Credit-Default Swaps: Weapons
Credit-Default Swaps: Weapons of Mass Speculation
Barron’s -
In the decade since credit- default swaps were invented, the market has exploded in size, to some $62 trillion of CDS deals outstanding from just $1 …
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Moving Towards Exchange-Traded Credit Default Swaps |
 BBC News |
CDS report: Bond risk retreats as traders shrug off MBIA, HSBC woes |
 Earthtimes (press release) |
PREVIEW-AIG seen posting another net loss in 1st-qtr |
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Buffett doesn’t see CDS market collapsing |
 Turkish Press |
Swiss Re profit falls 53pc |
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THE STRIKING PRICE DAILY |
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CDS may undermine debt governance -law professor |
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Norske Skog CDS surge wider on earnings -traders |
 AFP |
Reinsurance group Swiss Re’s first quarter profit falls |
MONDAY, MAY 12, 2008
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Credit-Default Swaps: Weapons of Mass Speculation
By JONATHAN R. LAING
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DON’T KNOW MUCH ABOUT derivatives called credit-default swaps, or CDS? There’s no reason one should. Even today, CDS, which represent bets on the default risk of various debt issues, remain an obscure corner of the global-finance market, inhabited mostly by big banks and brokerages, hedge funds and other institutions. Denizens of the CDS market strike customized insurance deals covering all manner of debt, from corporate, sovereign and municipal bonds to asset-backed securitization paper. There’s no formal clearing house for this over-the-counter market. Nor is there much public reporting of the pricing of the trades.
![[defaultbearcommando]](http://s.wsj.net/public/resources/images/BA-AM417A_defau_20080509154027.jpg) |
| Scott Pollack |
| Buying credit-default swap protection is the ultimate bearish bet. |
But don’t be fooled by the low profile of the business. In the decade since credit- default swaps were invented, the market has exploded in size, to some $62 trillion of CDS deals outstanding from just $1 trillion in 2000, according to industry estimates. This dwarfs the size of the underlying bond issues.
Beyond concerns about its size, the CDS market seems to have become a weapon of mass speculation that is destabilizing international debt and even equity markets. That looks to be true in the subprime-debt-induced crisis of recent months that still has the credit markets in a deep-freeze. At the height of the crisis, in the first quarter, the price of credit-default insurance for key financial companies zoomed to once-unimaginable heights, signaling rightly or wrongly the imminent default of their debt issues.
The run-up was induced partly by panic among debt holders and others seeking to hedge their financial exposure at any price. But other factors, some suggesting a deliberate attempt by bearish investors to sow doubt about a company’s financial condition and thus push up CDS prices, may have played a role. In the CDS market, a well-placed rumor of trouble, or snippet of negative analysis, can have an outsized impact on positions, because much like a put, the investor risks only the premium to control the action on a potentially large position. Buying CDS protection is the ultimate bear bet, and the incentive of CDS holders to accentuate the negative, particularly to the financial press, is almost irresistible.
There are intimations, at least, that such activity occurred. The Securities and Exchange Commission reportedly has launched an investigation of the role rumor-mongering might have played in fomenting the fatal liquidity crisis at Bear Stearns (ticker: BSC). Similarly, Lehman Brothers (LEH) was afflicted by a spate of rumors in the weeks before and after the bail-out of Bear in March, reportedly prompting another SEC probe.
One has only to look at the charts of one-year and five-year credit-default prices for both Bear and Lehman, collected by the price-reporting service Credit Market Analysis, to see the fast, sharp rise, and fairly sudden decline, in the companies’ CDS quotes. For Bear Stearns, at least, the spike in the price-protection costs triggered a fatal feedback loop.
In a separate example, New York Insurance Superintendent Eric Dinallo saw fit during a mid-February CNBC interview to tell William Ackman, head of New York hedge fund Pershing Square Capital Management, to be careful with some of his criticisms of monoline bond insurers Ambac (ABK) and MBIA (MBI). Dinallo cited, among other things, a New York State law that prohibits false statements about the financial condition of state-regulated insurance companies. Ackman has since become less vociferous in attacking the two companies. He declined to discuss his current positions in Ambac and MBIA, though sources say that in the past he has bet the ranch on the demise of both holding companies, with long positions in the one-, five- and 10-year credit-default swaps, and short positions in the companies’ stocks.
CREDIT-DEFAULT SWAPS WERE developed in the mid-1990s to offer investors a pure play on ever-changing credit spreads, or the yield gaps that exist between various debt instruments and ultra-safe Treasuries. Thus prices, or “premium rates,” are quoted in basis points, or one-hundredths of a percentage point of the par value of the bonds being insured. The buyers of CDS typically are hedgers seeking to protect against the risk of untoward widening in the credit spreads on their holdings, or speculators with no underlying debt positions, looking to profit from the same. In the event of a default, buyers receive the full difference between the par value and recovery value of the CDS-insured bonds.
A clutch of hedge funds have enjoyed huge returns in the past six months or so from the galvanic moves in CDS prices triggered by the collapse in the subprime-mortgage market and the resulting credit crunch. The big bucks were made by buying CDS on various mortgage-backed securities and on the debt of subprime-encumbered financial companies, including not only Bear and Lehman, but MBIA, Ambac, CIT Group (CIT) and Countrywide Financial (CFC).
Among hedge funds, two big winners last year were Passport II Global and Balestra Capital, Nos. 1 and 2 in Barron’s annual survey of the top 75 hedge funds (”Scaling the Heights,” April 14), with annual returns of 219% and 199%, respectively. Propitious CDS purchases also contributed greatly to the $12 billion in returns that John Paulson of Paulson & Co. rang up last year, the biggest annual haul any hedge fund has made.
All three fund managers caught the once-in-a-lifetime expansion of credit spreads in the past year or two, from negligible levels of, say, 30 basis points, or 0.3% of the bonds being insured, out to 1,000 basis points, or 10% of the bonds being insured. The profit on this position, when it was closed out a year later, wasn’t just a 10-bagger of the sort former mutual-fund legend Peter Lynch used to brag about. It was nearly a 100-to-1 return, after figuring in the present value of the carrying costs of 1.5% (five annual payments of 0.3%) and the payoff of 4,000 basis points (representing the 1,000 basis-point premium multiplied by the four years left on the contract).
A CLOSER LOOK AT OUR CHARTS indicates how emotional the CDS market became in recent months. CDS of Countrywide and Bear both rose to nosebleed levels in the first quarter, then plummeted after each company found a merger partner with a stronger credit profile. In other words, both Countrywide and Bear, as evidenced by their takeovers, had implicit equity value, even though, for Countrywide, the one-year CDS premium rate soared to 4,261 basis points, implying the likelihood of an imminent bankruptcy with a paltry recovery.
The CDS of finance company CIT and Lehman traced similar trajectories on short-lived rumors to the effect the balance sheets of both companies were too illiquid to ensure survival. Yet, look how quickly the fever passed after soothing words from the managements of each and the companies’ successful ability to raise capital.
![[deafualt chart]](http://s.wsj.net/public/resources/images/BA-AM439C_defau_20080509214408.jpg)
The CDS charts of bond insurers Ambac and MBIA show a different pattern. There’s the initial earthquake in January, followed by severe aftershocks in February, during congressional hearings on the monolines’ capital adequacy, and in March, when Bear Stearns melted down. CDS prices for the pair still are relatively elevated — at some 10% of underlying principal for Ambac, and 6.5% for MBIA on the most heavily traded five-year CDS paper.
Both insurers made some ill-fated forays in recent years into the asset-backed-paper market, including insuring some dicey subprime-mortgage securities. But the key question for Ambac and MBIA in recent months wasn’t their survival, as the CDS market implied, but whether rating agencies might lower the credit ratings on the companies’ all-important insurance units from triple-A to double-A.
In the worst-case scenario, such a downgrade would have impaired the companies’ ability to write new business. Yet even in so-called run-off, both companies would have prospered from the momentum of large and continuing investment income and premium flow from their books of long-term insurance contracts. Both companies would have had the claims-paying ability to meet all their obligations, while also returning $30 a share or more in capital to their shareholders in less than 10 years.
Dinallo, the New York insurance superintendent, perhaps put the issue best in a letter to Congress in February that became part of the monoline hearings record: “A move from AAA to AA still leaves a highly solvent, financially strong financial guarantor insurer, particularly when compared to the vast majority of other regulated insurers.”
What makes CDS trading in Ambac and MBIA so intriguing is that major owners of the CDS positions have been waging open rather than clandestine war against the two companies. The charge is being led by Ackman of Pershing Square, who has been betting against the monolines for the better part of six years. Yet that campaign has borne fruit only in the past six months or so, albeit spectacularly so.
AS THE CHARTS SUGGEST, ACKMAN’S ASSAULT ON the two companies seemed to go into hyper-drive in mid-January, when he appeared on Bloomberg TV declaring MBIA would need to raise more than $10 billion in new capital just to meet its future claims obligations. Its parent company — whose credit-default swaps he held — would be insolvent anyway by the end of 2008, he charged, because of the necessity of keeping all the existing capital in the claims-paying insurance subsidiaries.
About a week later, on Jan. 18, Ackman sent a letter to the rating agencies questioning their analysis of Ambac and MBIA’s capital adequacy at the insurance-unit level. Copies of the letter were provided to the financial media and received some coverage. On Jan. 30 he followed up with a letter to regulators that cited findings from his research indicating that claims losses faced by Ambac now had risen to $11.6 billion and those of MBIA to $12.6 billion.
As Barron’s has pointed out in stories about the monoline insurers (most recently in “MBIA: Priced for Catastrophe,” Jan. 21), these estimates are somewhat fatuous. The numbers didn’t take into account the effect of taxes, nor the present value of claims that might take as long as 40 years to play out. Ackman’s model also relied on seemingly Draconian assumptions.
About an hour before the stock market closed Jan. 30, Charles Gasparino, a CNBC commentator with similar views to Ackman’s, stated on air that he “felt in his gut” Ambac or MBIA or both would be downgraded that day. Never mind that nothing happened; the shares of both companies plummeted on the “news,” and the leading market indexes, which had been up as much as 1% earlier in the day, ended the day down 0.3%. Ambac’s CDS prices also hit an all-time high that day.
On Feb. 5, Ackman wrote the Fed and Treasury — in a letter provided to the media — that the bond insurers were “functionally insolvent,” but advised against bailing them out. He also charged the New York Insurance Department was remiss in allowing bond insurers to guarantee structured products like mortgage-backed paper.
It was after this epistolary “outburst” that Dinallo delivered his implied warning. Ackman since has acted mainly through surrogates in the media and elsewhere to paint a bleak picture of Ambac’s and MBIA’s future. Martin Peretz, editor in chief of the New Republic and a onetime academic mentor of Ackman at Harvard, intoned in his April 2 New Republic blog, “I wondered why, when MBIA showed early signs of expiring (which I believe it will still do…) it went back to Brown to dig it out of the muck. One answer is that he knows all the secrets of the rapacious and dirty work it did. It will not help.”
The Bottom Line:
The $62 trillion CDS market has become a destabilizing influence in the bond and stock markets. Rumor-mongering by CDS holders helped drive down many financial shares.
The Brown in question, Jay Brown, became CEO of MBIA again in February, after stepping down nearly a year earlier. He gently chided Peretz for failing to mention on Peretz’s blog that he was a major investor in Ackman’s fund, and therefore had a substantial financial interest in MBIA’s demise. According to Brown’s posting, there had been a dozen or more other postings by Peretz running down MBIA that lacked any such disclosure.
Ackman’s poison-pen campaign against Ambac and MBIA also inspired a hilarious parody that has circulated in recent months in Wall Street trading circles. The anonymous author, billed as Bruce Wayne, the most omnipotent Managing Founder of the Robert E. Lee Short Funds, addressed his missive to President Bush, His Holiness Pope Benedict XVl, Oprah Winfrey and Bono. It begins: “You don’t know me and it is unlikely you ever [will] seek to, but I am a rich and handsome man and I have made a huge investment whose profit depends on the decline of a stock [an obvious reference to MBIA] whose issuing firm is central to the stability of global financial markets.”
Some two pages later, after a send-up of Ackman’s research techniques and fear-mongering, the letter concludes: “Anyway thanks for everything, thanks for just being you. Thanks for being part of a system where I can seek to systematically destroy a decades-old company that is the linchpin of the entire financing system solely to enrich myself and further my franchise as a shareholder activist, like my hero Gordon Gekko….”
Ackman won’t discuss Pershing Square’s trading in Ambac or MBIA except to say his fund has made some substantial profits in both. He still insists both holding companies eventually will be “toast” as a result of capital starvation.
To Ackman, credit-default swaps are “great, great instruments.” It remains to be seen whether credit-default swaps, which often trade on raw emotion, also are good for investors in general.
http://online.barrons.com/article/
SB121037952364682261.html?mod=googlenews_barrons&page=sp
FELIX SALMON:
May 13 2008 5:29AM EDT
Moving Towards Exchange-Traded Credit Default Swaps
Ken Griffin wants to move to a system of exchange-traded credit default swaps:
Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.
That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.
“It’s not sexy, but it’s simple, it’s cost forward, its straightforward, and it’s what we should have done after 1998,” referring to the collapse of Long-Term Capital Management, a big hedge fund. He added that it “is a very sad commentary on where we are from a regulatory perspective” that such a move hasn’t happened already.
Of course, most big investment banks would hate such a plan, he acknowledged by telephone last week. “The investment banks and commercial banks benefit from the lack of transparency because they are the intermediary,” he said.
It’s a great idea, and I’m all in favor. For one thing, it would cut out the inter-dealer brokers, who cost a huge amount of money, leaving more for everybody else.
What are the obstacles? I don’t think it’s opposition from the big investment banks - the answer there is to simply get them to set up the new CDS exchange, which could well be worth billions within a couple of years.
There are big problems surrounding the whole issue of counterparty risk. The idea behind an exchange is that if A wants to buy a derivative, he can look at bids from B and from C and take the one quoted at a lower price. That’s then the market-clearing price for that contract, and the price can be made public for anybody else who wants to mark their positions to market.
With a CDS, however, A might prefer to do business with C even if C’s price is higher, if A has worries about B’s reliability as a counterparty.
These problems should not be insurmountable, and indeed a CDS exchange might be able to add a lot of value to the CDS market if the exchange itself somehow licensed its members and guaranteed their obligations. The cost of that counterparty insurance, it seems to me, shouldn’t be more than the amount of money currently skimmed off by the inter-dealer brokers.
The difficulty, of course, is how do we get there from here. Griffin blames the US regulators for not having done this already, but it’s not obvious whether they’re really the ones to do it. Then again, if the regulators don’t force the issue, there’s a good chance it’ll never happen.
http://www.portfolio.com/views/blogs/market-movers/2008/05/13/moving-towards-exchange-traded-credit-default-swaps?addComment=true
HENRY HU, Texas Law Prof:
http://www.reuters.com/article/bondsNews/idUSL1876966920080418
CDS may undermine debt governance -law professor
By Jane Baird
VIENNA, April 18 (Reuters) - The explosive growth of derivatives has made it possible that holders of credit default swaps (CDS) could sabotage the interests of a company and its other debtholders, a U.S. professor told a conference this week.
“Empty creditors could undermine debt governance,” Professor Henry T.C. Hu, professor of law in banking and finance at the University of Texas, told the annual meeting of the International Swaps and Derivatives Association (ISDA).
For example, a hedge fund or other investor could hold $200 million of a company’s bonds but could also have bought protection against default in the CDS market for $500 million worth of the company’s debt.
In that case, the investor stands to profit more from its swap position than it would lose from its bonds and may act to help push the company to fail, such as by opposing an out-of-court restructuring.
The issue is taking on greater significance as analysts and debt investors expect the rate of global bankruptcies to increase later in 2008 and 2009 from what have been historically low levels.
By debt governance, Hu refers to the creditor’s control rights in credit agreements and under bankruptcy law.
“Both loan contracts and the (U.S.) Bankruptcy Code are premised on the assumption that creditors … have an economic interest in the company’s success and will behave accordingly,” Hu and Professor Bernard Black wrote in a law review paper in January.
“Large-scale, hidden debt decoupling weakens our ability to rely on these assumptions.”
DERIVATIVES DECOUPLING
The January paper extended the work of the two professors, who published a paper in 2006 that caused a stir in the media and the market by identifying the risk of “empty voting” by shareholders with holdings of equity derivatives.
“The derivatives revolution in finance has made it easy to decouple financial voting rights from economic ownership,” Hu said at ISDA. “Decoupling of control rights can also occur on the debt side.”
The notional value of outstanding CDS on a number of companies is many times higher than the value of underlying cash bonds.
For that reason, ISDA has devised an auction process to determine cash settlement of CDS contracts in the event of defaults. When U.S. autoparts company Delphi Corp defaulted in 2005 for example, the value of notional swaps on the company amounted to about $30 billion, 15 times its $2 billion in bonds.
David Mengle, ISDA head of research, questioned, however, whether in practice an investor would end up holding both bonds and protection for a distressed company.
When companies are distressed, buying a hedge requires an expensive payment up front and dealers may be reluctant to sell protection, Mengle said.
As for companies that are not yet distressed, investors are not likely to buy and hold both bonds and CDS in a consistent way, he added.
There is no requirement for creditors to disclose their derivatives holdings, so the extent that they may have different economic interests in companies is not known.
Hu said, however, that bankruptcy judges and lawyers have told him that his theory explains instances of odd behaviour they have observed in recent years.
“One bankruptcy judge described a recent case wherein a junior creditor complained of too high a valuation being assigned to the bankruptcy estate,” the professors wrote in the January paper.
Debt decoupling is also playing a role in the U.S. housing crisis, Hu said.
When homeowners faced difficulty in the past, they could go to their lenders and try to negotiate waivers or modifications, but this is more difficult now that thousands of loans have been repackaged into portfolios, which have then been sold in pieces to investors.
“The President’s Working Group is calling on the banks to modify the terms of home mortgages, but they don’t have the right to do that,” Hu said. (Editing by David Holmes)
http://www.reuters.com/article/bondsNews/idUSL1876966920080418
UT Law Faculty - Henry T Hu
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Samples of Recent Papers: Henry T. C. Hu and Bernard Black, Equity and Debt Decoupling and Empty Voting II: Importance and Extensions, 156 University of … |
Research by Professors Henry Hu and Bernard Black Featured on …
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Jan 26, 2007 … Henry T. C. Hu and Bernard Black, The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, 79 SOUTHERN CALIFORNIA LAW REVIEW … |
SSRN-Debt and Hybrid Decoupling: An Overview by Henry Hu, Bernard …
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Hu, Henry T.C. and Black, Bernard S., “Debt and Hybrid Decoupling: An Overview” (April 1, 2008). M&A Lawyer, Vol. 1, pp. 4-10, April 2008 Available at SSRN: … |
SSRN-Hedge Funds, Insiders, and the Decoupling of Economic and …
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Jan 10, 2006 … Hu, Henry T.C. and Black, Bernard S., “Hedge Funds, Insiders, and the Decoupling of Economic and Voting Ownership: Empty Voting and Hidden … |
SSRN-The New Vote Buying: Empty Voting and Hidden (Morphable …
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Jun 5, 2006 … For the latter, see Henry T.C. Hu & Bernard Black, Empty Voting and … Hu, Henry T.C. and Black, Bernard S., “The New Vote Buying: Empty … |
FT.com
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A study by academics Henry Hu and Bernard Black concludes that, thanks to explosive growth in credit derivatives, debt-holders such as banks and hedge. … |
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Hedge Funds and the SEC: Observations on the How and Why of …
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Conglomerate Blog: Business, Law, Economics & Society
Mar 21, 2008 … Henry Hu gave his paper with Bernie Black, Equity and Debt Decoupling and Empty Voting II: Importance and Extensions, which recently …
www.theconglomerate.org/2008/03/conference-repo.html - 18k -
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