Credit Derivatives, Moral Hazard and Systemic Risk

"The derivatives tail is not simply wagging the dog -- but walking it around the block." (Gillian Tett, Financial Times) Financial regulators have begun to speak out publicly and at a rising volume about the risks of complex structured transactions. Such demonstrations from Washington are usually a sign that there is trouble brewing in the bowels of the financial system, especially with the democrats back in control of the Congress.

Fortunately, a growing number of market observers seem to understand that adding derivatives to a mix that includes excessive debt increases the overall risk to the financial system. Just about every credit professional we hear from says that there's a mounting problem in the world of OTC derivatives and structured assets. Many believe that as these problems become more obvious, credit spreads will widen over the course of 2007.

Last year we suggested that the explosive growth in credit derivatives and collateralized debt instruments is not only putting downward pressure on credit spreads, but lowering credit quality for the financial system as a whole. Our August 21, 2006 IRA comment, Wag the Swap, reported that rising equity market valuations and the growing number of LBO deals were being driven by derivatives issuance -- even as the underlying credit fundamentals of many large cap companies were deteriorating.

The spectacle of high and even medium quality public companies going private at multiples to pre-deal earnings and/or cash flow that make no economic sense, should be cause for concern. But when there are still many negative basis trades available in the CDS market, who's to say what is sensible? As a colleague opined over a dinner table in London many years ago, financial markets are not about economics, but rather the "yield to commission."

The web site www.dailyreckoning.com describes the current situation succinctly: "Private equity is not just an accident waiting to happen. Its more like financial joyriding. The enthusiastic drivers are new to the game, but have turbocharged their returns with high-octane debt. They don't know whether an economic downturn is around the corner, but it wont take much of one to send them skidding into disaster..."

The high octane additive driving the debt and equity markets higher, of course, is the OTC derivative. In the age of derivatives-enabled structured finance, the term "private equity" has become passé. Nearly every financial buyer deal we see coming to market involves a large degree of debt finance, regardless of the type of sponsor. Looking at the staggering numbers for public and private bond issuance in 2006, measured in the trillions of dollars, it seems clear to us, at least, that OTC derivatives and kindred structures like collateralized debt obligations [CDO] are driving a process whereby assets are being packaged and sold at prices that understate the true economic risk.

Despite clear evidence that the derivatives world is be driven over the precipice by powerful speculative forces, many risk professionals, managers and regulators pretend that a valid relationship exists between the quoted rate on credit default swap [CDS] contracts and the underlying credit worthiness of the obligor. But just as Merton models are used to imply the probability of default or "PD" of an obligor using equity market prices -- that is, a popularity contest -- the quoted rates on CDS are nothing more than a reflection of the short-term market view of a given issuer or asset category. The same forces which drove credit and CDS spreads to all time lows in 2006, thereby enabling the use of debt to replace equity in a growing number of cases, also under-price the credit risk premiums of many issuers.

In addition to the question of understated risk premiums comes the issue of liquidity. Given the collapse of credit spreads, it may no longer be prudent to assume that CDS contracts priced at current levels will be liquid as and when the credit derivative bubble bursts. The hedge fund which is long CDS protection may depend, indirectly, upon another hedge fund to perform on that guarantee. As the Amaranth episode proves, hedge funds live or die based on access to credit. Maintaining "confidence" in counterparties is absolutely required for the game to continue, but the assumption that the counterparties can and will have access to credit and thus perform on CDS contracts once spreads move significantly may not be reasonable.

Hedge funds, lest we forget, have neither minimum capital requirements like a bank nor statutory reserves like a reinsurer, thus the assumption of performance on a CDS obligation held by a hedge fund requires a degree of faith which may be unreasonable. The stability of the entire credit derivatives marketplace rests on the notion that a hedge fund with a CDS obligation will somehow have access to sufficient liquidity to perform, a dubious hope since the spreads on most names quoted in CDS are too tight to support a PD that makes economic sense.

Even were every CDS commitment backed by well-capitalized banks and insurers, and not hedge funds, in many cases there still would not be enough profit in these trades to make the commitment truly worth the obligor's while. And yet hedge funds and other investors cannot seem to get enough of these deals, perhaps because of the attractiveness of booking the premium income to boost current performance. Below are two hypothetical scenarios we offer for the consideration of our readers to illustrate some of these issues of risk premium and liquidity.

Act I: A CDS Trade Goes Bust

Writing CDS cover on the major US automakers has been a significant source of income for hedge funds for several years, in large part because these names have not defaulted. While many auto parts makers such as Delphi have failed, so far the automakers themselves have not been forced to file for bankruptcy protection. But consider what could happen should one of the Big Three auto manufacturers actually default and hedge funds which have been booking premium income on CDS trades and using leverage to finance same actually be called upon to perform.

Hedge Fund A is long shares of Ford Motor Co (F) at an average of $7 per share. F is a name we've written about in the past and one of the most liquid and heavily traded names in CDS. (Note: IRA principal Christopher Whalen is a long-time F shareholder.) Hedge Fund A buys $5 million notional amount of CDS contracts from Prime Broker to hedge the equity market risk, which is financed via borrowing from Prime Broker.

Prime Broker then buys CDS protection from another client, Hedge Fund B, in order to hedge its exposure to Hedge Fund A. Price of the deal to Hedge Fund A is 550bp per year for five years, but the dealer manages to make a profit, paying just 530bp to sell the CDS exposure to Hedge Fund B, this after F rallies a few weeks later. Hedge Fund A's CRO rates the trade as "low risk" due to the CDS protection, as does the CRO of Prime Broker.

Note that the PD implied by the 550bp CDS spread for F is around 5% or below a 1:20 chance of default in the next five years. We must confess that a PD of well below 10% for F seems a tad aggressive. For the record, we'd be sellers above a PD of 35%. The table below shows the asset quality profile for F compared with GM (GM) and Toyota (TM) from the IRA Corporate Monitor's Basel II Obligor Rating Tool using year-end data from 2005 as well as CDS spreads for each name. Note that the test results for F and GM probably will look a good bit worse when the full-year 2006 data is available.

A year goes by in our hypothetical scenario. It's January 2008 and F has run out of money and time. Bankruptcy looms, both for F and for those few suppliers which have not already gone through the restructuring meat grinder. Five-year CDS for F trades at over 1,800bp (about where F was in early 2006), but only in small size, $1-2 million.

Hedge Fund A has sold its equity stake in F at $3 per share, locking in a 60% loss on the cash leg of the trade. But when it tries to sell its apparently very profitable CDS position back to Prime Broker, the bid for the full $5 million face amount is only 700bp. Why? Because of the size and also because the market in F CDS is now completely illiquid. Thus whereas Hedge Fund A thought it had a low-risk, profitable trade in place with respect to F, in fact the fund takes a net loss on the F transaction.

Meanwhile, Prime Broker discovers that its CDS trade with Hedge Fund B is in trouble. Why? Because Hedge Fund B's principals have been falsifying their collateral disclosure and the fund's credit standing in the Street has slid into the dumper. Calls to Hedge Fund B are not returned. Eventually, Hedge Fund B goes bust and files Chapter 11. Prime Broker engages legal counsel and files a claim in the bankruptcy.

Hedge Fund B, sad to say, wrote too many CDS contracts at too low a spread, almost all of them via Prime Broker. More important, instead of putting aside premium income as a reserve to back the CDS obligation to Prime Broker (and others), Hedge Fund B simply took the premiums as current income to bolster its performance. When called upon to perform on these guarantees, Hedge Fund B lacked the financial reserves to make good on its commitments. Several of Hedge Fund B's key employees leave to start a new hedge fund.

Since CDS contracts are not exchange traded or fungible, both Hedge Fund A and Prime Broker eat a loss on both sides of the supposedly "riskless" F transactions. While the loss is not big enough to immediately kill Hedge Fund A or Prime Broker, the reputational damage is considerable. Hedge Fund A quickly sees its access to credit disappear and soon files Chapter 11 as well, creating a financial sinkhole that begins to pull drag down other funds and even the Prime Broker. Again, the Amaranth example comes to mind. The Federal Reserve Bank of New York calls a meeting with the derivatives dealer community to discuss the situation.

Act II: The CDO Trade & Mark to Model

Now let's look at another hypothetical scenario involving a CDO. This story comes to us care of a very well-placed friend in Washington. Imagine that the Prime Broker in our first example owns a $50 million position in a CDO deal which contains commercial real estate loans backed by newly constructed condominiums in the Washington DC area. That market is now awash in unsold condo units, so much so that many of the developers have been forced to convert the condo units into rental properties -- not a good sign.

Due to the tightness of credit spreads and the insatiable demand for structured assets, the first traunche of the CDO was originally priced at just 10bp over the curve, in large part because of a credit derivative wrapper from Hedge Fund A and a "AAA" rating from a major ratings agency. This paper was once viewed as being "risk free" by the Prime Broker's CRO, but with anecdotal reports of a bust in commercial real estate bubble appearing in the newspaper, Prime Broker finally decides to kick the paper out and take its loss now rather than risk going through an actual default.

The chief CDO trader of the Prime Broker starts to make calls around the market, looking for potential interest in the paper. She fully expects to get a bid in the 75-80 range, but is astounded when the chief trader at Hedge Fund C, which participated in the CDO deal when it first came to market, shows an indicative bid of 105, above the original issue price of the CDO. After a brief conversation, the Prime Broker sells the $50 million position in the CDO to Hedge Fund C at 103.50, booking a profit on the position instead of a loss.

Now why, you might ask, did the trader at Hedge Fund C pay up for paper that, by any rational measure, should be trading at a steep discount, sub-investment grade in fact? Because with the combination of the credit derivative enhancement and the blessing of the ratings agency, the trader is able to continue the pretence that the paper is investment grade, even though the deterioration in the value of the underlying collateral calls this into question. In fact, since many CDOs are illiquid and trade infrequently, by bidding up for the paper from the dealer, Hedge Fund C can actually report a profit and satisfy the new fair value requirements of FAS 157 for the entire position!

Whether you are talking about the CDS spread for F or a basket of loans in a CDO structure, the reality is that the extremely tight credit spreads visible in the marketplace today are not reason for joy but rather blazing red flags. Periods when CDS spreads have actually gone negative basis, where the collateral trades through the credit derivative spread, are not an indication of market health, but rather a grim sign that the financial markets have collectively gone insane and that prices no longer have any rational relationship to the underlying risks.

Disclosure: Author owns position in the above-mentioned stocks.