Past articles: 2008 CDS crisis and prospects for Malaysia

This article appeared on the Corporate page of The Edge Malaysia, Issue 788, Jan 11-17, 2010.


Credit Default Swaps – The insurance that did not protect

By Jasvin Josen

In just over a decade, the credit default swap (CDS) emerged on the scene, grew exponentially, found fame and fortune, and then crashed to the depths of public opinion - to the point that it is today blamed for the current financial crisis. The tarnished CDS is even accused to be “the monster that ate Walls Street” . It was created to cover asset losses if a default happened, similar to taking out home insurance to protect against losses from fire and theft. Except that it did not. The CDS was traded from investor to investor with no oversight ensuring that the “insurer” had the ability to cover the losses if the asset defaulted.

However, lately the Malaysian Rating Corp Bhd indicated that CDS should be introduced in the local financial market to spur bond trading . With the CDS being in an infant stage in Malaysia, this could be a sound move, as we may be able to avoid the pitfalls encountered by the early adopters and trade it as an enhanced and rehabilitated product. In doing so, we would first need to understand the objective of the CDS and how it works - this article will try to explain just that.

How the CDS came about

How do you mitigate risk when you loan money to someone? – the age old bankers’ dilemma. By the mid-90s, JP Morgan was burdened with tens of billions of dollars of debt and by law huge amounts of capital in reserve was needed in case any of the debt went bad. Bankers wanted something that would protect them if those loans defaulted and at the same time free up that precious capital. Like an insurance policy - where a 3rd party will assume the risk of the loan going bad, in exchange for regular payments from the bank, resembling insurance premiums. The instrument was called the Credit Default Swap.

Essential Features

A credit default swap is a contract between two parties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection and is called the "protection buyer." The second party gives credit protection and is called the "protection seller". The third party, the one that may go bankrupt or default, is known as the "reference asset".

To illustrate, A and B enter into a CDS contract where the reference asset is a Ford Motor plain vanilla bond with a notional of 100. The tenor of the CDS is 5 years. A is the protection buyer and he will pay a fixed premium (e.g. 2% of 100) at regular intervals (e.g. annually) to the protection seller, B. B in return will compensate A in case the bond defaults anytime in the 5 year term. Say at Year 3, the bond failed to meet the annual coupon payments. If this qualifies as a default event in the contract then B will have to compensate A for his losses. Now for A, his loss is really the principal amount invested in the bond (e.g. 100) minus what he can recover from the bond upon liquidation (e.g. 60). So A receives a payoff of 40 from B.

The price of a CDS is quoted by its premium. How much of a premium A pays B is largely connected to the default probability of the Ford bond. The higher the probability of default, the more premium is demanded by B as his chances of making the default payout is higher. Determining the default probability of the reference asset is a fascinating subject and can take a whole new chapter. Hence it is best to leave it for a separate topic at a later stage.

Note that A may or may not own the Ford bond. If A owns the bond, with the CDS in place, A’s position is flat (hedged) and B synthetically owns the bond (long the bond). The latter case is called a naked CDS where both A and B are synthetically short and long the bond.

The CDS is traded as an over-the-counter (OTC) product. As such, various features in the CDS are custom-made according to the parties’ preferences, causing it to be a non-standard product in the market. The main non-standard features are as follows:

• The default event or credit event, which can take many forms: bankruptcy, failure to pay, repudiation/ moratorium and restructuring to name a few. The CDS parties may choose to include all or some of the credit events in their contract. The restructuring clause is used differently in the US and Europe, it can cover a wide or limited range of restructuring events. Thus there could be several versions of a FORD CDS in the market, each having different definitions of restructuring clauses as the credit event, with different premium quotations.

• The recovery value, of the bond (60 in the above example), which is determined by auction. The auction system was put in place seven years ago to centralise agreement of the recovery rate on company bonds in default. The International Swaps and Derivatives Association (ISDA) calculates an average recovery value for the underlying bonds from various submissions by market makers.

• Settlement, usually in cash, where the seller pays the buyer the difference between the principal and the recovery value of the bond. However, physical settlement can also be stipulated in the contract. Here, upon trigger of a credit event, the buyer delivers the bond to the seller, and the seller pays the principal value of the bond.

Premium quotations for reference assets (or credit names) are done in a non-orderly fashion. Dealers quote them through e-mails. A financial information services company called “Mark It” provides a service only for interested market participants by pooling their quotes and providing an average price. This enables the participants to have an idea of how far or close their prices are compared to the market, especially for the less liquid names.

The Emerging “Monster”

CDSs were meant for businesses to shift credit risk to other firms, chiefly financial institutions (banks, insurance companies, fund houses, etc.) that are willing to bear them. A commercial bank concerned about its credit exposure to an airline company can just transfer some of its default risk to other banks via a CDS without actually selling the underlying loans. Within a few years, the CDS became the hot financial instrument, the “perfect” way to trade credit risk, by transferring it to investors with the appetite to take on this risk for a steady return.

But the humble CDS was then turned into a “monster” it was never meant to be. Disastrous events followed. Giant firms that were “too big to fail” were brought down to their knees. This story unfolds in the next article.

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This article appeared in Capital page of The Edge Malaysia, Issue 790, Jan 25-31, 2010.

Understanding credit default swaps: CDS spawns the even murkier CDO

By Jasvin Josen

In the last article, we learnt how the CDS was created to enable businesses to insure themselves against the risk of default. But someone needs to take the other side of the deal as a protection seller, and that usually requires a speculator.

The CDS became the speculator’s favourite instrument. In the insurance business, insurers who insure against fire and theft can set premiums on the basis of decades of experience. Financial markets are less predictable. The CDS soon evolved into complex structures that managed to make even the worst loans appealing to investors. The problem of moral hazard, well known in the insurance industry tainted the CDS business too. Sooner or later, speculators went bust.

The exponential growth of the CDS

According to The Depository Trust & Clearing Corporation (DTCC), in just over a decade, the CDS market swell to a $62 trillion market before collapsing to $25 trillion in Apr 2009 which is still almost twice the size of America’s GDP. It is believed that one reason the market took off so fast is that CDS allows speculation. You do not have to own a bond to buy a CDS on it, anyone and everyone can place a bet on whether a bond will default. Another reason is that the hedge funds joined in. Big financial institutions who sold protection to businesses hedged themselves by buying protection from hedge funds. Many of these hedge funds were just start ups being hardly solvent. At the same time, the sluggish interest rates further encouraged fund houses to focus on the attractive yields in the credit market.

The single name CDS with one reference asset soon spun off into many forms. The reference asset could now be a portfolio of credit names. The most interesting of these was the Collateral Debt Obligation (CDO). In a CDO, the underlying reference assets could be anything: bonds, mortgage loans, credit card loans, car loans, etc. In a Mortgage CDO, as creditors pay their instalments, the moneys go into a pool for distribution to the many investors (protection sellers). The investors are divided in tranches by seniority in making default payouts. The lowest tranche (Equity tranche) will take the first hit in any delinquency in mortgage instalments. Investors in this tranche have the highest chance of making a default payout; therefore command a very high premium. The top tranche (Super Senior Tranche) is of high credit quality as it will take the last hit in the pool. Rating agencies like Moody’s and S&P could assign the highest AAA rating to this tranche which justifiably paid low premiums.

Investors erroneously believed property prices would never cease rising and built a whole edifice of derivatives on the back of the housing market. In the U.S., rating agencies were unusually confident about securitised borrowings. They used the actuarial approach to value packaged loans which seemed to throw out very low default probability that supported the high ratings.

The Explosion

Hindsight, as they say, is 20:20, and little did any of the players know then of the dire consequences of these actions. Suddenly banks found that they could turn the worst mortgages into investment grade paper and sell them to investors like pensions and insurance companies. These big investors were attracted to the CDO as the returns were much more attractive than Treasury Bills. This brought about the moral hazard problem which led to irresponsible lending. Sub-prime mortgages were launched, where loans could be granted to creditors with bad or no credit history. After all, the entire credit risk could be transferred to someone else at the end of the day. The CDOs then spurred a massive explosion.

The Crash

As the housing market bubble began to deflate in Q3 2005, mortgage interest rates begin to rise and this triggered defaults which were obviously felt most by the subprime borrowers. Many of these defaults had to be born not by the commercial banks but investors like insurance companies and hedge funds. Among others, the massive losses caused the insurer AIG, hedge fund Bear Steins and investment bank, Lehman Brothers to crash.

Investment banks, not being in the business of directional deals but mainly warehousing, hedged their default risk of the CDOs with AIG. AIG started to become the protection seller to several CDOs including subprime ones. AIG being an AAA rated company then did not have to post any collateral upfront. This spurred them to keep on guaranteeing billions of assets without having to worry about having assets to back it up. AIG did not own the underlying loans either (naked CDS deals). So it could be selling protection on the same credit name over and over again. When the subprime borrowers did default, AIG’s liability was naturally amplified. Worse still, when the company was exposed to questionable accounting practises, its rating was downgraded. It now needed to post billions in collateral, which it did not have.

Bear Steins had fancy credit hedge funds that were heavily invested in seemingly low-risk CDOs, high grade AAA or AA. The fund was heavily leveraged by borrowing money in the low cost short term repos to buy higher yielding long term CDO tranches. The difference between the borrowing interest rate and the yield on the CDOs would generate the fund’s profits. As the subprime credit market blew over, the dried up liquidity in the repo market caused interest rates to shoot up, leading to the unsustainable business and downfall of the hedge fund.

In Lehman Brothers case, the investment bank was holding on to the very dangerous equity tranches of the subprime loans. It is unclear why they did this, whether it was a conscious decision or they were simply unable to off load the tranches. When the market blew over, Lehman’s loss was enough to cost it everything it had.

The valuation problem

A CDO is a complex structure but its valuation is a bigger headache. This made their exposure very hard to calculate, leading to a loss of confidence in almost all of them.

Being an OTC product with no observable market prices, valuation was judgemental and highly questionable. Mathematical models were far away from being standardised, to the like of the Black Scholes model in the interest rate and equity derivatives world. Counterparties would use different and often secretive models to estimate key perimeters like the reference pool’s default rate, prepayment rate and correlation of the loans in the pool. Insurance companies on the other hand used actuarial techniques which would throw out completely different values compared to investment banks. Worse still, some valuations were performed on opaque CDO structures where details of the credit pool itself were not transparent to all parties.

Counterparty Risk

In Warren Buffet’s Berkshire Hathaway annual report to shareholders he said "Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses - often huge in amount - in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)."

It was the general belief then that the bundling of property loans into securities had spread risk evenly throughout the system. What was overlooked was that counterparty risk could become complicated fast. A hedge fund could sell protection on the same credit name to different parties again and again creating a huge concentration of risk.

In the good times, although this risk was acknowledged it was fended off as negligible especially for counterparties with AAA rating. Was there a lack of oversight to keep this risk in check? This will be investigated in the next article.

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This article appeared in Capital page of The Edge Malaysia, Issue 792, Feb 8-14, 2010.

Understanding Credit Default Swaps: The Rehabilitation of the CDS

By Jasvin Josen

History details a number of financial crises, and it seems that in every crisis, a new occurrence appears to have got out of hand and needs to be curbed. The 1929 Crash witnessed commercial banks recklessly entering the market, making margin loans, trading stocks and other investment activities. The Glass Steagall Act separated banking sectors and investment houses to prevent banks from engaging in the stock market with our savings. On the black Monday of 1987, trading of equity derivatives brought about extreme volatility into the stock market, exacerbating panic. Exchange rules were tightened with circuit breakers and investment banking activities were separated from analyst research. The 2008 crisis now sees the CDS that needs restraining and rehabilitating.

In the previous article, lack of oversight on the CDS is largely blamed for the financial market catastrophe. This article will analyse the regulation atmosphere then and will go on to describe the rehabilitory efforts being put in by the U.S. (Europe is not far behind). It will also discuss the potential issues in placing some of the regulations and whether they are foolproof.

No regulation please

People naturally tend to look for holes in the system to find ways to do trades without government interference. The CDS and CDO markets were growing so fast that regulation was lagging behind. But it was also developing so lavishly that no one wanted regulators to step in. So market practitioners avoided new regulation by adapting the slightest directive possible to look compliant.

The Glass-Steagall Act that prevented commercial banks to double as investment banks also prohibited banks from getting into the insurance business. However in 1999 the Gramm–Leach–Bliley Act that was passed in the U.S. ended this division. Commercial and investment banking, plus insurance, came together again allowing mega financial firms like Citigroup to be formed. Then in 2000, a new law, the Commodity Futures Modernization Act stipulated that most OTC derivatives would not to be regulated as “futures” or “securities”. Instead the major dealers could continue to have their deals supervised under general “safety and soundness” standards. This made it very difficult to regulate the CDS.

AIG’s credit derivative deals were not regulated by the Fed or the Securities Exchange Commission; instead they were supervised by the Office of Thrift Supervision (OTS), a relatively small organisation that monitors savings and loan associations. The OTS apparently had only one specialist on insurance .

Regulation efforts and problems

The world is currently conferring and debating on the best way to remedy the circumstances that led to the financial crisis. While a revamp of regulation is being proposed for the banking industry world-wide, specific regulation is seen as necessary for the CDS business. Measures are being deliberated and implemented, but not without problems.

Counterparty Risk and the central counterparty house

The credit market had no public records showing whether protection sellers have the assets to pay out if a bond defaults. The Fed only supervised commercial banks’ CDS exposures, not of investment banks or hedge funds, both of which were significant issuers. Hedge funds are said to have written 31% of CDS protection . Sellers of protection were not required by law to set aside collateral in the CDS market. While banks ask protection sellers to put up some money when making the trade, there were no industry standards.

A clearing house acts as the buyer to every seller and seller to every buyer, reducing the risk of a counterparty defaulting on a transaction. A clearinghouse also provides one location for regulators to view traders’ positions and prices. But to have a central clearing system, the CDS contract must be standardised - as such, features like credit event, auction procedures, settlement, coupons, and effective dates are now being standardised. It is believed that this will enable trade compression (netting off); which may be inconvenient in the short term but has the potential to make the market more efficient.

The American Treasury has made specific proposals to trade and clear all “standardised” OTC derivatives on an exchange. When contracts are not cleared centrally, firms would incur strict margining and capital charges on their trades. Admittedly, this may ruin the chance of more exotic OTC species.

But in practise, the implementation by lawmakers seems watered down. Fewer derivatives and fewer firms seem to be involved. Should oil companies, airlines and fund managers, which routinely use derivatives for hedging, be in the system too? Hedge funds which are not strictly financial institutions may squirm out too. Even dealers may find a way with exempted firms (like food companies) to channel their derivative trades through.

The rules currently focus on single name CDS and indexed CDO (a standard basket of credit names) only. It is crucial not to miss out bespoke CDOs , e.g. the ones that caused the demise of AIG.

Margin calculation is an issue as well. Margins are calculated from volatility of historical prices. Customised CDSs and CDOs do not have historical data. Also, imposing strict margins is not necessarily fool proof. Clients will eventually look for segregated margin accounts.

Exchange Trading Platform

CDS, being privately negotiated contracts had no regulated exchange for prices in the market. Quotes were sent by banks to investors via e-mails. In 2007, Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDS. Apparently it did not work and was boycotted by banks which preferred to continue trading privately.

Banks dislike exchange-trading platforms because they narrow bid-ask spreads, undermining profitability. Others rightly argue that only a few OTC derivatives are amenable to exchange trading. It is like buying a package holiday from a travel agent. Everyone’s holiday is different.

OTC contracts are normally big; a single order could move the market price, creating uncertainty for traders. Alternatives are being worked out in place of an exchange- to allow broking over the telephone to continue or use an electronic trading system. But with these, the public arena is again missed out.

However, standardised CDS exchange with a central counterparty system may attract more players to the market, who like the idea that it is now so simple. Over time, some other new products may be created.

Naked CDS trading

Soros insists in his book (The Crash of 2008) that “only those who own the underlying bonds to be allowed to buy them. This would tame the destructive force and cut the prices of the CDS”.

According to a Barclays Capital Report on 9 Feb 2009, the proposed American bill is not clear on whether naked CDS trading is allowed. “Do participants need to own the underlying?”

Is it possible to limit naked CDS trading? Counterparties would no longer want to sell protection, even to those that own the bonds, since they probably do not own the reference asset as well and could not hedge themselves by buying protection from another company.

What next for Malaysia

The above are some of the main aspects of regulations around the CDS that are being ironed out globally. In the next and final article, I will focus on the prospective CDS in the local market. With the lessons the world has learnt, we will discuss possible measures to manage the CDS right from the start.

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This article appeared in Capital page of The Edge Malaysia, Issue 794, Feb 22-28, 2010.

Understanding Credit Default Swaps: Can Malaysia do it differently?

By Jasvin Josen

In the last three articles, we discovered how the CDS came about to hedge default risk but over time exploded and brought on the crisis. Now the CDS is undergoing painstaking rehabilitation to become a safer product in a hopefully more stable system.

Should CDSs be introduced in Malaysia? As I pointed out in the first article, the timing seems advantageous for we can learn from the market’s earlier blunders. However, deep thought must be put into outlining the product features and regulation around the CDS for the product to be traded successfully.

The prospective CDS in Malaysia

The Malaysian Rating Corp Bhd. believes that the CDS should be introduced to spur bond trading. This may not be the best motivation, as the CDS was primarily created to cover losses in case of a credit default. In fact, according to data compiled by Fitch in 2006 , investment grade and high yield bond trading experienced declines during the period of the CDS boom. Investors prefer trading CDSs compared to bonds. The CDS allows speculation by not owning a bond, just like an option on equity. The CDS is also easier to utilise as it allows cash settlement and enables investors to go short without having to borrow securities. Moreover, the CDS can be used as an early warning indicator; spread moves can tell sentiment on the underlying credit. The recent Dubai crisis saw its CDS spreads jumping in Nov 2009. As such, it is fair to conclude that the CDS will probably not stimulate bond trading per se.

However, that it no way indicates that Malaysia should not introduce the CDS, as it will certainly spur the credit market as a whole. Towards this end, the first step would be to introduce the standard single name CDS. In time, the standard first-to-default baskets and CDO will naturally follow. Where possible, these products should share the same features as the global market. An exchange and clearing house should be in place and all market participants, financial and non-financial must be included to prevent the motivation to find loopholes.

Allowing naked CDS trading is a delicate subject, but this will have to be allowed or else I do not believe the CDS market would flourish. In any market, we need speculators to be on the other end to take the risk, or there will be no liquid market.

As the CDS becomes more bespoke, the OTC market will grow, Bespoke products could be single name CDSs with step up coupons; with obscure maturity; tied to an option; or with an illiquid reference asset. It could also be first and nth-to-default baskets or CDOs with bespoke credit names. We must build adequate boundaries around the OTC market, following the outcome of the OTC credit market in Europe and the U.S.

Regulation measures

We know that global regulation efforts are experiencing issues and are still being debated, especially around the bespoke products that were the main cause of the crisis.

Keeping in mind the objectives of regulating the credit financial market will help to draft regulations more effectively. A recent speech by the Chairman of the U.K. Financial Service Authority (FSA) in Nov 2009 summed up the three objectives of regulation quite nicely:

  • Reforms around capital and liquidity to make the banking system a shock absorber rather than a shock amplifier
  • Reforms to deal with large systematically important, potential too-big-to-fail banks
  • Actions to reduce interconnectedness in OTC derivative markets; migrating as many contracts to central counterparty clearing systems, ensuring adequate capital and collateral against remaining bilateral contracts.
Bespoke credit derivatives cannot trade through the exchange but will have to remain as OTC products. However the counterparties and trades should be disclosed to a separate reporting channel. Collateral must be posted by the protection seller as a standard procedure. As pointed out in the last article, the calculation of the margin cannot be based on volatility of historical prices. However, other methods could be used to calculate margins, for example, taking a certain percentage of its mark-to-market value.

Transfer of credit risk by commercial banks ought to be reported and the protection sellers known and monitored. Insurance and Pension funds must be responsible for what sort of protection is sold. An industry rule that sellers must pose high (say 70%) collateral, regardless its ratings will control trading activity from getting out of control. All these may sound harsh - the Glass Steagall Act was viewed as too harsh but banks adjusted and all worked fine, until the Act was repealed.

The regulators

The regulators themselves must be credible in the public eye, ones who understand credit derivatives right from trading strategies to how it gets into the books of the counterparties. At the same time, rating agencies should never be complacent with any structure that might “appear” to be riskless. They also should use valuation techniques that are in line with the market to avoid major deviations in risk assessment.

Tackling valuation

Once the CDS has more than one reference asset, valuation becomes a challenge, as it involves estimation of correlation among defaults. The various modelling techniques available to estimate default correlation throws out extremely wide range of prices. We recall that other difficult parameters like counterparty risk and prepayment risk (for loan-based CDOs) were modelled far from reality as well.

There is still no standard valuation in place globally for the CDO; regulators will have to take a stance, either to allow the product but with one accepted valuation technique, or not to permit the product at all. I would advocate the former, as with the appropriate controls that promote transparency, the market can thrive.

Other considerations

In devising the regulations, the FSA also noted two important considerations besides direct regulation of the market. Firstly, determining the optimum level of capital ratios is vital. This can be very judgemental and difficult; too high a ratio will increase the cost of credit intermediation.

Secondly, the level of trading activity should not go beyond its economically efficient size. Three ways were suggested:

  • Regulating remuneration – this is an almost impossible job as in the long term. Already complex schemes are being devised in the UK for top executives to avoid the 50% tax and the super tax on bonuses above £25,000
  • Imposing appropriate capital requirements. The previous capital regime for trading activity based on value-at-risk models was found to be too simplistic and ignored liquidity risk
  • Taxes on financial transactions - Tobin tax which some (like Paul Krugman,Noble Prize Winner) believe could have prevented the crisis
Incidentally at the world economic forum in Davos recently, President Obama also proposed to limit the size of banks and their trading activities.

The repeal of the Glass Steagall act that separated investment and commercial banking activities may well have contributed to the whole CDS debacle. We hear a calling for a similar version of this Act now. At the time of writing, President Obama at the Davos forum put forward that deposit-taking banks would not be allowed to own, invest or sponsor proprietary trading, hedge fund or private equity business in order to protect the peoples’ money.

It is a concern that in Malaysia, several investment banks have commercial bank arms. Extensive government guarantees would just add to the moral hazard problem. A bank can operate with high leverage, safe in the knowledge that it will still be able to borrow and raise deposits cheaply, because creditors know they are guaranteed.

Conclusion

The CDS market had become somewhat a victim of its own success. The problems started when it branched off into the highly bespoke and complicated products like the CDO that deviated from the basic purpose of the market. The bundling of all kinds of loans into securities led to irresponsible lending. The modelling of the underlying factors was far from reality. Rating agencies also seem to misunderstand the risks of mortgage-backed securities.

But the future is bright for Malaysia if we could introduce the CDS in the right environment. The goal of regulation should be steered towards increasing transparency, improving information flow and enhancing liquidity, rather than restricting the natural evolution of the derivatives market. We should strike a fine balance between imposing controls while still maintaining a liquid and appealing market.

At the same time, authorities must continuously keep in step with global developments around product innovation, valuation and regulation. Local regulators should either adapt or stay abreast with the Basel Committee who is fundamentally reviewing their trading book capital regime. Finally one must keep in mind that regulations are never really foolproof; products in a free market continue to develop to keep the regulators on their toes.

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