Credit Swaps Feedback Loops Raising Corporate Borrowing Costs

An article in Bloomberg, “Credit Swaps Thwart Fed’s Ease as Debt Costs Surge ,” focuses on a noteworthy phenomenon, but does a lousy job of explaining it. I’m posting it nevertheless in the hopes that a reader in the relevant markets might shed some light.

The story tells us that corporate borrowers, even AAA ones like General Electric, are facing borrowing costs that seem inappropriately high due to the impact of correlation models for credit default swaps, which are no longer working properly.

The article states that as CDO prices fell, banks that owned them attempted to hedge them. OK, I get that part. They then began use indices to hedge the exposures. I get that too. But apparently they were using indices on corporate bonds like the the Markit CDX North America Investment-Grade Index.

Huh? A corporate bond index to hedge exposures that are significantly if not primarily real estate related? Presumably the use of an index from a completely different asset type was used to hedge CDOs based on the famed correlation models mentioned in the article.

But guess what? Markit was founded in 2001. Any models based on its indices have so little history as to be the functional equivalent of garbage, which is what we are seeing now.

The article is also not clear how the CDS prices are distorting the price setting for new bond issues. I assume it is because price formation no longer takes place in the cash bond market but in the CDS market (that’s been true for some time for secondary trading, since a lot of corporate bond issues don’t trade very much, if at all).

From Bloomberg:

Credit trading models used by Wall Street have gone haywire, raising company borrowing costs even as Federal Reserve Chairman Ben S. Bernanke cuts interest rates.

General Electric Co. is one of five U.S. companies rated AAA by both Standard & Poor’s and Moody’s Investors Service, making its ability to repay debt unquestioned. Yet when the Fairfield, Connecticut-based firm sold 2.25 billion euros ($3.35 billion) of five-year bonds last week, its annual interest payment was $17 million higher than on a sale nine months ago.

Borrowers from investor Warren Buffett’s Berkshire Hathaway Inc. to Germany’s HeidelbergCement AG face the same predicament. Yields on $5.12 trillion of corporate bonds tracked by Merrill Lynch & Co. average 2.05 percentage points more than U.S. Treasuries, the most since at least 1997.

The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent — a mathematical impossibility, according to UBS AG.

“The credit-default swap market is completely distorting reality,” said Henner Boettcher, treasurer of HeidelbergCement in Heidelberg, Germany, the country’s biggest cement maker. “Given what these spreads imply about defaults, we should be in a deep depression, and we are not.”

The problem started in the second half of last year when subprime mortgage delinquencies started to rise, causing investors to retreat from complex instruments such as synthetic collateralized debt obligations, or packages of credit-default swaps that became hard to value. The swaps are contracts based on bonds and used to speculate on a company’s ability to repay debt.

As values of CDOs began to fall, banks that had sold swaps underlying the securities started to buy indexes based on them instead, a method of hedging their losses on portions of the CDOs they owned. The purchases are driving the cost of the contracts higher, raising the perception that company bonds tied to the swaps are suddenly riskier and leading investors to demand higher yields throughout the corporate debt market.

The Markit CDX North America Investment-Grade Index, a gauge of credit-default swaps on 125 companies from Wal-Mart Stores Inc. to Walt Disney Co., has more than doubled since the start of the year. It jumped as much as 21.5 basis points today to a record 186 basis points, according to Deutsche Bank AG. The index dropped to a low of 29 in February last year…

Banks bought more contracts on indexes containing GE’s swaps after CDO pricing models broke down, sending the so-called default correlation to more than 100 percent last month from 60 percent in July, according to research from Zurich-based UBS.

The programs, which computed the value of the highest-rated portions of CDOs, implied that all companies in the CDX index would default if just one did. Banks often hold these senior tranches after arranging the CDOs for investors.

“The banks that have been using correlation to calculate their risk will have to go back to scratch,” said Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance. “By using correlation models as the main means of risk management, the engineers threw out sound banking practices.”….

The mathematical breakdown is compounding the decline by creating a vicious circle. As the cost of the swaps on the CDX index increases, the models signal a greater risk of defaults, and vice versa. A bank holding $100 million of the highest-rated portion of a swap-based CDO now has to buy $60 million of swaps to maintain its hedge against losses, JPMorgan said. A year ago, it would have had to buy $10 million.

“The recent unwind and activity in that market is also causing activity in our name,” said GE spokesman Russell Wilkerson. Swaps linked to GE’s financing unit are included in 67 percent of European CDOs, more than any other company, according to S&P.

Before the subprime collapse, the burgeoning CDO market had the opposite effect. Increasing demand for the underlying assets helped lower U.S. corporate bond yields to 1.28 percentage points over similar-maturity government notes in February 2007, the smallest spread since 2005, indexes from New York-based Merrill show. Synthetic CDOs pool swaps, while others package loans or bonds.

“It’s the key factor that brought spreads to irresponsibly tight levels up to the end of the second quarter of last year,” said Nigel Sillis, director of fixed-income and currency research at Baring Asset Management in London. “Now we’re seeing the reverse, except that the impact is far more negative than it was ever positive.”

One way to make the models useful again is to reduce the amount banks expect to recover from defaulted bonds to 30 percent of face value from 40 percent, according to analysts at UBS and New York-based Citigroup Inc. Banks would still have to buy more default protection though, keeping the pressure on borrowers.

“The unwinding of structured credit is eating away at the fabric of the corporate bond market,” said Suki Mann, a credit strategist at Societe Generale SA in London. “The increase in credit-default swaps is making it far too expensive to borrow.”

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8 comments

  1. vlade

    Not all CDOs are MBS based (although those got most airtime in the last few months). Quite a few syntetic CDOs are based on company debt.

    A general practice was that you mapped your CDO portfolio onto ITRAX/CDX in some way (say if you had only 5 different entities, you could say that the correlation was almost like ITRAX with some small mods…)

    The problem is more with model in general, and that the correlation is a very opaque and vague thing, even more so than volatility.
    You can track vol of an option on company’s stock, maybe even for years. You can’t track their default correlation by definition – because if you’re interested in it, they haven’t defaulted yet. In a way credit market correlation has the ultimate survivorship bias.

    Also, the correlation in the models is simplified so that instead of tracking say a matrix of 125×125 correlations you track only a single “super correlation” (base correlation). Of course, by doing so you loose information, and as a result can get very strange outcomes.
    When Ford/GM were downgraded few years ago, it was the first time the correlation models broke (the implied correlation from the model was nonsensical) and people had to fix them in a hurry. Of course, this debacle was later presented as the victory for the model, with people saying it has survived its big test. Yeah, right, said I.

    Of course, even if the model worked as proposed, hardly anyone was paying attention the the risk profile of the model, which was off-the-cliff. That is, you have virtually no risk for a long period of time/stress, but when it goes to the extreme right, the value just falls of the cliff. Which is exactly what happened.

  2. vlade

    On the CDS spreads distorting price: well, that should be pretty clear.
    If I can seel a CDS on a AAA entity such as GE with 150bp spread on 5 years, I’d be a fool to buy a 5 year GE bond which pays only 100bp over treasury.
    I could short the 5Y bond, buy a govvie and sell the 5Y protection and pocket nice 50bp with no risk (except for cpty one, but in this case I’m the one selling protection so it’s less of a worry).

  3. Yves Smith

    vlade,

    Thanks. One point I should have clarified is that the increased hedging (according to the article) was driven by worries about CDO price declines. That presumably would have been most acute in CDOs with some or a lot of real estate exposure.

  4. Noel

    I’m glad I wasn’t the only one that thought the article was badly written.

    wrt to credit risk being too high, there was a similar story with BAA recently

    http://www.noelwatson.com/blog/PermaLink,guid,f5c355be-b7ad-4e93-96b1-4dee8b737444.aspx

    I believe the CDOs they are talking about here are the CDX index tranches. In Europe the equivalent is the ITRAXX Europe. People tend to buy the index rather than the underlying constituents when buying credit protection as there is more liquidity (CPDO unwinds are rumoured to be doing this). This drives the index wider and the underlying single names drift wider as the arbitrage disappears. Looking at historical default rates the indices appear oversold – but there could be trouble ahead.
    The article mentions correltion over 100%. I assume a Gaussian model is being used – this doesn’t accurately reflect the credit markets (fat tails). There may be better models – Levy for example

    http://www.noelwatson.com/blog/PermaLink,guid,136d4b18-8d46-4687-8a83-0ef2f97ab805.aspx

  5. Anonymous

    “Huh? A corporate bond index to hedge exposures that are significantly if not primarily real estate related?”

    CDO of ABS => hedge with ABX, CDO of corporate debt => hedge with CDX/iTraxx.

    Regarding the paucity of data for CDS indices, single name CDS have been traded since, what, the mid-90s? Presumably some dealers have much more historical data than, say, Markit does.

  6. Yves Smith

    Anon of 8:52 AM,

    The article did not indicate that there has been price pressure in CDOs of corporate debt. Indeed, until the comments on this piece, I’ve never seen any mention of CDOs composed solely of corporate debt.

    There hasn’t been all that much corporate bond issuance, and there is good demand for investment grade names. Why would you need to bundle it into a CDO? I can see leveraged loans, but I was under the impression they mainly went into CLOs.

    Nevertheless, the media has made clear that CDOs are very heterogeneous, so a CDO could clearly contain some corporate debt exposure.

    While the CDS market started in the mid 1990s, volumes didn’t become significant till around 2003. And this is an OTC market. The only data a dealer would have in the absence of being able to buy data from a service is its own trades. Hardly representative in a not-deeply-traded market, particularly if the traders’ pricing was influenced by a need to change the shape of their book.

  7. Yves Smith

    Anon of 11:28 AM,

    I’m not saying it’s not highly liquid now, or that you can’t get plenty of data now. The data question came up regarding the integrity of information prior to 2001.

    8:52 AM said the dealers would have the information, which appears to be confirmation that there isn’t much older third party data. Having worked more than once with data in OTC markets, I can tell you the dealers’ own trade information (when the market isn’t deep enough to have good third party reporting) often isn’t very satisfactory.

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