Monday, April 9, 2012

Basis Trader Says Credit Default Swaps Are Fatally Flawed, Replace With Bond Futures

source: Adamt4 (flickr)
While I'm on the topic of credit default swaps, on March 19, CDS trader (or basis trader, where they own both the bonds and CDS) Ben Heller told Reuters blogger Felix Salmon on Felix TV that credit default swaps are a "fatally flawed product" and should be replaced by bond futures. He thinks CDS are flawed, not because of the spike in systemic counterparty risk CDS created in 2008, or that CDS encourages a creditor to pull the plug on a company to collect an insurance payout (credit default swaps = tradable financial life insurance only available to banks, institutional investors), but because the Greek "restructuring credit event", which occurred when Greek government bond holders (PSI) took a 53% haircut on their bonds in exchange for new bonds so Greece would avoid a "payment default", almost didn't trigger Greek CDS payments. First, here is ISDA's (International Swaps and Derivatives Association) reaction to the credit event in a blog post. The ISDA governs the OTC derivative markets and the documentation. They have a committee made up of banks and investment funds that determine credit events, which is interesting.

"The second point relates to the nature and definition of a credit event. As we said repeatedly, particularly here, a contract is a contract. One can speculate about what might be or what should be – and many did. But we repeatedly urged people to read and understand the contract as written. If they had, then there would have been little surprise that the DC could really not act until the collective action clauses (CACs) were invoked by the Greek government. This important step meant that the Greek restructuring was binding on ALL holders, which is a condition required for a credit event to occur under the restructuring clause. In addition, until the Greek government acted – and posted their action in the official government gazette – the CACs were not officially invoked. This too is required before a credit event can be declared. That’s because the DCs do not vote prospectively on credit events."

Interesting, so if CACs (collective action clauses) weren't enacted by the Greek government to force the debt exchange (haircut) on all bond holders, Greek bond and CDS holders would've had to take a 53% loss on their bonds without getting a CDS payout, which is why Heller said he'd rather play roulette. But, in the end, CDS basis traders were saved when ISDA called the debt exchange with CACs a "restructuring credit event" which triggered the CDS. Heller then said sovereign credit default swaps should be replaced by bond futures. Below are important points Heller made during the interview:

"I'm getting to the point where I have to conclude that this is a fatally flawed product".

"When you think about it, it's a product that on certain poorly defined credit events offers a random payout. So, if I want to do that then I can play roulette at the casino. If Greece were able to solve its debt problems entirely by reducing the principle amount of its bonds, cutting its debt in half such that all its debt now trades at par, you would have lost 50% of your investment in the Greek government bond and the CDS would have paid you precisely zero."

"I don't accept that that's what the documents actually say. The documents suffer from really every flaw that a document can have. They are ambiguous, vague (there's fuzziness), and they are incomplete, there are things that they simply don't address. In this case the document is ambiguous.

"Somehow somebody neglected to write clearly in the document that if they reduce the principal from 100 to 50, you can still deliver the bond as though it had a principal of 100. So this essentially disconnects the payout of CDS from credit losses on a bond in any restructuring where a sovereign decides to use collective active clauses to reduce the principal of the debt. And to me that's the way that restructurings are going to be done."

"For me when I think about this product, and I think about what I'm trying to achieve, I think a bond future would work, you know a set of emerging market bond futures would work better."





I also remember financial blogger Macro Man had a post about this on October 28, 2011:

"But there is a viable alternative. TMM would like to introduce their readers to the humble Bond Future. That long-standing, well-understood derivative that has provided liquidity, transparency and price discovery to bond markets in many countries for 40 years. Bond futures with deliverable bond baskets allow basis trading, speculation and hedging, without the idiosyncrasies of CDS contracts. But of course, futures markets aren't that profitable for banks... well, you reap what you sow, right?"

It's funny because even after the debt restructuring, Greek CDSs are still f*ing with the market!:

"Yields on new Greek bonds have jumped sharply in the past week amid worries over a shutdown of the market in insurance-like products used to hedge the risk of holding Athens’ debt."

I'm more interested in how credit default swaps put more weight on destruction than hedging, which puts other markets at risk. To me, equity options are the equivalent of health insurance and credit default swaps are like life insurance. But, life and death can be controlled by the owner of the insurable asset (creditor), which is similar to killing someone for an insurance payout. I've mentioned previously that equities and equity indexes have liquid options and futures markets that trade at the CBOE and CME, and are available to the public through discount brokers, so why aren't there liquid bond options and more bond futures available? I see that the bond market is starting to trade like stocks on the NYSE, and moving away from the illiquid, overpriced dealer environment, but what about asset-backed securities (ABS, MBS, CMBS) and credit default swaps? Why wasn't there an exchange traded ABX Index product pitched to every "retail" wealth management client rather than Lehman Brothers principal protected notes? If there were exchange traded credit derivative products available to the public, and banks were pitching a retail version of the ABX Index (via futures in ETPs, or whatever) to non-institutional clients, while Paulson & Co. (via investment bankers) was making billions shorting the ABX Index (aka buying the ABX CDS Index which shorts the referenced MBS), you'd think maybe charts going up and retail investors making good money would at least signal to strategists at banks, or the "sophisticated" subprime MBS or CDO buyers, aside from monitoring loan delinquency trends or even the ABX Indices on Bloomberg terminals, to maybe slow down the origination and securitization of toxic mortgages, and purchases of toxic MBS. But maybe not, since incentives for fees and bonuses kept the party going. Remember, these bankers were making markets in credit default swaps (subprime MBS credit protection) and blowing up their own firms at the same time!

After the financial crisis, billionaire fund manager George Soros mentioned how credit default swaps are "instruments of destruction" and should be outlawed. Here's more from his op-ed in the Financial Times on 6/16/2009, which was also posted at Soros.com.

"Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent.

Custom made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of AbitibiBowater and thatof General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else's life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed."

Soros on credit default swaps at Reuters.com on 6/12/2009:

"Soros said the asymmetry of risk and reward embedded in CDS exerted so much downward pressure on the bonds underlying the contracts that companies and financial institutions could be brought to their knees."
"Going short on bonds by purchasing a CDS contract carried limited risk but almost unlimited profit potential. By contrast, selling CDSs offered limited profit and practically unlimited risk, Soros said.

This asymmetry, which encouraged investors in effect to sell corporate bonds short, was reinforced by the fact that CDS were traded and so tended to be priced as warrants, which could be sold at any time, and not as options, he added.
"But the potential damage that CDS could do was not limited to financial firms, Soros added. He pointed to the bankruptcy of North America's largest newsprint maker, AbitibiBowater Inc ABWTQ.PK, and the pending bankruptcy of General Motors (GM.N)

"In both cases, some bondholders owned CDS and they stood to gain more by bankruptcy than by reorganisation.

"It's like buying life insurance on someone else's life and owning a license to kill," he concluded."

And here are John Paulson's own words on credit default swaps (WSJ on January 18, 2008):

"In betting on it to crumble, "I've never been involved in a trade that had such unlimited upside with a very limited downside," he says." (ha)

Here's an interesting report by the New York Fed I found on CDS vs. corporate defaults: Are Credit Default Swaps Associated with Higher Corporate Defaults?

"Are companies with traded credit default swap (CDS) positions on their debt more likely to default? Using a proportional hazard model of bankruptcy and Merton’s contingent claims approach, we estimate the probability of default for U.S. nonfinancial firms. Our analysis does not generally find a persistent link between CDS and default over the entire period 2001-08, but does reveal a higher probability of default for firms with CDS over the last few years of that period. Further, we find that firms trading in the CDS market exhibited a higher Moody’s KMV expected default frequency during 2004-08. These findings are consistent with those of Henry Hu and Bernard Black, who argue that agency conflicts between hedged creditors and debtors would increase the likelihood of corporate default. In addition, our paper highlights other explanations for the higher defaults of CDS firms. Consistent with fire-sale spiral theories, we find a positive link between institutional ownership exposure and corporate distress, with CDS firms facing stronger selling pressures during the recent financial turmoil."

How are the $700 trillion of notional illiquid OTC derivatives outstanding supposed to manage credit risk, fraud risk, oil spike risk, interest rate risk, financial risk, and liquidity risk all at the same time? Seriously, how do you honesty calculate all of this risk and counterparty risk effectively? After 2007 and 2008 happened, isn't it clear that OTC derivatives fueled systemic risk during the financial crisis rather than protect from it? In the end, I've come to the conclusion that this market has to be on exchanges to protect the financial system. Not hidden inside bank infrastructure and Bloomberg terminals for banks and hedge funds to either fuel or profit from margin calls and forced bankruptcies. There is some good news though. CDX futures may be arriving soon. Why didn't they take off in 2008? See: CBOT CDR NAIG Index Futures. Not profitable? Too much transparency? I actually charted out the Liquid 50 Credit Default Swap Index Future (CX) on September 16, 2008 when Lehman was trading at $0.22! The future was shut down soon after that. Here's more on the potential development of CDS futures.

Futures On Credit-Default Swaps Seen As Natural Evolution (WSJ)

"The swaps--traded over the phone or on-screen, with prices known only to trading partners--are the domain of asset managers and hedge funds with the sophistication and financial wherewithal to take on complex risks.

Futures, by contrast, are more routine instruments used by institutions and individual or "retail" investors. Futures prices are displayed publicly on exchanges, and customers can trade them directly with other customers--unlike in the swaps market, where a dealer is on one side of every trade.

Dealers have long been fiercely protective of keeping the status quo in credit-default swaps or "CDS" because they have booked fat profits from customers not being able to see where other customers are trading. But dealers believe that opening up the market with a futures contract could bring in a more diverse user base, and that they could make up for thinner margins with larger volumes."

"Kevin McPartland, principal at the independent research firm TABB Group, said these so-called "liquidity" issues would drive more trading in CDS and "that would only translate to demand for CDS futures" so long as they offered some economic benefits over the existing swap contract.

A dealer working on the CDX futures project said it could be a solution that would drive volumes because the contracts could be traded in smaller sizes than CDS, and this could appeal to investors not currently trading in swaps. "It's something that makes sense," he said."

I see that Kevin McPartland (of TABB Group), who was quoted in the article above, blogged about the article at Kevinonthestreet. The first comment by John Needham, of Needham Consulting, was more interesting though, in my opinion. Here's a portion of it. Why not cut the notional size of single-name CDS and put them on exchanges?

"By making the sizes smaller, and making the contracts more trade-able, I think there was an opportunity for clearing to create an S&P index-style CDS index future (or multiple of them) which could easily have led to more trading, greater liquidity, better price discovery, better hedging opportunities, and other benefits.

In time, single-names could have followed the path to futures-style clearing much like single-stock-futures followed the indices (though that analogy is stretched, I admit)"

There are already S&P/ISDA CDS indices, and they just added U.S. and European bank indexes:

"S&P/ISDA 100 CDS
S&P/ISDA CDS European Banks Select
S&P/ISDA CDS U.S. Consumer Discretionary Select
S&P/ISDA CDS U.S. Consumer Staples Select
S&P/ISDA CDS U.S. Energy Select
S&P/ISDA CDS U.S. Financials Select
S&P/ISDA CDS U.S. Health Care Select
S&P/ISDA CDS U.S. High Yield
S&P/ISDA CDS U.S. Homebuilders Select
S&P/ISDA CDS U.S. Investment Grade
S&P/ISDA Eurozone Developed Nation Sovereign CDS
S&P/ISDA International Developed Nation Sovereign CDS"


But, given how complex the settlement process is on credit default swap indexes, there's an issue with figuring out how futures on the CDX would be settled.

Push Sputters for Credit-Default Swap Futures (WSJ)

"The idea was for the futures to work much the same way as those on U.S. Treasury notes and bonds, which allow traders to wager on where prices will be on specific dates. The bankers hoped the so-called CDX futures would be traded by a range of hedge funds and high-frequency trading firms that make bets on relative movements among stocks, debt, currencies and interest rates.

But designing the new product proved highly complex. Dealers had a hard time figuring out how futures on the CDX would be settled, when the index wasn't a physical asset like a security or commodity that could be easily delivered from a seller to a buyer. Also complicated was how a futures contract would be affected if corporate-bond defaults triggered payouts among credit-default swaps in the index.

The challenge is, "how do you create a future on a swap" that on its own "is fairly complicated to begin with?" said Dave Klein, partner at Capital Context, a credit-research firm."

Either way, who made the debt markets so complicated? It is debt, the most important part of finance. Why are stocks, options (equity derivatives - minus total return swaps), and OTC traded penny stocks, easier to trade than leveraged loans, senior secured bonds, mortgage-backed securities, and credit derivatives? Why was it easier for someone to invest in penny stocks than distressed debt or the ABX CDS Index (with unlimited upside and limited downside) for pennies in 2006. It doesn't make any sense. CDSs aren't different from other markets. You can still lose money when buying put options (insurance protection) on a stock, and there are capital requirements. Is there a way for smaller leveraged loans (highest seniority in capital structure), senior secured bonds, MBS, ABS, CMBS, and smaller notional values of credit default swaps, to trade on an exchange for retail consumption? How would that work?

For transparency purposes though, it's nice that Bloomberg.com has sovereign CDS and a few single-name corporate credit default swap quotes and charts available (delayed) on its site for the public to see. I'm not a credit derivative professional or expert, but I witnessed how shadow OTC markets for loans and mortgages, mortgage-backed securities, asset-backed securities, commercial mortgage-backed securities, credit default swaps, CDOs, and synthetic CDOs (financial suicide bombs), distorted risk in every market, blew up the banks, and would have sent the economy into a depression if the Fed/government didn't bail out the insanity. So, there is obviously a need for efficient market pricing, liquidity, and transparency in the credit and CDS market. The "accredited investor" rule that says investment banks, commercial banks, hedge funds, insurance companies, CDO managers, and high net worth individuals, have the income, equity, and sophistication required to manage the credit market is incorrect, imho. Or it needs to be revised. The funny thing is, these accredited and sophisticated financial institutions were investing in fraud loans at risky mispriced valuations (90% LTV with mispriced appraisals, when the ABX Index was falling like a rock?), packaging these loans into securities, repackaging them into CDOs, playing with the insurance (CDS) that reference these securities, which ended up blowing up their firms and the whole financial system. So, I have a question: who was more accredited and sophisticated with their investment decisions, the homebuyers or loan buyers and packagers? Does someone need to be an accredited investor to buy a house?

In my opinion, normal people, not just the financial mathematical geniuses on Wall Street, should be the new community banks. Independent bankers, or a team of independent bankers with skin in the game, should be underwriting credits and lending money to communities through online banks, and have the ability to lend against assets (secured loans). Independent online banks could team up with larger financial institutions as a backbone, similar to the way independent financial advisors work. I mentioned previously that online investment managers and brokers like Covestor, Prosper, and SecondMarket (still locked w/ the accredited investor rule) could combine somehow and take on Wall Street (or team up). And don't forget the CME, Nasdaq and NYSE, they could also revolutionize these markets.

Lastly, check out this research paper on the ABX.HE index, the same index Paulson used to make $12 billion in 2007: The Bear’s Lair: Indexed Credit Default Swaps and the Subprime Mortgage Crisis.

"During the recent nancial crisis, ABX.HE index credit default swaps (CDS) on baskets of mortgage-backed securities were a benchmark widely used by financial institutions to mark their subprime mortgage portfolios to market. However, we find that prices for the AAA ABX.HE index CDS during the crisis were inconsistent with any reasonable assumption for mortgage default rates, and that these price changes are only weakly correlated with observed changes in the default performance of the underlying loans in the index, casting serious doubt on the suitability of these CDS as valuation benchmarks. We also find that the AAA ABX.HE index CDS price changes are related to short-sale activity for publicly traded investment banks with significant mortgage market exposure. This suggests that capital constraints, limiting the supply of mortgage-bond insurance, may be playing a role here similar to that identified by Froot (2001) in the market for catastrophe insurance.

So, what if there were more liquid and transparent "hedges" available on exchanges?

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