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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):

…it 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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A major international airport deals in derivatives…

November 10, 2009 in Finance

Contrary to what you might expect, the WSJ reports that San Francisco International has had great success in their adventures with interest rate swaps, providing a breath of fresh air amidst the media’s usual “swaps ruin the economy” fare. SFO has taken on interest rate exposure in 2005 and 2008 has two more contracts that will take effect in 2010. The swaps enable them to hedge the cost of their debt, and have lowered their cost per passenger by an astounding 31%.

The key to their success is this attitude:

“If we … can’t understand it, (we) shouldn’t be approving it,” Mr. Kone said.

Merely understanding something has never guaranteed a profit, but the opposite approach has ruined many financial endeavors. I applaud Kevin Kone, SFO’s head of capital finance, for his perception.

For the curious, SFO has published the full details and legal documentation of the swap contracts on their investor relations website.

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Measuring aggregate risk in CDS markets

September 25, 2009 in Finance, Risk

The ECB recently published this lengthy report (PDF link) on the state of the CDS market, with particular focus on counterparty risk. It is well worth a read for either a cursory overview or more in-depth look at the mechanics and concerns of that market.

Section 3.4 regarding counterparty risk measures was especially interesting to me. Consider the passage on the use of gross outstanding notional as an indicator of risk (emphasis mine):

The notional amount of a credit default swap refers to the nominal amount of protection bought or sold on the underlying bond or loan. Notional amounts are the basis on which cash flow payments are calculated.

The gross notional amount reported by the BIS is the total of the notional amounts of all transactions that have not yet matured, prior to taking into account all offsetting transactions between pairs of counterparties. As outlined above, gross notional amounts thus represent a cumulative total of past transactions. Using gross notional amounts as an indicator of counterparty risk may be misleading, as many trades are concluded with a single counterparty.

Once negotiated, CDSs bind both counterparties until the agreed maturity. Market participants basically have three choices when increasing or reducing their CDS exposures.

First, they can terminate the contract, provided the counterparty agrees to the early termination. Second, they can fi nd a third party to replace them in the contract, provided the counterparty consents to the transfer of obligations (“novation”). As a third option, dealers that want to unwind or hedge their positions can also enter into offsetting transactions, sometimes (though not necessarily) negotiated with the same counterparty as the hedged deal. The third solution is used extensively, and so the number of trades has surged, resulting in an increase in total gross notional amounts. Indeed, this technique, by contrast with the other two, does not eliminate previous deals and instead adds them together. The end result is that external market commentators tend to pay too much attention to the gross market values in relation to other measures of the real economy such as GDP, whereas net notional amounts, where accounted for, may be downplayed or perceived as being very low or moderate in relative terms given the huge gross notional amounts outstanding.

The gross notional amount reported by the BIS is the total of the notional amounts of all transactions that have not yet matured, prior to taking into account all offsetting transactions between pairs of counterparties. As outlined above, gross notional amounts thus represent a cumulative total of past transactions. Using gross notional amounts as an indicator of counterparty risk may be misleading, as many trades are concluded with a single counterparty.

Once negotiated, CDSs bind both counterparties until the agreed maturity. Market participants basically have three choices when increasing or reducing their CDS exposures.

First, they can terminate the contract, provided the counterparty agrees to the early termination. Second, they can fi nd a third party to replace them in the contract, provided the counterparty consents to the transfer of obligations (“novation”). As a third option, dealers that want to unwind or hedge their positions can also enter into offsetting transactions, sometimes (though not necessarily) negotiated with the same counterparty as the hedged deal. The third solution is used extensively, and so the number of trades has surged, resulting in an increase in total gross notional amounts. Indeed, this technique, by contrast with the other two, does not eliminate previous deals and instead adds them together. The end result is that external market commentators tend to pay too much attention to the gross market values in relation to other measures of the real economy such as GDP, whereas net notional amounts, where accounted for, may be downplayed or perceived as being very low or moderate in relative terms given the huge gross notional amounts outstandingNotional amounts are the basis on which cash flow payments are calculated.

The gross notional amount reported by the BIS is the total of the notional amounts of all transactions that have not yet matured, prior to taking into account all offsetting transactions between pairs of counterparties. As outlined above, gross notional amounts thus represent a cumulative total of past transactions. Using gross notional amounts as an indicator of counterparty risk may be misleading, as many trades are concluded with a single counterparty.

Once negotiated, CDSs bind both counterparties until the agreed maturity. Market participants basically have three choices when increasing or reducing their CDS exposures.

First, they can terminate the contract, provided the counterparty agrees to the early termination. Second, they can fi nd a third party to replace them in the contract, provided the counterparty consents to the transfer of obligations (“novation”). As a third option, dealers that want to unwind or hedge their positions can also enter into offsetting transactions, sometimes (though not necessarily) negotiated with the same counterparty as the hedged deal. The third solution is used extensively, and so the number of trades has surged, resulting in an increase in total gross notional amounts. Indeed, this technique, by contrast with the other two, does not eliminate previous deals and instead adds them together. The end result is that external market commentators tend to pay too much attention to the gross market values in relation to other measures of the real economy such as GDP, whereas net notional amounts, where accounted for, may be downplayed or perceived as being very low or moderate in relative terms given the huge gross notional amounts outstanding.

It’s easy to come up with an example which illustrates the problems with gross notionals (the ECB’s “third solution”):

Dealer A sells $1mm of protection to Fund X. The gross notional at this time is $1mm, and the maximum that could be lost (in an extreme case with 0% recovery and the original contract transacted at a zero spread) is also $1mm. Now Dealer B sells $1mm of protection on the same name to Fund Y. The gross notional is $2mm, and so is the maximum loss in the market. But what if Dealer B had sold CDS to Dealer A instead? Then the gross notional would still be $2mm, but only $1mm could be lost, as Dealer A has hedged its position completely. Thus, gross notional has overstated the risk present in the marketplace.

Net notional is a much better measure, but, in line with my parenthetical aside, does not quite capture the risk at hand; it only does so under extreme circumstances. (It also isn’t nearly as dramatic a number, so the media is more loathe to deal with it.)

In my experience, jump to default (JTD) and jump-or-bleed to safety (JTS) measures are instructive methods for evaluating risk. Most commonly, these measures are evaluated with respect to the reference issuer, but they are easily applied to the counterparty as well. However, calculating them in aggregate – at the market level – requires knowledge of the various contracts’ market values, data which is not presently made public (gross and net notional values are available from the DTCC).

Finally, the ECB makes the salient point that any market-wide counterparty risk measure must account for collateralization. There is some ambiguity there, however, because a contract which is fully collateralized on a mark-to-market basis still has considerable counterparty risk in a jump event. Frequently, protection buyers may find that to be wrong-way risk, meaning that the exposure to a counterparty is inversely related to that counterparty’s credit rating. For example, a counterparty defaults, driving credit spreads wider (a profitable event for the protection buyer) but also making other counterparties more likely to default (a very bad thing for the protection buyer).

In failing to find a clear, universal or simple risk metric for this market – which I don’t think is necessarily preferable given the over-reliance and under-comprehension placed on VaR after its wide dissemination – we may find that the best outcome is to strive for transparency in understanding. A strong education in the mechanics and risks of complex markets is an important step forward and a necessary prerequisite for market participants in both direct and regulatory roles.

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More reverse convertibles: cutting the nose to spite the face?

June 18, 2009 in Finance

Felix is back at the forefront of the “ban reverse convertibles” charge. He makes some salient points, but continues to encourage a slippery slope form of regulation that would ultimately handicap an industry to protect the naive daytrader.

Referring to embedded short options in general, he notes:

But retail-facing financial instruments should never embed such bets, because retail investors, as a rule, lack the sophistication necessary to be making such bets in the first place.

I suppose then that we should ban nearly every corporate bond (which contain embedded short calls at par), as well as the practice of “covered calls” (broker-jargon for a collateralized short put)? In fact, why not ban levered ETFs as well, since they are mathematically destined to wind up worthless? You can’t ban products just because someone isn’t capable of understanding it. Imagine if all industries bent to the will of the most naive user!

He continues:

Fernando looks at those investors and says it’s “their responsibility to be skeptical buyers”. No. It’s the stockbroker’s responsibility to act in the investor’s best interest, and it’s the government’s responsibility to prevent the sale of products which can end up being extremely damaging to those who buy them. As Elizabeth Warren famously says, no one has a problem with the government banning the sale of dangerous toasters, and dangerous financial products cause much more damage than dangerous toasters ever do.

Who is still foolish enough to think that their broker’s interest is in “looking out for them” as opposed to “selling stuff to make a commission”? And as for toaster ovens, well, it’s very easy to describe a bad toaster oven – it spontaneously combusts, or in some way fails to do something other than its stated purpose of charring bread. How can we tell if a financial instrument is deviating from its stated purpose? What is its stated purpose in the first place?

Imagine getting a call from your broker, saying that, “The stock you bought has dropped too much, so we’re going to refund you everything you invested because this isn’t how stocks are supposed to work.” That would be great – unless you were on the other end: “You sold stock to us, but it’s gone down a lot and we’re going to need you to reimburse us, since we didn’t buy it with the intention of losing money.”

Felix concludes:

The fact is that reverse converts, in particular, are the kind of product which can cause a great deal of harm; what’s more, they exist entirely so that banks can use their stockbroking arms to rip off their clientele. Banning them would do much less harm than selling them. So let’s ban them, and their ilk.

I can’t think of any product that doesn’t have the potential to cause “a great deal of harm.” Stocks, bonds – just about anything except a Treasury note (and even there…) can hurt investors. And as for the “exist solely” part, what exactly does Felix think stockbrokers do? Transaction costs are famously egregious! Oh, that’s right, he thinks they look out for the interests of their clients and try to protect them.

Basically, Felix’s plan is to ban anything that could hurt a naive investor. I have a better idea: ban naive investors from products they don’t understand. This has worked rather well with CDS: only qualified institutional investors may trade the product. In fact, there are many examples of products which require institutional status to trade. There is no need to cut off the nose to spite the face by banning certain products rather than simply restricting access.

Besides, let’s be honest, if you ban one bad product another will just pop up to take its place. The world is full of double-knock-in snowball ratchet options, and there’s always another salesman waiting to pitch them.

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Dead shoots?

May 22, 2009 in Economics

Happily, I’ve only used the term “green shoots” one time in the brief history of TGR, and then only sarcastically in the title of this cartoon (which I stand by, as this post should make evident).

The term has always struck me as ridiculous, and not solely because it was first uttered at a time when it was not only false, but utterly misleading. What’s worse is that the manner in which the media has pounced on the phrase has eliminated any shades of meaning, much as our eyes glaze over as reports of “billions of dollars lost” and “hundreds of thousands of jobs eliminated” come out — we have become desensitized by the magnitude of the concept and our overexposure to it (not to mention that no matter how many times we shut our eyes and whisper, it doesn’t seem to materialize).

Ultimately, the term has become synonymous with the “second derivative” argument – things are getting worse, but they are getting worse at a slower rate – green shoots sprouting! And while I don’t at all equate “not-as-bad news” with “good news”, I was happy to let the second derivative camp savor their banner phrase.

Until this morning.

For some reason, today I finally began to think about what “green shoots” really means: it represents the spring, rebirth and growth. It doesn’t stand for a positive second derivative, but for a positive first derivative – something universally aknowledged not to be the case. I find this revelation infuriating: if we don’t have a positive first derivative, representing growth, then how can there be green shoots, which also represent growth?

For those willing to continue reading, I’ll illustrate what I mean with graphs that may confuse more than they educate. Shall we? Let’s shall.

Follow a plant through it’s life cycle: it grows in spring, flourishes in summer, withers in the fall and essentially hibernates in the winter (I don’t know what the proper horticultural term is). Since I want to tie this back to derivatives and such, let’s get some math involved. A simple graph of the flower’s height above the ground might follow a sinusoidal curve and, courtesy of Wolfram Alpha really coming through, look like this:

Here is its first derivative:

And here is its second derivative:

In all these graphs, 0 is winter, 1 is spring, 2 is summer, 3 is fall, and 4 is winter again. Also, a key point is that because this is a graph of height above the ground, green shoots would be observed somewhere between 0 and 1, as the plant first emerges from the soil.

Now we need to figure out where we are in this hypothetical plant lifecycle. We know we have a negative first derivative, which puts us between 2 and 4 (summer and winter). We also have a positive second derivative – for argument’s sake – which limits us to sometime after 3 (fall). So we are in the space between fall and winter; our economic “plant” is withering away, albeit at a slower pace than it was during the first cold snap.

So, IF the plant metaphor holds (and let’s assume it does, for why else would we use the term “green shoots”?) and IF we are seeing the second derivative turn positive (and I’m not ready to aknowledge that, yet, but the green-shootists are) and IF the first derivative remains negative (no doubts there), we have not yet made it to spring. Only as we reach spring does the first derivative turn positive and green shoots emerge. Just to be absolutely clear: there are no green shoots yet.

(You’re right, I could have spared you and written that much earlier, but I wanted to use the graphs.)

You will notice that in the winter, the plant actually retracts back into the ground, but I suppose “brown shoots” or the titular “dead shoots” doesn’t quite capture the spirit of that positive second derivative. I’m sure there must be other plant metaphors, like “winter blossoms” or “the last leaves to fall”, that are more appropriate.

I suggest ”pushing up daisies”.

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