Thursday, 08 May 2008 02:00

The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath!

This is a DRAFT of part 3 of Reggie Middleton on the Asset Securitization Crisis – Why using other people’s money has wrecked the banking system: a comparison to the S&L crisis of 80s and 90s. As was stated in the earlier parts, I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. This installment should be very illuminating to those who are not familiar with the CDS markets. I urge discourse, conversation and debate. To me, it is necessary to make sure the world is as I percieve it. The recent bear market rally took back a decent amount of the directional, unhedged profit (that's right, I'm a cowboy), but it appears that is over and we will soon resume our descent back into reality. Just in case, let's review some history. I will also release some of my personal bank short research to illustrate how I am implementing these expected stresses to the banking system to my advantage.

The Current US Credit Crisis: What went wrong?

  1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
  2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
  3. You are here =>The counterparty risk analyses – the counterparty failure will open up another Pandora’s box
  4. To be Published: The consumer finance sector risk is woefully unrecognized
  5. To be Published: An oveview of my personal Regional Bank short prospects
  6. To be Published: Credit rating agencies – an overhaul of the rating mechanism
  7. To be Published: US Federal reserve to the rescue

And now, on to the report...

Emergence and the extraordinary growth of the CDS market

Innovation in the financial services industry created the Credit Default Swap (CDS) market to allow banks to hedge their risk as well as speculate on the health of any company. The evolution of CDS from the time it was first introduced by JP Morgan’s Blythe Masters (Head of Derivatives Department) in 1995 has been exceptional. The CDS over the counter derivative market has grown from US$900 billion in 2000 to US$45 trillion in 2007, almost twice the size of the US equities markets. The US$45 trillion market value of CDS contracts has grown more than 10 times of US$5.7 trillion corporate bonds which it insures. The major players in the CDS market are the commercial banks as its business evolves around the credit risks on the loans its disburses to corporations. The CDS market allows banks (theoretically) to transfer risk without removing assets from its books and without involving the borrowers. Credit default swaps also help banks to diversify their portfolio and gain exposure to various industries and geographies.

Insurance companies and financial guarantors emerged as dominant players in the CDS markets as net sellers of credit insurance protection. Insurance companies and the financial guarantor industry are the big sellers of protection in the CDS market, with a net sold position of US$395 billion and US$355 billion, respectively at the end of 2006. In addition, global hedge funds have emerged as active players in the CDS market. According to Greenwich Associates, the hedge funds are responsible for driving nearly 60% of all the CDS trading volume and 33% of the Collateralized Debt Obligations (CDOs) trading volume.

CDS has emerged over the last few years as an important tool to manage credit risk and has allowed banks to offset risk from their lending and bond portfolios. CDS has similar risk profile to a corporate bond. However, unlike a corporate bond the CDS does not necessarily require an initial funding which helps to build leveraged positions. Credit default swaps also assist in entering into a transaction wherein the cash bond of the reference entity of particular maturity is not available. In addition, by buying credit insurance (protection) of any reference entity, it provides the investors an opportunity to create a short position in the reference entity. Consequently, CDS having all these unique feature evolved as an important tool to diversify or hedge one credit portfolio and even take a long or short call on any company.

The two important factors driving the growth in the CDS market has been the strong US economy growth post 2001 and the low interest rate environment which has allowed for refinancing opportunities for marginal borrowers and deals that may have gotten into serious trouble without such a low cost capital environment – both resulting in very few corporate defaults thus encouraging banks to underwrite more credit insurance. The banks found it to be an attractive and low risk method to make profits since the number of failures were relatively few as the economy was in strong shape. In addition, the advent of speculators in the credit insurance market was a key growth driver for the CDS market as these contracts provided an alternative to bet on the company’s health. These instruments provided speculators a means to take short or long positions depending on their analysis of the company’s future performance.

Functioning of the credit insurance market

In a CDS transaction, the buyer and the seller of credit insurance protection enter into a contract wherein the buyer pays a fixed premium for protection against a certain credit event such as a bankruptcy of the reference entity, or default on the debt issued by the reference entity. Generally, there is no exchange of money between the two parties when they enter into the contract, but they make payments during the term of the contract. The key terms in the contracts entered between the parties are:

Event of Default: An event of default can occur if the counterparty to a CDS trade files for bankruptcy, or in the case of an insurance company, something functionally equivalent, such as being formally placed under supervision, or liquidation, etc.

Credit Event: A credit event generally refers to the occurrence of bankruptcy or failure to pay (and in some cases, a restructuring) of the reference entity of a CDS trade.

The trigger events can be broadly categorized as (1) bankruptcy, (2) failure to pay, (3) restructuring (4) Repudiation/moratorium, (5) obligation acceleration, (6) obligation default. Bankruptcy is the reference entity’s legal declaration of insolvency or inability to repay its debt. Failure-to-Pay occurs when the reference entity, after a certain grace period, fails to make payment of principal or interest. Restructuring refers to a change in the terms of debt obligations that are adverse to the creditors.

In the case of an event of default, the International Swaps and Derivatives Association’s (ISDA) calls for the mark-to-market value of the contract to be paid from the out of the money party to the other party, while in the case of a credit event, the protection seller would be obliged to pay the notional value to the protection buyer in return for securities delivered (where par amount delivered equals total notional, assuming physical delivery).

CDS are primarily of two types: Single name CDS and Multi name CDS

Single-name CDS: In a credit derivative contract where the reference entity is a single name.

Multi-name CDS: In a credit derivative contract where the reference entity is more than one name as in portfolio or basket CDS or CDS indices. A basket CDS is a CDS where the credit event is the default of some combination of the credits in a specified basket of credits.

The CDS insurance contract created primarily to transfer credit risk from bond investors to other parties may be insurance companies or hedge funds to protect against the default risk. However, as depicted in the chart below, the financial institutions may sell and resell the insurance contracts among themselves creating the ‘entanglement of credit risk’. This also makes it difficult to identify who bears the ultimate risk. This reselling of insurance contacts to another party has created a near untraceable credit risk web among the market participants.

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Source: The New York Times

The growth in CDS market in the last few years has outstripped that of the US equity and bond markets

The credit derivatives market has grown at a remarkable pace as reflected from the tremendous increase in total notional amount outstanding over the last few years. The total notional amount of credit derivatives as of June 2007 increased to US$42.6 trillion, an increase of 109% over the US$20.4 trillion reported in June 2006. This has been driven by both the rise in single name CDS and the multi name CDS instruments. The significant rise in the multi name CDS (traded indices) has notably surpassed the growth in single name CDS. Single name CDS’ total notional amount outstanding has increased from US$7.31 trillion in June 2005 to US$24.2 trillion in June 2007 while the multi name CDS has grown from US$2.9 trillion in June 2005 to US$18.3 trillion in June 2007.

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Source: Thomson Research

The CDS market has outstripped the growth in every other US market reaching US$45 trillion in notional amount outstanding volume. According to ISDA, the notional amount outstanding of credit derivatives grew 32% in the first six months of 2007 to $45.46 trillion from $34.42 trillion. The annual growth rate for credit derivatives is 75% from $26.0 trillion at mid-year 2006 surpassing the US stock markets at US$21.9 trillion, the mortgage security market at US$7.1 trillion and the US treasuries market at US$4.4 trillion. The ability to bet on the financial health of the company directly in the CDS market (go long or short by buying or selling insurance protection) and the rise in speculative interest saw the rise in the CDS volumes.

Creation of colossal US$45 trillion CDS market may unfold into trouble larger than subprime crisis

The creation of the massive US$45 trillion CDS market in the last few years, which faces some unique problems, can unfold into a massive bubble collapse that would easily dwarf that of the subprime crisis. The CDS are supposed to cover the losses of banks and bondholders in the event of default by companies. However, the CDS market has evolved from being primarily a means to hedge credit risk to a speculative and trading platform for a large number of banks and hedge funds. If the corporate defaults surge in the coming quarters (as Reggie Middleton, LLC expects them to) or there is default in payments of coupon and principal amounts, this could lead to a crisis far worse than what we have seen so far in the current “asset securitization crisis” and quite possibly in the recent history of the financial system. The high yield default rate has increased significantly (125%) in the last few quarters from 0.4% in 1Q 07 to almost 0.9% in 1Q 08. In addition, the monolines which are under considerable stress and play the role of both counterparty as well as the reference entity in the CDS market could spell major trouble for the market participants.

Spectacular growth of credit risk transfer instruments


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1 In trillions of US dollar. 2 Of BIS reporting banks; cross-border and local foreign currency claims. 3 Annualised. 4 Sum of cash tranche sizes by pricing date; includes only cash and hybrid structures. Hybrid portfolios consisting mainly of structured finance products different from cash CDOs are excluded. 5 Covers about 80% of index trade volume, according to CreditFlux Data+.

Source: IMF, CreditFlux Data, ISDA ; National Data; BIS Calculations


The CDS market originally developed to provide banks with the means to transfer credit exposure and free up regulatory capital rapidly became a market for speculators and investors to bet on the financial health of the reference entity. The smooth credit event settlements of the WorldCom and Enron have resulted in increased investor interest in the market. In addition to hedging event risk, some potential benefits of CDS include resulting in the popularity of the instrument are:

  • As a short positioning instrument which does not require an initial cash outlay
  • Provided access to maturity exposures not available in the cash market
  • Provided access to credit risk not available in the cash market due to a limited supply of the underlying bonds
  • Investment opportunity in the foreign credits without taking currency risk
  • The ability to effectively ‘exit’ credit positions in periods of low liquidity

Growth in the single name CDS


Source: Bank for International Settlement

The single name CDS has reported strong growth in the last few years growing from $7 trillion in June 2005 to $24 trillion in June 2007. Recently, the growth in single name CDS is lagging that in the multi name CDS as the growing popularity of the multi name products mainly the index CDS along with LCDS, LCDX and synthetic CDOs have gained in importance.


Source: Bank for International Settlement

The Below Investment Grade (BIG) (or junk) single name CDS contracts notional amount outstanding has increased to US$3.2 trillion in June 2007 from US$1.5 trillion in December 2005. At the same time the non-rated (again, junk) single name CDS contracts outstanding has increased to US$5.3 trillion from US$1.6 trillion.

Growth in Multi name CDS


Source: Bank for International Settlement

Multi name CDS, particularly the index CDS such as the DJ CDX index, the Itraxx Europe index gained significantly in popularity as evident from the rise in volumes. The total notional amount outstanding of multi name CDS has grown at a CAGR of 151% from June 2005 to June 2007 to US$18.3 trillion largely driven by DJ CDX and Itraxx Europe index. The DJ CDX IG (Investment Grade) and Itraxx Europe IG accounted for 49% and 40%, respectively of index sold positions.


Source: Fitch Ratings


The activity in the CDS market has also been driven by the increased issuance of synthetic collateralized debt obligations (CDOs) and other structured products that use CDS to obtain the credit exposure. However, the impact of such issuance on positions in the CDS market could be higher than reported by nominal amounts, as hedging structured credit products may involve selling a multiple of their face value, in particular in the case of more junior tranches whose prices are very sensitive to market conditions. Consequently, the effect of structured issuance on CDS volume is extremely difficult to measure correctly.


Source: Bank for International Settlement

The gross market value of CDS contracts have grown from US$188 billion in June 2005 to US$721 billion in June 2007, with multi name CDS growing significantly in the last few years.


Source: Bank for International Settlement

The global CDS market exposure has US$24.4 trillion of the assets in the tenor of maturity 1 to 5 years and US$15.4 trillion with maturity of over 5 years.


There has been a steady rise in the exposure toward below investment grade securities raising concerns on the increased chances of credit events happening in the CDS market. The BIG exposure of 40% in the credit derivative market, and 25% exposure toward BBB rated entities could eventually emerge into a potentially dangerous situation if the credit events trigger. Exposure to BIG securities has increased from a low of around 7.5% in 2002 to 40% in 2006, while exposure towards AAA has declined significantly. Reggie Middleton anticipates a significant surge in defaults in the lower and mid range of the credit quality spectrum as credit tightens and the negative macro environment takes effect on earnings and cash flows for marginal companies and market participants.


The trend toward lower-quality and unrated reference entities continued last year. According to a Fitch Report, approximately 38% of all CDx referenced at the end of 2006 was either speculative grade or unrated, as compared to 34% in 2005 and a mere 18% in 2003. This is attributable to market maturation as well as investors’ continuing search for higher yielding risk exposures in the spread-constrained environment.


The Global banks are primarily the net buyers of insurance while the insurance companies and financial guarantors are the net sellers of protection.



US mortgage market debacle has resulted in higher cost of credit insurance

The rise in defaults in the subprime mortgage backed loans in the US has been amongst the most factors for the broader credit crisis. The risk aversion stemming from the increase in defaults in the subprime loans and ALT-A loans spread in to the housing market, which has since spiraled into the current credit crisis. In 2007, almost 1.3 million US housing properties were subject to foreclosure activity, up 79% from 2006 levels.

The rising defaults, foreclosures and declining home prices set the tone for credit calamity. In the early part of 2008, as markets continued to witness funding and liquidity squeezes on investment vehicles, severe tensions in the interbank market and difficulties at some of the credit institutions further exacerbated the trouble in the credit market. The concerns over deteriorating asset quality, ratings downgrade of the monolines and the worsening macroeconomic outlook resulted in difficult credit market conditions.

The ABX HE AAA 07 index prices has declined from 85 in October 2007 to around 58 on May 02, 2008, before touching a low of 51 in the beginning of April 2008.



Source: Markit

The ABX HE BBB index prices traded at around 25 in the month of December 2007 and have declined significantly to trade below 10.

ABX- HE –BBB 07-2


Source: Markit

Widening of CDS spreads

Credit spreads reflecting the concerns relating to the broader economic weakness reached new highs in the background of ever rising financial sector strains. Investors across the globe grasped that the economic fallout from the US credit crisis will not be confined to the US only; consequently, markets across the globe witnessed huge sell off in the early part of 2008. This is evident from the increase in the credit spreads not only in the CDX North America Investment Grade Index, but the Itraxx Europe and Itraxx Japan indices as well. From the beginning of 2008, the US CDX NA IG index spreads rose 110 basis points to 193. Currently, the CDX NA IG index spread is 90 basis points. The CDX cross over spreads widened by almost 200 basis points from January 2008 to 465 in March 2008. At the same time, the CDX high volatility index credit spread widened by 196 basis points to 408 in March 2008.

The Itraxx Europe and Itraxx Japan indices have also broadly followed the CDX NA IG index as the concerns of the credit turmoil in the US spread globally. The stress in the financial markets was visible in other markets as the liquidity dried up and the dangers of systemic failure became imminent. The Itraxx Europe and Itraxx Japan indices have widened 186 and 207 basis points to trade at 261 and 243 basis points, respectively.


Source: Reuters

CDX cross over index and CDX high volatility index also witnessed a significant upsurge during the months of July 2007 and then again in January to March 2008. The CDX cross over index spread has contracted significantly from the high levels it reached in the month of March 2008, with the failure and subsequent bailout of Bear Stearns.


Source: Reuters


Major sectors witnessing the rise in CDS spreads – Insurance, Banking & Finance, Real Estate and Building & Materials – sectors that have been talked about the most on!!!

Percent Change in CDS spread by industry - 2007


Source: Fitch ratings

Percent change by CDS spread by industry – January 2008


Source: Fitch ratings


Problems in the CDS market and its repercussions

Rise in corporate defaults may spark off a chain reaction

According to Standard & Poor (S&P) ratings services, corporate defaults in the first quarter of 2008 in the US is beginning to climb significantly, keeping pace with the total number of defaults in 2007 and are expected to gain momentum through the rest of 2008 and 2009. S&P in its report "U.S. Corporate Default Outlook: Defaults rev up as leverage unwinds” stated that out of the 17 global corporate defaults in 1Q 08, 16 were US based defaults impacting debt worth US$8.8 billion. At the end of March 2008, the trailing 12-month issuer-based global default rate for all rated entities rose to 0.48 %. By region, the default rates were 0.70% in the US, 0.09% in Europe, and 0.10% in the emerging markets.

The global default rate for speculative grade entities was 1.14%, below the long term average of 4.35%. The US led the charge, with its speculative-grade default rate increasing to 1.40% after reaching a 25-year low of 0.97% in December 2007. S&P expects the US speculative-grade default rate to shoot up to a mean forecast of 4.7% in the next 12 months, which very well may stress test the newly burgeoned CDS market with the mystery web of credit counterparties.

US high yield default rate has been very low for several years


Source: Bloomberg and Fitch ratings

As can be seen from the graph above, we are at a trough in defaults and loss rates, and a peak in recovery rates. Even assuming we don’t enter into a historically significant default scenario, a simple return to mean values will seriously test the CDS markets as they now stand.

The US high yield default rate has been trending up


Source: Bloomberg and Fitch ratings

Widening credit insurance costs

The huge amount of losses on account of mortgage related exposure has seen many banks experience significant strain since the beginning of the current crisis. The increase in the level of CDS spreads since August 2007 represented increased distress among the market participants. The CDS spreads denoted the market price of insurance against the bankruptcy for any institution and failure to meet its debt obligations. The level of average spreads not only denotes the increased perception of systemic risk but also the market premium for bearing such credit risk. The CDS spread has widened significantly since the onslaught of the current turmoil in August 2007. Intervention from central banks, especially the US Federal Reserve and the European Central Bank in injecting large amounts of liquidity into the system has helped calm the fears to a certain extent, but the spreads continue to remain at high levels as the trouble is still far from over from an empirical perspective, and in direct contravention to the perception communicated in the popular media.

According to the Bank for International Settlement (BIS), North American investment banks reported significant surge in spreads from 50 basis points in July 2007 to a temporary peak of 100 basis points in August 2007 and then to 140 basis points in January 2008. In addition, the North American commercial banks and European universal banks witnessed surge in the CDS spreads. The increased level of CDS spreads coupled with increased co-movement implies that the market perceives a greater likelihood of joint defaults and, thus, higher systemic risk.



Role of financial guarantors in the CDS market

In the CDS market, the role of bond insurers needs to be clearly understood as they play multiple roles including that of the counterparty (the seller of protection) and as reference entity (on whom the CDS insurance contract has been created). There also needs to be a demarcation of financial guarantor holding companies and the regulated operating insurance entity as the financial guarantor. In case of a negative assessment of the financial guarantor counterparty risk (as a seller of protection), it could potentially result in a significant reversal of mark-to-market gains for those counterparties that purchased protection from these financial guarantors. The financial guarantors have provided credit protection to the stressed asset categories such as the subprime structured collateralized debt obligations (CDOs) and other structured finance products. Therefore, if a financial guarantor fails, the counterparties will suffer - we have a making of the very same type of systemic crisis that was allegedly averted with the Federal Reserve bailout of Bear Stearns – and quite possibly and a considerably larger level.

For those who are not regulars to my, we have provided deep dive analyses of the major monolines, warning of their insolvency and downfall last year - well in advance of their share price downfalls. See:

  1. A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton
  2. Tie-in to the Halloween Story
  3. Welcome to the World of Dr. FrankenFinance!
  4. Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billi
  5. Follow up to the Ambac Analysis
  6. Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibili
  7. More tidbits on the monolines
  8. What does Brittany Spears, Snow White and MBIA have in Common?
  9. Moody's Affirms Ratings of Ambac and MBIA & Loses any Credibility They May Have Had Left
  10. My Analyst's Comments on MBIA/Ambac/Moody's Post
  11. As was warned in this blog, the S&P downgrade of a monoline insurer reverberated losses through credit markets

In addition, CDS contracts have been written on financial guarantors specifically as the reference entity, on both the financial guarantor holding company as well as the operating company. It is likely that a large amount of protection has been written on both entities to possibly offset the counterparty risk or merely for the purpose of naked speculation. According to the Fitch Synthetic CDO Index, on a cumulative basis, six of the top 25 entities referenced by Fitch-rated synthetic CDOs have been either the financial guarantors or their parents as of 2006. In the case of CDS written on the financial guarantors, the market theoretically could face certain unique settlement issues should a credit event occur. Any potential crumbling of the financial guarantor could have significant impact for both the CDS in which the financial guarantor is the counterparty, and CDS in which the guarantor is the reference entity. Consequently, it will also affect the counterparties such as the broker dealers and various banks to revalue their positions and offsetting hedges.

Lack of regulatory authorities in the credit insurance market

The valuation of CDS contracts by banks and other institutions are typically done based on highly complex statistical models as they are generally bought and sold in the over the counter (OTC) derivative market. The nonexistence of any exchange or centralized clearing agent where these insurance contracts trade results in their prices not being reported to the general public. Furthermore, as the CDS contracts are sold and resold again and again among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim raising doubts about the counterparty failure and the impact on its books.

The lack of regulations and proper settlement mechanisms in the CDS market saw the Aon Corporation (AON) book huge loss on its protection sold to Bear Stearns. Aon, having sold credit protection to Bear Stearns, had hedged itself by purchasing protection from Societe Generale but had to ultimately bear the loss as it was unable recover losses from Societe Generale.

Bear Stearns provided a loan of US$10 million to a Philippine entity and demanded the borrower obtain a surety bond from a Philippine government agency, the Government Service Insurance System (GSIS). Bear Stearns, to further hedge default risk on the US$10 million loan purchased protection contract from AON for US$0.425 million. AON, to hedge this risk purchased protection from Societle Generale for US$0.3 million believing it made a cool profit of US$0.1 million. However, as the Philippines entity defaulted and the GSIS refused to pay on the surety bond, Bear Stearns sued AON based on the first CDS contract, which AON lost and had to eventually pay US$10 million to Bear Stearns. AON then went on to sue Societe Generale, and argued that the court's finding in the first action, that a "Credit Event" requiring payment had occurred under first CDS, mandated a similar result with respect to the second CDS. The district court initially ruled in favor of AON, but as Societe Generale appealed, the court ruled in favor of Societe Generale resulting in AON bearing a loss of US$10 million. My analysts have made the case available: pdf Aon/SocGen case 86.42 Kb and for general reading, see pdf The Basel Committee on Banking joint_forum on Credit Risk Transfer_2008_update.

Now, if one were to multiply this by tens of thousands of transactions and by multiples of billions of dollars, you can begin to see the gravity of the counterparty and credit risk that abounds in the unregulated CDS markets! The court reversed its decision and ruled in favor of Societe Generale, stating that "the terms of each credit swap independently define the risk being transferred." The court parsed the language of second CDS and noted that "the risk transferred to AON and the risk transferred by it was not necessarily identical." AON had sold Bear Stearns protection that expressly included a failure to pay by GSIS as a Credit Event. However, what it bought from Societe Generale was slightly different. The second CDS contained protection against a condition resulting from any act or failure to act by the Government of the Republic of the Philippines or any agency thereof that has the effect of causing a failure to honor any obligation issued by the government of the Republic of the Philippines. The risks for which protection was sold under first CDS and second CDS did not match up. From a legal and practical perspective, this caveat is a potential time bomb for all OTC CDS contracts and transactions that are custom scripted and not cleared through a universal exchange. Although the US banking system is working towards a centralized clearing house for CDS, the current system is a time bomb waiting to be bailed out!

The judgment was that the first CDS contract and the second CDS contract are two separate contracts, the language is slightly different too, so legally, the resolution of the first CDS doesn't automatically grant the similar conclusion to the second CDS. Thus, the judgment to pay Bear Stearns can't be used and referenced for the second lawsuit, as a result, the risk can't be assumed to automatically be transferred. If one were to extrapolate the results of this case to the broader environment, combined with the murky credit risks and liquidity issues in times of duress, it is easy to come to the conclusion that CDS held by banks, hedge funds and large institutions for the purpose of risk management are quite the IMPERFECT hedge.

The court concluded and I quote “We therefore conclude that neither the default, which constituted a Failure to Pay under the Bear Stearns/AON CDS contract, nor the Republic's failure to honor its alleged statutory obligation, constituted a Failure to Pay under the AON/Societe Generale CDS contract. For the same reasons, neither event constituted a "Repudiation." They similarly do not satisfy the other definitions of Credit Event enumerated in the AON/Societe Generale CDS contract.

Counterparty bankruptcies that can result in a domino effect across the financial system – getting a clearer idea of why Bear Stearns was bailed out!!!

The valuation of CDS insurance contracts on the books of various banks who bought protection will be largely impacted in case of counterparty bankruptcies. Under normal circumstances, a bank believes that it is hedged against the corporate bond exposure as it has bought protection in the CDS market and does not write off the losses on its bond holdings. However, in the event of the counterparty who sold insurance is unable to pay its clams, then the banks needs to book the loses in its account (in addition to the sunk cost of the CDS premium) which could lead to more writedowns and severely dent profitability and in many cases, solvency.

The Federal Reserve has been very proactive in fighting the current crisis by slashing interest rates to 2.0% (and arguably negative rates in real terms), opening up discount window to borrowers, and even bailing out financial institutions. The US Federal Reserve committed US$29 billion to back Bear Stearns assets and an additional $30 billion loan directly to Bear Stearns itself, to facilitate JP Morgan Chase’s purchase of the stricken investment bank for US$2 per share – later increased to $10 per share due to shareholder led derision. The US Fed helped JP Morgan Chase bail out Bear apparently because they stood to lose the most from a Bear Stearns bankruptcy. For example, as Barry Ritholtz of the Big Picture points out, JP Morgan has the greatest derivative exposure of any of the investment banks and it is believed that it had huge exposure toward BSC as counterparty.

If Bear Stearns was the counterparty (insurer) to JP Morgan on much of its mortgage-backed security portfolio, it then becomes apparent why JP Morgan had to step in. To avoid a Bear Stearns bankruptcy so that they would not be forced to take toxic assets back onto their own balance sheet and avoid massive write-downs. If JP Morgan Chase‘s exposure towards Bear Stearns was large enough, then JP Morgan Chase itself could have been left significantly impaired.


Counterparty risk exposure of various commercial and investment banks

The credit insurance CDS market is generally bought and sold over the counter making it difficult to exactly grasp the depth of the markets. Moreover, the parties involved in the transactions are not disclosed making it impossible for any lay man to measure the amount of risk transferred and who bears it. However, the Office of the Comptroller of Currency (OCC) Quarterly Report on Bank Trading and Derivatives Activities provides an insight into the credit derivatives market.

According to the OCC, banks witnessed trading losses to the tune of US$9.97 billion in 4Q 2007 as compared to trading income of US$2.3 billon in 3Q 2007 and US$3.9 billion in 4Q 2006. This loss, the first ever quarterly trading loss for the banking industry as a whole, is attributable to weak trading results, and reflects unprecedented turmoil in the markets, particularly for credit trading.

Top 25 commercial banks and trust companies in derivatives (as of 31 December 2007)





Total credit derivatives bought

Total credit derivative sold

Credit derivatives as a % of Total assets

Bought credit derivative as a % of total assets









































































































































































































Source: OCC fourth quarter bank trading and derivative activity report


Source: OCC fourth quarter bank trading and derivative activity report


JP Morgan Chase, Citibank and Bank of America have the largest credit derivative exposure followed by HSBC bank and Wachovia Bank. Considering only the credit derivatives bought positions of the various banks, HSBC bank and JP Morgan Chase credit derivative exposure as a percentage of total assets is significantly higher at 326% and 306%, respectively.


Top Reference Entities Year End – 2006 by Gross Sold and Gross Bought Protection by Notional Amount


Source: Fitch Ratings

Automobile Majors such as General Motors, Daimler Chrysler and Ford Motors top the list of reference entities on whom the CDS insurance contracts have been written.

Top Reference Entities Year End – 2006 by Gross Sold and Gross Bought Protection by Trade Count


Source: Fitch Ratings


On a trade count basis, financial institutions such as Fannie Mae, Deutsche Bank and Merrill lynch are among the top 25 reference entities.

Reference Entity by type - 2006


The analysis of the breakup of the type of reference entities brings out an interesting observation as 8% is accounted for by the structured finance products category. Corporates account for 63% while financial institutions for 23%.

Top 20 counterparties 2006 by Notional Amount – who bears the ‘ultimate risk’


Source: Fitch ratings

Morgan Stanley, Deutsche Bank, Goldman Sachs and JP Morgan Chase are the top four counterparties – these are names who have so far been perceived as “too big to fail”. However, given the way this crisis has unfolded, these are the parties who will be bailed out (if required) to prevent a systemic meltdown. The Bernanke led Fed has made it crystal clear that they are willing to use their balance sheet to prevent the natural, albeit potentially disorderly effects market forces on this country’s fifth largest bank and 9th largest counterparty. Just imagine what may lay in store for the new purchasers of Bear Stearns or the Street’s Riskiest Bank, who happens to sit at the top of this list (I don’t call it the riskiest bank on the street for nothing). For those who are not regulars to the blog, we have went into detail on both of these banks (with a significant warning of failure) as well as an overview of the credit situation months before the collapse of Bear Stearns:

In the next installment of this series I will share the short positions in my personal account that reflect the research in this document. I also suggest those who are not familiar with the blog to browse and search through the various categories to get a feel and flavor for what we have been working on for the past calendar year.

Last modified on Thursday, 08 May 2008 02:00


  • Comment Link Ken Friday, 16 May 2008 00:45 posted by Ken

    "this means as new home prices fall"

    this is my point exactly - any homes being built right now are getting more expensive to build. The subcontractor must raise their prices in order to make a profit and in turn the pass that on to the builder. The builder must raise his price to make a profit or they will be building a home and selling it at a loss if they sell it for the prices existing in the current market. So what is going to happen it that the builders are going to quit building houses since they can't sell them for a profit. But I guess I could be wrong about all of them going BK. As long as they have a life line (investor) to pay for their office administration costs they will survive even though they have halted construction and are losing money each quarter (sort of like a dot com money losing company). None of their subcontractors will be working though. With much higher oil (going to over $250 a barrel) coming soon the US is going to go into a major depression. Inflation is going to sky rocket. There will be a flood of homes on the market like you've never heard of before along with massive unemployment. I don't think that the support for these builders will last much longer, sooner or later investors are going to realize the market ain't coming back.

    It's amazing what's made of oil. At a burn rate of 86 million barrels a day and all the major oil wells in the world going into decline and demand going up, the price of oil has nowhere to go but straight up. Even if demand slows, it will make little difference. Without oil to use tomorrow our society would be paralyzed. What scares me is when there is not enough to go around no matter how much people are willing to pay for it. That is when the shit is really going to hit the fan. from Petroleum.htm

  • Comment Link sivere Thursday, 15 May 2008 20:43 posted by sivere

    "Think about it. Oil has just doubled in the last year. That means the the cost to build a house has just doubled ..."

    First I am not sure the relation is quite that direct, but even so, taking your hypothesis: This means that as new home prices fall, eventually they should start rising again, because new homes are less of an option. So it may not be all bad news.

  • Comment Link Ken Thursday, 15 May 2008 14:23 posted by Ken

    Think about it. Oil has just doubled in the last year. That means the the cost to build a house has just doubled in the last year. oil is expected to double again from here by Jan 2010 putting gas at $10.00 per gallon. Meaning the costs to build a house will have doubled again. So if the construction of a house costs $250,000 today it will cost $500,000 by 2010. Just to construct that same house. With oil doubled,for a new home builder to try and compete with a depressed real estate market and make money it is IMPOSSIBLE since the costs have just doubled and are going much much higher. So as the inventory of homes in the US grows because of forclosures and the prices come down because of over supply and less affordiblity due to a economic depression the costs to build those homes are sky rocketing. The builders are dead. Every single one of them. They will not be able to sell anything, and they will take losses on every piece of inventory they have. It is inevitable.......

  • Comment Link Johnny Lay Thursday, 15 May 2008 11:00 posted by Johnny Lay

    Reggie has prepared a place for all us rookies (I'm one for sure) to discuss these type items. I'm not smart enuff, but I would love to read what others think. I'll supply dumb questions.

  • Comment Link sivere Thursday, 15 May 2008 10:40 posted by sivere

  • Comment Link Reggie Middleton Thursday, 15 May 2008 07:11 posted by Reggie Middleton

    Point taken, but keep in mind that this blog is not necessarily for "actionable ideas", it is a digital diary of my thoughts and opinions on the global macroeconomic investment scene. For someone who consistently espouses "actionable ideas", you would have to visit the likes of Cramer, I hold no opinion as to the quality of those ideas (actually, I do, but I will keep them to myself), but alas, those sites are paid information services while I am literally just a pure blog of my opinions and experiences.

  • Comment Link Peter Thursday, 15 May 2008 07:02 posted by Peter

    There seem to be great sophisticated ideas running through your blog. Something for everyone. While it can be educational for many professionals and non-pros alike, I guess some of us occasional readers would like to see more focus. For example, the story on BSC (and options issues). That seemed a bit far fetched and detracts from the more well thought out examination of financial issues in this climate. Of course CDS are big news and new news for many, and the market is readjusting to "new and unknown risks, at least unknown risks to many". And while I don't doubt "you" were well aware of these before the crisis, and maybe had even written about them, in order for their to be any relevance to the overall market today, or any actionable ideas, there would need to be substantially more quantification for earnings, valuations, ratings. JMHO

  • Comment Link naif denali Sunday, 11 May 2008 17:03 posted by naif denali

    I Find this link very good for explaing all these differen't type of ponzi scams. You may want to have a look if you like me and now very little about these things.

  • Comment Link Reggie Middleton Sunday, 11 May 2008 00:05 posted by Reggie Middleton

    Thanks. I am fairly sure the CDS market poses the most systemic risk to the financial system right now. The risk stems from a lack of prudent credit risk management, not necessarily the concept of CDS itself. Well, we shall see.

  • Comment Link John Huber Saturday, 10 May 2008 21:50 posted by John Huber

    Not to take anything away from your great post, but you are using last year's numbers:
    The results of the ISDA year-end survey of the over-the-counter derivatives market, released at the trade group’s annual meeting in Vienna, show that credit default swaps (CDS), including single-name CDS, baskets and portfolios of credit and index trades, remained by far the fastest growing class. The notional amount outstanding of CDS increased 37 percent over the second half of last year--to $62.2 trillion from $45.5 trillion at mid-year--and was up 81 percent for all of 2007, from $34.5 trillion at year-end 2006.

  • Comment Link Reggie Middleton Friday, 09 May 2008 08:33 posted by Reggie Middleton

    I've had this discussion with my wife, who is the internal auditor at a prominent financial firm. I explained to her, from a short seller's perspective, if the clearing agent actually gets up and running in the short term (doubtful), then the real excitement begins as counterparties attempt to unwind their OTC CDS (many of which they really don't want to be in right now, ex. the monolines vs. the IBs) in an effort to transfer the obligations to the exchange. We will start to a lot skeletons bursting out of the closet.

    As for being too big to fail, well it might just be too big to rescue as well. Imagine trying to prop up the entire equity market - oh yeah, we don't have to imagine that, do we?

  • Comment Link M M Friday, 09 May 2008 07:57 posted by M M

    The size of the synthetic CDS market relative to the underlying obligations is large. There have been issues raised in the past with the settlement of contracts when an obligor defaults, and what constitutes an event of default. Delphi was a case in point and passed the test. On the negative a number of hedge funds get up to 20x leverage from their PBs depending upon the credit (IG), although this has scaled back considerably (there is more to go in the shadow banking contest)

    Whilst I agree with a number of points, my view is this market is in the too big to fail camp. I think this was the real reason why JP was asked to take over Bear owing to the large number of CDS contracts. Indeed the regulators are now discussing a exchange for settlement rather than bilateral contracts which is the bulk of transactions currently.

    If I am wrong on the too big to fail camp, and there are a number of reasons you have given - then we will all be selling apples shortly. rgds

  • Comment Link George Hadley Thursday, 08 May 2008 22:55 posted by George Hadley

    I look forward to reading about your current short positions.



  • Comment Link Reggie Middleton Thursday, 08 May 2008 19:07 posted by Reggie Middleton

    It appears the CDS post came just in time. I have a lot more waiting to be posted, I just need to get the time to get it up on the blog. Consumer finance, regional banks, individual shorts. I will give away the store over the next few days...

  • Comment Link Reggie Middleton Thursday, 08 May 2008 19:06 posted by Reggie Middleton

    Well, it does appear that the insurers are going to have a rough season. A) this is a soft premium cycle, B) those that binged on CDS are going to get done. I don't necessarily buy that conservative super senior nonsense, primarily because of the silly perpetual HPA assumptions that went into the models in the first place. Super senior AAA tranches will probably get touched a lot quicker than many thought.
    I have a decent amount of professional experience with AIG and I didn't bother to dig into their books enough to discover the damage until it was too late. If AIG gets hit this hard, just imagine what MBIA has in store for us. The CEO has already written a "let me explain" letter a few days ago.

    From WSJ:
    AIG to Raise Capital After Big Loss
    May 8, 2008 5:40 p.m.

    American International Group joined the ranks of the credit crisis's biggest losers Thursday, reporting a $7.81 billion first-quarter loss and announcing plans to raise $12.5 billion in fresh capital as losses on complex securities soared.

    The insurer said profits were hurt by a $9.11 billion hit on its portfolio of derivatives sold to hedge securities that have plunged in value and $6.82 billion in losses on investments. AIG reported another $6.82 billion in impairments that for accounting reasons only showed up on its balance sheet.
    [Martin Sullivan]

    The blows brought AIG's total write-downs and losses from the credit crisis to more than $30 billion, with another $9 billion-plus in damage just to the balance sheet, putting the insurer in the same league as UBS AG, Citigroup Inc. and Merrill Lynch & Co.

    The massive losses spooked investors and could deal a blow to optimists who have bet the worst of the crisis has passed.

    The cost of protecting AIG's bonds against default soared after the announcement, and the insurer's shares plunged 8.7% to $40.30 in after hours trading. Standard & Poor's cut its credit rating on AIG one notch to AA- and put it on watch for a further downgrade.

    "Although we expected that AIG would have some losses in the first quarter, the level of the additional losses exceeds these expectations," S&P analyst Rodney Clark said in a release.

    The insurance company reported a net loss of $7.81 billion, or $3.09 a share, compared with year-earlier net income of $4.13 billion, or $1.58 a share. Analysts polled by Thomson Reuters were expecting a much smaller loss of 76 cents a share.

    To repair the hole opened by the losses, AIG on Thursday launched a $7.5 billion offering of common stock and other equity securities. Another offering of hybrid securities will follow later. AIG had a market capitalization of $110.19 billion at the close of trading Thursday.

    Even as it sought more capital to repair its balance sheet, AIG raised its quarterly dividend 10%, to 22 cents a share.

    "While we anticipated a difficult trading environment, the severity of the unrealized valuation losses and decline in value of our investments were beyond our expectations," CEO Martin Sullivan said in a release.

    AIG has multiple exposures to the housing crisis, and results were weak across the board. Its financial-products unit manages its derivatives portfolio of credit default swaps written on collateralized debt obligations backed by residential mortgages. The financial services unit swung to an operating loss of $8.77 billion in the first quarter from a profit of $292 million a year earlier.

    The company's asset management unit posted an operating loss of $1.25 billion versus profits of $758 million a year ago amid losses on hedges, lower investment returns and depreciation expenses related to real estate investments acquired late last year.

    The life insurance unit swung to an operating loss of $1.83 billion from a profit of $2.28 billion on hedging losses and damage to investment income from "volatile capital markets." Operating income in AIG's big general insurance operations fell 57% to $1.34 billion.

  • Comment Link Mark Edmunds Thursday, 08 May 2008 16:50 posted by Mark Edmunds

    It is a bit of a stretch to discuss the financial guarantors' earnings in this thread, but the comment about shoes dropping is enough for me. Here's what seems likely.

    1. Assured Guaranty (after close today) will report large losses on credit default swaps, probably in the $500M to $800M range before taxes, but will also report impressive revenue and market share growth. Another $100M or so (pre-tax) losses could be reported on second lien exposure.
    2. SCA (after close today) is a wild card. If SCA's auditors require a liability to be recognized on the disputed Merrill contracts, the MTM loss for the quarter is likely to be in the range of $1.5B-$2B. If SCA's auditors allow this liability to be erased for financial reporting purposes, SCA could break-even .
    3. MBIA (Monday morning) estimated MTM losses follow: ABS CDO and CDO-squared -- $900M, CMBS -- $900M, CLO -- $400M, asset-liability management business (non financial gauranty) -- $300M. MBIA's estimated credit impairment losses on these is a crap shoot because this is even more subjective than mark-to-model, but $500M seems like a reasonable estimate. In addition to this, $500M (perhaps higher) seems like a reasonable estimate for HELOC losses for the quarter. Overall, this adds to $2.5B of total pre-tax losses, of which $1B represents credit impairment losses. I suspect that MBIA has not funneled capital into the insurance subsidiary so that funds can be diverted to the asset-liability management business. Technically, municipalities need a reason to withdraw funds, but it would not seem that difficult for them to come up with reasons. A signficant percentage of assets held by the A/L mgmt operation are not very liquid (e.g., ABS CDOs wrapped by monolines), so a "run on the bank" by municipalities could create major problems short-terms. This is different from the insurance subsidiary where losses could create big problems but there is no short-term liquidity risk.

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