I hate it when I get contradictory information from supposedly reliable sources, which happens upon occasion when the topic is CDS.
The latest Institutional Risk Analytics newsletter is again after one of its favorite objects of ire, credit default swaps. One of its beefs is that the collateral posting rules are a joke. Key excerpts:
The under-collateralized wagers that are CDS contracts threaten the solvency of financial institutions around the globe, this despite the efforts to reform the system via enhanced clearing mechanisms, increased collateral and margin requirements……
But alas, one of Wall Street’s dirty secrets is that most of the CDS dealer banks don’t post margin with one another at all! If CDS dealer banks were actually compelled to post real, effective collateral with other dealers to back performance, then the entire CDS market would collapse. Indeed, that is what is happening right now, in slow motion. As leverage in the global banking system is being forced down, the CDS market is being squeezed out of existence by a market that can no longer ignore the inherent contradictions in these OTC options…
the op-risk issues with CDS are as nothing compared to the pricing and funding problems with these contracts. In that sense, the focus on back office problems facing CDS and indeed all OTC derivatives has been a canard, a distraction from the real issue, namely the bankrupt intellectual basis for the CDS contracts themselves….
What Geithner and Fed Chairman Ben Bernanke failed to tell the Congress, President-elect Barack Obama and the American people is that CDS dealers don’t post any effective collateral at all with other dealers. So much for the legal requirements for safety and soundness in 12 CFR. If Barack Obama and the Congress ever needed a final reason to strip the Fed of all regulatory responsibility for financial institutions, the coming nuclear winter of CDS unwind is it…..
You see, in the make believe world of interdealer CDS, when a “margin call” occurs, no cash or securities actually change hands. Instead the CDS dealers merely shuffle some paper around and effectively rely on the overall credit standing of the other banks, much as they do in foreign exchange or money market transactions. And virtually none of these dealers even attempt to model the actual default risk in CDS!.
Mind you, this is from a guy who sells a very high end research product to top tier institutional investors and knows the regulatory scene well.
However, this left us a little perplexed, since we had understood that the reason the Lehman CDS settlement went well was that the counterparties had to post margin when Lehman BK’d, so the stress event was before-hand (hence all the ugly market action in October due to the need to sell something in order to post margin). And we recall seeing a great chart that showed CDS collateral calls to hedge funds, and they shot up in October.
So this undermines IRA, no? Not exactly. It appears that hedge funds are kept on a short leash, at least when on the protection writing side, and are subject to pretty tough collateral posting rules:
…..margining for hedge funds tends to be somewhat more stringent. They typically post collateral at 100% of their current exposure, and furthermore might also be asked to post collateral to cover close-out risk on their contracts for a certain number of days going forward. The estimation of forward exposure is done through forecasting future scenarios.
But this factoid does not prove or disprove the IRA contention, it merely says that hedge funds who write CDS do indeed pony up quickly. Moreover, the ISDA does everything it can to burnish the image of the CDS market, so like the National Association of Realtors’ comments, you need to read their comments about the market with a fistful of salt.
And to give you an idea of the general utility of information about CDS, I found this old post: “Barclays: Counterparty Risk in Credit Default Swaps Only $36 to $47 Billion.” AIG disproved that estimate.