans. For example, the existence of the "negative basis trade" is predicated on pricing inefficiency. In a negative basis transaction, commonly undertaken by investors including insurance companies, the investor purchases a bond issued by the reference entity and hedges the credit risk by buying protection on the issuer using a CDS contract. The transaction is designed to lock in a positive margin between the earnings on the bond and CDS fees. Negative basis trades exploit market inefficiencies in the pricing of credit risk between bond and CDS markets.
In early 2009, for example, the pricing of corporate bonds and CDS on the issuer diverged significantly. For example, the CDS fees for National Grid, a U.K. utility, were around 2% per annum compared to National Grid's credit spread to government of around 3.30%. Similarly, Tesco, the U.K. retailer, had CDS fees of around 1.40% against a credit spread to government of around 2.50%.
Another area of pricing discrepancy is the relative pricing of different firms. For example, in early 2009, bonds issued by borrowers rated "A" were trading at a higher credit spread than bonds of borrowers rated lower (say "B") in the bond market. At the same times, CDS fees for borrowers rated "A" were trading at a lower level than CDS fees of borrowers rated lower (say "B") in the credit derivatives market.
CDS contracts also are supposed to enhance information efficiency by improving availability of market prices for credit risk, thus allowing more informed decisions by market participants. But CDS contracts traded in the private OTC derivative markets provide limited dissemination of market prices, thereby limiting price discovery and any informational benefits. In reality, pricing and trading information is only available readily to large active dealers in CDS contracts – knowledge that may allow these dealers to earn economic profits.
Benefits of CDS contracts must be balanced against any additional risks to the financial system from trading in these instruments. While CDS contracts did not cause the current financial crisis (excessive reliance of debt did), they may have exacerbated the problems and complicated the process of dealing with the issues.
Risk reduction or risk creation?
The CDS market originally was predominantly a market for transferring and hedging credit risk. The contract itself has many attractive economic features and can serve useful purposes in hedging and transferring risk. Even this hedging application is dogged by some of the identified documentary issues that may reduce the effectiveness of CDS contracts as a hedge. Such problems may well be fundamental to the nature of the instrument and incapable of remedy, at least easily.
In recent years, the ability to trade credit, create different types of credit risk to trade, the ability to short credit and also take highly leveraged credit bets has become increasingly important. To some extent, the CDS market has detached from the underlying "real" credit market. If defaults rise, the high leverage, inherent complexity and potential loss of liquidity of CDS contracts and structures based on them may cause problems.
The excesses of the CDS market are evident in the recent interest in contracts protecting against the default of a sovereign (known as sovereign CDS). For example, the CDS market for sovereign debt is increasingly pricing in increased funding costs for the United States. The fee for hedging against losses on $10 million of Treasurys currently peaked at about 1% per annum or 10 years (equivalent to $100,000 annually). This is an increase from 0.01% per annum ($1,000) in 2007.
The specter of banks, some of whom have needed capital injections and liquidity support from governments to ensure their own survival, offering to insure other market participants against the risk of default of sovereign government (sometimes their own) is surreal.
The unpalatable reality that very few, self-interested industry participants are prepared to admit is that much of what passed for financial innovation was specifically designed to conceal risk, obfuscate investors and reduce transparency. The process was entirely deliberate. Efficiency and transparency are not consistent with the high profit margins that are much sought after on Wall Street. Financial products need to be opaque and priced inefficiently to produce excessive profits or economic rents.
In October 2008, former Federal Reserve Chairman Alan Greenspan acknowledged he was "partially" wrong to oppose regulation of CDS. "Credit default swaps, I think, have serious problems associated with them," he admitted to a Congressional hearing. This from the man who on July 30, 1998, stated that: "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary."
On March 6 of this year, Bloomberg News reported that Myron Scholes, the Nobel prize winning co-creator of the eponymous Black-Scholes-Merton option pricing model, observed that the derivative markets have stopped functioning and are creating problems in resolving the global financial crisis. Scholes was quoted as saying that: " [The] solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and … start over…''
As the global economy slows and the risk of corporate default increases, it remains to be seen whether CDS contracts act as instruments of risk reduction or amplify risk. Recent debates about and regulatory proposals to regulate CDS markets show a disappointing and limited awareness of these issues, most worryingly amongst people who claim to know!
Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).
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