Monday, September 22, 2008

Sleep-Deprived CDS Rant

Catching up from a couple of days spent at a conference last week, which might as well have been a cave, so divorced from connectivity the venue was and so divorced from the crisis the discussion was.

I had one interesting discussion, though, regarding, as it turned out, credit default swaps. There's a fair amount of discussions of these today, since what happens to such swaps in the light of the market's gyrations, will pretty much determine which and how many institutions live or die in the coming weeks.

You can get a reasonably simple look at them here, though it concentrates on laying the blame for the recent mess on elements within John McCain's coterie. [Actually, scratch that. I've just read this sentence: "Um, sirs? Is it altogether a good idea to run up debts {The writer is referring to the outstanding notional CDS} exceeding all the assets it's even possible to hold" Which is like saying that New York Life has $280 billion in debt]

I've written about them. And here's a fairly innocuous idiot's guide from the uniquely suited Julie Satow in the NY Sun.

Credit default swaps allow people who've bought debt to offset the risks of such debt defaulting, or people who don't own the debt to speculate on it defaulting. The first would be a fairly useful way for people to manage their exposures to potential credit events if they had a fairly large relative or total exposure, while the second would allow investors to profit from credit events on fairly widely-known names.

My discussion centred on a pretty bespoke type of high-yield bond, whose particulars I'll have to leave out because I've written about it during my dayjob. But such bonds don't trade much, have a small number of interested specialist investors and do have a public rating, though it is below investment grade.

I spent hours asking who was buying these bonds before a kindly banker took pity on me and explained that these bonds weren't being sold to anyone. They were kept by the underwriter and then "hedged out". I tried to get a handle on it - was it through shorting, or through the purchase of call options or what? The first didn't make much sense, since there wasn't really a close enough type of security for the holder to short, although there were a few types that might work. Call options would have been too expensive.

It was only in this discussion last week that I finally heard someone tell me that the holder was hedging them through the use of credit default swaps. Now, I'm not a huge believer in perfect markets, hell I even thought that monolines had a viable business model (Ahem). But I'm still trying to get it into my head why on earth this CDS slapped on a rather bespoke bond that was retained by the underwriter was the best way for the borrower to get his hands on the cash rather than just trying to sell the bond to someone that would love it properly.

Left behind in all the discussion about financial market interconnectedness and financial weapons of mass destruction ((c) Warren Buffet, the only man in America who is ever allowed to buy a utility) is just why CDS was always such a cheap way to hedge out these risks, so much so that an entire financial product was structured on the back of this comparative cheapness.

There are, I guess, several reasons why CDS might be cheaper than just owning the bond, including interest rate risk, liquidity risk, and other non-default risks that investors get compensated for. And I recall very vividly that some institutions (**cough**monolines**cough**) might be pricing cheaply protection either to build market share or because ratings agencies or regulators are giving them generous capital treatment, which usually involves some kind of unstable arbitrage opportunity. It certainly would explain why all those banks decided to hold on to the super-senior, or, ahem, least risky, bits of securitization deals and just hedge the exposure out through CDS.

But there's a looming sense that this crisis comes down to the financial services industry's need to eat its own young in more elaborate ways rather than performing the more prosaic task of directing capital to its users. There's a theory, which I think Felix Salmon has been a big proponent of, that demand for only the tastiest AAA paper gave us the securitization mess.

Well, that's as maybe, but a fairly large amount of the garbage swilling around in banks portfolios is more either fee-driven garbage (whether stupidly bespoke CDS deals, or LBO loans that were created to drive advisory fees), or regulatory arbitrage opportunities masquerading as hedging strategies, and it's garbage that can't really be laid at the door of the ratings agencies. There were rooms full of people at AIG Financial products whose job was to write such CDS contracts, and I cant tell you why they didn't just go ahead and buy some of those bonds, either.

Think of this as the contribution of the greasy sly kid at the back of the pitchfork-bearing crowd.


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