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I am going to break with tradition here, and actually put the last paragraph of this opinionated research missive in the beginning so everyone get’s the hint.

 

In summary, we have a Clear and Present Danger – How the CDS market will unfold?

The derivative markets replaced the cash markets in the trading of debt, resulting in the evolution of a novel form of risk – counterparty risk. The uncertainties about risk in this complex financial system arise from the unprecedented degree of financial leverage placed on real economy capital structures. Never in the history of financial turmoils have we faced an economic downturn with so much paper assets and such poor credit quality riding companies’ future.

 

Who would be left holding the bag is a trillion dollar question for the financial system. Banks account for 40% of all written CDS, representing US$18.2 trillion notional exposure, while hedge funds sell 32% of all CDS contracts worth US$14.5 trillion, having a miniscule US$2.5 trillion in net assets under management. In addition, financial guarantors are also massive sellers of protection. Those left holding the bag will be the buyers of CDS, owners of CDOs, and the counterparties of the financial guarantors of CDOs (synthetic CDOs are a pool of CDS). Insolvencies may become commonplace in the near future.

Compressing the US$62-trillion CDS Market: Does Reduction in Notional Amount Ensure Lowering of Counterparty Risk?

 

In continuation with our earlier study titled “The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath!,” I proffer trenchant commentary from market participants and a discussion on how the CDS fiasco may unfold.

 

Contrary to what is oft published in the media, notional amount does not provide a true picture exposure – The notional amount of US$62 trillion is simply a nominal figure that references the "underlying" bonds and loans being protected by the use of credit derivatives. Market pundits believe that to understand the impact of the losses on these CDS portfolios, one must focus on the net exposure to CDS transactions rather than on the notional amount, as the notional amount of derivative contracts does not provide a useful measure of either market or credit risks. According to the Office of Comptroller of Currency (OCC), the “net” current credit exposure is the primary metric used to evaluate the credit risk in bank derivatives activities. A more risk-sensitive measure of credit exposure would also consider the value of collateral held against counterparty exposures.

 

PIMCO’s Bill Gross estimates losses on the basis of US$45 trillion of credit default swaps (CDS) outstanding at the end of 2007. These swaps are used to speculate on the likelihood of a borrower repaying the debt. Mr Gross anticipated a default rate of 1.25% and reckons that contracts worth nearly US$500 billion will be in trouble. He assumed a 50% recovery rate and anticipated trouble worth US$250 billion in the CDS market.

 

Several market experts believe that Mr Gross is blowing the CDS trumpet to evoke fear among investors and has overstated the losses. In their opinion, the focus should be on the net exposure of these transactions, as many of them hedge or offset one another. According to a recent Fitch Ratings survey, the estimated net exposure (gross less netting) is less than US$1,000bn (i.e., US$1 trillion). Assuming a default probability of 2% and a recovery rate of 25%, protection sellers would have to settle an aggregate of US$15bn of losses. The figure is significantly lower than US$250 billion losses estimated by Mr Gross in the CDS market. The major flaw in this assertion is the rampant counterparty risk that has not been taken into consideration. In addition to the credit risks where a 2% default rate has been applied, one must now layer on top an additional counterparty risk which can exponentially compound risks and confound market participants who actually believe they are still dealing in a credit only environment.

 

A number of market participants came out with their estimates of CDS losses; for instance, Andrea Cicione of BNP Paribas estimated that losses could range from US$32 billion at best to US$158 billion at worst case.

 

Considering the CDS market as a new insurance industry that has inherent as part of its very essence, which is to provides protection against default on a highly customized but very private basis and whose providers reserve nothing for future losses on these contracts and have no central regulatory or clearing authority, rampant cross party market, counterparty and compounded credit risks. In such a scenario, it becomes difficult to picture the outcome if insurance policies worth US$45 trillion (now US$62 trillion) were to experience actuarial average losses of 5% with no one having US$2.25 trillion to bear the cost, not to mention the litigation issues arising from imperfect settlement procedures.

 

The difference of opinion over the right measurement of the CDS market is due to the complex and overlapping nature of transactions. For instance, a bank might sell US$50 million of protection on a firm and then buy US$30 million of protection on the same company from elsewhere. The contracts total $80 million, but the bank's net exposure is only $20 million. The process in practice is known as netting, which is a legally enforceable arrangement between a bank and a counterparty that creates a single legal obligation covering all included individual contracts. This means that a bank’s receivable or payable, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement. However, the exact nature of settlement of CDS contracts, due to the overlapping nature of the CDS market, will be a thing to watch out for as macro conditions worsen and the number of defaulting companies rises. In addition, and as mentioned before, the added counterparty credit risks stemming from the inclusion of various different parties based upon a heterogeneous hodge-podge of credit risk screening procedures (or lack thereof) may theoretically increase exposure to certain parties with netting procedures in place, in lieu of decreasing said risks. The following UBS vs. Paramax litigation is case in point.

 

UBS and Paramax Capital International are engaged in a legal battle related to the protection purchased by the former. UBS asked Paramax Capital to sell its protection on US$1.3 billion of the most highly-rated slices of a collateralized debt obligation (CDO) made up of subprime residential mortgages underwritten by UBS Investment Bank.

 

Paramax claims that the UBS hedge was cosmetic in nature. In May 2007, when the original agreement was signed, the terms were a fraction of the market rate. Paramax had only US$200 million under management, while the company’s agreements with its own investors limited it to commit no more than US$40 million to any single deal. Thus, Paramax claims, it could never be able compensate UBS fully for any meaningful loss in value of the US$1.3 billion UBS was trying to insure. Any netting facilitated by the Paramax hedge is essentially, and always was, non-existent. If UBS used its claims paying resources to the max, while relying on the Paramax hedge, it would be exposed to a full loss of the insured amount at best, or even more if leveraged funds were involved (the investment banking’s business life blood is leverage, hence it is nearly always involved).

 

 

ISDA aims to reduce notional amount

The Federal Reserve Bank of New York has asked dealers and big buy-side firms to reduce the size of the notional CDS market to improve the processing speed of trades and establish a central clearing house. The new platform initially addresses only the compression of single-name trades. The players in the CDS market aim to reduce this US$62-trillion sector by bringing in proper mechanisms and platforms. The International Swaps and Derivative Association (ISDA) and 13 dealers are seeking to accelerate the reduction of outstanding trades through a new platform supplied by Creditex (the inter-dealer brokerage) and Markit (provides pricing data for the market). The compression process will terminate some of the existing trades and replace them with far fewer transactions. This compression of CDS volumes will help banks lower capital cost while maintaining risk at levels similar to larger number of trades. The compression of credit derivative portfolios of major dealers is a big issue facing the market today. How far it would bring down the inherent risks in the market and the extent of the impact on multi-name CDS remain matters of debate.

 

 

Mammoth size of CDS market intimidates the already shaky financial markets

The CDS market has grown at an astonishing pace over the last five years to US$62 trillion. The nominal growth in the CDS market has primarily been driven by the rise in the number of market participants, such as hedge funds. According to BIS, the CDS market is estimated at US$62 trillion outstanding, almost five times the US national debt and more than three times the US GDP. The stupendous growth in CDS is worrying market participants as the repercussions of losses in this sector could be significantly higher than expected. 

 

CDS spreads widen across the CDX NA, itraxx Europe and itraxx Asia Indices

The credit spreads are again beginning to spike up as witnessed in the month of March as financial firms continue to write-down assets. The CDS spreads reflect the concerns in the broader economic weakness as housing slump continues and consumer confidence hits a bottom. The CDX NA IG (investment grade) index, after touching a high of 193 basis points in the month of March, once again rose to 143 basis points in July 2008. The surge in the index indicates that the credit crisis has re-surfaced with several financial institutions continuing to report huge losses in the 2Q 08 quarterly results on account of CDO and subprime mortgage investments.

 

CDX NA IG and Cross over Index

image001.gif

Source: Reuters 3000

 

CDX NA IG tranches witness increased stress as spreads widen

The spreads of various tranches in the CDX NA IG index are again beginning to witness increased stress as trouble in the financial market is far from over. The junior mezzanine and the senior mezzanine tranches in the CDX NA IG index are beginning to rise. Junior mezzanine tranches spreads rose to 600 basis points, while senior mezzanine spreads increased to 300 basis points in early July 2008. We believe this indicates the uneasiness among market participants with respect to losses in financial markets and the overall economic conditions in the US. The latest quarterly results of most financial firms are a sign of problems persisting in the financial world. Morgan Stanley recorded a significantly lower result than anticipated.

 

CDX NA IG tranches spread

image002.gif

Source: Reuters 3000

 

ITraxx Europe indices also increase

The Itraxx Europe cross-over index is rising due to deteriorating credit quality. The surfacing of problems at European power houses, such as UBS, has increased risk perception among market participants. The Itraxx Europe cross-over junk rated index declined significantly and is anticipated to drop further as credit quality continues to worsen. The index has risen 107 bps since May 2008 to 540 basis points.

 

Itraxx Europe index

image003.gif

Source: Reuters 3000

 

In the Itraxx Europe indices, the sub-financial indices witnessed a significant rise in the CDS spread and are beginning to climb again. The non-financial index is also picking up, reflecting the worsening macro scenario in the European region.

 

Itraxx Europe index

image004_copy.gif

Source: Reuters 3000

 

Asia faces the brunt of crisis denoted by widening spreads – Is Asia the next to fall?

The Itraxx Asia indices witnessed a similar surge in spreads over the last two months as that seen during the March turmoil. According to CDS traders, the cost of protecting Asia-Pacific corporate and government bonds from default has increased.

 

The Markit iTraxx Japan index advanced almost 60 basis points from the beginning of June to 149 basis points on July 8, 2008. The benchmark of 50 investment-grade Japanese companies, including All Nippon Airways Co. and Japan Tobacco Inc., climbs on perception of deteriorating credit quality. Japan's wholesale inflation rate rose to a 27-year high in June as companies raised prices to counter record oil and commodity costs. According to the Bank of Japan, producer prices climbed 5.6% from that a year earlier raising concerns over the inflation in the economy.

 

The iTraxx Asia Ex Japan IG index rose 67.5 basis points to 173 basis points, while the HY index surged 110 basis points to 580 basis points.

 

The Markit iTraxx Australia index advanced 4.5 basis points to 167.5 basis points. The benchmark is tied to the debt of 25 companies, including Qantas Airways Ltd., and BHP Billiton Ltd. Contracts on high-yield and investment-grade borrowers in Asia outside Japan also rose. The macro scenario in most Asian economies dependent on the US is likely to take a hit as the downturn in the US continues. Moreover, rising concerns over oil and food inflation are burdening economies in the region.

 

Itraxx Japan and Itraxx Asia Ex Japan –IG and HY

image005_copy.gif

Source: Reuters 3000

 

Settlement of CDS contracts in case of credit events to raise real problems among counterparty settlements

The entire financial market is concerned about settlement issues that could arise in the event of trigger of credit defaults. The contracts are triggered by a "credit event", broadly defined as a default by the reference entity. The buyers of protection are not protected against “all” defaults. They are only protected against defaults on a specific set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging of that loan. These factors will likely result in a number of legal issues with respect to the settlement and long-drawn court battles between the parties.

 

The sheer size of the CDS market is likely to have repercussions across the financial world and may pose a systemic risk. According to Satyajit Das, a CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. The exact nature of the mammoth CDS market defaults and the settlement procedure to be adopted will become clearer with the passage of time.

 

In the case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement); or, the parties can settle the transaction in cash.

 

There are very few instances that would help us understand the exact nature of settlement in case of credit events. For example, when Delphi defaulted, the volume of CDS outstanding was estimated at US$28 billion against US$5.2 billion of bonds and loans. On actively traded names, CDS volumes are substantially greater than outstanding debt, making it difficult to settle contracts. In the case of Delphi, the settlement price was 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100% – 63.38%) or US$3.662 million per US$10 million CDS contract. How the losses written on a number of index contracts, such as the CDX NA IG and Itraxx Europe indices, unfold remains to be seen.

 

In the CDS market, the financial guarantors (Ambac and MBIA) and hedge funds are generally the protection sellers. Everybody is aware of the problems at financial guarantors as their protection has practically no perceived value in the market. Consequently, banks having counterparty risk on hedges with financial guarantors, such as Merrill Lynch, Canadian Imperial Bank of Commerce, and Calyon, are taking losses on account of their exposure.

 

Is netting the magical pill to save the CDS fiasco?  What if it fails to cure the malaise?

The perception in the market is that the netting of CDS contracts among parties will result in significant downsizing of the CDS market. According to Robert Bliss and George Kuafman, netting, wherein the net exposure is calculated per counterparty, not based on each CDS contract, cash settlement, and regulatory legislation granting extraordinary seniority to credit derivatives counterparties (close-out), may not completely neutralize systemic risk arising from sheer CDS market size exceeding underlying assets by a factor of 10. Netting might actually increase systemic risk by favoring counterparty risk concentration. This is an important tidbit, particularly when considering the amount of concentration that already exists. A handful of money center and investment banks are counterparty to an extreme (if not majority) amount of exposure as it is.

 

After the subprime fiasco that was primarily caused by lax underwriting activity, the CDS mess has also grown bigger (in size) than the bond and equity markets, and poses a threat to the stability of the financial system. Many market participants believe that the netting of CDS contracts will result in a decline in potential losses from the CDS market, and losses may not be as huge as predicted by market pundits. 

 

Exposure of major players to CDS market

Among investment and commercial banks, JP Morgan Chase has the highest exposure to the CDS market. HSBC is among the top five players in the CDS market, having credit derivative exposure of US$1.3 trillion, more than 700 times its asset base of US$188 billion. Bank of America, Citibank, and Wachovia Bank are the other major players in the CDS market with significant exposure.

 

RANK  

 BANK NAME  

 TOTAL   Assets

Total DERIVATIVES 

Total Credit derivative (OTC)

CDS as a & of assets

1

JPMORGAN CHASE BANK

1,407,568

89,997,271

8,121,236

577%

2

BANK OF AMERICA

1,355,154

37,939,665

3,098,984

229%

3

CITIBANK NATIONAL ASSN

1,292,503

37,691,434

3,351,191

259%

4

WACHOVIA BANK NATIONAL ASSN

666,241

4,884,775

453,900

68%

5

HSBC BANK USA NATIONAL ASSN

188,463

4,279,737

1,341,013

712%

6

WELLS FARGO BANK NA

486,886

1,440,229

2,088

0.4%

7

BANK OF NEW YORK

128,342

1,058,618

2,052

1.6%

8

STATE STREET BANK&TRUST CO

147,472

904,593

238

0.2%

9

PNC BANK NATIONAL ASSN

128,623

248,705

5,793

4.5%

10

SUNTRUST BANK

174,716

241,369

2,158

1.2%

11

MELLON BANK NATIONAL ASSN

41,727

192,105

0

0.0%

12

NORTHERN TRUST CO

67,962

164,605

264

0.4%

13

NATIONAL CITY BANK

152,519

158,612

2,250

1.5%

14

KEYBANK NATIONAL ASSN

97,979

134,344

8,594

8.8%

15

U S BANK NATIONAL ASSN

237,269

99,610

1,656

0.7%

16

REGIONS BANK

139,766

69,741

222

0.2%

17

BRANCH BANKING&TRUST CO

131,916

61,752

348

0.3%

18

FIFTH THIRD BANK

64,564

55,993

255

0.4%

19

RBS CITIZENS NATIONAL ASSN

130,820

54,602

252

0.2%

20

MERRILL LYNCH BANK USA

63,003

46,761

9,248

14.7%

21

FIRST TENNESSEE BANK NA

37,064

37,901

0

0.0%

22

LASALLE BANK NATIONAL ASSN

71,098

36,884

2,269

3.2%

23

UNION BANK OF CALIFORNIA NA

57,413

32,063

0

0.0%

24

UBS BANK USA

27,989

31,177

0

0.0%

25

DEUTSCHE BANK TR CO AMERICAS

38,216

30,693

4,578

12.0%

 

And this brings us full circle back to the 1st paragraph...

 

Clear and present danger – How the CDS market will unfold?

The derivative markets replaced the cash markets in the trading of debt, resulting in the evolution of a novel form of risk – counterparty risk. The uncertainties about risk in this complex financial system arise from the unprecedented degree of financial leverage placed on real economy capital structures. Never in the history of financial turmoils have we faced an economic downturn with so much paper assets and such poor credit quality riding companies’ future.

 

Who would be left holding the bag is a trillion dollar question for the financial system. Banks account for 40% of all written CDS, representing US$18.2 trillion notional exposure, while hedge funds sell 32% of all CDS contracts worth US$14.5 trillion, having a miniscule US$2.5 trillion in net assets under management. In addition, financial guarantors are also massive sellers of protection. Those left holding the bag will be the buyers of CDS, owners of CDOs, and the counterparties of the financial guarantors of CDOs (synthetic CDOs are a pool of CDS). Insolvencies may become commonplace in the near future.