7/28/2019 Credit Trader http://slidepdf.com/reader/full/credit-trader 1/56 A Credit Trader 1 Inaugural Post Hi and welcome to my blog: ‘A Credit Trader’.This is an inaugural post where I’d like to introduce myself and describe the blog. In brief, I am a trader for a Tier I broker-dealer (not many of those left!) focusing largely on the credit markets, though I do dabble often in FX and rates. Across the credit product/market spectrum I focus on everything from credit default swaps on corporate/sovereign names to cash bonds and loans to CDO’s to credit indices (CDX, iTraxx). The reason for starting this blog is mainly to provide a unique perspective on important economic and market happenings but from a credit market perspective. There are many blogs that offer thoughts on fundamentals of credit markets. Where I think I can offer unique information and analysis is via my professional niche and perspective. What I would like to do here is to root those fundamentals in the market data, pricing levels and quantitative models used in the trading credit products. More specifically, it is my intention for the blog to provide the following information: 1.Market color (including both what the buy-side traders are focusing on as well as what the market believes and is pricing in) and how that relates to what’s going on in the fundamentals. I am often frustrated by how other bloggers don’t make it explicit where the data they use came from or what number-crunching models they have used to arrive at the stated conclusions. I will outline precisely this process and happily offer all excel models to those that request them. 2.Some of my posts will focus on models that we use on the sell-side to price certain instruments or to better understand risk 3.I will also occasionally talk about trading opportunities that either come from market dislocations or fundamentals
This is a CDSW Bloomberg screen for General Electric. This is the standard tool that is used to calculate
mark-to-markets for credit default swaps. You can get to this screen via the following sequence in
bloomberg:
WCDS <GO> → Enter GE in the ticker field → CDSW <GO>
One caveat to add here is that the Recovery Rate is a factor going into the calculation of the probability
of default (for a given CDS spread level, the higher the assumed recovery rate the higher the probability
of default and vice-versa). Here, Bloomberg defaults to a 40% recovery which is a standard assumption
for high-grade credits.
In reality, the recovery as determined in either the workout process or in the CDS post-default auction
process can be wildly off, especially for Financials. For example, Lehman recovery was determined to be8.7% (roughly speaking, where the Lehman senior unsecured bonds were trading a month after the
determination of default)- a far cry from the 40% assumption.
This is very similar to the life-insurance actuarial approach where to calculate expected probabilities we
look at the history of actual rating migrations and defaults. Row headers mark the rating at the
beginning of the period and column headers mark the rating at the end of the period.
In this case, the matrix shows data for period length of 1 year. So, for example, reading from the matrix,
historically a BBB-rated company was downgraded to BB a year later with a frequency of 4.74%. In this
case, we are after the right-most column under D which tells us the 1-year default probability of a
company with a given rating. In our case of a AAA GE, the 1-year historical probability of default is zero.
What this tells us is that in the period of 1981-2003, no AAA S&P rated company has defaulted within a
year.
What I say above requires a little bit of handwaving because we are ignoring the timing and intra-periodsequence of ratings changes. Also, to be more precise we should really be using a sector-specific ratings
migration matrix, especially in the case of Financials which tend to be more “gappy” than companies in
other sectors (given that they are much more leveraged than “regular” companies and depend much
more on general confidence). But it will work for our illustrative purpose here.
In order to calculate multi-year default probabilities (i.e. a default probability term structure) we need to
create multi-year (2-year, 3-year, etc) version of the matrix above. We do this simply by multiplying the
matrix by itself and again reading off the right-most cell (i.e. AAA→D).
The table below shows the probabilities of default using this approach (2nd column) as well as the
probabilities using the CDS approach described above but with a more realistic 20% recoveryassumption. As you can see, the two methods are wildly off. Though normally, there is a large risk
premium (especially in high grade) priced into credit spreads over historical default probabilities, in the
The Enabling Factors of the AIG’s CDS Underwriting Business were the following
AIG did not have to post collateral on the trades which, combined with their view of these
trades being “free money”, meant they sold protection in astounding size
US Investment Banks needed entities to sell them super-senior protection so they could
“complete the capital structure” and continue originating CDOs. Monolines and CPDC’s were the
other enablers.
European Banks needed AIG to sell them protection to provide regulatory capital relief under
Basel II
The Misunderstood (by AIG) Nature of AIG’s Risk
AIG believed that the likelihood that super-senior tranches take losses was so infinitesimal that it was
“money good”, according to Joe Cassano, the former head of the unit. As I mention above there are two
interesting issues to consider here: one of correlation and the other of mark-to-market vs. default risk.
Correlation
On the first point, and taking housing as an example, it’s likely that AIG underestimated the probability
of super-senior tranches suffering losses since for this to happen you would need a nationwide fall in
housing prices (something we havent seen too often) as actual mortgage bonds making up the CDO tend
to be well diversified by region. If you look at the data, you would think the likelihood of this happening
is nil, however, this is exactly what happened. Although AIG avoided the worst vintage years, it clearly
underestimated the risk that a banking crisis followed by a recession would have a nationwide impact on
housing prices . Continuing the logic, if one super-senior tranche gets hit, indicating we are in a
nationwide slump in housing prices, that means other super-senior tranches are very likely to be hit as
well. Selling protection on ABS CDOs on a diversified nationwide portfolio of mortgages is quite differentfrom holding a well diversified portfolio of fire insurance policies. The former is much less diversifed
than the latter
Mark-to-Market vs Default Risk
The second point about AIG’s risk has to do with the fact that instead of taking a well-justified massive
punt on super-senior tranche default risk (infinitesimal), it instead took a massive punt on credit spread
(i.e. mark-to-market) risk and it did so close to the top in the credit market. Simply backtesting this
strategy and assuming a high corelation between all credit products (well-justified), AIG would have
blown up several times in the last 20 years. By the time default risk became a possibility, AIG will have
run out of cash posting collateral to its counterparties, which is effectively what happened this time
While we know our potential future exposure, what we are really after is the counterparty credit
exposure. This number represents the possibility of loss of value in the trade due to a counterparty
default and is basically equal to the difference in values between a risk-free trade and a risky trade i.e. atrade that takes into account counterparty default risk.
In practice, this amount is reserved against the trade or, in other words, not recognized immediately.
Right/Wrong-way Exposure
The credit exposure calculation above is essentially the expectation of discounted exposure contingent
on a default by the counterparty. So far we haven’t said anything about a dependence between the
counterparty credit quality and the exposure.
When that dependence exists, it is known as right-way/wrong-way risk. Wrong-way risk means the
exposure increases as the counterparty credit quality worsense. Clearly, wrong-way risk is undesirable
as the counterparty is more likely to default just when our trade is more likely to be mtm-positive to us.
Wrong-way risk trades include the following:
A bank receives fixed and pays floating oil price to an oil producer (wrong-way because an oil
producer’s credit quality will suffer when oil prices are low just when the bank’s trade is
positive-mtm to the bank)
A bank buys usd/brl forward from the brazilian government (wrong-way because the trade is
positive to the bank when BRL depreciates, which suggests a lower government credit quality –
see Russia’s experience defending the RUB)
A bank buys CDS protection from an insurance company (wrong-way because credit spreads
tend to be correlated suggesting that when the trade is positive mtm to the bank, the insurance
co’s credit spread is wider)
Did you catch that last one? This is what happened with AIG.
In fact, I would argue that the credit quality of AIG was not just somewhat correlated to the credit
quality of the insured CDOs but was in fact 100% correlated, especially in the case that matters i.e.
impairment of super-senior tranches. By the time this happens AIG will have gone bankrupt posting
collateral and even if it survived up to this point the very high correlation between the super-senior
tranches it wrote protection on means AIG would have to pony up an unbelievable amount of cash.
US CDS above 100bps: it’s a MAD MAD MAD MAD World!
The recent widening in United States Credit Default Swap levels has gotten a lot of attention once it
cleared the magic 100bps level intra-day.
As with any CDS-related news, you will get heated commentary in the blogosphere with a large
perception of folks simply calling for all CDS trading to be banned. The general consensus appears to be
“don’t the buyers of CDS realize that in the event of default by US, these contracts are not likely to be
honored anyway?” This is Krugman’s line. Taleb chimes in with “It would be like buying insurance on the
Titanic from someone on the Titanic”.
As with any heated commentary there’s bound to be a lot of misunderstanding of what this recentwidening actually means and where it comes from. I’ll try to tackle this issue point by point below. For
those of us with ADD (myself included) here’s a brief summary:
Traders don’t buy CDS because they think the name will default; they buy CDS because they
think the spread will widen – I make this point in my AIG post. It follows that extrapolating any
default information from wider CDS spreads can be misleading
An apples-to-apples comparison of US CDS spreads suggests that $-denominated US CDS (the
standard contract that is quoted in the news is the €-denominated one) should be trading at
half the level it is now, perhaps making the recent news a lot less exciting
The standard CDS contract is sufficiently complex so that the end-game buyers of CDS can be
betting on something much more innocuous than a “default” such as a restructuring of privately
negotiated tiny-size debt issuance
Sovereign CDS (US included) has actually lagged both rising financial as well as systemic risk and
has only now caught up, making the recent move largely expected
CDS is not a “default” trade – it is a “spread” trade
The most important point to be made here, the sam e one I make in my AIG post, is that, one shouldn’t
look at CDS as a “default” trade. Though their pricing is clearly driven by the likelihood of default and the
payout upon default, I can tell you that 99% of people buying CDS do not believe that the entity upon
which they are buying protection will actually default. In this, they are similar to investors in stocks.
People buy and sell stocks because they think the stock in question will increase or decrease in price.
Same goes for CDS.
I think the confusion largely stems from people viewing CDS akin to insurance. Though this is an easy
analogy to make, it is, in fact, wrong. What motivates people when they buy fire insurance is that, in the
unlikely case their house is consumed by a fire, they will get reimbursed. This is not what drives the CDS
market.
There are two key differences between CDS and the insurance analogy:
1. I don’t need to have a position in the entity’s bonds or loans in order to trade CDS on the same
entity (while I do need to own the house I buy fire insurance on)
2. As I mention above the vast majority of traders don’t trade CDS because of a view on default –
they trade CDS because of their view on the level of CDS spreads expecting to lock in a MTM
profit on the trade. Though you can probably save yourself some premium on fire insurance by
installing sprinklers it’s clearly not as easy to do nor is it the primary motivation for fire
insurance in the first place
Sovereign CDS is not a “fundamental” trade
I think one thing we can safely dismiss as the driver behind the widening of US CDS spreads, or in fact
any sovereign spreads, in the market is any kind of fundamental view of where these spreads should be.The difficulty behind trading CDS on a fundamental default probability basis has to do with the fact that
in order to put a number on an absolute default probability you need to have a firm view on: a) default
likelihood, b) recovery upon default, c) devaluation of the local currency, to the extent that CDS you are
It is actually difficult to have a firm view on the absolute default probability of any sovereign,
particular, the United States. The fact is that developed sovereign defaults are relatively rare
(outside of Spain’s relatively orderly 6 defaults within 100 years starting in the 16th century). As
far as United States, my best guess is that we would need to go back to the Civil War to find aproper case of a “default”, though even here you would have to stretch. This was when the
Confederacy issued cotton-backed bonds to finance the war against the North. Once the South
lost New Orleans (making it impossible for South’s creditors to take physical delivery of cotton)
and began to run out of cash, it became clear that it was only a matter of time before the
Confederacy defaulted. By the end of the war the Confederacy’s “greybacks” were worth 1 cent
on the dollar. The North refused to honor the Confederacy’s debts and the rest is history. In the
20th century developed sovereign defaults are relatively rare, especially after the World War II.
European defaults/restructurings in the 20th century (Rogoff)
Getting a guage on expected recovery by a sovereign is not any easier. These range from the
teens in Russia and Ivory Coast to 69% in Ukraine.
Though much of protection traded on sovereigns is in a currency other than the local currency
(i.e. Brazil CDS is traded in USD not in BRL), for local currency trades one has to be aware of the
likely devaluation of the local currency in case of default. Those of us old enough to rememberwill recall the Argy peso going from 1 to over 3 in its peg to the dollar. I touch upon this in the
Quanto CDS but suffice it to say that buying protection on Germany in EUR rather than USD
means that €CDS levels should trade around half of $CDS levels.
Though people like to focus on the round 100bps number, what’s mising from this is the fact that US
CDS is traded in euros and that in order to do a proper apples-to-apples comparison to US-traded
corporates you would need to first translate the EUR spread to a USD equivalent spread. This translation
is largely a function of how much the local currency will devalued in the case of default (ignoring the
small impact of rate, fx and credit volatilities and correlations). So, if you think that the dollar will
weaken by 50% relative to the Euro in the case of a US default then the fair USD-denominated US CDS
spread should trade around 50bps.
Do sovereign CDS trade in currencies other than the standard contract currency? In fact they do and the
biggest market is in Latin American CDS denominated in local currency. If you think CDS is an “obscure”
market, then this is the ultra-obscure one. It is largely driven by sovereign issuance of US-denominated
debt that they swap to their local currency (in order to remove the stain of “original sin” ie non-local-ccy
issuance). Normally, they would just do a simple USD/local-ccy interest rate swap. However, the trick is
to do a clean asset swap instead which is simply an interest rate swap that is credit-linked to themselves
which can save the country upwards of 100bps on the swap. Corporates in Europe and Latin Americatend to do this “self -reference” trick as well – though it is illegal in the US.
For Latin American CDS, this local currency discount can be anything from 25-60% on 5y CDS (it varies
depending on the tenor and tends to be downward sloping).
The “non-default” default
The word “default” has been thrown around a little too easily lately with respect to CDS contracts. The
concept of default is, generally speaking, a very loaded one that brings to mind long bread lines, a
crippled banking system and runaway inflation. In the context of CDS, the concept of “default” is a very
specific one. For this reason, CDS language talks about a “credit event” rather than a “default” and can
include such actions as restructuring of debt, repudiation of debt, moratorium and accleration. In
summary, the following issues need to be considered in the context of Sovereign CDS.
The nature of the “credit event”. For Western Europen sovereigns, for instance, these include a)
Failure to Pay, b) Repudiation/Moratorium, c) Restructuring. Latin American sovereigns add to
this list Obligation Acceleration which was a near possibility when Hugo Chavez declared his
country’s pullout from the IMF. The point here is that something like a restructuring of debt can
be much more benign than an outright default (i.e. a failure to pay). So, a CDS can often price in
a less dire scenario than the likelihood of “default”.
Generally, anything counting as “Borrowed Money” can trigger a CDS credit event. This can
often be a small privately negotiated loan rather than a large bond or loan trading in the market.
If you ask a Sovereign CDS trader why his names are wider today his likely response is “The index is
blowing up, dude. Now do you have anything to do?” The simplest answer is that sovereign CDS is wider
because everything is wider. And the simplest answer is often the right one.
Backstopping Financials The move wider in sovereign CDS can be attributed to the expected covergence between sovereign and
bank CDS spreads on the back of countries backstopping their financial systems. Countries have either
bailed out certain institutions directly (Lloyd’s, RBS, ING, etc.) or have guaranteed bank deposits
(Ireland, Germany,e tc.). While sovereign spreads have initially lagged the spreads of their financial
systems, once it became clear that the sovereign was willing to underwrite the tail risk of their banks, it
made sense for their spreads to converge. And if financial spreads refused to come down to the level of
the sovereign, then sovereign levels would rise to the level of financial spreads. This was likely driven by
two things: a) relative value trades of selling bank CDS and buying sovereign CDS betting on the
convergence, b) continued buying of bank CDS as a hedge against bank paper. This led to sovereign CDS
widening to the level of bank CDS rather than the other way around.
The Systemic Hedge
One way to understand the widening in sovereign spreads is by tieing sovereign risk to some other risk
in the market that should be driven by the same views or needs. The typical buyer of sovereign CDS,
apart from the marginal trader punting on Austrian eastern european exposure of the inability
of Iceland to convince the world they’ve got things under control are the Investment Bank credit
portfolio groups. These departments generally manage hundreds of billions of loan and derivative
exposure across the bank. Their mandate is to protect the bank from an increase in non-performing
loans. Normally, the counterparties to the loans do not trade in the market (either in CDS or stock) or
are not liquid enough for the groups to go out and hedge in these assets. So, what they normally end up
doing is buying systemic risk hedges in large size with the expectation that in the scenario a large portionof the bank’s loans goes bust, the world will be in such a state that their systemic hedges will offset the
deterioration in the loan book. Though out-of-the-money S&P puts figure prominently in their hedges, in
the world of credit we can look at a) super-senior spreads, b) financials spreads, c) sovereign spreads.
Assuming 40% recovery, the CDX super-senior tranche (30-100%) will be impaired after 40% of the CDX
portfolio. Although it’s clearly difficult to envision the state of the world in this scenario, we can safely
So, though often painted as a credit risk issue, this episode was really a liquidity/technical problem.
Bring on the Technicals
Here, I briefly describe what, in addition to the above issues, could be the technical drivers of wider
sovereign CDS, and US CDS in particular:
Credit-Linked Notes Unwinds. As we all know retail investors are the best negative gamma
traders. They buy high and sell low. It is not impossible that there were investors who werelooking to add a few basis points to their “risk-free” trade by adding US CDS risk. It is also
possible that as the crisis deepened they grew less comfortable with the risks in the trade and
unwound them, suggesting that the origination desks needed to buy back the US CDS protection
they initially sold, pushing CDS wider
Liquidity in US CDS is not fantastic judging by two things: a) US dealers don’t trade it and b) the
bid/offer spreads is 10bps or around 12% of the CDS spread. By comparison bid/offer spread in
the CDX index (most liquid product in credit) is less than 1%. When you factor in these issues
with the fact that in the current environment there are likely to be more buyers than sellers, you
will see the CDS spreads widen to accommodate that
So, in summary, what do I make of US CDS widening? Well, not much apart from making it another
cocktail conversation topic. Let’s revisit this issue once investors start discounting all their treasury
holding by the US CDS spread… starting with China and their $1.7trn portfolio. Now that would give us
Now, we can argue that $10mm notional in IRS is not equivalent to $10mm notional in CDS given the
different nature of tail risks in the two products, though here I would point to some emerging market
countries that have had short-dated rates north of 100% meaning the exposure on a IRS could actually
be greated than in a CDS.
But CDS was designed to disperse risk. Now we realize that it was, in fact, concentrated – Gillian Tett
CDS was not designed to disperse risk, per se. Instead, It was designed to do two things:
1. allow banks to get regulatory capital relief on their loan books letting them free up capital
2. allow banks to more efficiently manage credit risk (without CDS, a bank would have to sell the
loans to get rid of the exposure, which is something it would be loath to do as the reference
entity is likely to discover this, putting the banking relationship at risk).
But CDS contract language is complex and credit event settlements may not work as advertised –
Satyajit Das
First, CDS language is actually not that complex if you’ve read the ISDA. Second, if the language is
“complex” then it’s because CDS deal with low-frequency and potentially large contingent liabilities
which are important to get right. In fact, I would use the word rigorous rather than complex. As far as
auction settlements, witness the 30+ smooth instances in the last three years, especially in the case of
Lehman and the agencies.
On the second point, Das uses the example of the Delphi settlement writing “Delphi had 37% recovery
when recovery was set by Fitch at 1-10%”. This is very misleading. The 37% recovery was a level where
a) Delphi bonds were actually trading at the time of the settlement and b) where holders of bonds could
be made whole against their protection positions (in any case the holder of bonds and CDS does notcare where the auction recovery is settled since the P/L on the bond is offset by the CDS regardless of
the actual recovery).
My guess is that the Fitch recovery numbers was a fundamental view of where the recovery would be on
the bonds had Delphi gone through the workout process. This number really has no bearing on CDS (as
CDS is not designed to hedge against the final workout price), especially if your view is that Delphi
intends to come out of bankruptcy protection which tends to be the case with American companies.
But AIG failed because of CDS
This one is pretty hard to argue with. Yes AIG wrote massive amounts of protection on superseniortranches of ABS CDOs. As spreads widened, it had to post increasing amounts of collateral. Further, a
downgrade triggered ratings-based collateral triggers which quickly led to its demise.
Here I would argue that it wasn’t CDS, as such, that led to the failure of AIG. Rather it was the
First, AIG never had to post collateral when it entered the trades, something which led them to view the
business as “free money” and likely caused them to sell more protection than they would have
otherwise.
Second, collateral postings were not managed well as AIG had continuous disagreements / negotiations
with its counterparties on the amounts to post. Presumably, if they were required to post collateral dailythey would have acted sooner to unwind their positions.
Third, ratings-based triggers exacerbated the problem as such triggers are procyclical and subjective.
I would also argue that CDS should not be considered by insurance companies as a business opportunity.
I and others have commented on the high correlations (both between individual bonds in the CDO as
well as performance of CDO’s in an extreme event). I will just add two points that further draw a
distinction between CDS and proper insurance policies.
First, the obvious difference between a CDS and a proper insurance policy, such as flood or fire
insurance on a home, has to do with the fact that a CDS is synthetic while a home is “funded”.What that means is that I can write as much CDS as my heart desires (the outstanding principal
of a bond has no bearing on how much CDS can be traded) while you can write only a single
insurance policy on a home. This automatically limits the amount of exposure insurance
companies can take on (ignoring further the reserves they need to hold against this policy).
Second, lets’s say you are a proud owner of a fire insurance policy on your home and one day
you spot a man having a cigarette 30 feet from your home. Will you call your insurance company
and demand collateral given the increased risk of fire? Probably not, but this is what happened
in the case of CDS (yes I am simplifying, of course)
On the collateral side, clearly it was a mistake to let AIG and the monolines not post collateral.
Establishing a clearinghouse will make sure this won’t happen in the future. However, apart from these
two cases, margin requirements on CDS do exist and are followed rigorously. Hedge funds do post
collateral to dealers when they trade CDS. It’s true that some hedge funds have to post minimal
amounts, however those funds open up their books to dealers. In fact, in the case of Lehman, ISDA
commented that 2/3 of the CDS exposure was collateralized.
Tell that to the DTCC that have been documenting gross and net notional amounts of the vast majority
of CDS trades since 2006.
DTCC
But allowing AIG to fail would have caused AIG’s counterparties to fail as well, given the $100bn+
payouts
This is actually more subtle. First, the payments to AIG’s counterparties don’t accurately represent each
party’s exposure to AIG. For example, if the government paid $13bn to Goldman, it does not mean that
Goldman would have lost $13bn had this not happened. This is due to the following:
Some protection written by AIG is likely to have been collateralized. In fact, this is what
Goldman has claimed.
Banks likely bought protection on AIG to protect themselves in case of AIG failure. A bankruptcy
by AIG will have allowed the banks to monetize this protection.
The problem facing the banks had AIG failed has less to do with their $ exposure to AIG and more with
their position exposure to AIG. For example, let’s say I buy $100mm of protection from AIG and then I
buy protection on AIG to hedge against the case of AIG’s bankruptcy. Let’s say AIG does in fact go bust.
In the ideal scenario the collateral plus the AIG hedges offset exactly my CDS MTM exposure against AIG,then the banks don’t actually lose money. However, the problem is that they are now long risk $100mm
of protection (because their $100mm short risk position against AIG is now gone). What happens then is
the market realizes that a dozen banks have massive long risk positions in much of the same trades that
they will all now try to hedge at the same time. Spreads blow up and the banks lose.
Finally, I am ignoring such comments as Bear Stearns and Lehman collapsed because of CDS or that CDS
can be used to drive companies into bankruptcy both of which probably don’t deserve discussing.
In his latest WSJ post, Soros outlines why he thinks “naked shorting” i.e. buying of CDS without a bond
position should be banned.
My commentary to his points are in italics below:
• AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or
covering their positions. Perhaps I’m reading in too much into this sentence but to e xpect AIG to
somehow have hedged or offset its CDS trades is akin to an insurance company kidnapping sick people
who have bought life insurance and sticking them in incubators to prolong their life. AIG sold protection
because it viewed selling CDS as an insurance business. The oft-uttered phrase that AIG was a hedge
fund are missing the point that these trades were buy-and-hold; AIG was not in the business, unlike a
hedge fund, of dynamically trading in the market.
• What we must take away from this is that CDS are toxic instruments whose use ought to be strictlyregulated. I like when the conclusion is stated upfront without any salient points.
• It *heavily regulating CDS] would also save the U.S. Treasury a lot of money by reducing the loss on
AIG’s outstanding positions without abrogating any contracts. In fact, the US Treasury had three options
in dealing with AIG’s trades: 1) take over AIG and have AIG’s counterparties face the government, 2) post
enough cash to cover AIG’s collateral calls, 3) unwind AIG’s trades. It chose 3 which I think is the worst
option as a) it locks in massive losses, b) it does so at the absolute wides of the market (spreads naturally
blew out as soon as the market realized AIG was in big trouble), c) it commits the most amount of cash
upfront.
• Since they *CDS] are tradable instruments, they became bear-market warrants for speculating on
deteriorating conditions in a company or country. CDS can be used as easily to go long risk as short risk.
In fact, for each nefarious speculator betting on the demise of the poor company by buying protection,
there is an avenging angel who is sitting on the other side of the trade and is a seller of protection.
While, it is true that there can be heavy one-way flow in CDS on the back of strong protection buying or
selling which will drive the market in one direction, the dealers obviously adjust the CDS levels up or
down based on this flow at which they are happy to take the other side of the trade.
• Thus, we must understand financial markets through a new paradigm which recognizes that they
always provide a biased view of the future, and that the distortion of prices in financial markets may
affect the underlying reality that those prices are supposed to reflect. “Reflexivity” strikes again. I don’t
think it has ever been news that the prices of assets affect investor psychology which will, in turn, have
an effect on the prices of financial assets. This is certainly true of all other assets including CDS.
• Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit
potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry
encourages speculating on the short side, which in turn exerts a downward pressure on the underlying
bonds. If the CDS product payoff profile is so skewed in favor of buyers of protection, why did credit
spreads rally for many years until 2008. Also, if the average price of a high yield bond is in the 50s vs. an
average historic recovery (yes recoveries in this cycle will be lower) of 40 – that suggests that the payoff
profile is in favor of protection sellers, not buyers. Finally, gamma is on the side of protection sellers as
well as duration increases as spreads rally – in other words, a protection buyer makes less marginal
dollars for each basis point of widening in spreads since risky duration goes down. This can be seen via
the Merton debt/equity model as well. Also, for distressed names, protection tends to be priced upfront
which means that buying protection in expectation of a quick default is actually quite expensive.
• People buy them not because they expect an eventual default, but because they expect the CDS to
appreciate in response to adverse developments. I don’t understand what i s wrong with this. If the risk of default increases, protection should be more expensive. That’s called a fair market.
• AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously
overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk. AIG was
insuring mark-to-market risk rather than default risk which is where they went wrong.
• A decline in their share and bond prices can increase their financing costs. That means that bear raids
on financial institutions can be self-validating. Lehman went bust largely because it could not raise short-
term funding, not because of any CDS pressure. A rating downgrade caused the stock price to fall,
making it difficult for Lehman to raise enough cash by issuing equity which caused rating agencies to
downgrade it further, leading…. Also, Morgan Stanley CDS traded wider than Bear or Lehman and yet it
miraculously survived. I guess reflexivity is only invoked when it works, kind of l ike those technical
indicators.
• I believe that they *CDS] are toxic and should only be allowed to be used by those who own the bonds,
not by others who want to speculate against countries or companies. What is wrong with speculation as
such? Should we ban short-selling in stocks forever and ever? Metalgesellschaft lost a lot of money on
commodities and Orange county on moves in interest rates. Let’s ban those as well. Also, reading this
sentence suggests that CDS can only be by those who hold bonds. So, will sellers of protection be
required to hold bonds as well. I’m sure this is not what Soros meant, just thought I’d be cheeky.
Europe has tended to have lower recoveries than US due to the fact that companies are normally
liquidated rather than allowed to restructure as under the Chapter 11 process, though this has recently
changed. The threat of liquidation means there is less of a premium for the probability the company
comes out of bankruptcy. Also, a company that is more likely to be liquidated is going to try harder tomilk its assets to the last drop to survive which will result in lower recovery.
Sectors have tended to have different historic recoveries with Utilities the highest (as these companies
own hard assets) and Telecoms the lowest.
There is also a correlation between the rating of a company and its subsequent recovery as a slow bleed
of a company’s assets is more likely to result in downgrades as well as lower recoveries.
Big Bang Theory: Fixing Annuity Risk by Recouponing CDS
Pop-quiz! In which market can you actually lose money by being too right? Well, credit derivatives,
where else? Read on for an explanation.
One of the recent Big Bang changes in the CDS market has been the recouponing of CDS to 100bp or
500bp. This change achieves two things: enhances fungibility and liquidity for clients and solves the
vexing risky annuity issue that has brought much pain to dealers throughout the years.
Why Recoupon CDS?
To illustrate the basic motivation for the recouponing change consider a reference entity that has one
bond outstanding and no loans. Trading the credit of this company is pretty easy: you’ve got a single
security with a fixed coupon and an observable market price.
Now imagine that CDS starts trading on the name. Each day the spread moves you’ve got a different
tradable product out there whether at 100bps or 150bps or 500bps or even upfront + 500bps running.
So if a dealer does 10 bond trades, he’s either paying or receiving the coupon on the bond so the tradesnet out, nice and simple. However, if the same dealer does 10 CDS trades, it will likely have 10 trades all
with different coupons and hence with different time decay, convexity and duration profiles, making risk
management more difficult. Here, by the way, we are not even considering potentially different
restructuring clauses, lookback credit event effective dates, roll dates and accrual periods.
Why not simply unwind previous trades, rather than put on new trades? Well, unwinding previous
trades essentially means trading in off-market CDS which, as first time CDS participants quickly find out,
carries an extra bid/offer cost – in fact, when quoting a level many dealers will explicitly ask you whether
it’s for a new trade or an unwind of an existing position. The other problem is that only clients (i.e.
buyside firms) can unwind CDS with dealers, not the other way around. In other words, dealers cannotexactly call up a client and ask them to unwind CDS trades just because it suits the dealer’s book.
So, if dealers charge extra for unwinding existing CDS positions, why don’t clients just put on new
trades? The quick answer is that the practice guarantees continuous growth of the CDS book which will
significantly stretch risk management/systems resources of small funds. The extra complexity comes not
only from booking the trades, but also from calculating daily exposure and managing collateral on the
positions. Also, by doing new trades, rather than unwinding existing positions, a fund will add
counterparty risk, which it may need to manage by buying protection which adds even more trades to
The problem was, of course, that the hedges, or short positions, were done mostly with monolines.
Merril, for example, gave their net CDO exposure only as $7bn, which consisted of $30bn gross CDO
exposure against $23bn of hedges. What the bank omitted to say was that $20bn of those hedges were
on with monolines. Assuming, 50% losses on the CDOs and a default by the monoline, real exposure was
actually more than double the declared amount.
Lehman
Estimates of net CDO protection written by monolines come to around $125bn of mostly super-senior
but also some junior super-senior and mezz exposure. Assuming 40%/60% recoveries, losses from
monolines defaults would come out to around $50bn. This is a conservative assumption as
1. not all monolines would default
2.
the banks hold some collateral / have collateral agreements in place (AAA monolines had muchless strict collateral posting provisions and it appears even ACA, which due to its A rating was
required to post collateral, won forbearance agreements from its counterparties)
3. the banks hold hedges against the monolines (though this will have been recognized long before
the writedowns on the cash assets as vanilla CDS on liquid names are marked-to-market)
Without going into detail, the case of Merrill is particularly disheartening from a risk management
perspective as it appears to have committed two basic mistakes. Just as the investors were becoming
wary of CDO’s, and ABS CDO’s in particular given the apparent weakness in the housing market, one
division of Merrill continued accumulating cash ABS assets just as another division was failing to find
buyers for the securitized products.
Why Merrill was aggresively buying up assets it knew could no longer be offloaded is puzzling and
speaks of disincentives in the firm. At some point though, the bank did realize that this practice was not
a particularly wise strategy and if it couldn’t find buyers of the cash assets it was going to find a seller of
CDO protection. At that point the only insurer willing to stick its neck out was ACA (XL Capital having
walked away) which was even then on particularly shaky ground. Merril put on $10bn of hedges with
the firm, however, soon after ACA was downgraded and the bank was again swimming naked.
The obvious question is why did banks have exposure to monolines in the first place? The short answer
is the negative basis trade (isn’t it always?).
Moody's
The slightly longer answer is that, as mentioned, above some banks used the monolines to hedge their
exposure to CDO tranches while they waited to offload them to investors.
1. For example, say a bank comes out with a $1.5bn issue of a CDO but can only find interest for
half the size. The internal trading desk, whether it wanted or not, would have to hold whatever
wasn’t placed.
2. Another reason was that a monoline wrapped tranche could be marketed as a higher quality
product (super-AAA rather than a plain AAA) and so could reach a broader set of investors.
3. Also, buying protection from monolines was often the only way to manage the risk of CDOassets as single-name CDS on ABS CDOs hadn’t come into the existence (or at least standardized
existence) yet.
4. Finally, this trade was attractive from a regulatory capital perspective and, more importantly,
was positive carry which meant that holding it on the books seemed like a good strategy given
the cheap balance sheet cost and a failure to recognize that funding costs may rise in the future.
What are the considerations for monoline way-ness risks:
1. An important question a bank has to ask itself each time it does a trade with a client that may
expose it to counterparty risk (i.e. a derivative rather than a fully funded trade) is what is the
client’s motivation for doing the trade. For example, if a client is punting in the market in an
attempt to make up for heavy losses on other trades, the bank should be more cautious. Inrecent years, municipal insured penetration has steadily declined, driven by increased investor
risk appetite (less need for wraps) and a perception by municipalities of a fundamental bias in
the rating methodology for their sector. This has led the monolines to expand into new markets
and consider new business opportunities just as the price of risk was hitting new lows. Rating
agencies were also keen to expand the structured products business for which they gathered
high fees. They may also have influenced the monolines to pursue the business as a way to
diversify their revenue stream and ultimately keep their AAA ratings. Also, a client that is
aggresively pursuing highly leveraged opportunities outside of its historic mandate, for example
a corporate putting on exotic curency trades, is particularly at risk as it points to possibly broken
risk controls and poor risk management. As the market discovered later, the monolines thatwere particularly aggressive in bidding for structured finance business, such as ACA, were the
ones that would be less able to withstand losses in a stress environment
2. The key difference between the staid muni bond insurance business and the new CDO tranche
insurance business that monolines were underwriting has to do with the static/dynamic mark-
to-market risk profiles of the two products. This is an important consideration as the mark-to-
market gains and losses are linked to the capital the insurer is required to hold as well as the
collateral it may be required to post. An insurance provider prefers a lower mark-to-market
sensitivity (and hence less onerous capital charges and potential collateral calls) if the product it
is insuring performs badly, all else equal. For example, for a typical bond, the MTM sensitivity
decreases as the credit risk worsens (since the duration of the bond decreases) – exactly what
the insurer prefers. In the case of a super-senior tranche, however, the MTM sensitivity will
actually increase – precisely in the worst possible time (since the delta of the tranche will
increase). To provide intuition for this, consider the tranche as a initially deep-out-of-the-money
option on expected loss. The wider spreads rise, the closer the super-senior tranche is to
suffering impairment and hence the higher its sensitivity to credit spreads. So, as the
performance on these tranches suffers, the insurers would be marginally more on the hook for
each basis point wider in spread. An attempt by the insurer to delta-hedge its exposure is likely
to lead to losses since the monoline would be hedging a negative-gamma position and locking in
losses with each rebalancing trade as spreads move.
3. If at some point, monolines decided to offload their super-senior tranche exposure because of
their view of the market or as a preventative measure to shed risk, they would likely find it very
difficult to do so. The scenario in which super-senior tranches are under stress is a scenario
when liquidity is at a premium and buyers of risk are on the sidelines.
4. Going back to the point briefly mentioned above, super-senior tranches are likely to sufer in a
“systemic” crisis environment – precisely the one in which we find outselves today. This
environment is the one where the monoline itself would be struggling, unable to source newbusiness as issuance and risk appetite dry up. It would be difficult for the monoline to find new
sources of revenue to offset the bleeding in cash due to collateral postings or recapitalization
efforts.
5. Poor performance of super-senior tranches would put additional stress on the monolines which
may ultimately lead to ratings downgrades – precisely what we have seen in the last few years.
Ratings downgrades would automatically trigger collateral calls and increased capital cushions,
precisely when the monolines would be least able to afford it. Though rating agencies try to rate
companies “through the business cycle”, the fact is that there are more downgrades than
upgrades during recessions.
6. The hedging of monoline exposure by banks will increase the stress on these companies. Since
the monoline spreads are correlated to super-senior tranches, banks having counteparty
exposure to these insurers found that their exposure increased as credit spreads widened. This
caused them (at least for the one who were actively hedging their exposure) to buy protection
on the monolines exacerbating the perception of monoline risk in the market and leading to a
7. Recoveries in an environment of high defaults would be lower than average putting further
pressure on monolines.
8. An alternative to buying protection on the monolines to manage the banks’ exposure was to buy
protection on the underlying bonds in the CDO. This was not possible in the early stages of the
market as single-name ABS CDOs did not trade. However, in the last few years liquidityimproved and banks were able to source protection. However, buying protection on CDS will
likely push cash bond and CDO spreads wider which will increase banks’ exposure and cause
further MTM losses to the monolines
9. We should differentiate willingness from ability to pay. Insurance companies are generally loath
to make payouts on policies, so it is not surprising that we would witness monolines balking at
making payouts on the CDO tranches. Merrill, sued SCA over $3bn of CDS positions. AIG has also
tried to wiggle out of some protection it wrote. This is not surprising as none of the insurers ever
considered it remotely possible to have to pay out on these contracts which contributed to
insufficient reserves and lax risk management. There is also some controversy over side letters
suggesting that neither the insurer nor the insured expected cash to change hands on these
contracts.
10. Though few people take ratings very seriously (especially now), the fact was that Merril entered
into contracts with ACA (then A-rated) to buy protection on a AAA underlying. The ratings
suggest that ACA is more likely to default than the product on which it is providing insurance.
This is actually worse than “buying insurance on the Titanic from someone on the Titanic”.
The monoline crisis provides a textbook case for the do’s and don’ts of managing counterparty risk and
why some banks ended up suffering much more than if they had pursued a more sound risk
management strategy. Greed will get you every time…
Below I list the trades executed by municipalities that have been particularly prominent in the news.
VRDNs
The most interesting trade to come out of the muni crisis has been the debacle seen in the variable rate
market. The two types of variable rate muni securities are VRDOs and ARS. They are broadly similar butvary in puttability (VRDO’s are puttable, ARS’s are not), denominations, monoline coverage, investor
types etc.
The most important thing, which is common to both types of securities, is that the interest rate resets
periodically according to some basic rules (auction-failure for ARS or a result of the remarketing
process/changes in specified index for VRDO). The interest rate resets either to whatever rate clears the
market or in the case of auction failure, steps up to a very high level so as to compensate those investors
who were not able to sell their securities. These securities were very popular with muni issuers simply
because, even after all the structuring fees (bank letter-of-credits and monoline insurance), the variable
short-term rates paid by issuers were less than if they had issued long-term fixed rate debt.
The rates paid on the VRDO’s have tended to track the front-end cash/Libor levels. For this reason, the
municipalities, bowing to the wisdom of risk management, hedged their interest rate exposure by
paying fixed on interest rate swaps (or buying interest-rate caps). The floating index on the swaps was
typically 67% of Libor. So, in the ideal case, the muni is paying a floating rate while receiving pretty much
the same rate on its swap hedge on which it pays fixed.
When the market grew suspicious of monolines, paricipants rushed to put the bonds back to the market
just as the bids retreated from auctions. Clearing rate levels shot up and ARS’s hit their maximum rates –
most well-known in the case of Port Authority which started paying 20% vs. an earlier 4%.
So, the net result was that the floating rates the muni’s were paying on their VRDN’s shot up (owing to
general illiquidity as well as the concern around monolines), while the floating rates they were receiving
on the swaps collapsed (as interest rates fell) – meaning the muni’s managed to lose money both on
In retrospect, the municipalities made a number of key mistakes:
Liquidity risk – the most fundamental mistake was similar to the one that befell the Structured
Investment Vehicles: the reliance on short-term debt. Once cracks appeared in the monoline
wraps and investors withdrew into cash, the muni’s were not able to roll over their debt. The
municipalities were effectively subsidizing the rate on their debt by writing a massive liquidityoption. They compounded the problem by backstopping their own short-term debt with
impossibly high rates, knowing full well that paying such rates on their debt was not sustainable.
The realization by the market of lack of demand for variable-rate securities and the unstainably
high rates paid on the debt only added to the lack of confidence in muni debt
Monolines – anything having to do with monoline wraps tends to be procyclical meaning it will
exaggerate the pain on the wrapped products. The basic point is that the nature of the monoline
business suggested that the time when an investor will seek to benefit from the wrap, is exactly
time when that wrap will be worthless. Apparently, some municipalities have also agreed to
post collateral in the case of ratings downgrades, something which would tend to happen when
the monolines are gone, the economy is in recession and cash is at a premium and difficult to
raise and swaps are negative-MTM to the muni’s.
Rates – municipalities may be forgiven for failing to foresee the silly price action in 30y swap
rates which are still trading below 30y treasury yields. This was due to hedging of structured
rate notes by dealers issued mostly to individual investors. The massive rally in rates has led
banks to receive fixed in size in the long end of the swap curve in a largely illiquid market. This
has led to large losses to the swap hedges done by municipalities. Most of these have tended to
be in the long end of the curve, just where the rally has been most brutal.
Selling swaptions
Second on the list of poorly-thought-out trades has been the selling of interest rate swaptions. On the
face of it, the motivation for selling swaptions looks quite reasonable. The muni issuer sells a payer
swaption (on exercise the muni will pay the fixed strike). If the swaption is exercised, the muni pays
fixed, receives floating and at the same time issues floating-rate bonds and uses the proceeds to refund
the outstanding issue of bonds. Net result is a locked in synthetic rate for the issuer with some savings
from the swaption premium.
This all sounds well and good except for the fact that the banks end up dictating if and when the
municipalities issue debt. This decision to issue debt is not based on any fundamental funding need, but
rather on the performance of a single trade done with the bank.
A cursory look through the news shows that Erie School District, Philadephia National Airport and
Alabama Schools have all sold swaptions. This suggests that if rates were to fall they, and many other
counties and districts who have also sold swaptions would need to come to the market and issue debt,
Without going into detail, the basic structure of the trade can be summarized by the following chart.
Salient points of this trade are the following:
If the market goes in the client’s favor, they make a little money and the trade matures in short
order
If the market goes against the client, the notional amount on the trade increases and the
maturity extends.
Exporters who did the trades claimed they were being done for hedging purposes. For example, aMexican company exporting tortillas to the US market received dollars and needed a product that
effectively made them short USD/MXN (ie whereby they sold dollars and bought pesos in the market). It
is true that these trades positioned these companies the right way, unfortunately the trades were done
in much larger size than the hedging operations required and the timing (knock-out components) plus
leverage on the trades (which typically flipped from 1 to 2x the size when it went against the client) had
no fundamental bearing on the actual financial flows.
It’s not clear how popular this trade was with municipalities though history of municipal involvement
with FX stretches all the way back to 1995 when the State of Wisconsin Investment Board lost $95mm
from MXN peso trades. Add to this the fact that municipalities pile in, along with companies and retailinvestors, into popular trades at the top of the market suggests that should see losses on such trades
The classification of the trades described above can be summarized as follows:
1. Basis Risk – these are trades done for fundamental reasons, like obtaining cheaper funding, but
go sour occasionally because they expose the investor to some tail risk. VDRN’s was one such
trade that exposed muni’s to tail funding/liquidity risk as described above. The key here is tounderstand that the only reason muni’s were cheapening their funding was by selling a liquidity
option to the market. So long that these tail options are viewed as risk free, municipalities will
continue making the same mistakes. In reality, nothing is free in the market, and issuance
decisions will be made on a more sound basis in the future if all risks are properly taken into
account rather than swept under the rug.
2. Leverage – these are the typical “investment” trades based on a particular view of the market.
The danger lies in the execution of the view (e.g. structured notes), as well as the leverage taken
separately by the investors (via reverse repo’s).
3. Punts – these are trades done for apparently “investment” or “hedging” reasons. What
differentiates punts from normal investment trades is the fact that the punt is done in a market
where the investor can have no competitive advantage or insight relative to other players in the
market. In other words, the answer to Ken Fisher’s question “What do I know that others
don’t?” cannot be answered satisfactorily. These trades often figure in FX markets and often
executed long after the popular press begins writing about their virtues. The FX KIKO, which is
based on the carry trade, is an example of such a trade.
In order for the market to move beyond the news cycle of losses by municipalities and other
unsophisticated real money investors, there need to be some fundamental changes. These changes have
to come from both sides of the equation: municipality investment mandates and bank risk management
policies.
Recent news has made it painfully clear that municipalities need to abstain from certain kinds of risks.
These risks include the 3 categories mentioned above because each one has the potential to bury them,
if left unchecked. In general, municipalities do not have the resources to run a full-fledged asset
management organization, suggesting that their investment mandates need to shrink significantly.
Although, generally speaking, the allocation of more power and decision-making ability to the local
levels is not a bad thing, what we cannot have is a situation where part-time town board members
without strong and dedicated risk management support staff make decisions that put at risk pensions of
thousands of other people, while guided by biased investment advisors.
Investment mandates for municipalities need to be made on a state, if not the federal level and there
has to exist a framework for escalating problems higher up before they explode. For example, a county
finding itself in financial difficulties should not think that the only way out of trouble is to finance its
budget by selling a ton of swaptions to the next friendly dealer that comes along.
On the bank side, dealers need to adapt consistent trading and “know-your-client” standards with
municipal counterparties. These should not only include a relatively conservative set of products, but
also collateral calls so that “punts” and leveraged trades, to the extent they are allowed to happen at all,
are unwound/collateralized early and are treated with more care and tracked closely.
The traditional treatment of counterparty risk does not hold for unsophisticated investors like
municipalities who can easily claim in court (often with good reason) that they did not understand therisks in the trades they were doing. Clearly, this will happen only when trades go bad adding its own
particular wrong-way risk to these trades for banks.
There needs to be greater emphasis placed on the motivation behind client decisions to do certain
trades. For example, an interest rate position done for genuine hedging of risk (preferrably without any
basis risk) is very different from a short swaption position done to raise cash. The latter is a clear red flag
and suggests that the client is essentially doubling down to get out of a financial jam. The risk
management function of the banks should ensure that such trades are not done.
Many companies, such as Microsoft, have sold equity puts on their own stock as a way to cheapen the
cost of stock buy-back programs or lock in their cost. Since the 1992 SEC ruling, these trades have been
attractive to corporates, driven partly by the tax-free treatment of the put premia received by the
companies. The basic motivation behind the trade is that if the stock price rises, the puts expireworthless and the company offsets the higher stock price it pays on the repurchase (if it decides to go
ahead with the repurchase anyway) with the premia it received on the puts. If the stock price falls, the
company is essentially delivered its own stock at the strike price – thus having locked in the stock
repurchase cost at the time of the sale of the puts.
Self-Referenced Debt Structures
Synthetic Debt Repurchase
Stock repurchase programs are fairly common and well-established. In the fixed income world, the debt
equivalent of a stock repurchase plan is a Debt Repurchase which can take the form of either Cash orSynthetic programs. Though less flexible than their synthetic counterparts, cash debt repurchases can be
executed via open market debt purchases (which is more common for a buyback of a fraction of the
outstanding debt) or via public debt tender offers (which is geared toward buying back all or a significant
portion of an outstanding debt security).
Synthetic debt repurchase seeks to replicate the economics of its cash cousin with enhanced flexibility
and reduced execution costs. Here, the issuer enters into a Total Return Swap with a bank with a
particular issuer’s debt security as the underlying asset. The bank will pay the issuer interest and
principal payments made on the underlying security and, to the extent the maturity of the TRS is shorter
than the security, settle the price difference at maturity. Similar to the cash outlay on the cashrepurchase, the issuer will post collateral on the TRS to the arranging bank.
Self-Referenced CDS/CLN
Here, the company sells protection on itself. Though they are, in effect, identical, there are two flavors
of the trade: 1) collateralized CDS or 2) Credit-linked Note. A fully collateralized CDS is essentially a CLN
(i.e. a bond)., while a partially collateralized CDS (say, 50%) is a called a leveraged CLN. Such trades
usually have embedded spread or MTM triggers that are tied to the either the level of the CDS or the
MTM of the trade.
This trade may be appealing to a company if its bond/CDS basis is positive i.e. it earns a higher yield byexecuting the trade via CDS rather than cash bonds. Also, if the company believes the widening in its
credit spreads is overdone, it can sell CDS on itself and unwind at tighter levels, though it would then be
open to insider and/or market manipulation charges. Finally, as a funding trade, it may make sense for a
corporate to buy its own short-dated CLN at L+x, rather than put cash on deposit or buy Tbills that offer
In fact, this is what MBIA did in 2002 when it bought CLNs linked to its subsidiary. Bill Ackman has talked
about this trade in his broader criticism of the company. Effectively, by purchasing its own CLN’s MBIA
benefitted publicly by improving the weighted-average rating on its portfolio and causing its CDS
spreads to tighten, while at the same time, hurting its liquidity (by having to post cash for the CLNs) and
leveraging itself up on its own creditworthiness - two issues that were not disclosed.
As far as the Milan trade, the story looks pretty simple – Milan had some cash that it needed to put to
work. Rather than go to the market and buy Italy bonds (which I’m sure is well within the mandate of
Italian municipalities just as buying US Treasury bonds is well within the investment mandates of US
muni’s), it chose to structure the trade in a synthetic fashion – either to match a particular
maturity/target yield/notional schedule etc.
So, a tad overblown if you ask me.
Collateral Enhancement
Though potentially a red flag, a company can, in some cases, increase its credit line with a lender byassigning a long protection trade as collateral, though the increase will not likely be 1:1 for the amount
of protection given increased counterparty exposure to the lender on the CDS trade.
Improving Recovery/Funding
A neat trick that improves recovery prospects for subordinated debt holders while providing senior-level
funding for the issuer without increasing the outstanding amount of senior debt involves selling sub
debt to an investor and at the same time entering into a TRS where the investor pays the total return on
the sub debt in exchange for L+x.
This achieves the following benefits in some jurisdictions:
The senior noteholders see an improved position in the capital structure with the sale of
subordinated debt.
The investor sees an improved recovery profile on the net trade. Say, sub and senior recoveries
are 20% and 50% respectively. The investor receives the 20% on his sub debt plus 50% x (1-20%)
on the TRS, which beats the recovery of the senior noteholders.
The issuer obtains senior-level funding, without showing any increase in the outstanding
amount of senior debt
Improving Credit Ratios
A way for a bank to improve its credit ratios is to do the following. Find a bank (investor) to put up $100
for issuer’s subordinated debt. This $100 is then roundtripped back to the bank in exchange for a zero-
recovery CLN linked to the issuer. So, in case of a default the bank will find itself with a liability worth
zero and an asset worth the subordinated recovery, a net of greater than zero. The issuer will be
required to hold some $8 of capital against the CLN, with a net capital increase of $92.
Let’s say you’re an Emerging Market corporate or a sovereign that would like to issue a sizable amount
of debt. You have two choices: you can issue in your local currency or you can issue in a foreign
currency, let’s say a major currency like USD. The benefit of issuing in the local currency is that you are
not taking any FX risk i.e. your revenue/taxes are in your local currency – the same currency which youwill use to pay interest to investors. The downside, however, is that the market for locally-denominated
debt may not be large enough to digest the issuance, at least at levels that are attractive to you. On the
other hand, issuing in USD taps a much larger market, however you will now have pretty serious FX risk
as the size of your debt will grow if the local currency depreciates relative to the USD. This is the
problem of “original sin” that all emerging market issuers are keen to avoid.
So, what’s an enterprising Emerging Market issuer to do? The obvious solution is to hedge the FX risk
with a cross-currency swap. You issue debt in USD and then enter into a swap where you receive USD
from a bank and pay the local currency, thus hedging your exposure. Feeling pretty good about yourself
and about to pull the trigger, you get a call from a credit marketer of the same bank who tells you that
he can pay you 50bps more on the swap than the rates desk. What’s the catch? The catch is that in the
event of default by you, the cross-currency swap is extinguished.
This is not much of a catch – who cares what happens in the event of default, especially if you have one
less trade to worry about during the workout/restructure process. An important caveat is that this trick
can only work when local currency rates exceed foreign currency (USD in our example) rates. Why? If
local currency rates are higher, that means the currency is expected to depreciate relative to USD
throughout the trade, which means that while the earlier cashflows are expected to be a net positive for
the bank (+ve carry), later cashflows, including the large principal payment, are expected to be worth
little for the bank. Adding credit risk to the structure means the scenarios when the bank is receiving
cashflows that are worth less than what it is paying are less likely, hence the bank can afford to pay
more to the issuer on day one.
This trade has been very popular, for instance, with Latin American sovereigns but less so with
corporates, largely due to the lack of liquidity on corporate CDS. In fact, a good guage of whether
corporates/sovereigns are doing this trade can be found in the quanto CDS market where banks will go
to hedge the local-ccy denominated CDS risk they are taking on via this trade.
Kangaroo Bonds
This structure involves a higher recovery in case of default for the investor in exchange for better
financing to the issuer. Say, an investor buys a $100 issuance and at the same time buys $200 of CDS
from the issuer. In case of default and 50% recovery, he will recover $50 on the bond and will have a
claim of $100 against the client, on which it will recover an addition $50, this making him whole. He will
consequently pass on this benefit to the issuer via significantly better funding.
