cds

You can’t argue too much with the SEC’s gentle suggestion that maybe banks should tell people, in a consistent format, what’s up with their European debt exposure. It seems to be a thing that is on investors’ minds, so why not have the SEC try to put their minds at ease:

“Our staff has been working with banks to improve their disclosure about sovereign-debt exposure for several months,” SEC Chairman Mary Schapiro said in a written statement released Monday. “Even so, I understand this is an area of focus and uncertainty that could really benefit from further transparency and consistency, particularly as we head into annual reporting season. I think the staff’s guidance should help achieve that goal.”

Yep. The release is here and contains a good list of things you might want to know, including things like “The effects of credit default protection purchased separately by counterparty and country,” “The fair value and notional value of the purchased credit protection,” and “The types of counterparties that the credit protection was purchased from and an indication of the counterparty’s credit quality.” It’s not exactly a standardized form for disclosure that will allow everyone to do detailed comparison among the banks and/or sleep well at night, but it should at least shame people into giving reasonably detailed substantive information so that when your bank blows up you at least won’t be surprised at which European country did it. That seems good. It even seems like what the SEC is supposed to do.

The Journal, ever fair, finds a token objector, sort of: Read more »

Bloomberg reported today that, back in July, David Einhorn and some other people decided that (1) betting against European sovereign debt was, and would remain, a good idea, but (2) doing it in CDS form was kind of dumb, so (3) they’d switch to doing it in physical form, by borrowing and shorting the debt. Here’s what Einhorn had to say in his July investor letter:

The letter touched on two risks tied to credit swaps on European sovereign debt, including regulators’ attempts to fashion a Greek bailout in a way that prevented the contracts from paying out. The second risk was the possibility that banks that wrote billions of dollars in credit swaps on sovereign debt might not be able to make good on their obligations should a country such as Greece actually default.

Let’s talk about that first reason for a minute because I think it’s sort of illuminating. The problem is that Europe was in July, and is now, and wow that’s depressing, trying to cobble together a “voluntary” debt exchange where holders of Greek debt happily hand it in to Greece and get back a thing with a 50% face value haircut that is also a piece of crap. If you’re a European bank who owns Greek bonds and CDS to hedge them, and you feel pressured to accept that deal, then you feel like the “insurance” you bought on your bonds should “pay out,” I suppose, though that’s all fairly hypothetical. If on the other hand you’re David Einhorn and you bought CDS and then Greece haircuts its debt, you feel like your bet against Greek debt has been vindicated so it should pay out. But it doesn’t, says ISDA, because the exchange was voluntary and there was no “credit event” under the rules governing your CDS. Read more »

Here is a wonderful sentence:

A key insight from the enhanced BIS credit derivatives data is that non-rated multi-name credit risk sourced from multiple sectors has been transferred from derivatives dealers to IFGCs, SPVs and OFCs.

Yeah! Wh … what?

It’s from the quarterly review of the Bank for International Settlements, which is a delightful hodgepodge of hard-to-read charts, hard-to-read sentences, and general oblique glances at the guts of the global financial system. It is both glancing and gutsy. There are reams of tables. Give it a read.

The quote above is about this:

Everything clear now?

I love charts and all but I mostly think in stories, and I’m trying to parse together the story for these facts because they seem somehow important. It seems to go like this. Read more »

Fitch released a report today saying “ohmygod banks Europe” and the market went down and maybe there’s a causal link, whatever.

The report mostly takes notice of US banks’ European exposures in general, and the mystery of net versus gross derivatives exposure in particular, in which one asks “if Bank A sells CDS on $100bn of Italian debt to Bank B, and buys CDS on $100bn of Italian debt from Bank C, then when things go pear-shaped is it on the hook for zero (because it has no ‘net exposure’) or $100bn (because Bank C goes belly-up) or somewhere in between (because of collateral, sub-1 correlations, etc.)?”

It’s an important question: net exposures are manageable, gross exposures are terrifying, and there are legitimate questions about whether in a stress case the netting could break down. Various people who are smarter than me have tried to triangulate around parts of the answer using public data.

I don’t know the answer and doubt I’ll find out, though my gut is that netting should kind of sort of mostly work (I find Graph 5B of this, and the definition of “bilateral netting,” oddly comforting). What troubles me today, though, is that Fitch has no clearer answer than I do. Read more »

Here’s a trade. I’ve got these bonds, see? I will sell them to you. You will pay me $100 and get $100 face amount of bonds (if you like, you can get $80 or $120 face value of bonds, depending on where the bonds are trading – but let’s make them par bonds, to keep things simple).

But we’re not done. I will also write a contract under which, if these bonds default prior to maturity, you can hand them back to me, and I will give you back your $100. My loss will be the $100, minus whatever I can get from the defaulted bonds. In exchange for this commitment from me, you will pay me a running payment. That payment will be equal to (1) the coupon payment on the bonds (remember, they’re par bonds, for simplicity), minus (2) a risk-free rate of equal maturity, plus or minus (3) a basis driven by the cost of funding and differences in relative demand for different sorts of payments. Let’s say the bonds pay 6%, the relevant risk-free rate is 2%, and our funding costs are 50bps. Then you pay me 350bps running. The payments, and the contract, expire at maturity of the underlying bond.

Ah, but you have an objection. You’re paying me this running payment in exchange for my promise to cash you out if the bonds default – but how do you know I’m good for it? Fair. Why don’t we do this. I will collateralize that promise. At first my collateral will be quite small, since default is unlikely so the expected value of my promise is small, but it will go up if the bonds decline in value and/or my credit deteriorates.

Okay, fine, now we’ve got a deal. So … what is our deal? I’ve sold you bonds in a spot sale – that much seems clear – and we’ve got … this other thing, this contract. What do we call that contract?
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We’ve noted here before the irony that Europe is both (1) screwing with your ability to get paid on CDS on shaky European sovereign debt (sort of) and (2) hoping people will buy more shaky European sovereign debt because they can get tradeable first-loss protection, suspiciously reminiscent of CDS, from the EFSF on those bonds. The further irony is that, at the same time as it’s touting the free transferability and liquidity of that first-loss protection as a selling point, Europe is moving to restrict investors from owning sovereign CDS unless they can prove they really need it, to hedge sovereign debt or correlated assets.

Today FT Alphaville has the details on the potential EFSF-issued first loss protection (full Q&A here). The plan would be to let member states who are “under market pressure” to issue bonds along with “partial protection certificates” that would, on a payment default on the underlying bond, pay off an amount equal to the principal loss on the bond, up to some cap. The EFSF is coy on the cap but admits it might be around 20% of the bond’s principal. The payoff would be in the form of EFSF bonds, which are currently AAA rated: so if your Spanish bonds, say, only pay off 50 cents on the dollar, you’d get an extra 20 cents face value of AAA rated EFSF bonds of unspecified terms.

Importantly, these certificates would be freely tradeable:
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  • 27 Oct 2011 at 1:08 PM

Mandatory Greek CDS Post

The Greek CDS situation is sort of puzzling, but it’s possible, and popular, to overstate its puzzlingness. We have probably been guilty of doing so in the past. In brief: if you hold Greek bonds, you sort of have to hand them over and get back other, shinier Greek bonds with half the face value. How sort of? The text of the statement is “we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors,” which is an attractive invitation although it does not exactly indicate that the party is occurring right now. But that sentence is code; it was negotiated by the banks’ trade group and is a sort of quid pro quo for bank recaps and general regulatory approval so you’d expect most – not necessarily all – of the banks to be onside. The fact that the statement was released suggests that everyone thinks there are soft commitments to exchange from the banks holding the large majority of Greece’s debt, though they’ve thought that before.

If everyone who holds Greek bonds does the exchange, then Greece never defaults. They just did a voluntary exchange. This presents a problem for Greek CDS: if there’s no default, there’s no credit event, and CDS never pays off even though bondholders lost 50% of principal. This is ISDA’s official conclusion and it’s just sort of self-evidently right, although some people disagree.

Felix Salmon sums up the general outrage:

[O]n one level, the ISDA statement that this still isn’t a Greek default, for CDS purposes, makes some sense. I’d probably make the same decision myself. But on the other hand, this does make a farce of the idea that credit default swaps constitute default protection, at least in the sovereign arena. If they don’t protect you against this, what earthly use are they?

Well, with most derivatives, it’s important to remember that the marginal investor isn’t buying them for payoff-at-maturity but for the market moves along the way. People equate CDS to insurance but it’s not. If you buy life insurance, it pays out if you die and it doesn’t if you don’t; if you just decide to take up drunk cliff-diving you don’t get any interim payment. Most CDS never pays out because defaults are rare, but it’s still a healthy market. Most investors don’t primarily care if CDS pays off when they crystallize a loss by handing in a bond in a pseudo-voluntary pseudo-default, because they’re unlikely to do that. They care if their CDS mark goes up, in a realizable way, while their mark on the bond goes down. And it sort of does:
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