Credit & Economy | 1st Capital Growth

CDS Debunking - Facts

I’ve been reading a lot about the fears of the CDS markets and its really annoying me. I figured it would be prudent to state some facts that have been mistated in the press for those that are interested. Plus it just annoys me that people insist upon making shit up about CDS because they just don’t understand the product.

1. The size of the market: $54.6 Trillion.

I used to compile the monthly reporting to ISDA that collects data on banks’ positions in OTC derivatives for the bank I used to work for. Typically, they ask you for net and gross notional amounts. When looking at the ISDA Market Survey, which is the report that the media uses when quoting this figure, its not clear whether they are using gross or net notional amounts. Another report published by the Bank of International Settlements actually specifies gross notional and quotes a number around $45 trillion in June 2007. What is the difference between gross and net? Well, if I bought protection for $10m on General Motors and then sold protection for $10m, then my net notional would be $0 and my gross notional would be $20m. The report states that “gross market values are adjusted by adding the total gross positive market value of contracts to the total gross negative market value of contracts with non-reporting counterparties only” while to avoid double-counting, it halves positions of dealers that have positions against each other. It still doesn’t give solid information about whether those numbers that dealers are reporting are net or gross. Assuming that it is net, the proportion of dealer-to-dealer trades is far outweighed by dealer-to-client trades, by probably 6 or 7 to 1. So if they are taking gross notionals of trades facing clients (also called sales trades) and halving the small minority of trades facing other broker-dealers, then the statistics are widely overstated.

2. Credit-Default Swaps are ticking time-bombs, also referred to as “Weapons of Mass Destruction” by Warren Buffett.

I still don’t understand this statement. To me, this says that CDS are the most riskiest of all investments available. Let’s take a quick look at the risks.

CDS subject investors to 3 main types of risks: credit, recovery and default. Credit risk is the risk that credit spreads will change. Recovery risk is the risk that underlying recoveries upon default will change. Default risk is the exposure risk that the underlying issuer will default. The underlying instrument of CDS are bonds. Credit risks are generally the most significant for names that are less likely to default while recovery and default risks tend to be more significant for names that are more likely to default. For names that fall in between those spectrums, changes in credit and recovery tend to offset each other. The closer to perceived default CDS trades, the more they start to trade like a bond, where the credit spread has less of an impact than the recovery assumptions. What risks are investors taking when buying bonds? Credit, default/recovery, interest rate, liquidity. As with CDS, they have similar risks in terms of credit, default and recovery risks, but they also have additional, significant risks: interest rate and liquidity. Since bonds are funded, they are sensitive to the discount curve based on Treasury bond yields. CDS have similar risk but because they are not funded, the interest rate risk is miniscule relative to bonds. And the big one, liquidity risk, has seen to cripple bonds in the current credit liquidity crisis while the CDS market is still a highly liquid market. It is arguable that the CDS market has helped investors hedge against falling bond prices but as I discussed in the prior post, basis risk has exploded reducing the efficiency of that hedge.

The VIX Index, the index of equity market volatility has spiked to as high as 60, which represents more than double your normal volatilities expected and priced into equities. (I should give you a comparison of the levels of volatility of credit spreads because its just the logarithmic changes in daily returns and such but I don’t feel like it. I just know that equities are always on the top of the list of volatile instruments. These levels peg the risk of equities at all-time highs which has been apparent in the current market with unprecedented swings of +/-500 points any given day in the Dow Jones Industrial Average. If you look at the CDX Investment Grade Index, which is an index of Investment Grade issuers in the bond market, the index hovered around 50-80bps during the summer and is now trading around about 200bps. The equity markets have lost about 30% since June. If you assume a $10M 5Y trade in the CDX IG 10 index, you could assume about a $600k loss since June - let’s assume a cool $1M loss because of convexity and tighter recovery assumptions that are plauging the market as a result of more probable default probabilities. If you take $10M in the equity markets since June and you have a $3M loss. If you are invested in bonds, you loss would be much greater than $600k but not as much as $3M most likely. But there are bonds that have lost even more than 30% because of drying up liquidity so its possible depending on what names you are invested in. If you were invested in secured debt (loans), you could see even greater losses. It probably goes without saying that if you were invested in MBS or other types of ABS, you wish you invested in equities. Of course, its always the case that you want to be on the right side of the trade - regardless of where the market is going, but I think its apparent that the risks the bonds and equities expose you to are exponentially greater than CDS. If you wanted to call it a day on your $1M loss on your $10M position in the IG 10, then you unwind. If you want to get out of your $10M in bonds or equity, plan on getting out at even greater losses because of the general lack of liquidity in the market, especially in the bond market. As $10M isn’t that huge of a position, you will still probably have to unwind your position in smaller lots when you can easily do an offsetting trade or simply contact the counterparty to unwind your $10M CDS position.

3. The CDS market does not require financial firms to take capital in reserve in case they have to pay off their bets.

This is partially true but not so much when it really matters most. Let me explain.

It is true that there are no requirements on posting collateral or capital in reserves when trading. However, all broker-dealers and other market-makers in the CDS market require clients (hedge funds, mutual funds, etc.) to post margin and regularly require increases on that collateral when spreads widen. As I stated before, sales trades (trades between broker-dealers and clients such as hedge funds) make up the vast majority of outstanding trades in the market. And the vast majority of trades require margin - just like when retail investors trade equity or commodity derivatives on platforms such as E-trade. The other side of the trade facing the broker-dealer obviously does not require margin and this has been the unprecedented situation that has occurred in the market where the market-maker is defaulting, creating counterparty risk where none was thought to exist. Of course, the collateral posted by clients with trades facing Lehman is now part of the overall bankruptcy proceedings and will most likely not be returned 100%. I don’t disagree that this is a problem and that a centralized exchange or clearinghouse would solve this problem, but I did want to clarify the issue.

Another factor in this is the distressed market. This is the market that trades CDS with underlying bonds trading at the perceived recovery that would result from a default. I wrote about this previously that distressed CDS trade with points upfront. I’m not sure at which point this occurs but at some point, spreads get so high, so wide that the market decides to trade with a flat 500bps plus a percentage of the notional in the trade upfront - in cash. Even though this isn’t seen as capital in reserve, it really is. If I bought protection on a distressed CDS contract I could pay 10-20pts upfront depending on the name traded. On a $10M contract, I would pay $2M upfront to the counterparty and pay a running 500bps quarterly. So if there was a default, the protection seller would actually only be paying another $4M assuming a 40% recovery. Yes, the distressed market does only represent a small portion of the CDS market, but alternatively it represents the vast (if not the entire) majority of the population of likely defaults. Points upfront get into the 30’s and 40’s for those that are really about to jump off the cliff.

4. CDS instruments are the reason why we are in this crisis.

I don’t even know where to begin. First of all, the CDS market is a highly liquid and developed market since it’s inception in 1994. Since the initial defaults occurred back in 2005 with Collins and Aikman and the airlines, ISDA has done a lot to hammer out issues that propped up along the way and protocols developed by them have created a streamlined series of directions or instructions for participants to follow when settling triggered contracts. The claim from what I understand is that the counterparty risk the banks now suddenly exhibit would cause defaults which would cause defaults would cause defaults. I can’t say whether or not this would occur, but the reason we are in this crisis is because the economy’s foundation is built upon credit and is dependent upon banks lending to each other in addition to the use of bad assets as collateral for issued credit securities. There are a lot of reasons why we are where we are but one of the big reasons has to do with how leveraged the world economy is, which makes it heavily dependent upon credit from banks all over the world. CDS makes this more complex because your counterpart could be a bank that may default while the underlying issuer that the contract is based upon has nothing to do with the bank. This is classic counterparty risk that exists in all OTC derivatives where you are not trading with an exchange but with a private institution. This risk has always existed and has been monitored by any banks with a Risk Management department worth its salt. No doubt is CDS a large market, but interest rate swaps are large too and not controlled by an exchange. Variance Swaps, commodity swaps, total return swaps? Granted, there is no default leg on these types of swaps and that is where I believe most of the counterparty risk would be an issue, but total return and variance swaps can both have extremely large settlement amounts just like CDS.

Now, the media won’t get off the fact that synthetic CDOs are being sold at price as low as 10 cents on the dollar because they contained exposure to Lehman. Why is this news? A synthetic CDO is basically a package of CDS trades that you can’t unwind and are thinly traded because they are bespoke bonds based on any combination of underlying issuers. The fucking dumbest idea on the planet. Pricing is based on its composition so its pretty straightforward to price. It basically enables people who can’t trade CDS to trade funded packages of CDS trades that are tailored to the a certain type of exposure that the investor is looking for. I get it but think that its better to just buy the bonds or loans and tailor your own exposure through a mixture of other products that can be unwound more easily. The fact that they are trading low because they have exposure to Lehman is not really news to me (duh!). Its like reporting that its wet because its raining.

Also, everyone thinks that the banks will fall like dominoes because they think the market is really $54.6 trillion in size when its not. Plus, banks have netting agreements that net payments to reduce operational risks and streamline the settlement process. There is a company (TriOptima) the also works to regularly reduce trades outstanding by trilateral and bilateral netting which would reduce greatly the gross exposure while not changing overal net exposure, thereby reducing operational risk further. TriOptima performs these exercises for every credit event for both single-name and index instruments.

5. The CDS market is completely opaque.

Depository Trust and Clearing Corporation (DTCC) has been working to rampup hedge funds and other clients through broker-dealers so that clearing trades between counterparties is more streamlined, reducing operational risk and the amount of time it takes to settle and confirm trades. They have developed a trade information warehouse that tracks trades that use their service. The biggest dealers in the market use this platform so its safe to say that the majority of the market is accounted for. This platform greatly increases transparency and allows participants to track their exposures, handling credit events, reduces errors, etc. Markit Partners offers substantial information on pricing submitted by market participants and market news specific to the CDS market. Surely, you don’t see trading volumes like you do in equities and bonds, but I wouldn’t say that the market is completely opaque. I’m sure there are other sources that offer information on trading volumes but won’t drill-down to intraday times like equities do. Also another issue is that you can’t go to Yahoo or Google to get prices but retail investors can’t trade them anyways. The market participants that trade these contracts have the info they need. Again, I do know that as this product is traded by a wider audience, you will have greater transparency. The problem with that is that you are now more likely to have participants trading these instruments who don’t know how to. The answer to this problem is a centralized exchange or clearing house that becomes the counterparty to all trades in the market. I think that would create a better marketplace and help monitor the market in general.

I hope this has helped to debunk some of the mistatements that seem to surface in the media. Hit me up with any comments.

October 22nd, 2008 | Posted in Credit & Economy | No Comments

A Lesson in Basis Risk

Basis.

Your typical CDS and bond default-risk neutral trade consists of being long CDS and long bond. This trade is done 100 or 1000 times over on practically every credit trading flow desk and credit trading hedgie. Usually this is done within the same corporate entity. This is how it is usually done via the flow desk. Hedgies tend to be more creative, playing off of different tiers of debt within the entity (secured vs. unsecured) or even between entities of the same company, which is not only showing a view of basis but also a view on recovery, depending on how the trade is layed out.

The simple basis trade described above is basically being long negative basis. Its negative because the underlying is cheaper than the derivative implies. Going back to the example, you are long the bond (the underlying) and long the CDS. Being long CDS is actually almost economically like being short the bond. In risk terms, you are long risk the bond and short risk the CDS. Its all one in the same. Long CDS = short risk. Anyways, this trade is typically negative because again the underlying is cheaper than the derivative implies. If you reach back several months into your brain, you can remember some of the CFA material that states that corporate bond yields include 3 components: discount rate (treasury rates), credit spread, and liquidity spread. CDS is basically the same thing as a corporate bonds minus the discount rate and the liquidity spread. CDS is purely a credit instrument. So going long the bond and long the CDS, you still have interest rate and liquidity risks left unhedged. A flow desk will typically go short treasuries or IRS in order to hedge the interest rate risk, leaving just the liquidity risk unhedged. This is very typical.

This negative basis trade is profitable because typically bonds are cheaper than what credit spreads imply. Traders tend to buy low and sell high, which is generally the idea here. In positive basis situations, where the bond is more expensive than what the CDS spreads imply, its generally more difficult to short a bond than to go long a bond so negative basis trades are easier to execute. The money made here is all in the basis. Basis tends to converge to 0 over time so getting in when basis is wide (very negative) means buying the bond super-cheap and then over time the CDS spreads and the bond price gets back into sync.

In today’s markets, basis is blowing way, way out. The reason? Credit liquidity. The only unhedged part of this trade. Credit liquidity usually isn’t that big of a deal and only applies to those that are trying to unload or loadup on very large lots of bonds (50mm+ lots). The bond market is getting crushed as CDS spreads aren’t widening enough to imply the prices that are seen in the market. While folks generally gauge the market by looking at the S&P or the DJIA, this is bloodletting that hasn’t stopped since Lehman declared bankruptcy. Even on days when the markets rallied, credit liquidity is still in the dumps causing basis to get wider and wider still. It leaves one beside oneself.

Experiencing the credit markets last week has truly been a lesson in the massive risks that basis poses, the risk that is usually underestimated. If you were a basis trader, this is now the time to get in. The problem is the most of them are already there, trying to get out. Now would be a good time for a basis fund. When the market comes back, you will truly make a killing. But the question is when is it coming back and will there be a new equilibrium or level of basis when it does come back? Well find out soon enough. Hopefully.

October 2nd, 2008 | Posted in Credit & Economy | No Comments

Net = Net = Net = Net

I’m so sick of people saying “Net-Net”. Net is it, finito, el fin, done! Net is net is net is net is net is net.

Stop saying “Net-Net” because you look and sound like a dumbass.

September 30th, 2008 | Posted in Credit & Economy | No Comments

No More Section 8? Sounds like a plan to me!

Bloomberg and the AP are reporting that the primary sticking points of Republicans are getting ironed out, which is a definite relief. Being a tax-payer myself, I don’t favor the idea of paying for someone else’s bad trade(s).

The govt is going to limit golden parachutes for those that participate and will receive preferred warrants from those said companies that will allow the govt to make a profit for the taxpayers. Earlier, Paulson and Bernanke alike stated that it was not likely that the taxpayer would make any money on the deal, but that was with their original terms, which did not include warrants from participating companies. I mean, if the govt is going to turn into a private-equity/distressed hedge-fund where every taxpayer has a stake, at least we need to make a profit. The idea that taxpayers are becoming sharedholders into a distressed securities fund is crazy, but could be worse. Also, only $250B is immediately available with another $100B available upon president approval. Of course, if Bush is still residing at the time that the Treasury requests the add’l $100B, he’ll signoff without batting an eye. (Bush has no fucking clue what this is going on and probably thinks that they are giving him $700B, which is why he’s trying to get it passed so quickly. Sorry Bush, this is not for you.) Als0, the remaining $350B would require approval from congress.

This is now being taken seriously as a last ditch effort for companies - and not rubber stamped as a outright bailout. Kind of like the funding window that the govt offers for companies and individuals as an emergency for funding - not the first choice.

Luckily, there is also a committee and sheriff that will appointed to oversee the use of the funds so there will be some kind of oversight over the taxpayers’ money. So no section 8! I hope to get a copy of the new Bill so I can read it with my own eyes. Reading about the fact that Republicans are fed up with the Bush’s spending habits and want to get back to basics is refreshing. This situation is basically the last straw with the Bush administration and its obvious that the Republicans are virtually staging a coup in their revolt of Paulson’s plan, but I have to agree with them on every point. Fuck Bush! His administration has brought us here. With the SEC’s feeble attempts at looking like they are actually trying to do something about the situation by inacting the “no short-sales” rule is too little, too late. Again, I have said this before and now I’m reading a new article supporting my claim in the NYT that short-sellers don’t short-sell to bring the price down, they short-sell as a result of downward price momentum. Its not the cause, but the result of falling prices. Any good trader would sell-short if the price was falling. The book I just read, writen almost 100 years ago, stated the same thing. Things haven’t changed one bit.

Hopefully, with the new terms, banks will think twice about taking advantage of it and will use it as a last resort, which would probably inevitably end up in liquidation. There needs to be conditions met before money exchanges hands in any deal. Risk needs to be paid for and this is no different.

September 28th, 2008 | Posted in Credit & Economy | No Comments

Paulson has gone Section 8!

I seriously think that Paulson is taking a huge misstep by the language in Section 8 of the $700B Bailout Plan. First of all, I’m seriously against it. I believe in free market capitalism and this is not. Section 8 is below in its entirety:

Decisions by the Secretary pursuant to the authority of this Act are
non-reviewable and committed to agency discretion, and may not be reviewed
by any court of law or any administrative agency.

Can you seriously say that giving these greedy wall street fucks $700B in taxpayer’s money without oversight is the right thing to do? I’m all about making money and love money as much as the next guy, but those assholes put us here and they need to get us out. I think a series of super-senior bridge loans and revolvers with Goldman-esque fees of say LIBOR+2000bps on the bridge loans with 100bps commitment fees on revolvers that reprice quarterly at LIBOR+2500bps upon funding. Also, change bankruptcy laws so judges can help homeowners keep their homes and pay off their mortgages. There is a lot of blame to go around from the Subprime brokers and the lack of oversight over credit checks - or the lack thereof, to the amount of leverage and concentration of MBS that banks were allowed to exist in, post-LBO frenzy caused by seriously cheap credit, to the lack of oversight by the SEC, to the credit-rating agencies, to the amount of investment properties that people thought they could afford. Banks that are overly-concentrated in Subprime MBS should fall. The financial market should shrink and people need to be taught a lesson. Again, I’m all about money and making lots of it, but if I make a bad trade, I don’t expect taxpayers to pay the bill. Its setting a really bad precedent. I expect Michael Moore to make a movie about this. We’ll see.

September 27th, 2008 | Posted in Credit & Economy | No Comments

Credit Liquidity and the Capital Arb Trade

Bloomberg put out an article some time ago - that I can’t seem to find - and it described how the current leveraged loan market demand was being partially fueled by hedge funds and other trading desks putting on the capital arbitrage trade.

This a basic relative value trade. There are several ways about it, but the general idea is that you buy the loan, which resides in the secured portion of the capital structure. Then you sell protection of equivalent CDS on the unsecured portion of the capital structure, which is usually the most liquid CDS. Generally speaking, secured loans have historically had recoveries of around 85% while unsecured bonds recover around 40%. Spreads and prices have an inverse relation and usually follow a similar relationship - or basis - during normal market conditions. As bonds become relatively expensive to CDS, there is positive basis. If bonds are relatively cheap to CDS, there is negative basis. The negative basis trade is also a very popular trade that capitalizes on this basis. That is usually done within the same debt tier of the capital structure but when you start playing off of secured debt vs unsecured debt vs equity, then you have to include other variables, like recovery levels. The idea with playing off of the secured and unsecured debt tiers is that the recovery in the unsecured debt is going to be lower than the recovery on the secured debt. So if there is a default and you bought 100MM in protection in the unsecured bond and 100mm of the secured loan (that was bought at par), then you will recieve 1-Recovery x Notional on the long protection position, which would be close to 60mm and you would only lose 15pts on 100mm or 15mm, so your net gain is approximately 45mm. Not a bad trade.

Bonds and loans in distressed situations will trade at their recovery. Price = recovery. So if you put on the cap arb trade I discussed before by playing off of the secured and unsecured debt tiers, then you have to consider the recovery. Its important to not put a rubber stamp on this type of trading, especially in today’s environment. These cap arb trades are blowing up in people’s faces because of the changes in recoveries that the lack of credit liquidity is causing. What you are seeing put another way, is that basis blowing way out. The relationship between prices of the underlying and the respective CDS spread is coming apart since bonds normally trading closer to historical recovery levels are now trading near much lower recovery levels. The boom of leveraged loans helped spurn this trade on and those that put this trade on during the LBO leveraged loan explosion bought their loan most likely near par, bought protection on the unsecured bond and maybe put on recovery swaps to lock in a recovery rate for a certain portion of the loan position. Normally, the spreads of the unsecured bond would widen more than what the price of the secured loan would imply so as you are marking down the loan, you are getting gains on spreads widening out on the unsecured CDS that you bought protection on. In this case, the loan market is getting pummelled by the current credit markets because companies are having trouble finding new short-term funding that will allow them to roll-over their current secured debt into new secured debt. Companies that were distressed before this credit crisis went into overdrive are finding their loans trading in the secondary market getting severely marked down because the market has dried up.

People in these trades are trying to slowly unwind their massive loan positions while loan marks are dropping 5-10pts almost daily. Its turning into a viscious cycle that is causing massive losses for those that put on this type of trade because their long loan position is getting continually marked down due to the massive unwind. Another problem is that some are left with only partially covering their loan position with CDS, which is making it worse. Again, there are a lot of ways to do this trade depending on the situation, the company’s capital structure, potential refinancings or events like mergers/acquisitions. My opinion is that those in this position need to hold on, buy recovery swaps with as high of a strike as you can, buy as much CDS on the unsecured bond. The best case is that the issuer redeems the secured loan at par and the widening that was captured in the long protection position and all is in the black. But with today’s markets and the lack of funding available, there will most likely be a lot of pain felt while credit liquidity is really, really tight. What if the issuer redeems somewhere below par?

I was trying to think about the best way to hedge credit liquidity in this type of trade, and I don’t know what that is. The only thing I could think of was over-hedging with the long protection position and maybe shorting equity if you think that things are going to continue to sour. If you want to bring equity into the fold, then you should really understand the capital structure and be able to put on a view based on current market conditions, the company’s outlook and their financing options. I would think that shorting equity would always be the way to go, but I wouldn’t assume anything - avoid the rubber stamp.

On a final note, the current Fed bailout strategy has started to turn into takeovers that aren’t your normal takeovers. JPMorgan just bought ONLY the assets from WaMu - at a discount to boot! Normally, at least the bondholders are covered, but these days both the equity and the bondholders are fucked. This would put the cap arb trade is great peril. Among many other investors. Let’s see how Wachovia pans out. The next to go? Fortis. Trade on!

September 27th, 2008 | Posted in Credit & Economy | No Comments

Longest Week Ever

So last week was the longest week ever. Before Lehman went up on smoke, I was hoping to talk a bit about Credit Gamma, which is better known as convexity. But then utter chaos made last week the longest week ever.

It all started on Sunday, Sep 21. I had planned on having a relaxing weekend with the wifey, but it was interrupted by a call from my boss that I had to come in the office. Everyone was called in. Of course, the news was that Lehman was filing and that we needed to get as much work done as possible ahead of the avalanche of work and analysis that would ensue the rest of the week. So I put in about 6 hrs or so to get stuff where it needed to be. I discovered that a lot of desks were up and running on Sunday and late into the night as well. Early on Monday, about 3am, flow traders were sending out runs and desks began trading. I guess as long as you have a counterparty to trade with in the OTC markets, then trade on. The desk that I work for was having a tough day of course and we were scrambling with slow systems, mile-a-minute news and adhoc requests. Of course, there are people - the analysts - that are asking, “so I know what we do when we have a credit event, but what do we do with the trades facing Lehman?”. Good question.

Well, generally speaking all trades facing Lehman are now considered claims and should be put off to the side until bankruptcy proceedings are underway. Its kind of like having a mass novation out of each trade facing Lehman - or at least that’s the way that it should be done at the bigger banks. If you are a small-time firm, not sure how that work play out. Either way it spells good times all around!

So, Lehman recoveries were marked at 25 early in the week and are now at 16 and are probably going to stay there until the auction for delivering for CDS. Not sure if this will be physical delivery or cash, but either way getting to the new MTM is a cinch. Let’s say you bought protection for 10MM. Forget the spread you traded at - it doesn’t matter. If currently recovery is at 16 so the MTM on the trade is going to be 1-Recovery*Notional. In this case, your new MTM or NPV is 8.4MM. After default, the only thing that matters is recovery- spread levels or imlpied spread levels make no difference because the curve is in default. This simulates the fact that if you bought protection, you will deliver the bond at the price of 16, which is recovery and receive 8.5mm in cash for the difference between recovery and par. So if you owned the bond and bought it at par and also bought protection, you should be net flat, which is the point of buying protection in the first place. When the auction occurs where the CDS traders get together and bid on bonds for delivery on their long CDS positions, the official recovery rate is set and then all settlements are determined.

I knew this year was going to be like another 2005, where the airlines declared and some of the auto vendors also declared, but nothing like this. This week we had (and still have) 3 official defaults that have yet to be settled: Tembec, Fannie Mae/Freddie Mac, and Lehman. Fannie Mae and Freddie Mac were handled much differently but was still determined to be a credit event.

On the following Mon, Sep 22, overnight funding rates spiked to 22% as banks hoarded money. The range was literally from 4% way up to 22% from Mon thru Wed. The LIBOR curve came down a bit after that but is still a bit inverted from the 1-3 week timeframe and then comes down and begins upwardly sloping. Desks should be looking to fund their positions for the 1-3mo maturities in my opinion because those still scrambling are taking the overnight rate. In the long-run, I think you should capture about 100-150bps savings on funding if you do that, but we’ll see how the curve starts to shape up.

Losses from what I heard were in the 100s of millions from my friends. Obviously, they weren’t short financials.

September 23rd, 2008 | Posted in Credit & Economy | No Comments

Credit Delta

I’m not an expert in the greeks. I have studied them for the CFA, but that only means that I’m ready to take a test and not necessarily explain or apply anything. The CFA does go far to make sure that you understand the concepts in application and not just in theory, but still doing one thing and studying about it are 2 different things.

Again, back to the idiots on the flow desk. Typically, when a trading desk is estimating their cds pnl, they use what’s called Credit Delta to calculated it. Credit delta is the similar to what CFA calls DV01, which is the present value of the yield changing by one basis point or PVBP. CDS technically doesn’t have an interest rate component like bonds do so its better referred to as CS01, which is the present value of the credit spreads changing by one basis point. If you did your homework on the fixed income portion of the CFA, you know that bond yield has several components: liquidity spread, rates (discount), credit spread. On CDS, the credit spread enables you to trade in only the credit component of the bond yield. Also realize that for bonds all of these components change, affecting the bond price. So if your yield is 7%, you could say that you have 2% of that representing rates, 1% representing liquidity, and 4% representing credit spread. The CDS on that bond with similar maturity should trade at 400bps to match the credit spread. In practice, the liquidity spread is somewhat ignored for pricing CDS and the bond z-spread is used as a proxy, usually. When trading however, liquidity is embedded into the price so large lots can have different prices than smaller lots. For all intents and purposes, we’ll ignore the liquidity spread. So if you know how credit spreads changed on a given curve and you also know the CS01, then you can calculate the pnl by multiplying the two. This is how the desk estimates pnl for CDS.

For example, if you had a 30bps widening on the curve, which could be from 150bps to 180bps on the credit curve, and a CS01 of $1000, then you just lost $30,000. This is simplified. In actuality, the CS01 of any trade is broken down into buckets that correspond to the maturity points on the curve and then summed to get the overall DV01. See my little pic below:

This trade is a 10MM buy of protection with a spread of 295bps and is showing you the pnl of a 10bps change in credit spreads. Generally speaking, you can estimate the CS01 of a CDS trade by dividing the notional of the trade by 10,000 and multiplying that by the duration, which is usually always around 4 for a 5Y trade (magnitude of the spreads can have an effect but its small so we’ll ignore it for simplicity). The screenshot you see above shows more refined numbers that can be generated from a program that values and prices derivatives like FinCad. There are some residual numbers in the 4Y and lower buckets from using this program, but it doesn’t mean much materially when estimating pnl. You have to remember that until you have unwound the trade, you are estimated your current unrealized pnl. In reality, the LTD pnl, which is the same thing as the NPV, is an approximation of the cashflow that you should expect when unwinding the trade. The number you estimate is rarely exactly what the counterparty is going to pay you but its usually within about 1-2%. These products are traded over-the-counter and everyone is estimating NPV based on their own default models and probabilities so everyone is going to come up with a slightly different number. Bloomberg terminals have a screen called CDSW that is usually used as a proxy and generally accepted as the market standard but there are always slight differences. My point is to not sweat over the details and that you may get slightly different numbers when doing your own calculations, but they should be close to what I’m seeing and probably never exact.

Getting back to how the desk estimates pnl, you can now see how straightforward it is to figure out what you would lose/gain in your CDS position based on the CS01 and changes in the spreads. One thing that the guys in the flow desk don’t account for in this estimate is how changes in the discount rates will affect the NPV, or put another way how changes in rates can affect your pnl. As you should know by now, CDS is a purely credit instrument. On the other hand, bonds are credit and rates instruments, which is a fancy way of saying that both changes in credit and rates will affect the value of a bond. If you know anything about calculating NPV based on future cash flows, you know that adjusting the discount rate used in the calculation will change the NPV. Larger yields create smaller NPVs and vice-versa. This is the same mathematical relationship between bond yield and price as price is the same as NPV. So if you have a CDS contract where you are paying or receiving 295bps on 10MM in notional quarterly for 5 years, then you should expect changes in rates to effect your overall NPV. Changes in NPV equal your daily pnl. Our estimate of credit pnl using CS01 and changes in credit spreads doesn’t account for this change. I won’t get into estimating your DV01 for CDS right now because I need to understand better how to estimate it before I start saying things that are just plain wrong. The one thing to know is that the more in-the-money or out-of-the-money you are in a CDS contract, the more that changes in rates will affect your pnl. This is because there is a larger different between the market spread and the trade’s spread and this is the amt that is being discounted to come to a present value. The closer to mark that your trade is, the less that changes in rates will affect your overall pnl.

The reason why I give the flow guys such a hard time is that they miss this point. They estimate their pnl and end up being way off from actuals because they had a big day in rates and are way in-the-money in their position. I actually had a trader tell me that he never had anyone tell him that before about rates and asked me why nobody ever told him. I never went to business school or anything but studying for the CFA, you learn about this whole NPV phenomenon so I tried to hold my breath and not be too much of a smart-ass and just played dumb. Luckily, I never had issues with having to explain credit gamma, which bond folks will know better as convexity. Well, I have to finally get back to work and continue explaining pnl so I can go home and start drinking.

August 10th, 2008 | Posted in Credit & Economy | No Comments

Reminiscing about “Reminiscences”

Reading the news ticker today on Bloomberg, I find that history continues to repeat itself. “Reminiscences of a Stock Operator”, authored by Edwin Lefevre, is a first-person story about a big swinging-dick stock speculator/trader/market-maker from about 1909 to around 1915. He is rediculed by the press and other speculators as being a insiduous bear. Throughout the story, he’s stating his claim about why he selling short and why anyone should sell short. The coined phrase that every successful trader knows is to sell high and buy low. So why is it that the there is such animosity to those that do sell short. The Bloomberg article read, “Short-sellers are the often-despised traders who place bets that stocks will go down.”

The article is really about naked short-selling, which is basically intentionally creating false negative rumors in order to make money. Its manipulation. The book has many anectdotes about this same thing, which is usually done by insiders but also by many other players. The public is always the last to know about anything, right or wrong. That is a fact.

The problem that I have is that these naked short sellers are in it for quick profits, not long-term damage. If you hold a position in something and the price moves down and then back up, you have lost nothing. The problem comes when the public starts trying to trade on this misinformation, not necessarily in the change in price. Granted, if there wasn’t a stir created, nobody would have sold out of their positions as a large discount, but on the flip-side if those long would just stay long and weather the storm, the price will bounce back to where it was and probably higher once the rumors were discredited. I don’t know how the SEC is going to crackdown on the rumormill, but good luck. There’s also not much of a story here in my opinion because this has been going on forever. For those of us that are speculating and trading as for more than investing purposes, this is more of an issue, but nothing new. Its definitely not robbing the “widows and orphans” as the douchebag Peter J Henning stated from Wayne State University Law Sch

Archive for the 'Credit & Economy' Category