Derivatives

  • 30 Mar 2012 at 3:04 PM
  • Banks

Investors Want To Put All Their Run-Off-With-My-Money Risk In One Place

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One way I like to imagine the world is that there’s sort of a constant amount of financial risk and entropy tends to increase, so that as time goes by everyone increasingly ends up facing the same financial risks as everyone else (though quantities and leverage vary) and idiosyncratic risk is a rare and beautiful flower and so I dropped a good portion of my net worth on Mega Millions this morning because what else can you do? Entropy increasers could include index funds, or converging bank business models, and I guess you could profitably ponder the fact that the big banks are now living on DCM fees until M&A comes back and what that could mean for a model of “we need to split up the big banks to avoid too-big-to-fail risk.”*

One thing it could mean is get the hell away from banks. So for instance you could quite reasonably be worried about putting all of your money in collateral accounts with the banks who are your derivatives counterparties because hey MF Global just lost all the collateral you put with them, and so you are, reports the Journal based on the Fed’s Senior Credit Officer Opinion Survey on Dealer Financing Terms: Read more »

  • 16 Mar 2012 at 12:36 PM

Derivative Accomplishes Purpose And Unwinds At Market Price

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You can read the Jamie Dimon “Don’t gloat about how bad Goldman is. Did you hear me? Don’t gloat about how BAD GOLDMAN IS. The fact that GOLDMAN is BAD is of no interest to our clients. Or the press. Don’t leak this to the press!” memo two ways. One is, y’know, what it sounds like: Dimon gets to score some easy/meta points by spreading it around that his business practices are so superior that he doesn’t even need to spread it around that his business practices are superior. The other is that making money off of clients isn’t something invented at Goldman Sachs and anyone at JPMorgan who throws stones is likely to be clonked on the forehead by a ricochet. (Or possibly by a deranged fictional whistleblower!*)

The latter interpretation is probably right for James Gorman’s more full-throated defense of Goldman because whoops: Read more »

  • 06 Mar 2012 at 6:48 PM

Greek Debt Management Guy Thought His Partners In Obscuring The National Debt Would Be The Last People To Rip Him Off

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I can’t even comprehend Bloomberg’s story about the Greece-Goldman swap-debt-whatever kaboodle, so let’s talk about the philosophy of derivatives for a minute. First the story:

Greece’s secret loan from Goldman Sachs Group Inc. (GS) was a costly mistake from the start. On the day the 2001 deal was struck, the government owed the bank about 600 million euros ($793 million) more than the 2.8 billion euros it borrowed, said Spyros Papanicolaou, who took over the country’s debt-management agency in 2005. By then, the price of the transaction, a derivative that disguised the loan and that Goldman Sachs persuaded Greece not to test with competitors, had almost doubled to 5.1 billion euros, he said.

There are at least three reasons to use derivatives. First you could be into some actual informed shifting of risks from those who want to pay to get rid of them to those willing to be paid to bear them, or from those who have Risk X and want Risk Y to those who etc. Boy are there a lot of textbooks that talk about this. And I suppose it even happens sometimes. You could imagine that a vanilla interest rate swap entered into by a corporation on its bonds or credit facility could qualify as this. I guess people who trade listed options to do covered-write strategies or speculate on takeovers or whatever fall in this category, maybe modulo the “informed.” (Sometimes!)

Then there’s tax and regulatory arbitrage. This is time-honored and much of it, particularly the stuff with the best names, is focused on tax dodging, but there are also various other regimes – securities laws, accounting, whatever – that you might want to get around with derivatives. Paying $10 for CDS with a maximum payout of $10 purely to lower your capital requirements is a recent amusing/egregious example.

The thing that wasn’t mentioned in the CFA Level I derivatives primer is principal-agent arbitrage. This is … first of all, let’s say this isn’t a derivatives issue, or a financial-industry issue, it’s like a life issue. (Some would say it’s why there’s an M&A business, for instance.*) Read more »

  • 08 Feb 2012 at 3:46 PM

New Rules May Prevent Banks From Blowing Themselves Up For Cheap

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If you’re in a certain line of work, and I bet you are, then your main concern about things like the Volcker Rule and increased capital requirements for banks is that they might reduce your comp. If you’re in that line of work, you’re also probably the sort of person who has a higher than average aversion to having your comp reduced. However, you’re also the sort of person whose comp everyone else would be happy to see reduced, because you make too much already you greedy jackass.

That poses a quandary because nobody’s all that interested in hearing your arguments against the new rules, even if they’re good arguments and not 100% about your own personal remuneration. One thing you could do is get proxies to make your arguments. If you think that the Volcker Rule will reduce liquidity in foreign government bonds, you could suggest to foreign governments that it’s really important that they lobby against the rule on your behalf. You did that. Good work. Let’s see how it turns out. If it turns out well, the next step would be to get other clients to say “well, we want liquidity in our [stocks/bonds/rate swaps/whatevers] too,” since that would then be a more compelling argument.

I think that’s what’s going on in this sort of amazing FT article, but something has gone terribly wrong: Read more »

  • 23 Jan 2012 at 3:23 PM
  • Banks

Paying Bankers In Derivatives Worked Out So Well For Credit Suisse That They’re Going To Do It Again

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Dealbreaker has long admired Credit Suisse for being on the cutting edge of creative approaches to compensation. In 2008, they gave bankers bonuses consisting of “toxic assets” to (1) incentivize the risk-takers to stick around and (2) remind people that “toxic assets” is a meaningless term if you don’t consider price. That worked out okay. This year, they’re giving junior mistmakers bonuses consisting of nothing, as a gentle reminder that there are other, similarly nonremunerative careers that might be better suited to their interests and talents. That also seems to be working. And now there’s this piece of magic:

Credit Suisse Group AG, Switzerland’s second-biggest bank, plans to pay a portion of senior employees’ 2011 bonuses in bonds packaged from derivatives linked to about 800 entities.

The move “is a risk transfer from the firm to employees,” Chief Executive Officer Brady Dougan, 52, wrote in a memo to the firm’s staff and obtained by Bloomberg News. “We are trying to strike the right balance and align employees with shareholders. These measures help to put us in a good place and to perform well in 2012.” …

The bonds mature in nine years and will pay a coupon of 5 percent for Swiss franc holders and 6.5 percent in U.S. dollars “for holders elsewhere,” Dougan wrote. Credit Suisse will absorb the first $500 million of losses on the portfolio, according to the memo.

How can you not love this? My favorite part is that shareholders eat the first tranche of losses. OOOH NO BANKSTERS ROBBING SHAREHOLDERS, you think – well, not you, but someone thinks – except no. Read more »

  • 07 Dec 2011 at 4:21 PM

With A Name Like Feline Pride It Has To Be Good

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Sometimes it’s useful to be reminded that not all financial structuring is designed to get around capital requirements or defraud customers. Some is designed to get around taxes and defraud the treasury! One group of people who like to think about that kind of thing is the Congressional Joint Committee on Taxation, who took some time out from shouting about payroll taxes yesterday to have a geeky hearing about the state of financial instrument taxation. Short version is, they’re not all that happy about it.

The JCT staff generally say pretty smart stuff about tax policy, and they get that shit is fucked up and bullshit. Or as they put it more diplomatically:

The timing, character, and source rules apply differently to (and are sometimes uncertain for) equity, debt, options, forward contracts, and notional principal contracts. These five basic instruments can be combined in various ways to replicate the economic returns of any underlying asset. … The flexibility of financial instruments also creates great difficulties in the taxation of financial instruments. This report provides examples of taxpayers’ uses of financial instruments to achieve desired timing, character, and source outcomes and describes how the tax laws have or have not addressed this tax planning.

There are two useful takeaways here. One is kind of weird: there are a bunch of fairly basic things (exchange-traded notes, CDS) where nobody – not the IRS, not the JCT, nobody – knows how they’re supposed to be taxed. That … seems like a bad thing. And, I’m going to guess, not so much the fault of evil financial innovators.

The second takeaway, which is related but more satisfying to fulminate about, is that evil financial innovators can mix and match stuff until they get any tax result they want: Read more »

  • 23 Nov 2011 at 2:31 PM
  • CDS

The New York Fed Is Not Buying Any Crazy CDS Conspiracy Theories

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I have a hazy memory of those exciting days in 2008 and 2009 when the world was going to be remade, shiny and new, with all of the risk gone from the financial system. The way we were going to get rid of all the risk, as I recall, was with the Volcker Rule and transparency around derivatives trading. That way, no shady prop trading of derivatives could blow up our financial system again, as long as you don’t think too hard about the word “again.”

Anyway, how’d it work out? Well, the New York Fed, who you’d think would have something to say about all of that, put up a note today about transparency in CDS trading. Their feelings about transparency in CDS trading can be summed up as “meh, we could take or leave transparency in CDS trading.” Specifically:

Data on trading activity in the CDS market paint a mixed picture of the likely impact of trade reporting rules. The high levels of standardization of trading and contractual terms are apt to enhance the ability of market participants and policymakers to interpret the reported transactions. However, the low frequency of trading diminishes the potential price discovery benefits of real-time trade reporting.

So real-time trade reporting won’t cause undue problems for dealers because most CDS is in fact a pretty standardized product that can be reported on a comparable basis. There’s “an impressively high level of standardization of contract terms and market conventions” in single-name CDS, including things like standardized coupons, payment dates, and the fact that “47 percent of single-name transactions and 84 percent of index trades … are in the five-year tenor.”

But no one will care about that reporting, because there just isn’t that much trading. This is based on a longer New York Fed paper from earlier this year, which we’ve mentioned before, but this graph is worthy of another look:

You could quibble with the data design (next graph I do will have three color-coded categories, “big numbers,” “medium numbers,” and “small numbers,” and they will be interspersed randomly across the graph!) but let. it. go. Instead let’s talk about the fact that for something like 1,200 of the 1,500-ish corporate CDS reference entities, the average trading frequency is less than once per day. Read more »

  • 09 Nov 2011 at 5:11 PM

In Which BoNY Mellon Maybe Understands Derivatives A Little Too Well

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Bank of New York Mellon is back in the news for offering a special promotion to its valued FX customers: if you act now, instead of screwing you with the worst possible price for your FX trades, they will not do that. OWS is working!

The thing about that is … well, wait, let’s start with something more important: I don’t really think that Gretchen Morgenson understands anything about derivatives. That would be ridiculous. Good to have that off my chest.

What I meant to say yesterday was not that she did, or that anything she’s said about derivatives was technically correct. It was that getting all excited about how she mislabeled a repo a swap misses the point. If a repo and a swap have substantially the same cash flows and achieve substantially the same economic effect – here, letting MF Global leverage a position by separating funding from credit risk – then there’s nothing substantive about calling one thing a “repo” and another a “swap.”

BoNY Mellon, though, shows that what you call a thing actually can matter. Thinking that everything is a derivative may lead to confusion and anger if you’re, say, Gretchen. Because Derivatives Are Bad. But, if you’re me, thinking that everything is a derivative might make you a little bit more sympathetic to BoNY. Because I don’t think that what they were doing was – or was only – screwing their customers by secretly giving them the worst price of the day. I think that they were “long a floating-strike, intra-day option on their FX transaction.” Read more »

  • 08 Nov 2011 at 11:04 AM

In Which Gretchen Morgenson Gets Credit For Understanding Derivatives

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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?
Read more »

  • 28 Oct 2011 at 1:43 PM

If You’re Not Into Greek CDS Any More, Maybe You Can Buy This Monstrosity

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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:
Read more »

  • 28 Sep 2011 at 1:04 PM

CDS Levels May Not Be The All-Purpose Indicator That WSJ Thought They Were, Reports WSJ

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The New York Fed and the Wall Street Journal have both been studying how liquid the CDS market today and have released their conclusions today. Short answer: not that liquid. From the WSJ:

In recent years, credit-default swaps—contracts that give the buyer the right to collect a payment from the seller if a borrower defaults on its obligations—have risen from obscurity to an avidly tracked barometer of the financial health of everything from Bank of America Corp. to Greece. … Yet a Wall Street Journal analysis shows that actual trades in these widely cited derivatives are few and far between—and the quotes that market observers bandy about often aren’t based on actual trades at all.

What I liked most about the FRBNY study is that it not only looks at overall liquidity but – sort of – gives you a window into the breakdown between what you could call “initiation trades” and “closeout trades.” And this in turn tells you something about not just “liquidity” in the abstract but about how market makers go about providing that liquidity.
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