naked capitalism

David Murphy says:

IRS, like many commentators, has a prejudice against the CDS market I fear, and it isn’t going to let the facts get in the way of a good panic. The vast majority of inter-dealer CDS are done under ISDA masters that cover all derivatives dealing between the counterparties, so net margin is posted on the entire portfolio of equity, credit, interest rate and commodity derivatives between the counterparties. Typically this is done daily with low thresholds (so that if the net exposure is greater than, say, $20M, collateral is posted). Dealers also control their potential future credit exposure (how much money they might be owed if there is a move in the market) using limits based on simulations.

The only issue that does arise here is that CDS can (do not always but _can_) jump in value on default. The margin process works well if there is a slow slide to default with the credit spread widening. It works less well, obviously, if you get a point default from a tightish spread, as in Parmalat. Given where spreads are right now, there aren’t many credits this applies to at the moment…

Anonymous says:

they don’t have to post collateral or on margin, they are net zero anyway?

i find it surpising they “don’t” have to post collateral, and would be more willing to accept that they are “not asked” to post collateral, witness “NYmag’s” article on Lehmans. At some point, Jamie Dimon asks them to “post collateral” to open the doors another day, presumably some assessment of CDS risk is covered under that blanket margin call?

vlade says:

David Murphy has described it well. Pretty much everyone has collateral agreements (or CSAs, Credit Support Annex to the ISDA agreement), and they definitely tend to cover CDSes (although they can be not included, as it’s an enumerative document, and you need to state explicitly what is covered).
The few cpties that don’t tend to post collateral at all, are AAA rated parties, but there’s generally a clause where the party has to start posting (in one huge jump) should they be downgraded.

vlade says:

Slightly different but importnat point on this: CSA’s have no set way of valuing a contract (and I can’t remember whether there’s an arbitrage clause in the ISDA), so it’s not uncommon that you get an argument about the value of the collateral posted. More so these days, with the market being dislocated.
Even vanilla IR swaps can have significant different valuations if using different yield curves. So, it’s not like a plain margin call where the amount is indisputable.

vlade says:

@Bena re valuations:
That worked sort of ok when the times were good. Now I’m seeing quite a few arguments over valuations on even vanilla IR swaps (that’s why I mentioned it). To simplify, the value of IR swap depends on how you do your curves. Last year has blown some people’s assumption from the water (say assuming minuscule basis on different tenors), and so can come with valuation hugely different from other people – even though both of them are using their tried-and-tested methodology. And I ommit trvialities like how you interpolate on the curves, what you include in the short end of the curve, how and whether you overlap etc. etc. (these tend to drive much smaller differences than the basis blowout).

Loudocracy says:

I think the confusion here is due to the failure to distinguish between initial margin and mark-to-market margin.

What happens when a hedge fund sells a CDS is that they have to post initial margin with the dealer, perhaps 15%, to account for the hedge fund’s theoretical lack of relative creditworthiness. When a dealer sells a CDS to a hedge fund, they do not post the equivalent initial margin.

(When you buy a CDS you do not have to post initial margin, generally, since you only owe premium and if you don’t pay then you don’t get the benefit of the payout if a credit event happens).

Once the trade is on, both parties post margin to each other to account for the change in value of the CDS on a daily basis; this is the mark-to-market margin.

So it is perhaps true to say that dealers don’t post margin on the initial risk transaction, but do on the variation movements.

In the Lehman case, there was a very big change in the value of the CDS after the bankruptcy. This amount was margined because it was a change in the mark-to-market. Normally you don’t see such big fluctuations in the value of a CDS so in a plain vanilla case where there is less risk of bankruptcy there is less margin but there is also less exposure.

Anonymous says:

If banks don’t require margining of CDS contracts that’s news to me. I feel like an idiot for posting collateral every morning when they call for it. For every contract there is an initial haircut, used to be as low as 1% of the notional but is much higher now. Plus 100% of the current exposure of course. These indeed are updated every day by every counterparty. People used to be lackadaisical about margin but I guarantee every credit officer who wants to keep his job is watching their margin requirements like a hawk. Call it early and often is the new manta.

ndk says:

But a friend is arguing that the supply is way down as foreign banks are going under.

A lot of shops selling vol and insurance have been under, shall we say, mild stress recently. The governments have decided to backstop to every financial firm in the world while running 10% of GDP deficits. Chicken, egg, who knows, but I tend to blame the chicken.

ccm says:

David Murphy: The vast majority of inter-dealer CDS are done under ISDA masters that cover all derivatives dealing between the counterparties, so net margin is posted on the entire portfolio of equity, credit, interest rate and commodity derivatives between the counterparties.

If you read the whole of the IRA’s post, you will find that this is precisely the situation that the IRA is worried about. There are two problems:

(i) posting collateral on the net portfolio obligation in no way guarantees that an institution has the liquidity to cover obligations on a specific default. We need to remember that CDS values “jump” by design — i.e. the actual event of default is all but guaranteed to precipitate a large change in value. While the market handled Lehman well, the market could not possibly have had more warning signs of that default — Lehman’s problems had been leading the business section of the news for months.

(ii) Given the valuation problems for even plain vanilla derivatives right now (see vlade), how is it within anyone’s imagination that the net margin posted as per ISDA protocols is meaningful? The ISDA is getting a good bite in the butt from it’s implicit reliance on the efficient markets theory.

Every single major collapse was precipitated by interdealer margin calls: Bear, Lehman, AIG. And we probably just haven’t heard about Citi yet. While the press hasn’t connected these margin calls with CDS (except in the case of AIG) and the ISDA agreement probably prevents the margin calls from being attributed to any specific type of derivative, I think the IRA is just reading the writing on the wall.

Anonymous says:

The plot with collateral thickens as each bank (as previously stated) has “netting” agreements by legal entity across all products with their counterparties. Hence 5 long and 5 short = 0 w/ counterparty a. Key issues that have historically muddied the water beyond confirmation delays have been the ability to “novate” positions away from conterparty a without counterparty a’s knowledge hence 5 – 5 does not equal zero. Further muddying the water is the fact that most IB’s look at their portfolios using a very high level aggregate risk analysis that also nets longs/shorts …. the old saying ” clever by half” is really the more appropriate way of looking at many of these transactions. For Wall Street Banks these products have been a tremendous fee generator without any of the balance sheet funding implications (i.e, capital funding or regulatory capital). Forget expecting collateral to compensate for the scale and madness of these products. The real pain of these products lies in their “Heisenberg-like” qualities … on equity prices and overall firm stability. Naughty, naughty, naughty.

Mike S … NJ Earth

jmd says:

CDS are not the problem…nor is portfolio-margining…the problem is that the desks taking on risks have had no effective controls from their rah-rah credit officers and risk managers for the past 5+ years.