ICE Emerges as Credit-Default Swap Clearinghouse Frontrunner

By Matthew Leising and Shannon D. Harrington

Jan. 15 (Bloomberg) — Intercontinental Exchange Inc., the second-largest U.S. futures market, is emerging as the leading candidate to run a clearinghouse for the $29 trillion market for credit-default swaps.

Analysts at Morgan Stanley and CreditSights Inc. said this week that Atlanta-based Intercontinental, also known as ICE, will likely be the industry choice to back the contracts because of its partnership with Goldman Sachs Group Inc.,JPMorgan Chase & Co. and seven other banks that account for over 80 percent of the trading. A clearinghouse may earn as much as $400 million in annual revenue, according to Keefe Bruyette & Woods Inc.

An ICE victory would mean the securities firms that control a market responsible for billions of dollars of losses will continue to shape the way the contracts are traded. ICE is competing against CME Group Inc., the world’s largest futures market, NYSE Euronext, the owner of the New York Stock Exchange, and Eurex AG.

“People have some concerns over the banks’ influence, but no matter what entity this goes to, you’re going to have a lot of dealer influence,” said Brian Yelvington, a New York-based strategist at fixed-income research firm CreditSights. “I don’t see how you get away from that.”

Regulators in the U.S. and Europe are pushing the banks to form a clearinghouse to curb risks in the market, where trades are typically negotiated privately between banks and investors such as hedge funds.

Regulators’ Hopes

The New York Fed said in October that it was “hopeful” one or more credit-default swap clearinghouses would begin guaranteeing trades by the end of 2009.

Dealers in the market probably lost hundreds of millions of dollars on trades with Lehman Brothers Holdings Inc. after the collapse of the securities firm, Moody’s Investors Service analysts estimate. American International Group Inc. ceded control to the U.S. government in exchange for a bailout loan after it couldn’t come up with collateral on more than $440 billion in contracts linked to mortgages and other debt.

A clearinghouse, capitalized by its members, spreads the risk of default and aims to keep markets stable by acting as the buyer to every seller and seller to every buyer.

The move to clearing over-the-counter contracts such as credit-default swaps is also part of derivatives exchanges’ efforts to earn new revenue after futures trading slowed last year.

Banks’ Backing

ICE Chief Executive Officer Jeffrey Sprecher built his company with the backing of investment banks Goldman Sachs and Morgan Stanley. Now he’s planning to purchase Clearing Corp., the former clearinghouse for the Chicago Board of Trade, which is owned by New York-based Goldman Sachs, Morgan Stanley, JPMorgan, Citigroup Inc., Merrill Lynch & Co., Bank of America Corp. in Charlotte, North Carolina, Deutsche Bank AG in Frankfurt and Credit Suisse Group AG and UBS of Zurich.

The nine banks that own Clearing Corp. agreed to move their credit-default swap trading to the ICE U.S. Trust clearinghouse, Sprecher, 53, said on Dec. 10 at a Goldman Sachs investor forum in New York.

“If we were trading broccoli, we’d affiliate ourselves with agribusiness,” Sprecher said in an interview last month.

ICE declined 28 percent this year after falling $2.84, or 4.6 percent, to $58.99 yesterday in New York Stock Exchange composite trading. The Standard & Poor’s 500 index dropped 29 percent this year.

Investor Protection

Credit-default swaps were conceived to protect bondholders against default and are now used to speculate on the creditworthiness of companies. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

CME Group, which traces its roots to 1848, says it’s premature to declare a winner in credit-default swaps clearing.

“This is way too soon to make any pronouncements about what will happen competitively in the market,” CEO Craig Donohue, 47, said last month in an interview. “You have two very different proposals out there. Many of the dealers we’re talking to very much want to keep their options open to participate on more than one platform.”

As much as 40 percent of the profit at Goldman Sachs and Morgan Stanley stemmed from private over-the-counter transactions, according to CreditSights.

‘Antagonistic Relationship’

“The CME has a very good brand and is very well- capitalized, but they’re in the futures space and they’ve had an antagonistic relationship with the banks,” said Craig Pirrong, a finance professor at the University of Houston. “It was a very slick move for Sprecher to move in and fold Clearing Corp. into the ICE operation. He’s always had a good relationship with banks.”

Between $100 million and $400 million a year in revenue is up for grabs for a clearinghouse owner through fees from clearing credit-default swap trades, according to estimates by Wachovia Capital Markets and Keefe Bruyette.

About 84 percent of the gross credit-default swap trades outstanding are between dealers, according to Depository Trust & Clearing Corp. data as of Jan. 9. About 16 percent are between dealers and clients such as hedge funds, while 0.1 percent are trades between two parties that aren’t dealers.

CME Group has said it will process existing bi-lateral credit-default swap trades with its clearinghouse only if both parties to the trade agree.

Hedge Fund Combination

The company joined with Chicago-based hedge fund Citadel Investment Group LLC, in part to attract derivatives traders at hedge funds. The Chicago exchange also offered as much as 30 percent of the equity in its credit-default swap venture to potential partners.

Donohue said negotiations about those stakes are showing “very good interest.” He declined to name any funds or banks that have invested.

CME Group’s clearing plan must still be approved by the U.S. Securities and Exchange Commission. ICE U.S. Trust is awaiting SEC and Federal Reserve approval.

ICE’s acquisition of New York-based credit-default swaps broker Creditex Group Inc. last year and an agreement with London-based index owner Markit Group Ltd. also gave the company access to the two firms that administer auctions used to determine the price on which most of the contracts are settled after an underlying company defaults.

“Markit and Creditex — that really gives them people who understand how that product is marketed, how it’s traded and how they’re valued,” said John Jay, a senior analyst at financial services consulting firm Aite Group LLC in Boston. “That’s a very key thing.”

To contact the reporter on this story: Matthew Leising in New York at mleising@bloomberg.netShannon D. Harrington in New York at sharrington6@bloomberg.net;

Last Updated: January 15, 2009 00:01 EST

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Rehabilitating CDS (Credit Default Swaps)

http://www.economist.com/opinion/displaystory.cfm?story_id=12562363

Derivatives

Giving credit where it is due

Nov 6th 2008
From The Economist print edition

The credit-default swap needs reform, not abolition

FINANCIAL innovations tend to go through four phases. At first, they are hailed as proof of the brilliance of the bankers who devised them. Then they succumb to rampant speculation, as investors try to exploit them. And that leads to revulsion, as a crisis causes widespread losses. The question is: should the fourth phase be rejection or rehabilitation?

The latest innovation to pass through the cycle is the credit-default swap or CDS. Despite its forbidding name, the CDS is a simple idea: it allows an investor to buy insurance against a company defaulting on its debt payments. When it was invented, the CDS was a useful concept because more people felt comfortable owning corporate debt if they could eliminate the risk of the issuer failing. The extra appetite for debt helped lower the cost of capital.

 

 

• http://www.nytimes.com/2008/02/17/business/17swap.html?pagewanted=3

By GRETCHEN MORGENSON

Published: February 17, 2008

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

 

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In the Shadow of an Unregulated Market

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A Primer on Credit Default Insurance

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.

It is entirely possible that this market can withstand a big jump in corporate defaults, if it comes. But an inkling of trouble emerged in a recent report from the Office of the Comptroller of the Currency, a federal banking regulator. It warned that a significant increase in trading in swaps during the third quarter of last year “put a strain on processing systems” used by banks to handle these trades and make sure they match up.

And last week, the American International Group said that it had incorrectly valued some of the swaps it had written and that sharp declines in some of these instruments had translated to $3.6 billion more in losses than the company had previously estimated. Its stock dropped 12 percent on the news but edged up in the days after.

A.I.G. says it expects to file its year-end financial statements on time by the end of this month with appropriate valuations.

Placing accurate values on these contracts is just one of the uncertainties facing the big banks, insurance companies and hedge funds that create and trade these instruments.

In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.

But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.

As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.

“This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.”

Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.

In late 2005, at the urging of the Federal Reserve Bank of New York, market participants agreed to advise their trading partners in a swap when they assigned contracts to others. But it is unclear how closely participants adhere to this practice.

It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim.

Credit default swaps were invented by major banks in the mid-1990s as a way to offset risk in their lending or bond portfolios. At the outset, each contract was different, volume in the market was small and participants knew whom they were dealing with.

Arcane Market Is Next to Face Big Credit Test

Published: February 17, 2008

(Page 2 of 3)

Years of a healthy economy and few corporate defaults led many banks to write more credit insurance, finding it a low-risk way to earn income because failures were few. Speculators have also flooded into the credit insurance market recently because these securities make it easier to bet on the health of a company than using corporate bonds.

 

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A Primer on Credit Default Insurance

Both factors have resulted in a market of credit swaps that now far exceeds the face value of corporate bonds underlying it. Commercial banks are among the biggest participants — at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter.

JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.

But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.

The market’s popularity raises the possibility that undercapitalized participants could have trouble paying their obligations.

“The theme had been that derivatives are an instrument that helps diversify risk and stabilize risk-taking,” said Henry Kaufman, the economist at Henry Kaufman & Company in New York and an authority on the ways of Wall Street. “My own view of that has always been highly questionable — those instruments also encourage significant risk-taking and looking at risk modestly rather than incisively.”

Officials at the International Swaps and Derivatives Association, a trade group, say they are confident that the market will stand up, even under stress.

“During the volatility we have seen in the last eight months, credit default swaps continue to trade, unlike other parts of the credit market that have shut down,” said Robert G. Pickel, chief executive of the association. “Even if we have a series of credit events at the same time, we have the processes in place to enable the market to deliver.”

Such credit problems have been rare recently. The default rate among high-yield junk bonds fell to 0.9 percent in December, a record low.

But financial history is rife with examples of market breakdowns that followed the creation of complex securities. Financial innovation often gets ahead of the mechanics necessary to track trades or regulators’ ability to monitor the market for safety and soundness.

The market for default insurance, like the subprime mortgage securities market, is a product of good economic times and has boomed in recent years. In 2000, $900 billion of credit insurance contracts changed hands. Since then, the face value of the contracts outstanding has doubled every year as new contracts have been written. In the first six months of 2007, the figure rose 75 percent; the market now dwarfs the value of United States Treasuries outstanding.

Roughly one-third of the credit default swaps provided insurance against a default by a specific corporate debt issuer in 2006, according to the British Bankers’ Association. Around 30 percent of the contracts were written against indexes representing baskets of debt from numerous issuers.

But 16 percent were created to protect holders of collateralized debt obligations, complex pools of bonds that have recently experienced problems because of mortgage holdings.

There is no exchange where these insurance contracts trade, and their prices are not reported to the public. Because of this, institutions typically value them based on computer models rather than prices set by the market.

Neither are the participants overseen by regulators verifying that the parties to the transactions can meet their obligations.

The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks’ books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.

Arcane Market Is Next to Face Big Credit Test

 

 

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Published: February 17, 2008

(Page 3 of 3)

Investors are already reeling from the recognition that major banks inaccurately estimated losses from the mortgage debacle. If further write-downs emerge as a result of hedges that did not work, investor confidence could take another dive.

 

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A Primer on Credit Default Insurance

To be sure, the $45 trillion in credit default swaps is not an exact reflection of what would be lost or won if all the underlying securities defaulted. That figure is impossible to pinpoint since the amounts that are recovered in default situations vary.

But one of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against.

To the uninitiated trying to understand this complex market, its size might initially seem a comfort, as if there were far more insurance covering the bonds than could ever be needed. But because each contract must be settled between buyer and seller if a default occurs, this imbalance can present a problem.

Typically, settling the agreements has required the delivery of defaulted bonds if the insurance buyer wants to be fully covered. If the insurance contracts exceed the bonds that are available for delivery, problems arise.

For example, when Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company’s debt exceeded the value of underlying bonds tenfold. Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt.

Market participants worked out an auction system where settlements of Delphi contracts could be made even if the bonds could not be physically delivered. This arrangement was done at just over 36 cents on the dollar; so buyers of protection on Delphi who did not have the bonds received $366.25 for every $1,000 in coverage they had bought. Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond.

That is why the valuation of these contracts is of such concern to some participants.

As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in.

“The insurance business is very difficult to quantify risk in,” said Mr. Farrell of Annaly Capital Management. “You have to really read the contract to make sure you are covered. That is going to be the test of the market this year. As defaults kick in and as these events unfold, you are going to find out who has managed this well.”

And who hasn’t.

AIG’s subprime hit

Published: February 11 2008 21:19 | Last updated: February 11 2008 21:19

Another day, another loser in the global game of subprime hide and seek. As the Group of Seven finance leaders said over the weekend, there could be $400bn of losses in the financial system linked to US subprime mortgages.

Yet only $120bn have been revealed so far. American International Group’s confession on Monday reveals where some more of the losses were hiding.In December, the US insurer announced a $1.05bn to $1.15bn charge for October and November for credit default swap (CDS) insurance it wrote against collateralised debt obligations backed by subprime mortgages.

EDITOR’S CHOICE

AIG puts two-month subprime loss at $5bn - Feb-11

Revelation of losses puts heat on AIG chief - Feb-11

AIG’s derivative woes hit confidence - Feb-11

Subprime losses could rise to $400bn - Feb-10

Editorial comment: Ratings reform - Feb-11

Now, alongside PwC’s conclusion that AIG had a “material weakness” in its reporting, that charge has been increased to $4.9bn. That is largely the result of a change in methodology. Last time AIG did not mark its exposure to where the cash bonds were trading – instead it made an adjustment for where it believed the CDS should trade. Now, it has effectively acknowledged there is not good enough market data on the CDS, so it has reverted to pricing off the cash bonds.

That is the good news. The latest valuation should provide a better basis for worst case scenarios.

The trouble is, the AIG numbers are only marked as at November 30. Its $63bn of exposure to subprime CDOs is likely to have taken a further hit since then. And the latest revelation will surely make investors more concerned about how much of the missing $280bn of estimated system-wide losses are lurking on insurance companies’ balance sheets.

There will come a point when the downwards spiral of mark-to market losses stop, and, in some cases, are reversed into gains. But, given the deleveraging taking place in the financial sector and continuing house price misery, that moment is still some way away.

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Copyright The Financial Times Limited 2008

http://www.ft.com/cms/s/1/4172507e-d8e4-11dc-8b22-0000779fd2ac.html

Auditor conservatism.


Auditors have been trying to encourage a common approach to valuation, amid predictions that this will shed new and harsh light on the full scale of the financial damage caused by the subprime crisis.

AIG produced the revised figures after PwC, its auditors, concluded that there was a “material weakness” in the way the insurer valued its exposure.

AIG told investors in December that it estimated valuation losses on its credit default swaps for October and November at just over $1bn. But that was after an “adjustment” based on the assumption that the risk of default implied by CDO bond prices was higher than should be reflected in the value of the insurance. This adjustment was $3.64bn in November alone.

AIG has scrapped the adjustment because market conditions mean it cannot “reliably quantify” the figure.

AIG puts two-month subprime loss at $5bn

By David Wighton, Aline van Duyn and Stacy-Marie Ishmael in New York

Published: February 11 2008 16:18 | Last updated: February 11 2008 23:55

American International Group sent tremors through the markets on Monday when the insurance company raised its estimate of losses in October and November from insuring mortgage-related instruments from about $1bn to nearly $5bn.

The announcement came as a number of companies are preparing to release audited accounts for 2007. Auditors have been trying to encourage a common approach to valuation, amid predictions that this will shed new and harsh light on the full scale of the financial damage caused by the subprime crisis.

AIG produced the revised figures after PwC, its auditors, concluded that there was a “material weakness” in the way the insurer valued its exposure. The world’s biggest insurance company by assets saw its shares tumble 11 per cent, wiping $14bn off its market value.

Measures of credit risk in both the US and Europe reached new record levels indicating widespread investor risk aversion. This followed persistent pressure on markets last week amid fears about corporate and commercial property debt defaults.

Shares in European insurance companies fell heavily on the news, although observers said most did not have such exposure to US credit markets and used different accounting policies.

AIG’s move came after Peer Steinbrück, Germany’s finance minister, warned at the weekend that losses on securities linked to US subprime mortgages could reach $400bn. Some of those losses will be borne by companies such as AIG which have provided insurance for investors in collateralised debt obligations, complex instruments composed of mortgage-backed bonds.

AIG has written $78bn of credit default swaps on CDOs, which protect the purchaser from a CDO’s failure to pay.

The primary providers of the hedges are bond insurers such as MBIA and Ambac, whose ability to pay claims is causing growing concern in global markets. These have written about $125bn of protection on “senior tranches” of CDOs, according to data from Standard & Poor’s.

AIG told investors in December that it estimated valuation losses on its credit default swaps for October and November at just over $1bn. But that was after an “adjustment” based on the assumption that the risk of default implied by CDO bond prices was higher than should be reflected in the value of the insurance. This adjustment was $3.64bn in November alone.

AIG has scrapped the adjustment because market conditions mean it cannot “reliably quantify” the figure.

Catherine Seifert, analyst at S&P, said the news was “troubling” and AIG would “have an extremely difficult time regaining investor confidence”.

Copyright The Financial Times Limited 2008