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.

 

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.

 

 

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 

 

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

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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

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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.

 

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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.

 

ABX-HE- AAA -07

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

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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 BoomBustBlog.com!!!

 

Percent Change in CDS spread by industry - 2007

Source: Fitch ratings

Percent change by CDS spread by industry – January 2008

Source: Fitch ratings

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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.

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