Credit Default Swap Worries Go Mainstream

Those of us who have an eye for trouble have been nattering about the credit default swaps market from time to time. This $46 trillion unregulated market has suddenly captured the imagination after AIG reported in an 8-K filing that it had certain weaknesses in its internal controls and that the value of its credit defaults swaps had fallen in October and November by $4.88 billion, and oh, by the way, they still haven’t figured out December. Their previously reported loss estimate on CDS was a mere $1 billion.

Now AIG has a big balance sheet, so even though this is painful and embarrassing, they’ll be able to absorb the damage (unless December turns out to have been a black hole). But if a company heretofore regarded as savvy could get it that wrong, who else might be in trouble?

This article by Gretchen Morgenson in the New York Times, “Arcane Market Is Next to Face Big Credit Test,” gives a reasonably good overview of the credit default swaps market, although we quibble with some of its emphasis and views.

One assumption that undergirds the piece is that the event that will test this market is increased corporate defaults. We disagree. Counterparty risk will emerge as a problem long before we see a rise in companies in financial extremis.

CDS are only as good as the party the wrote the guarantee. Monoline insurers, followed by hedge funds, were the big protection writers. Yet the role of the bond insurers is not mentioned once in this article (the article cited data on the activity of banks, who are only one of many types of participants in this market). Merrill Lynch has already taken $3.1 billion in writedowns due to financial guarantor counterparty risk on CDS.

Now what makes this situation really hairy is that the amount of CDS outstanding is a very big multiple of the underlying credits on which they are written (I’ve seen estimates as high as 12 times; the Morgenson article suggests a level more like 8 times). Aside from speculation, one of the reasons the CDS volume is so high is that some of the CDS are entered into to hedge other CDS positions.

Now follow the bouncing ball: a financial player that has written guarantees gets into serious trouble. Suddenly everyone realized any CDS written by that institution are probably not worth much. That means positions they thought were hedged aren’t.

That will lead to a cascading series of events: firms may take losses, try to unwind CDS, etc. But if one counterparty is at risk, the last thing anyone is likely to want to do is expose themselves further, since everyone will be panicked that other seeminlgy solid players will be revealed to be wanting (remember how commercial banks were reluctant to lend to each other in the interbank market for similar reasons?) So trading may well become difficult precisely at the time when some parties need to Do Something Now. Thus the ability to undo or offset any mess that arises will probably be compromised, making those efforts costly.

A second issue is that the article implies that back office problems are a recent development. In fact, operational issues have plagued the market almost from the get-go. These derivatives are processed manually, and as the article mentions, difficulties often result when trades are assigned to third parties, which are often accompanied by faxes or spreadsheets from the trading floors. Dealers have been promising to improve their operations, but the results seem slow in coming.

Third is that the article fails to mention that the cash settlement method has resulted in the CDS hedges not working properly. This fact is not well advertised; market participants like to point to the performance of CDS in the few recent bankruptcies as a vindication of the market. As a recent Financial Times article by Satayjit Das explained:

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement)….

Shortage of deliverable items and practical restrictions on settling CDS contracts have forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement (based on the market price of defaulted bonds) for physical delivery. In Delphi, the protocol resulted in a settlement price of 63.38 per cent (the market estimate of recovery by the lender). The protection buyer received 36.62 per cent (100 per cent – 63.38 per cent) or $3.662m per $10m CDS contract. Fitch Ratings assigned a recovery rating to Delphi’s senior unsecured obligation equating to a 0-10 per cent recovery band – far below the price established through the protocol. The buyer of protection may have potentially received a payment on its hedge below its actual losses – effectively it would not have been fully hedged.

From the New York Times:

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.

It is entirely possible that this market can withstand a big jump in corporate defaults, if it comes. But an inkling of trouble emerged in a recent report from the Office of the Comptroller of the Currency, a federal banking regulator. It warned that a significant increase in trading in swaps during the third quarter of last year “put a strain on processing systems” used by banks to handle these trades and make sure they match up.

And last week, the American International Group said that it had incorrectly valued some of the swaps it had written and that sharp declines in some of these instruments had translated to $3.6 billion more in losses than the company had previously estimated. Its stock dropped 12 percent on the news but edged up in the days after.

A.I.G. says it expects to file its year-end financial statements on time by the end of this month with appropriate valuations.

Placing accurate values on these contracts is just one of the uncertainties facing the big banks, insurance companies and hedge funds that create and trade these instruments.

In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.

But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.

As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.

“This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.”

Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.

In late 2005, at the urging of the Federal Reserve Bank of New York, market participants agreed to advise their trading partners in a swap when they assigned contracts to others. But it is unclear how closely participants adhere to this practice.

It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim.

Credit default swaps were invented by major banks in the mid-1990s as a way to offset risk in their lending or bond portfolios. At the outset, each contract was different, volume in the market was small and participants knew whom they were dealing with.

Years of a healthy economy and few corporate defaults led many banks to write more credit insurance, finding it a low-risk way to earn income because failures were few. Speculators have also flooded into the credit insurance market recently because these securities make it easier to bet on the health of a company than using corporate bonds.

Both factors have resulted in a market of credit swaps that now far exceeds the face value of corporate bonds underlying it. Commercial banks are among the biggest participants — at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter.

JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.

But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.

The market’s popularity raises the possibility that undercapitalized participants could have trouble paying their obligations.

“The theme had been that derivatives are an instrument that helps diversify risk and stabilize risk-taking,” said Henry Kaufman, the economist at Henry Kaufman & Company in New York and an authority on the ways of Wall Street. “My own view of that has always been highly questionable — those instruments also encourage significant risk-taking and looking at risk modestly rather than incisively.”

Officials at the International Swaps and Derivatives Association, a trade group, say they are confident that the market will stand up, even under stress.

“During the volatility we have seen in the last eight months, credit default swaps continue to trade, unlike other parts of the credit market that have shut down,” said Robert G. Pickel, chief executive of the association. “Even if we have a series of credit events at the same time, we have the processes in place to enable the market to deliver.”

Such credit problems have been rare recently. The default rate among high-yield junk bonds fell to 0.9 percent in December, a record low.

But financial history is rife with examples of market breakdowns that followed the creation of complex securities. Financial innovation often gets ahead of the mechanics necessary to track trades or regulators’ ability to monitor the market for safety and soundness.

The market for default insurance, like the subprime mortgage securities market, is a product of good economic times and has boomed in recent years. In 2000, $900 billion of credit insurance contracts changed hands. Since then, the face value of the contracts outstanding has doubled every year as new contracts have been written. In the first six months of 2007, the figure rose 75 percent; the market now dwarfs the value of United States Treasuries outstanding.

Roughly one-third of the credit default swaps provided insurance against a default by a specific corporate debt issuer in 2006, according to the British Bankers’ Association. Around 30 percent of the contracts were written against indexes representing baskets of debt from numerous issuers.

But 16 percent were created to protect holders of collateralized debt obligations, complex pools of bonds that have recently experienced problems because of mortgage holdings.

There is no exchange where these insurance contracts trade, and their prices are not reported to the public. Because of this, institutions typically value them based on computer models rather than prices set by the market.

Neither are the participants overseen by regulators verifying that the parties to the transactions can meet their obligations.

The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks’ books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.

Investors are already reeling from the recognition that major banks inaccurately estimated losses from the mortgage debacle. If further write-downs emerge as a result of hedges that did not work, investor confidence could take another dive.

To be sure, the $45 trillion in credit default swaps is not an exact reflection of what would be lost or won if all the underlying securities defaulted. That figure is impossible to pinpoint since the amounts that are recovered in default situations vary.

But one of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against.

To the uninitiated trying to understand this complex market, its size might initially seem a comfort, as if there were far more insurance covering the bonds than could ever be needed. But because each contract must be settled between buyer and seller if a default occurs, this imbalance can present a problem.

Typically, settling the agreements has required the delivery of defaulted bonds if the insurance buyer wants to be fully covered. If the insurance contracts exceed the bonds that are available for delivery, problems arise.

For example, when Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company’s debt exceeded the value of underlying bonds tenfold. Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt.

Market participants worked out an auction system where settlements of Delphi contracts could be made even if the bonds could not be physically delivered. This arrangement was done at just over 36 cents on the dollar; so buyers of protection on Delphi who did not have the bonds received $366.25 for every $1,000 in coverage they had bought. Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond.

That is why the valuation of these contracts is of such concern to some participants.

As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in.

“The insurance business is very difficult to quantify risk in,” said Mr. Farrell of Annaly Capital Management. “You have to really read the contract to make sure you are covered. That is going to be the test of the market this year. As defaults kick in and as these events unfold, you are going to find out who has managed this well.”

And who hasn’t.

Print Friendly, PDF & Email


  1. Dr. Housing Bubble

    Great article. Reminds me of Ambac with an approximate market cap of $1 billion yet probably has insured $100 billion of dangerous debt. Insurance is written on $5.7 trillion of underlying assets while the CDS market hovers in the $40+ trillion range? Now that is what I call maximum leverage.

  2. Anonymous

    I’m confused. Das’s article says “Some 60-70 per cent of ultimate CDS protection sellers are financial guarantors (monoline insurers) and hedge funds”. Elsewhere one reads that monolines ‘insured’ CDOs. What form does monoline-originated CDO default protection actually take, then? Do the monolines write insurance on CDOs, or sell CDS? From a risk point of view these two activities may be very similar, but from a legal and regulatory point of view they aren’t the same at all. If the monolines actually protect CDOs via CDS (unregulated), rather than via insurance (the regulated business of monolines), what are the rights of holders of monoline-guaranteed CDOs when a monoline is broken up?

  3. Anonymous

    It would be interesting to see more explanation on the difference between monoline insurance and regular CDS. As I understand it, there is an important issue as to how defaults are settled over time. CDS effectively pays the net marked to market, but monolines pay the replacement cash flow over time, which greatly alleviates up front settlement costs. This must be an important factor in assessing overall systemic risk.

  4. Anonymous

    Seems like the totality of CDS and monoline insurance is 0 sum in one sense. But the critical systemic risk must be the deviant distribution of the sum across individual positions. The biggest exposures would seem to be those with large net liability positions (mostly the monolines) and those with large gross asset positions (i.e. ‘book runners’ like hedge funds and banks who have hedged their CDS sales with purchases, but with large gross counterparty exposure on purchases.)

  5. Anonymous

    The FT article quoted gives an inaccurate picture of CDS contracts: “The buyer of protection may have potentially received a payment on its hedge below its actual losses – effectively it would not have been fully hedged”. The buyer of protection can always opt for physical delivery where they will receive $1,000 for every $1,000 of bond notional delivered. An existing bond position can always be accuratelt hedged with CDS contracts. The high receovery rates determing by the protocols can, however, reduce the profitability of using CDS contracts as speculative shorts.

  6. Anonymous

    “…To be sure, the $45 trillion in credit default swaps is not an exact reflection of what would be lost or won if all the underlying securities defaulted. That figure is impossible to pinpoint since the amounts that are recovered in default situations vary…” Wouldn’t the total loss be equal to A(amount of default by the issuer/borrower of the original underlying security that is being hedged) plus B(fees charged by genius middlemen on the original transaction and all subsequent hedging transactions related to the original instrument)?

  7. Anonymous

    NY Times article: “These instruments [CDSs] can be sold, on either end of the contract, by the insurer or the insured. […] Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold. As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.”

    Really?? It’s hard enough to manage counterparty risk if you’re uneasy about skeletons in your counterparty’s closet… but it’s outright impossible if you have no way to even find out who your counterparty is.

    Say you bought an automobile insurance policy from Warren Buffett, but two years ago he sold it to the North Korean State Cabbage Planning Commission and never bothered to tell you… are there truly no restrictions on transfer?

  8. Anonymous

    from a securities lawyer:

    disclaimer: i do securities and bankruptcies but state insurance regulation can be very weird and is not my practice area.

    there are interesting issues i think should be addressed directly and at length.

    assume a state regulator is charged with the responsibility of protecting the insureds. certainly a receiver would have the fiduciary duty to do so.

    first: says who any or all of these are insureds to begin with. if bank X went to monoline Y and entered into a CDS where X would pay Y 15bps annually on a notional amount $Z representing some CDO tranche in return for Y paying X any losses absorbed by the tranche represented by $Z, says who that is legally a policy of insurance and that X is an insured? Do you think that every CDS is a policy of insurance (it had better not be, or a whole lot of people have liability for unlicensed insurance operations). If it’s not a contract of insurance then X is an unsecured creditor of Y and should come behind policyholders.

    But there’s a far more interesting question:

    Look at the muni “assurances” and assume for now that they are policies of insurance.

    They are insuring the policyholder for the benefit of the beneficiary the timely payment of interest and principal (I assume).

    They are not insuring the policyholder that the market will assign any particular ratings quality to them (the monoline).

    We have here what mathematicians call an ill-conditioned problem.

    A small change in something produces huge (highly nonlinear) changes in something else.

    If the ratings of the monoline got lowered from AAA to A+, and concomitantly all the muni bonds insured thereby with native ratings below AA- thus had to get dumped by their holders and the world looks like its coming to an end, exactly how is that an impairment of the monoline or its claims-paying ability or liquidity or cash flows, per se?

    If (and presumably at A+ this would be the case) it were overwhelmingly likely that in runoff the monoline could service its foreseeable claims, then exactly what is the basis for receivership or any other state-imposed remedy?

    Realize, it’s not the worry that the monolines will not be able to pay their claims that’s precipitating this, it’s the worry that third parties – remember that, it’s third parties who hold the munis, like funds and individuals and insurance companies – who have relied on a certain fourth-party rating (the rating agency) are being inconvenienced.

    If my water utility issued a bond with an implicit rating of A- and insured it with MBIA and life insurance company Q now has $100M of it on their books and if MBIA is downrated to A+ then Q has to increase its reserves by, say, $20M, exactly how does that implicate MBIA, which again has guaranteed only to make good missed interest or principal payments, not to itself be rated at any particular level?

    And obviously, if you argue that it would make it hard for new muni issuers to come to market because they couldn’t sell their paper, particularly given the presence of Buffett who is a real AAA, don’t you find it Alice in Wonderland to argue that current policyholders (assuming the CDO stuff is an insurance policyholder) get screwed for the sake of future policyholders (those putative future muni issuers) who don’t even exist yet?

    Bizarre…this purports not to be to protect the claims paying ability but rather the financial rating of a monoline, and to sacrifice what (if they are) are current policyholders for the benefit of future ones.

    Just nuts.


  9. Anonymous

    (I’m the first Anonymous above, the confused one)…

    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.

  10. Yves Smith

    Sorry to be late to this discussion, let me add a couple of points that may help….

    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.

  11. Anonymous

    “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.”

    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).

  12. foesskewered

    AnonFebruary 17, 2008 7:43 PM

    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.

  13. Yves Smith

    The issue is that with a credit downgrade, the hedge is considered to be less secure and therefore worth less. In the case of a negative basis trade, the banks used monoline insurance as a hedge, which enabled them to accelerate the profits over the life of the trade into the current period. As I understand it, for those trades in particular will have to be revalued (ie, the acceleration of profits reversed) if the insurance is no longer AAA.

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

  14. Yves Smith


    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).

  15. foesskewered

    Yves, frankly, the guy sounds as if he’s preparing for a legal battle and is merely mouthing the “safe” words that the legal counsel has advised. When things get ugly, what really matters is enforceability and pragmatism, whatever the clauses. Such talk should have sent all counterparties straight to emergency legal consult. what do you think?

  16. Yves Smith

    Yes, I agree. I’ve never seen a video of Dunton, but the quotes I’ve read in news stories and that letter to the regulators (the rebuttal to Ackman) came off as arrogant and defensive. You don’t take that tone with people who have power over you.

    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.

  17. Anonymous


    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.

  18. Dimitri Raziev

    Current Problems in CDS

    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.

    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.

    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
    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.

Comments are closed.