Accounting Issue:
The GAAP or the IFRS rules does not provide any specific
guidelines on how to record CDS price in the financial statements.
The accounting perplexity arises since the book value is not sufficiently
representative of the market value. In addition, the mathematical complexity
induces the difficulty for the accountants to calculate the right CDS value.

Monitoring
the CDS data:
According to the financial news the market of CDS is approximately $45.5 trillion.
“It represents roughly twice the size of the entire United States stock market”.
The amount of the financial data that have to be process is enormously high
which causes the banking information system to default or unable to support
entirely the CDS transactions.

Unregulated Market:
The credit default swap market is similar to the one of
mortgage back securities since they are both not subject to rule. The CDS market has
skyrocket in the financial downturn since bondholders were expecting to hedge
their credit risk. However, the lack of regulation in the CDS market causes
additional difficulties. It became impossible to track all the transactions
over the counter market which will probably lead the intervention of the
Security and Exchange Commission or the Commodity Futures Trading
Commission. It will be common to see Federal Reserves or Central banks
to intervene in the derivatives market.

Speculator:
The CDS popularity in the financial market brought many traders to speculate.
They use the credit default swap to bet against the health of companies.
Particularly, hedge funds that are tracking companies in distress using CDS in abundance
since they are having access to liquidity and are able to bet high amounts against
companies in failure.

Tracking the insurance
agreement:
The contract agreement needs to be carefully analysed
since the buyer of CDS may lose the track of the insurer. For example, party A buys CDS
from party B to protect against default on the bond, or on a company health. However,
the transaction doesn’t stop at party B since the latter might sell the contract to party C
and the party C might sell its to party D. Often the time, there is no specific agreement
in the contract saying that the insurer cannot sell the contract to a second party. “In the
case of default party A may have to track down the final party in the insurance agreement.
However, this party may or may not be in a position to pay the bond’s full value.”

Valuation Method:
Pricing the CDS Requires high expertise in mathematics and
high proficiency in the financial market which is limited in corporations
that are valuing such product. Sufficient knowledge is necessary to give an accurate price
or an approximation of the market value of the CDS. In addition, the intricacy of multiple
assumptions makes the valuation method unrealistic.

The Anon of Feb 17 10:00 AM seems to be defining the term “buyer of protection” to refer solely to someone who owns the underlying bond and is hedging, as distinguished from someone using CDSs for speculative shorting.

I had to read what he wrote twice, but it seems he’s not really contradicting Das, just taking the position that you can’t legitimately call it “protection” if you don’t own the underlying security. I’m not sure if it’s a worthwhile distinction to make.

There were a lot of other ways to have played it, “Gee, we are glad Mr. Ackman wrote. This give us the opportunity to clear up the misunderstandings that have developed regarding our insurance policies…..”

Investors who have been on conference calls over the years with MBIA claim the company has never responded candidly or fully to Ackman’s charges. They act like they have something to hide, and whether they do or not, people seem to have come to believe that they are hiding something.

I’m glad you commented. I wrote something in an unclear fashion, and then I have separate questions about how things play out with CDOs (I wish I could get some deal documentation to understand how they worked better, but apparently even the Fed can only get it when people are so kind as to pass it along to them).

To put it another way: I am likely to reveal the extent of my ignorance, so anyone who knows better please speak up!

As I understand it, monoline insurance is pay-as-you-go. If an expected interest payment is missed, they have to make up the difference (BTW, I assume this applies only to the senior tranches, but those are where the vast majority of the economic value of these deals lies).

Now where things have the potential to get weird in on the obligation to make up any shortfall in principal payments. In normal old fashioned debt deals, there are things called covenants, which are promises by the borrower to behave in certain ways, like maintain a minimum net worth and interest coverage. Either a breach of a covenant or a payment default gives the lender the right to accelerate principal, ie, demand repayment in full (it’s a bit more complicated, there is a notice period and the borrower has the opportunity to cure the fault, but you get the drift).

Usually this forces a renegotiation of terms but can sometimes trigger a bankruptcy.

I haven’t the foggiest how this works with CDOs (as in what acceleration rights the lenders/investors have). Since you have multiple tranches with different interests, the effect of an acceleration provision would be to force liquidation, since I doubt you could get all the classes to agree on a new payout scheme.

Now MBIA in particular has been asserting the losses won’t come home to roost any time soon. But we are going to see the worst of the crunch in 2008-2010 (remember the Alt-As and option ARMs).

A second issue is that these deals aren’t long-lived to being with. A real MBS person would know better, but as I dimly recall, the average mortgage is outstanding five years or less, despite maturities of 15 to 30 years on the underlying mortgages, between people moving and refinancing (of course, in a rising interest rate environment, the duration of mortgage securities rises since people don’t refinance). And the subprime CDOs were repackagings of the bottom tranches of RMBS, so those cash flows in the original models had to have been assumed to disappear rather quickly (remember, subprime borrowers were expected to refinance). So CDOs themselves are relatively short-lived assets. Even in the normal course of events, if they were going to come up with a payment deficienty, it would presumably be in five years or less. And this business was most heavily written in 2005 and 2006, so the average remaining life of the CDOs that the monolines have insured is presumably less than that. So again I have trouble with these being characterized as long-tailed exposures.

The third issue is MBIA CEO Dunton’s statement that for some deals written in 2008, they weren’t obligated to pay until the maturity of the original deal was reached, which is 20 to 30 years out, ie, which means that even if there was an acceleration and/or a liquidation, too bad.

Dunton by citing 2008 deals makes it sound as if that was a common practice with MBIA’s CDOs and subprime RMBS. In light of the discussion above, I can’t see why anyone would regard that as acceptable terms, so I question how prevalent that really was historically. Perhaps if he is referring to a RMBS passthrough, yes, but it doesn’t seem plausible with a CDO (oh, and as I now recall, only 3 CDOs have been done this year, so it probably is RMBS, since he referred to “8 of 17 deals”. So he cited a factoid in a way to lend itself to misinterpretation).

How the revaluation of the hedge plays out in for regular hedges is beyond me.

This is gonna sound silly and confused, which is me on a monday morning , but the monoliners don’t pay till a trigger event or as yves pointed out earlier sometimes till ultimate maturity which would mean the argument doesn’t stand.

The focal point of the worry is more of what we don’t know (eg who’s gonna crack) and how the snowball’s gonna grow, it’s kinda like getting on a plane , watching a disaster movie and then envisioning various scenarios when the turbulence gets bad and you glimpse the wing engine catching fire (we landed but that was in the bad old 80s) , how this mess pans out is pretty much anybody’s guess.

If a bank has hedged a CDS with monoline insurance, and the monoline only has to cover the ongoing cash flow, couldn’t the bank reflect the hedge as marked to market in its capital position? This would hedge the bank (in its capital position, although not in its cash position). And if the monoline is making the contractual payments, it might argue that its capital is not impaired (which I think is MBIAs argument against Ackman).

When I’ve written before about CDOs, I’ve always stressed that there are three ways they can be credit-enhanced: via insurance, via CDS, and via overcollateralization.

What makes the discussion confusing is that the monolines (at least in some of their discussions) refer to their insurance on CDOs as CDS (”insured” CDS). This is in some ways quite deceptive, since (at least per a letter by MBIA sent to the regulators in response to a letter by Bill Ackman), monoline “CDS” are not tradeable (although the CDOs are) and their payment obligations are considerably later than tradeable CDS. An event of default triggers the obligation to pay for normal CDS, while the monoline variant doesn’t have to pay till the CDO is liquidated. In some deals, payment is not due until ultimate maturity (as in if your CDO defaults in year 2 but the maturity is year 20, you don’t get paid until year 20).

This is so different than the operation of normal CDS that I wonder whether these policies can be contested if the insurers regularly referred to them as CDS and (and the “and” is very important), the monolines would have reason to know their buyers didn’t understand the differences (say they were party to discussions with rating agency or investment bank models using the wrong assumptions) and didn’t correct them.

Long winded way of saying: I imagine if the monolines didn’t pay out, as they claim they don’t have to, in the event of a default, some clever lawyer will find a way to sue no matter what the agreement says. Remember, even if he doesn’t win, that gives him an excuse to get into the mononline role in CDO deal structuring which might be so embarrassing (remember it took just a few emails to sink Jack Grubman) that they might settle to avoid embarrassment. And even if the monolines hadn’t been facing downgrades, that sort of bad PR would also be very damaging to their product

Anon of 10:00 AM,

With all due respect, Das is a hard core derivatives geek. He is right on this one.

With Delph, the CDS written were 12 time the outstanding cash bonds. The reason the cash settlement process was developed was that there was such a scramble to acquire the bonds that they were trading at 70 cents on the dollar, an unheard-of level for a company in that sort of distress.

So if you had had to acquire the bonds, you would have gotten only 30 cents of the dollar, worse than the 36 cents on offer, and still inadequate given the liqiudation value.

The fact that the amount of CDS written is a considerably multiple of the underlying leads to distortions in the payoff process that work to the disadvantage of the buyer. And because the bonds really were trading at 70 (even though that was due to liquidity issues rather than their real economic value), there was no way an unhappy CDS holder could protest.

I’m amazed they are still as popular as they are given that outcome, but as I said, the industry has gone to some lengths to talk up Delphi as a success as comparatively few people know the details (I came across them by mere happenstance).

Securities lawyer Fred,

That’s a very good statement of the problem. I have been amazed that the regulators think they can force a breakup plan on the monolines (and I’m also surprised that Ambac is going along, although that was reported by Dinallo and may be a bit ahead of where things lie). My understanding is that they can intervene only if claims paying ability is in doubt.

MBIA is almost certain to fight them. This will prove very revealing.

Thank you Fred, that’s what I was wondering about. My summary: if CDO holders and muni holders are both ‘insureds’ in the relevant legal sense, then breaking up the monolines could keep a few lawyers busy for a fair while, and it won’t be the quick process Spitzer and Dinallo want.

Ratings – muni investors just don’t believe them any more, do they? The resulting extra funding cost will make a mess of muni budgets, whether or not there are more monoline downgrades. So there is a genuine problem to be solved, urgently.

Given the possible legal complexities, Warren B’s rather mocking reinsurance offer (or similar from anyone else with credibly deep pockets) may still be the quickest, cleanest way out of this very splendid mess. I suppose he can just wait it out.