naked capitalism

Even though the (supposed) supervising grownups in the credit default swaps market keep making reassuring noises about the credit default swaps market, I am not entirely convinced, mainly because the picture is still somewhat murky.

Witness the Bloomberg story today, which tells us that the CDS market is smaller than we thought, roughly $34 trillion in notional amount according to the DTCC versus a not-long-ago report of $62 trillion from the IMF. The Bloomberg story create the impression that the new smaller number is solely due to the netting, when other factors may have played a role. First, we have also four large settlements (Freddie, Fannie, Lehman, and WaMu). Second, my impression is that most CDS agreements run three to five years. With spreads widening massively in the credit crunch, plus certain formerly important protection writers no longer active (AIG, Ambac, MBIA, Bear) and hedge funds (another important source) less active in aggregate, one would imagine we have had some runoff, as outstanding agreements have matured and new ones have not been written in the same volume.

The part that leaves me scratching my head is this:

The collapse of Lehman Brothers Holdings Inc. contributed to a decline in financial markets last month because no one knew how many contracts were outstanding on the securities firm, or who holds them. Estimates ranged as high as $400 billion, though the actual amount turned out to be $72 billion, the DTCC said.

After subtracting redundant trades, only $5.2 billion actually changed hands, DTCC said last month, the first time it had released such information from its data warehouse.

The problem is that DTCC can only talk about DTCC settled trades, and those apparently did go smoothly. However, as Chris Whalen from Institutional Risk Analystics reported last week, some players decided not to settle through DTCC. Why? DTCC used an auction process and did not require those seeking to collect on their insurance to produce Lehman bonds. If you were reasonably well hedged, you’d presumably go through DTCC to get it over with.

However, it appears quite a few banks did not participate in the DTCC settlement (the only reason I can think of isif you were a protection writer and NOT well hedged, you’d have every reason to compel coutnerparties to produce the bond. You basically have nothing to lose. You might get more in bankruptcy (or upon sale) than the under 9% that the bonds were priced at in the auction. And if enough people like you are demanding that protection buyers produce the bonds, there would be a scramble to buy them, driving prices up, and if you got really really lucky, maybe your counterparty would find it very costly to procure the bond and would opt for a cash settlement at a much more favorable price to you. But since that appears not to have happened, perhaps a kind reader could explain why to me). And Institutional Risk Analytics contends the number who opted out was not trivial:

Of course Don Donahue is providing the straight skinny on the flow of transactions which have actually participated in the DTCC auction. But consider that other than holders of CDX and some holders of single name CDS not offended by the prospect of cash settlement, there remain a large number of total holders of CDS for Lehman who do not wish to take cash settlement and indeed are expecting to receive the underlying bonds.

Now the apparent non-event from the Lehman CDS auction is a source of media frustration. Wasn’t there supposed to be a breakdown in the CDS markets, a dramatic failure event a la Lehman Brothers? But the merchants of doom should take heart.

The bad effect of the CDS market comes not merely from when there is market dysfunction and an individual counterparty fails. That happens often enough, but the prime broker-dealers clean up the mess quietly so as not to roil the markets. Remember, the dealer already owns the counterparty’s collateral through the credit agreement, so there is no point forcing the issue with a messy and noisy bankruptcy. Right? This is why the media rarely hears of fails in CDS.

No, as with the repatriation of the Structured Investment Vehicles onto the balance sheets of C and other money center banks, the true significance of CDS comes when the markets function smoothly, as after a default event like Lehman. The trigger event putting a single name CDS contract in the money results in a liquidity-raising event for the seller of protection, who must fund the purchase of the debt at par less recovery value – whether or not the other party actually owns the debt!

This process of funding the CDS is reportedly a factor behind the high rates of dollar LIBOR in London and illustrates how cash settlement derivatives actually multiply risk without limit. Through the wonders of cash settlement, the derivative-happy squirrels at the Fed, BIS and ISDA created a liquidity-sucking monster in OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers. But remember two things: a) In some single-name CDS contracts, the buyer of protection must deliver to get paid; and b) in those contracts, where the buyer fails to deliver, the provider of protection can walk away.

We hear that there are more than a few EU banks which wrote CDS on Lehman over the past several years, CDS which were written at relatively tight spreads. These banks did not participate in the DTCC auction and instead have chosen to take delivery on the Lehman debt, forcing them to fund a nearly 100% payout on the collateral. A certain German Landesbank, for example, took delivery on $1 billion in Lehman bonds that are now worth $30 million, and had to fund same. Does this example perhaps suggest a reason why the bid side of dollar LIBOR in London has been so strong?

As one veteran CDS trader told The IRA on Friday, “It’s not that people can’t fund, it is that people have got to fund these CDS positions. These banks don’t have access to sufficient liquidity internally to fund, so they hit the London markets… The Fed and the other central banks must start to deal with the huge overhang of currently hidden funding needs from the CDS and other derivatives.” Another market observer suggests this is precisely why the Fed and other central banks have been furiously putting reciprocal currently swap lines in place.

Thus the DTCC process appeared likely to have the parties most likely to pose a problem for the CDS market, inadequately hedged protection writers, NOT participate. Thus we cannot be certain how “well” the Lehman settlement really went (meaning how large the payouts were)

In the blind man and the elephant game, DTCC probably has a sense of what most of the elephant looks like. But I get bothered when casual readers might assume it has a comprehensive view (the Bloomberg article acknowledges that indirectly by saying, “a Depository Trust & Clearing Corp. report that gives the broadest data yet”). I’d feel much better if they admitted there were gaps and reassured us that they were less than X rather than remaining silent and letting the public assume they know more than they might really know.