Credit Derivatives

Bloomberg new has gone especially gloomy lately. On Tuesday it was the really, really long expose on counterparty risk in credit default swaps. Today Mark Pittman follows up on variable interest entities, the ugly step child of the off-balance sheet special purpose vehicles that Enron made infamous.
We wrote about these way back in February, when people were first waking up to the fact that banks had undisclosed exposure to mortgage backed securities held by VIEs. Now lawmakers, regulators and accounting standards people are considering rules that would prevent off-balance-sheet treatment for VIEs.
Bloomberg highlights one short-lived VIE with a particularly unfortunate name. Launched by Citigroup just as the mortgage market was collapsing, the $2.5 billion entity known as Bonifacius Ltd was loaded up with subprime mortgages. Six months later it was dead. Bonifacius, as our readers with classics degrees undoubtedly know, was named called “the last of the Romans” by historian Edward Gibbon, author of The Decline And Fall Of The Roman Empire. Bonifacius “fought and died for a fading empire.”
Citigroup’s `Last Roman’ CDO Shows Enron Accounting [Bloomberg]

Moody’s Multi-Billion Computer Bug

As it turns out, our robot overlords are destroying human civilization.

Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models, a Financial Times investigation has discovered.
Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.

Simple question: If a computer bug is Moody’s excuse, why did these things get triple A ratings from Standard & Poor’s also?

CPDOs expose ratings flaw at Moody’s
[Financial Times]

Credit Default Swaps: The Next Subprime?

Today’s must-read story is Bloomberg’s David Evans on counterparty risk in the credit default swap market. The credit default swap market is the focal point for a lot of fear these days. It’s lightly regulated, non-transparent and there’s thought to be lots of trading on inside information in the market. Rising defaults, particularly in riskier so-called “high yield” debt (also known as “junk bonds”), now has many people worried that credit default swap market could be worse than subprime. Yves Smith describes it as “a disaster in the making.”

The credit-default-swap market has been untested until now because there’s been a steady decline in global default rates in high-yield debt since 2002. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody’s Investors Service.

Since then, defaults globally have dropped to 1.5 percent, as of March. The rating companies say the tide is turning on defaults.

Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002.

Many large institutional investors and banks have bought credit default swaps from counter-parties, often hedge funds, without adequate knowledge of financial position of the seller. Many sellers might be unable to pay, particularly if defaults cascade, with many coming at once. When defaults ramp up and those investors try to collect on the insurance policies they bought, they are likely to discover that many investors cannot afford to pay.
Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, estimates that hedge funds that will be unable to pay banks for credit default swaps tied to at least $35 billion in defaults. That’s his conservative estimate. He also says the uncollectables could go as high as $150 billion.
That’s pretty scary, we’ll agree. Of course, there has been a lot of fear and loathing about credit default swaps for quite some time. Not too long ago the complaint was that the lack of transparency was creating opportunities for insider trading. Evans’ story is admirable because it ties the risks of the CDS with the media’s favorite financial villain, hedge funds. With all the losses coming from Wall Street titans like Bear and Citi, it’s been hard to blame the hedge funds for creating “systemic risk.” But it looks like that trade is back on.
Also, we can’t talk about credit default swaps without remembering our favorite version of the old “you have two cows” joke.

Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults
[Bloomberg]

  • 20 Jun 2007 at 12:10 PM
  • Banks

Bear Stearns Hedge Fund Fire Sale Already Under Way

bearstearnsblackandwhite.gifThe last minute effort by Bear Stearns to rescue its High-Grade Structured Credit Strategies Enhanced Leverage Fund seems to have collapsed. Moments before midnight last night, the Wall Street Journal’s Kate Kelly reported that Merrill Lynch was going to push forward with its plan to sell at least $850 million of mortgage-related securities it seized from the hedge fund. This morning the New York Post’s Roddy Boyd said that end had come for the fund. And now CNBC’s Charlie Gasparino is reporting that JP Morgan and Deutsche Bank have already begun selling collateral they seized from the hedge fund.
The securities were collateral assets for leverage the banks had extended to the debt-heavy fund. The fund has reportedly been battered by bad bets in collateral debt obligations and mortgage securities. The widely publicized trouble in the subprime sector helped make shorting subprime—which hedge funds did through a complex array of swaps and derivative products offered by investment banks—a popular and profitable bet late last year and earlier this year. But when banks reportedly began to ease credit terms on mortgage holders in a coordinated effort to stave off mass defaults and a meltdown in the market, many of these positions went bad for the fund.
[How leverage and bad directional betting crushed the fund, after the jump.]

Read more »

Gino_Tzannatos_large.jpgIs the market for credit default swaps rife with insider trading? That depends on what you mean by insider trading.
Use the term in a loose sense—say defining “insider trading” as trades where one party has material nonpublic information unavailable to their trading counterparts—and the answer is clearly yes. There is a lot of that sort of insider trading in the credit default market, and there is likely to be even more as the market grows and more players gather around the table.
But since federal securities regulations against insider trading apply only to insider trading in securities, the question of whether this counts as “insider trading” in a strictly legal sense is murkier. Credit default swaps do not fit the traditional definition of securities. Prior to the enactment of the Commodity Futures Modernization Act of 2000, there was a lot of debate over the legal answer to the question of whether they should be categorized with the most common types of securities-stocks and bonds. The CFMA split the difference by declaring that swaps were not securities but that insider trading and other federal anti-fraud measures still applied to swaps where the underlying credit was a security, such as those based on publicly traded bonds.
But this has been controversial from the start. Few of those trading in the credit default swap market were calling out for protection from insider trading. Many hedge funds and other debt-holders active in the credit default market lack the kind of internal controls and so-called “Chinese Walls” that investment banks and brokerages have had to build to prevent insider trading in securities. And most of the other market participants are aware that this is the situation. In short, there is plenty of asymmetrical information in the credit default swap market but that fact is widely–even symmetrically–known. Moreover, the legal status of more complex financial products not directly tied to individual securities remains murky.
Regardless, it seems the regulators are exactly crying out to enforce insider-trading laws against the traders in the credit default market either. Right now no US regulatory agency claims oversight jurisdiction for credit-default swaps. Not the SEC. Not the Commodity Futures Trading Commission. Not the Treasury Department. Not the Federal Reserve.
Since no one enforces insider trading laws in the credit default swap market, and apparently no one has the jurisdiction to enforce insider trading laws, it seems the laws only apply to the market in some metaphysical, theoretical sense. There’s something of a tree falling in an empty forest thing going on with the application of insider trading laws to credit default swaps. If a statute applies insider trading regs to credit default swaps but no one enforces it, does the tree make any sound?
Over on his new blog at Portfolio, Felix Salmon points us toward the remarks of Erik Sirri, the director of the SEC’s division of market regulation.
Salmon writes:

Sirri came out and said what everybody in the markets knows but nobody wants to admit: “In a world of important pricing efficiency, you want insiders trading because the price will be more efficient. That is as it should be.”
Sirri then went on to explain that insider-trading laws should still exist, for the purpose of investor protection. But he added that he thought it “very important” that credit default swaps be traded – something which won’t happen if the tradable contracts fall under insider-trading regulations while the present bilateral contracts don’t.

Sirri’s rationale here seems relatively simple. Insider trading laws have efficiency costs but the government has made the decision that in the case of markets for securities those costs are outweighed by the gains in investor protection and investor confidence. Part of the reason for deciding things in this way is because the government, corporate America and the large brokerages want ordinary investors to feel confident they are playing on something of a level playing field with those with potentially better access to information. But in trades involving more sophisticated players trading more sophisticated financial products, it’s far from clear that this rationale applies. Do we really need to protect hedge funds from other hedge funds and investment banks in credit default swap trading? The enforcement and compliance costs with insider trading rules may outweigh the benefits.
Nonetheless, it is entertaining watching the easily scandalized become so easily scandalized when a regulator mentions the benefits of insider trading. One question: why are so many of the easily scandalized also British?
[Editor’s Note: The image above is of JP Morgan Chase CDS trader Gino Tzannatos. We illustrated this item with Gino’s picture because it was one of the few nice looking pictures of a debt derivatives trader we could find. Nothing in this item is intended to imply that Gino has ever violated any securities laws, engaged in insider trading, done anything unethical or behaved in a particularly British manner.]
[Correction: An earlier version of this item made a clearly erroneous statement about the current state of the law with respect to credit default swaps. This has been corrected and clarified.]

SEC Official: Insider Trading Makes for Efficient Markets
[Portfolio.com]
Earlier from Felix Salmon: Does the SEC regulate the CDS market? [felixsalmon.com]
Earlier on DealBreaker: As It Turns Out, Some CDS Trades May Be Made With Inside Information [12.14.06]

We cannot remember a time when there wasn’t concern about possibly widespread insider trading in the credit derivative market. Today, the Wall Street Journal is prompted to cover the story by a statement “12 trade associations for the U.S. and global financial markets” who are promising “to promote fair and competitive markets in which the inappropriate use of material nonpublic information is not tolerated.”
Twelve! Must be serious.
But the Journal does a good job of covering the mechanism for how inside information may be leaking out into the markets.

The potential misuse of confidential information is a significant concern as more banks and institutional investors now have access to private information through their participation in the booming market for syndicated loans, which are financed by groups of lenders.
A number of companies and private-equity investors are using syndicated loans to finance major acquisitions or refinance old debt, and typically provide lenders with more information and financial projections than they share with stock and bond investors.
One deal mentioned in the Credit Derivatives Research report was the acquisition of Freescale Semiconductor Inc. by a consortium led by private-equity firm Blackstone Group. In the weeks after Blackstone approached the company about a possible acquisition in May, prices of derivative contracts tied to Freescale’s debt climbed more than 25%, according to data from Markit Group. When news of a $17.6 billion buyout deal became public in September, those contracts more than tripled in value.

Since we used to work in the syndicated loan business, we can safely say that it is impossible to underestimate the level of inside information the lead banks on a syndicated loan deal get during the diligence process. We’ve been on deals where the bankers arranging the deals probably knew more about the company than the chief financial officer. It would be surprising if some of this information didn’t occasionally leak out.
What’s more, the syndication process involves getting on the phone with a lot of potential lenders to sell the debt and spread around the risk. This is certainly a tip-off that something is happening at the company, and often it’s something that will probably increase credit risk.
That said, it’s important to emphasize that securities laws do not make all trading on non-public information. The Journal quotes Larry Ribstein on this point.

“There’s definitely a lot of trading on nonpublic information, and that’s only going to increase with the growing clout of hedge funds,” says Larry Ribstein, a law professor at the University of Illinois.
But he notes there is a distinction between that and insider trading on information that is illegally obtained. “There’s all kinds of information floating around that could signal merger activity,” Prof. Ribstein adds.

Trading Groups Are Agitating Over Apparent Leaks on Street [Wall Street Journal]