Another day, another article demonizing CDS

November 28, 2009 in Finance

Bloomberg has a new article up about how the CDS market is starting to crumble - the sort of piece that looks like it's been sitting on a back burner waiting for an excuse to stoke the flames of derivative fear (thanks, Dubai!).

One of the article's chief arguments is that "credit-default swaps tied to Thomson SA, the Paris-based owner of film processor Technicolor Inc., paid some holders 30 percent less than those with contracts expiring a day later." First, however, a technicality - CDS can only expire on four days of the year: the 20th of March, June, September and December (the so-called "roll dates"). Thus, the description of contracts that expire "a day later" is inaccurate. This brings me to a key point: one of the nice things about (most) fixed income is that the terms are... well, fixed. Traders know in advance when a contract will terminate, as well as the quantity (or at least the terms) and timing of any future cashflows. Those definitions extend to procedures in the event of default.

The credit event in Thomson's case was one of restructuring, the procedures for which were recently updated as part of ISDA's new "small bang" European protocol. Naturally, in a restructuring event - the debate over whether it should even constitute an event will be left for another post - it may be tough to claim that insurance should pay out. On the one hand, the fixed income product that was being insured just had its terms adjusted (no longer fixed, no longer the same!). On the other hand, the present value of the cashflows should be unchanged which in theory would make investors indifferent (obviously, that's not the case). Without a cessation of payments, it's hard to claim that insurance should pay the balance. Therefore, rather than have all insurance contracts pay out uniformly for all referenced bonds, which would fail to capture the odd nature of the restructuring event, traders agreed to set up "buckets" which will each pay out a value deemed fair by market action. The buckets are divided by time to maturity; in Thomson's case, there were multiple buckets including a 2.5 year bucket, a 5 year bucket, and a 7.5 year bucket. This way, debtholders could more accurately match their insurance claim to the affected bonds.

The crux of Bloomberg's argument seems to be that a swap maturing on the last roll date of one bucket would pay differently than one maturing on the first roll date of the next bucket (note the semantics - none of this "maturing one day later" language). But under the terms of the protocol, which market participants ratified, that seems appropriate to me. Remember, fixed income means terms are defined in advance. If Thomson had bonds that matured one day before the restructuring was announced, then those bonds would pay out par while bonds maturing the next day would presumably have crashed on the revelation that there isn't cash to pay them in full (remember, unlike CDS, bonds can and do mature on any day of the year). That actually just happened with the Nakheel December 2009 bonds, which were trading well above par before Dubai's surprise announcement brought them back to the 70's overnight. In sum, the fact that some fixed income instruments are treated differently than other is not alarming - maturity and seniority are prime components of the fixed income market and naturally force bonds into differently performing buckets on a daily basis.

So if we can't fault CDS for the fact that one contract pays out differently than another, maybe we can find something to be upset about because the 2.5 year bucket recovered 30% more than the 5 year bucket (in CDS terms, recall that recovering more means the contract pays less: if a bond recovers its full value, the insurance would pay out nothing at all). But here's a secret: the disparity arose because of problems in the underlying cash market, not the derivatives market! Okay, it's not really a secret. Euroweek figured it out well before the auction even took place:

Most of Thomson’s deliverable obligations are thought to be complex private placements and little is known about their documentation. It is possible that none will be deemed eligible for delivery.

CDS payouts aren't determined by a bunch of traders standing in a room shouting - they are set by the market-clearing price on bonds ("deliverable obligations") that are submitted by CDS holders in return for insurance payouts. It's a straightforward system: CDS buyers purchase bonds in the market, then give them to the CDS sellers in return for their par value. The net payment is therefore par less the bonds traded price, or recovery. If there are few bonds available, or little transparency or liquidity about those bonds, then their market price will fluctuate for technical reasons rather than fundamentals. This phenomenon can occur with any traded security: short squeezes are perhaps the most familiar example. That's exactly what happened with Thomson - so few of the short-dated deliverables were available for public trading that the market clearing price was bid up extremely high. In the next bucket, bonds were more liquid and so reflected recovery more accurately.

Euroweek described it nicely (again, well before the auction even took place): is very likely that there will be a shortage of deliverable obligations and a scramble to get hold of what is available. The consequent short squeeze will drive up prices and the recovery rate much higher than it would otherwise be — good news for protection sellers but bad news for the buyers. For example, the most likely and liquid deliverable obligation, according to Citigroup analysts, is the June 2012 revolver, which would fall in the 2-1/2 to five year maturity bucket. It has been pushed from a 40% price to 70% in recent days.

But the real difficulties lie in the 0 to 2-1/2 year bucket. Thomson, a French media firm, was a regular member of the main iTraxx Europe Index from series 1 to series 7 and was thus much referenced in index CDOs. There are a lot of single name hedges against the name with maturities between now and 2012, putting particular pressure on the 0 to 2-1/2 year bucket.

I'm still waiting for the article titled "CDS auction goes smoothly despite problems in bond market."

To Bloomberg's credit, there is a deserved debate over restructuring events and CDS more generally outside the Bang protocols (and even within them). Moreover, the Thomson example - though I disagree with the author's specific points - is a good one for demonstrating how settling CDS remains a mystifying and seemingly arbitrary process. There is no doubt that further clarity is needed, for the benefit of all market participants. The rest of the article deals with the lack of transparency into what qualifies as a credit event and murkiness following that declaration. I have to point out that though the arguments there have merit, their very existence demonstrates that CDS by nature doesn't force companies into default or anything along those lines - otherwise these arguments would be settled by a simple imperative to bankrupt the firm.

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