• home
• tags
• Search
• Feed

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:

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: 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 9^th 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:

• The Riskiest Bank on the Street
• Banks, Brokers, & Bullsh1+ part 1
• Banks, Brokers, & Bullsh1+ part 2

• Reggie Middleton on the Street's Riskiest Bank - Update
• Is this the Breaking of the Bear?

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.

---

Add this page to your favorite Social Bookmarking websites

TrackBack URI for this entry

Comments (19)

Subscribe to this comment's feed

Next little shoes to drop
written by Mark Edmunds, May 08, 2008

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.

• 
• +3
• 
• 

...
written by Reggie Middleton, May 08, 2008

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
By ANDREW EDWARDS
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.

• 
• +2
• 
• 

...
written by Reggie Middleton, May 08, 2008

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...

• 
• +3
• 
• 

...
written by George Hadley, May 08, 2008

I look forward to reading about your current short positions.

Regards

George

• 
• +2
• 
• 

Excellent post
written by M M, May 09, 2008

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

• 
• +0
• 
• 

...
written by Reggie Middleton, May 09, 2008

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?

• 
• +1
• 
• 

CDS notional now $62 Billion
written by John Huber, May 10, 2008

Reggie
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.

http://www.securitiesindustry.com/news/22270-1.html

• 
• +0
• 
• 

...
written by Reggie Middleton, May 10, 2008

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.

• 
• +0
• 
• 

...
written by naif denali, May 11, 2008

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. http://www.youtube.com/watch?v...re=related

• 
• +1
• 
• 

...
written by Peter, May 15, 2008

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

• 
• +1
• 
• 

...
written by Reggie Middleton, May 15, 2008

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, et.al. 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.

• 
• +1
• 
• 

Time to Solve the Problem
written by sivere, May 15, 2008

www.TakeBackTheFed.com

• 
• +0
• 
• 

...
written by Johnny Lay, May 15, 2008

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.

• 
• +0
• 
• 

With peak oil nearly all the home builders are going to go bankrupt - there is no way around it.
written by Ken, May 15, 2008

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.......

http://youtube.com/watch?v=NlVNyJFBCxc&feature=related

• 
• +0
• 
• 

Response to Ken
written by sivere, May 15, 2008

"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.

• 
• +0
• 
• 

response to sivere
written by Ken, May 15, 2008

"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.

http://www.ranken-energy.com/Products from Petroleum.htm

• 
• +0
• 
• 

Bloomberg reports on CDS Risk
written by Reggie Middleton, May 20, 2008

Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults

By David Evans
Enlarge Image/Details

May 20 (Bloomberg) -- It's Friday, March 14, and hedge fund adviser Tim Backshall is trying to stave off panic. Backshall sits in the Walnut Creek, California, office of his firm, Credit Derivatives Research LLC, at a U-shaped desk dominated by five computer monitors.

Bear Stearns Cos. shares have plunged 50 percent since trading began today, and his fund manager clients, some of whom have their cash and other accounts at Bear, worry that the bank is on the verge of bankruptcy. They're unsure whether they should protect their assets by purchasing credit-default swaps, a type of insurance that's supposed to pay them face value if Bear's debt goes under.

Backshall, 37, tells them there are two rubs: The price of the swaps is skyrocketing by the minute, and the banks selling the insurance are also at risk of collapsing. If Bear goes down, he tells them, it may take other banks with it.

``There's always the danger the bank selling you the protection on Bear will fail,'' Backshall says. If that were to happen, his clients could spend millions of dollars for worthless insurance.

Investors can't tell whether the people selling the swaps - - known as counterparties -- have the money to honor their promises, Backshall says between phone calls.

``It's clearly a combination of absolute fear and investors really not knowing,'' he says.

On this day, a CDS-market meltdown doesn't happen. In a frenzy of weekend activity, the Federal Reserve and JPMorgan Chase & Co. rescue Bear Stearns from bankruptcy -- removing the need for the sellers of credit-default protection to pay up on their contracts.

Chain Reaction

Backshall and his clients aren't the only ones spooked by the prospect of a CDS catastrophe. Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis.

CDSs, which were devised by J.P. Morgan & Co. bankers in the early 1990s to hedge their loan risks, now constitute a sprawling, rapidly growing market that includes contracts protecting $62 trillion in debt.

The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb.

``It is a Damocles sword waiting to fall,'' says Soros, 77, whose new book is called ``The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means'' (PublicAffairs).

``To allow a market of that size to develop without regulatory supervision is really unacceptable,'' Soros says.

`Lumpy Exposures'

The Fed bailout of Bear Stearns on March 17 was motivated, in part, by a desire to keep that sword from falling, says Joseph Mason, a former U.S. Treasury Department economist who's now chair of the banking department at Louisiana State University's E.J. Ourso College of Business.

The Fed was concerned that banks might not have the money to pay CDS counterparties if there were large debt defaults, Mason says.

• 
• +0
• 
• 

Nice blog
written by jeff, May 25, 2008

Nice work Reggie. Really enjoyed your piece on CDS's. Learned a lot. 45 trillion. Damn thats a big shoe. Defaults are just getting started. Now I see why AIG took such a big hit. They insured $500 billion of this crap. No wonder they took a 7 billion dollar hit in the first quarter. I think I will short them on Tuesday.

Great work!

• 
• +0
• 
• 

...
written by JPMorgan, November 17, 2008

Derivatives Week

N.Y. AG Probes Brokers On CDS

New York Attorney General Andrew Cuomo has subpoenaed eight interdealer brokers to produce data and other communication regarding their activities in credit default swap trading. People familiar with the situation say Cuomo, as well as the Securities and Exchange Commission in a separate inquiry, are looking to identify dealers who during August and September may have spread false information to manipulate CDS prices. Two of the exchanges uncovered were emails between Marcos Brodsky, a partner at Phoenix Partners, and Roman Shukhman, a credit derivatives trader at JPMorgan. According to documents, the first email from Brodsky suggested Goldman Sachs was looking to sell a CDS index position, while the second one, from Shukhman asked about seeking notification for when a Deutsche Bank had entered the market.

• 
• +0
• 
• 

Name

Email

Website

Title

Comment

smaller | bigger

Subscribe via email (Registered users only)

I have read and agree to the Terms of Usage.

Write the displayed characters

Add Comment Preview