10 December 2008

Outlook for 2009: It's All About Credit Default Swaps

This time last year, we put down a marker regarding what we expected to be the issues for 2008, namely the collapse of the housing bubble and the related slide in the US economy. Today we make another prediction: that the unwind of Wall Street's rancid leverage pile will dominate the economic and political scene in 2009, both in the US and around the world. The chief engine of that deleveraging will be CDS, the vast, unregulated market in leveraged bets fostered and encouraged over two decades by former Fed Chairman Alan Greenspan and the academic economists who populate the Fed staff in Washington.

Now Treasury Secretary Hank Paulson and Fed of NY chief Tim Geithner are trying to protect this massive pile of unfunded gaming contracts from inevitable liquidation. The under-collateralized wagers that are CDS contracts threaten the solvency of financial institutions around the globe, this despite the efforts to reform the system via enhanced clearing mechanisms, increased collateral and margin requirements. One IRA reader named Marco waxes effusive as to the palliative effects of enhanced margin requirements: "Just as regulators set the minimum amount of margin for securities/options (giving brokers flexibility to ask for MORE margin), and can increase it/ decrease it by fiat, the same should be done for CDS margin requirements. In this manner, whenever it appears that the tail is beginning to wag the entire dog, these margin increases will prevent exaggerated movements from taking place."

Would that it were so. You see, if you go back to the positions taken by NY State Insurance Commissioner Eric Dinallo, who has recently backed away from his proposal to unilaterally regulate entities that write CDS protection to insurance companies, the minimum margin would effectively be a letter of credit that demonstrates the ability of the writer of CDS protection to fund the purchase of the underlying bond at par. But alas, one of Wall Street's dirty secrets is that most of the CDS dealer banks don't post margin with one another at all! If CDS dealer banks were actually compelled to post real, effective collateral with other dealers to back performance, then the entire CDS market would collapse. Indeed, that is what is happening right now, in slow motion. As leverage in the global banking system is being forced down, the CDS market is being squeezed out of existence by a market that can no longer ignore the inherent contradictions in these OTC options.

Now you know why we have taken the view that the only way to deal with situations such as AIG is bankruptcy. Funding the AIG CDS portfolio is an open-ended proposition. But of course Paulson, Geithner et al would rather use tax dollars to subsidize this example of global casino gambling rather than tell the American people the truth about AIG and the other large CDS dealer banks such as C and JPM. And the truth, in our view, is that these large, CDS dealers are basically insolvent, with or without the distorting effects of fair value accounting. And the solvency problems arise not only because of their own CDS positions, but because their dealer counterparties have problems of their own. You may recall a couple of years ago that our former boss Gerry Corrigan, who is now global risk honcho for Goldman Sachs, started to complain publicly about the horrendous state of the back office procedures for clearing CDS.

While GS is and has been one of the chief beneficiaries of the global CDS casino, Corrigan finally started to agitate for change back in 2004 - change that only slowly came online until the DTCC picked up the ball and made it happen. You may also recall that Tim Geithner et al at the Fed began to jawbone the CDS dealers to start "netting out" their CDS exposures with one another. But the op-risk issues with CDS are as nothing compared to the pricing and funding problems with these contracts. In that sense, the focus on back office problems facing CDS and indeed all OTC derivatives has been a canard, a distraction from the real issue, namely the bankrupt intellectual basis for the CDS contracts themselves. What Geithner and Fed Chairman Ben Bernanke failed to tell the Congress, President-elect Barack Obama and the American people is that CDS dealers don't post any effective collateral at all with other dealers. So much for the legal requirements for safety and soundness in 12 CFR. If Barack Obama and the Congress ever needed a final reason to strip the Fed of all regulatory responsibility for financial institutions, the coming nuclear winter of CDS unwind is it.

You see, in the make believe world of interdealer CDS, when a "margin call" occurs, no cash or securities actually change hands. Instead the CDS dealers merely shuffle some paper around and effectively rely on the overall credit standing of the other banks, much as they do in foreign exchange or money market transactions. And virtually none of these dealers even attempt to model the actual default risk in CDS! "When CDS first began to appear in the markets, traders did try to do some work on the probability of default of a given name" one senior risk manager in New York tells The IRA. "Unfortunately, all of these efforts have been dropped in favor of a more efficient if less sound methodology based upon short-term volatility." The risk manager, who is responsible for the portfolio of one of the largest universal banks in the world, goes on to say that while he expects to see CDS evolve into a different product configuration, he doubts that an exchange model will work because "it implies a huge decrease in leverage" for the dealer banks.

Our contacts in Chicago agree. One reader of The IRA named Bob, who has close ties to the CME and the Chicago futures community, says that clearing members are reluctant to put their capital on the line to support a new CDS contract because they view the current market as toxic waste. Why should any clearing member of the CME put their capital at risk behind a central counterparty for CDS when the pricing of this market is so clearly out of alignment with the underlying risks? The fact of the matter is that, in many financial institutions, single name CDS has become a tool for supporting equity prop trading, not insuring against obligor default. Most traders of CDS have no idea about the probability of default or P(D) of the underlying credit. Nor can they demonstrate why the spreads on a given CDS contract has any relationship with the underlying P(D) credit basis, the cost of funds for that name, or anything else.

And where do CDS traders get their P(D) for their tactical trading desk "models," if we can dignify these methods with that label? Well from the Bloomberg terminal of course! Bloomberg and other global data vendors collect survey CDS spread "data" from the dealer community and calculate what is called P(D) based on - you guessed it - volatility! Equity volatility, bond volatility or just the VIX, depending on the trader. It is just market prices and efficient market theory all over again. As long as the players of this version of Liar's Poker agree that the P(D) on the Bloomberg is right, the market appears to function. But the basic relationship between spread/price in no way adequately quantifies the actual risk of default or the cash flow requirements for a provider of protection. CDS spreads are all just about trading short-term equity volatility, thus our long standing position that using CDS spreads as an indication of credit worthiness is a truly ridiculous position, especially when CDS spreads are used in contracts and securities indentures! Can you imagine obligating your organization contractually based upon a nonsensical indicator such as volatility or CDS spreads? But today there are lawyers and bankers in the marketplace who are advising clients to do just that.

As another CDS trader at a major pension fund told The IRA last week: "There are no models in CDS today. If you have an ISDA counter-party agreement between institutions, then there is no collateral at the individual transaction level. It is all dealt with via the ISDA treaty at the institution-to-institution level and thus there is no effective limit on leverage." Or as another risk manager opined: When NY Insurance Commissioner Dinallo made his proposal to unilaterally regulate CDS early in 2008, was he playing a win-win scenario? Was he merely a stalking horse for the other regulators or did Dinallo ever really mean to regulate CDS? Good questions. Given the description above, we must ask: is the dealing of CDS within large global banks "safe and sound?" Does allowing large banks to trade CDS vs. ephemeral benchmarks such as equity volatility not put the entire global financial system in peril? Well, we may find out the answer to that question sooner rather than later.

We hear from a very well placed Buy Side investor with extensive business interests in the US and EU that three primary banking institutions in Europe, two French and one German, have such significant CDS exposure and other problems that they cannot even begin to fund the payouts anticipated over the next quarter. The funding squeeze reportedly is exacerbated by a near-collapse among weaker players in the hedge fund market, who were accustomed to receiving loans from one large French institution, which then stupidly converted the loans into equity. That's right. This past summer, when the bank put out a call for redemptions of $4 billion in hedge fund investments, says the source, only $400 million was returned. And the French bank also used these same hedge funds and others to reinsure some of its own CDS exposure. Sound familiar? Yup, just like AIG.

Unlike the approach taken by Paulson and Geithner to bailout AIG and JPM (via the Bear Stearns rescue), however, the investor claims that EU officials are considering a moratorium on CDS payments by the three Euroland banks in question. The banks would be given ten years to write down their CDS and hedge fund exposures and would receive additional infusions of capital by their respective governments. The source claims that French banks have such huge exposure to both hedge funds and CDS, sometimes linked together, that the positions are beyond the ability of the EU governments to bail them out without a cessation of CDS payments. The IRA was not able to obtain a comment from EU officials over the weekend about these allegations. We'll be making some calls Sunday night and Monday. But if this unconfirmed report turns out the be true, then the beginning of the end of the CDS market as we have known it will be at hand. And ironically, the catalyst for the final solution will come not from the failure of a US dealer, but instead by a moratorium on CDS payments by an EU bank.

In the event, as other governments around the world follow the very reasonable example of the EU, the OTC derivatives market will implode and these unfunded liabilities may very well force the nationalization/liquidation of C, JPM and AIG, among others. And in the event, Hank Paulson, Tim Geithner, Alan Greenspan, Ben Bernanke and other senior officials at the Fed in Washington are going to have a lot of explaining to do to the Congress, to a new President and the global financial community. Tell us again, Chairman Greenspan and Chairman Bernanke, just why do you believe dealing in OTC derivatives and particularly CDS contracts are activities that are safe and sound for global banking institutions?

The Institutional Risk Analyst

No comments: