Friday, October 28, 2011

TMM's Ex-Product Sketch

As we approach month-end, after what has been one of the most eventful months of TMM's careers, we thought we'd expand upon our somewhat mischievous obituary yesterday.

In all seriousness, TMM have argued for some time that the Sovereign CDS market is ill-designed, particularly with respect to developed markets. Several bank analysts and traders - including Citi's Willem Buiter - have spent the past 24 hours trying to argue that the Sovereign CDS market will be unaffected by the latest Greek restructuring. Now, TMM rate Professor Buiter as one of the smartest people they have ever met, however, they strongly believe that he has got this wrong. So TMM now switch deftly from meta-physical poetry and paraphrase Monty Python:

"I wish to complain about this CDS what I purchased not half a year ago from this very investment bank"
"Oh yes, the Hellenic Republic... What's wrong with it?"
"It's not paid out, that's what's wrong with it."
"No, no, it's just voluntary, look."
"Look my lad, I know a dead product when I see one, and I'm looking at one right now"
"No, no, it's not dead, it's just voluntary."
"Voluntary?!"
"Yeah... remarkable product, Sovereign CDS... beautiful name, innit?"
"The name don't enter into it. It's not paid out."
"Nah, nah... it's voluntary"
"Alright then, if it's voluntary, I'll ask it again... HELLOOOO ISDA! I've got a nice bid/ask spread for you when you pay up, ISDA CDS!"
"There it moved"
"No it didn't, that was you pushing the market"
"I did not!"
"Yes you did! Helloooo ISDA!! IIIISSSSSDDDAAAAA!!! ISDA CDSSSS!!! PAAAAYYYY UUPPP!!! ISDAAAA.... ...now that's what I call a dead product."
"No, No, it'll pay next time."
"Look, my lad, I've had just about enough of this. That product is definitely deceased, and when I bought it not half a year ago, you assured me that it would pay out when Greece defaults, and that it's lack of movement was due to traders being tired and shagged out after a long night at Stringfellows"
"It's probably pining for the Subords."
"Pining for the Subords?! What kind of talk is that?! Look, why didn't it hedge my bonds the moment they defaulted?"
"The Sovereign CDS prefers not to pay for voluntary defaults, it's beautiful product... lovely name..."
"Look, I took the liberty of examining that contract, and I discovered that I had reason to believe that it hedges a default as it has 'default' in its name."
"Well of course it's got 'default' in its name, otherwise we wouldn't have been able to sell it."
"Look, matey... this product wouldn't pay out if an asteroid the size of France hit Athens. It's bleedin' demised."
"It's not... it's voluntary..."
"It's not voluntary, it's passed on. This product is no more. It has ceased to be. It's expired and gone to meet its seller. This is a crap product. It's a fix, bereft of value, my P&L's in pieces. If you hadn't have said it would pay out on default, it would never have traded. It's gone down the toilet and joined the CDO unsellable. THIS IS AN EX-PRODUCT".

But jokes aside, TMM are incredulous that banks have been able to get away with selling Sovereign CDS for so long. The ill-design of the product is palpable - for it not to pay out in the event of a 50% haircut (60% in NPV terms) because the restructuring was "voluntary" is laughable. Sovereign CDS has turned out to be less useful as a hedge than a glass panel in a nudist camp. This is an exceptionally serious issue for the credit market as banks have used CDS to hedge their bond holdings, loan books and other related country exposures, particularly from CVA desks. And this is what worries TMM - these desks have been very large players in the Sovereign CDS market, hedging counterparty and country risk on bank balance sheets. Given the now exceptionally questionable quality and value of these swaps as a hedge, both in terms of MTM moves and in terms of eventual pay out, TMM expect that auditors and risk managers will be alerted. Hedges that offset bond positions are likely now to have lost money and require banks to restate their earnings, while at the same time reduce their gross books. TMM find it particularly amusing that this effectively represents a wealth transfer from US/UK and German banks toward those of France and Austria.

But this was all avoidable. TMM have been arguing for years in favour of the migration of vanilla derivatives on-exchange. And in particular, while TMM agree that the Corporate CDS market has improved both liquidity, price discovery and market efficiency, it does not appear to be like this with respect to Sovereigns. There have been many cries of "it's a fix, the politicians have changed the rules!". Well, that's not all that surprising is it? TMM have many times highlighted that the difference between this crisis and the banking crisis was that in 2008 the banks had to play to someone else's rules. In a sovereign crisis, the sovereign plays to its own rules and these it can be change to suit its purpose. We cannot help but feel the schadenfreude at how jealously banks guarded their CDS franchises of large bid/ask spreads and price opacity has backfired. Because there was never any reason why Sovereign CDS needed to be structured as it is. Why...?

There have been many cries to regulate or ban the existence of Sovereign CDS, both from the sovereigns that felt their nations under attack, and by the masses who see them as one of Satan's investment bank tools designed to steal from the poor. Rather than ban or regulate further, TMM feel (as noted above) that all it would take is for the auditors and risk managers to declare them invalid as a hedge (which they have now proved to be) and these CDS will be confined to the financial bin. If, however there are still folks stupid enough to see value in them, then true to Darwinian theory, they should be left free to trade them. Let's be honest, Greek bonds with a 50% haircut still have a better payout than the National lottery... and no-one's banned that yet.

But there is a viable alternative. TMM would like to introduce their readers to the humble Bond Future. That long-standing, well-understood derivative that has provided liquidity, transparency and price discovery to bond markets in many countries for 40 years. Bond futures with deliverable bond baskets allow basis trading, speculation and hedging, without the idiosyncrasies of CDS contracts. But of course, futures markets aren't that profitable for banks... well, you reap what you sow, right?

And on that note, TMM wish their readers a very good weekend.

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ADDENDUM:

Having received many insightful comments, TMM thought they would attempt to clarify a few points:

1) Sovereign CDS has been seen as an MTM hedge due to its correlation with country-related assets. As per one comment, if it is not known for several years whether or not it will pay out, via lawsuits, then it is hardly a "liquid hedge".

2) It only works as a hedge for a hold-out if a re-default does indeed occur and is ruled to be coercive by ISDA DC. By definition of “holdout”, this is only works for a minority of investors, and therefore its liquidity, pricing and usefulness as a hedge for banks will have to reflect this.

3) It is too complex as a product given the intentions behind it - to hedge the credit risk of the underlying asset.

4) Differentiation between voluntary and involuntary default provides politicians (or whoever else) a means to prevent their trigger inevitably leads to the question: your 100%-guaranteed working parachute has just had a moth fly out of it. Are you *sure* it will work when you need it to?

5) Finally, regarding the very valid point that the flaws of Sovereign CDS are common to all OTC derivatives, including ones that are a lot more liquid and actively traded, like vanilla interest rate swaps (IRS). Given the recent (as well as the not so recent) shenanigans around the LIBOR fixing, TMM agrees. However, let’s note that a) the vanilla IRS market has responded to these issues and there has been a sustained push to get away from OTC and onto exchange; b) there’s no question that there’s a LOT less settlement/litigation risk and uncertainty for contracts like vanilla IRS and FX options; c) the very fact that we’re not having discussions about the validity of the current mid 10y par swap rate suggests that there’s a lot less ambiguity among market participants about these derivatives. There are, obviously, other issues with vanilla IRS, e.g. pricing of these contracts under different funding assumptions, but the uncertainties that these issues introduce into the marketplace are not sufficient to cause a significant disruption. Moreover, the IRS market is responding and adapting as we speak.

There are two conclusions: as per another comment, either markets will need to price in the probability of actually getting paid, when they will get paid, and which court will govern that decision, not just the probability of default. This is an exceptionally difficult thing to do. Alternatively (or, indeed, additionally) markets need to come up with a simpler product that provides the hedging requirements without such uncertainty and complexity. TMM would suggest that bond futures, which are inherently simple, with a long and well-understood history, are a more appropriate model for such a hedge.

And there we were thinking that CDS was only stupid in its complexity. Now we’re forced to conclude that, additionally, it’s even complex in its stupidity.

24 comments:

Anonymous said...

spot on. It should be said though that CVA desks (and others I guess) were primarily using sov-cds to hedge P&L volatility. Since moving CVA to MTM (not TMM) a great deal of volatility has been introduced into the balance sheet - da management noticed that counterparty risk was behind it and demanded action. Sov CDS not only hedges SOV counterparty risk but all the other counteraprty risk from that nation that doesnt have a CDS or bond curve and can only be marked by proxy to.. the sovereign CDS. Mark-to-market is all well and good when there is a market, but forcing everything to "fair value" tends to produce the illusion of markets where there really isn't any. I doubt many really thought Sov CDS for developed nations a) would be required for default, b) would work properly in default. After all Sovs have tanks and make up laws as they go along (thats what they are for after all) and banks.. well.. don't.

Anonymous said...

I don't understand why you are labelling CDS dead. If you are a European bank, and are forced into the exchange, yes, your CDS hedge is not protecting you. But if you are a hedge fund/non European entity, no one is forcing you to do the exchange. Note that they can't get around this by taxing bond principal (there is language in the bond prospectus to prevent this, and it woould trigger default).

Anonymous said...

Your work is almost always exceptional. This is a rare case where i think you've missed something... Investors are not forced to participate and can holdout of a deal. The CDS will absolutely work as a valid hedge.

abee crombie said...

TMM, I just wanted to make a comment regarding your recent commentary and market calls. Bravo!

For all the "doom" crowd, "TMM as reverse indicator" and others (you know who you are) this blog has been spot on over the past 3 months, and did so with insightful yet witty posts

keep up the good work. I for one appreciate it immensely.

my take is that Soverign CDS = another instance of money managers herding into a new product without reading the fine print..

Martin Ghoul said...

With all due respect, Anon @ 1.06PM, it is you who's missed something...

It's, indeed, entirely likely that the holdouts will do just that and, well, hold out. And guess what happens when you're one of those people and you expect a CDS payout in spite of the ISDA DC conclusion that it wasn't a credit event? A lawsuit happens, that's what. A lawsuit akin to the one that, relatively recently, was eventually resolved in the 2nd US District Court of Appeals (after being initially dismissed). This in itself isn't a problem. However, a derivative that is likely to pay out after several years of litigation (with all the costs thereof), shouldn't be priced and traded in the mkt the way Greek Sov CDS is. Are you, as a buyer of these contracts, pricing the "settlement" procedure correctly? Are you including the litigation costs in the PV? Are you calculating the expected value of the eventual payout using the right time horizon and the right probability of the court siding with you? Do you know which jurisdiction's court will be deciding the matter?

Anonymous said...

This is a dead parrot indeed but it might be miraculously resurrected by an obscure HF that does not trade with OPM and so will be able to resist all sorts of pressure when holding out for full payment from the Greeks.

M.Goul made some fair comments "And guess what happens when you're one of those people and you expect a CDS payout in spite of the ISDA DC conclusion that it wasn't a credit event? A lawsuit happens...."

BUT the bond holder will be expecting a full bond payout and not a CDS payout. Should full payment not occur at maturity it will then be clear that the ISDA will have to change their verdict. No payment when bond presented = credit event; there is no way around it. Then the CDS hedge will come good.

Is there just one crackhead out there that could trigger this? I bet there is but even if he does we probably won't find out (will be paid in full but in silence).

Matador

Finance Addict said...

in the Greek case the CDS hedge is not protecting you precisely because holders are not forced to do the exchange. strange but true: http://bit.ly/vmoMxv

Anonymous said...

@Martin Ghoul-
this is anon. from 12:56. The point is not to expect payouts on CDS if ISDA rules non-default, the point is that holdouts will continue to get paid on their bonds after the exchange. If they do not, ISDA will rule a default.

If your point is that derivative contracts are costly to enforce, you are right. Are interest rate swaps and FX option markets dead too? They are all OTC derivatives.

cpmppi said...

Thanks for your thoughtful comments.

A few points:

1) Sovereign CDS has been seen as an MTM hedge due to its correlation with country-related assets. As per Martin Ghoul's comment,
if it is not known for several years whether or not it will pay out, via lawsuits, then it is hardly a "liquid hedge".
2) It only works as a hedge for a hold-out if re-default does indeed occur. This is only the case for a minority of investors, and therefore its liquidity, pricing and usefulness as a hedge for banks will have to reflect this.
3) It is too complex as a product given the intentions behind it - to hedge the credit risk of the underlying asset.
4) Differentiation between voluntary and involuntary default provides politicians (or whoever else) a means to prevent their trigger inevitably leads to the question: your 100%-guaranteed working parachute has just had a moth fly out of it. Are you *sure* it will work when you need it to?

There are two conclusions: as per Martin Ghoul's comment, either markets will need to price in the probability of actually getting paid, when they will get paid, and which court will govern that decision, not just the probability of default. This is an exceptionally difficult thing to do. Alternatively (or, indeed, additionally) markets need to come up with a simpler product that provides the hedging requirements without such uncertainty and complexity. TMM would suggest that bond futures, which are inherently simple, with a long and well-understood history, are a more appropriate model for such a hedge.

cheers,
cpmppi

Anonymous said...

"TMM expect that auditors and risk managers will be alerted."
You can rule out the first party - auditors. The cohabitation with too-big-to-ignore client FIs will again see them bow to some long-date rationale not to reval.

Anonymous said...

Pining for the subords!!!! Brilliant!

yra h said...

TMM---YOU SHOULD BE BUYING AM SEATS AT THE CME/BOT IF YOU BELIEVE WHAT YOU WRITE ABOUT THE BONDS---$130,000 trading right which rents for 1500 a month---YRA HARRIS{NOTES FROM UNDERGROUND}

Anonymous said...

Mr Macro Man,
What is your opinion on which entities will be "required" to "voluntarily" submit? Clearly Euro banks will. But what about, say, Citi or JP Morgan, US based but with signif Euro operations? What about major European based hedge funds?

Fuguez said...

Aha - the birth of the sovereign CDS re-insurance market.

There's one born every minute

Anonymous said...

My question is does anyone have an opinion or insight as to why the US dollar is absolutely getting murdered? Thanks

JohnL said...

Did these guys just shoot themselves in the foot?
Putting the value of sov. CDS in doubt, diminishing their value as a hedge, will only drive yields up.....no?
TED, LIBOR3, SPGATR, ITGATR seem to be agreeing.

theta said...

Hilarious, one of my favorite MP scenes! Excellent post. Keep it up guys!

Anonymous said...

TMM, as opposed to the premium you have to pay for a CDS, a bond exposes you to potentially unlimited losses.

Corey said...

Sounds like someone sold Greek CDS, if that's the case then they served their purpose nicely, making money by placing a bet...

Anonymous said...

Excellent post but I must disagree with the conclusions. With rudimentary quant skills I can already see how banks’ risk managers, quants, and developers can solve the obvious holes blown through their approach to sovereign risk. I give you the stochastic recovery rate model. Of course to make it plausible a negative correlation with sovereign rating must be added. This won’t take more than a week worth of coding and only two extra cells on a spreadsheet. I imagine this will suit everyone’s needs perfectly. Think about it for a second, you can easily dynamically hedge your CVA book by buying more protection as a sovereign’s credit conditions deteriorate since the recovery rate is approaching zero at the limit. This property of the model is not as bad as it seems, option traders live strange behaviour of models daily (deltas on a digital with spot sitting on the strike is one example). Wonderful post team macro but I’m afraid you prematurely write off the ingenuity of financial engineers.

Anonymous said...

Excellent post but I must disagree with the conclusions. With rudimentary quant skills I can already see how banks’ risk managers, quants, and developers can solve the obvious holes blown through their approach to sovereign risk. I give you the stochastic recovery rate model. Of course to make it plausible a negative correlation with sovereign rating must be added. This won’t take more than a week worth of coding and only two extra cells on a spreadsheet. I imagine this will suit everyone’s needs perfectly. Think about it for a second, you can easily dynamically hedge your CVA book by buying more protection as a sovereign’s credit conditions deteriorate since the recovery rate is approaching zero at the limit. This property of the model is not as bad as it seems, option traders live strange behaviour of models daily (deltas on a digital with spot sitting on the strike is one example). Wonderful post team macro but I’m afraid you prematurely write off the ingenuity of financial engineers.

Anonymous said...

I argued before that it would take just a crackhead HF manager to trigger this thing off. Well, add the Greek pensioner representatives in the list that will keep increasing. With their reserves being wiped out after the haircut looks like they will stick two fingers up on this agreement. It would be funny if it was the Greeks themselves that set the CDS off but I wouldn't blame them at all.

Matador

"Along with the legal effects occur pressure on administrations of Funds not to accept the new framework agreement, otherwise the employee representatives on the boards will declare the next few days refusal to sign the agreement and legal action for annulment of decisions."

http://translate.google.com/translate?sl=el&tl=en&js=n&prev=_t&hl=en&ie=UTF-8&layout=2&eotf=1&u=http%3A%2F%2Fwww.enet.gr%2F%3Fi%3Dnews.el.politikh%26id%3D321978

Anonymous said...

Interventionfestinthehouse says...going through history its getting similar in an inverse way to those thingymebobs when mullets were in and piss-ups were named in honor after hotels.

Anonymous said...

Interventionfestinthehouse -

Food for thought

http://blogs.wsj.com/
marketbeat/2011/10/28/
stock-market-now-on-pace-
for-best-month-since-1974-
yes-1974/