Rakesh Saxena

Netting Derivatives: Slippery Slope Marred by Opaqueness

Dear oapoki: FYI I have been working with ISDA contracts for a very long time, and have reviewed hundreds of such contracts when closing derivative transaction, though I am not a lawyer by profession. If you have read any of these contracts with precision you will realize the point I am making: that where the shift in the fundamental nature of the contract towards "insurance driven" coverage did not fully capture the risks involved and the counterparty risk. I am not suggesting that such contracts should be abandoned. - Rakesh


On Mar 07 09:00 AM oapoki wrote:

> It is sad to see you guys commenting on these, admittedly complex
> issues, with no idea what you are talking about.
>
> Has any of view taken a look at an ISDA contract? Has any view used
> an ISDA contract in practices? Has any of view wlaked through the
> process of netting in a bankruptcy?
>
> I would simply state that "action talks and BS walks". It is not
> accidental the the derivatives industry has grown to these levels
> - they add value because they enables participants to hedge risks
> - even if people misuse thes einstruments (like everything else).
> In the absence of the ISDA agreement, with its associated actual
> netting (not imagined as the author contends) benefits (as we have
> seen in the case of Lehman), we would have chaos.
>
> ISDA contacts have proven to be extremely robust in the face of extreme
> conditions, and I hate to see what would have happened intheir absence.
>
>
> So be acreful what you are wishing for!

Financial Company Default Risk

Good summary by Bespoke. But, Crocodilian, you have a valid point, which the regulators must clarify immediately before talking about a central clearing house. How "central" are these CDS contracts? What the variation levels in their contract terms? Many thanks - Rakesh


On Jan 10 07:33 PM Crocodilian wrote:

> Thanks for this. I've been interested in the precise terms of the
> CDS contracts-- and what precisely constitutes a default. We've had
> any number of complex transactions, and these companies often have
> a holding company/operating subsidiary structure.
>
> I've yet to see any discussion about the particulars of WaMu, for
> instance, were the operating subsidiary was purchased by JPM/Chase,
> but the holding company (and its debt) were left outstanding.
>
> In cases like these, or like Bear Stearns, I assume that the CDS
> is not triggered -- but that would depend on the specific language
> of these. In starting to read up on these intruments, there's a remarkable
> opacity and complexity to them, along with room for disagreement
> . . . "credit events" are determined by a "calculation agent", usually
> a third party.
>
> But grounds for disagreement and litigation are many, and there's
> no reason to believe that these instruments will speedily resolve.
> Here's a description of a recent litigation:
>
> "The court first examined whether a credit event had
> occurred. Citibank argued that a particular credit event applicable
> under the contract—an “Implied Write- down”—had occurred because
> the securities held by the Millstone CDO (which had issued the Class
> B notes) had decreased in value. VCG argued that the Implied Writedown
> provision only applied if there was a writedown in the Class B Notes
> themselves, regardless whether there was a decrease in the value
> of the securities in the Millstone CDO. After analyzing the CDS contract
> and the indenture for the Millstone CDO, the court concluded that
> the Implied Writedown provision referred to collateralized assets
> held by the CDO and not to the notes issued by the CDO. Accordingly,
> the court found that Citibank’s determination that a credit event
> had occurred in the form of an Implied Writedown was proper and that
> Citibank was entitled to judgment on the pleadings on that issue."
>
>
> (from "Manhattan Federal Court Enforces ‘Clear’ Terms of Credit Default
> Swap Contract on Pillsburylaw.com website)
>
> The point of all this is that not only are the amounts of outstanding
> CDS contracts huge, but their terms are not necessarily crystal clear
> . . . imagine if you had to litigate to effect settlement of your
> options trades!

Netting Derivatives: Slippery Slope Marred by Opaqueness

Dar rc whalen: Good point re getting rid of traditional ISDA contract formats in favour of insurance-driven documentation. Many thanks- Rakesh


On Jan 07 03:15 PM rc whalen wrote:

> Good comment. The last several graphs are especially important. I
> still do not think people appreciate how entirely screwed up CDS
> contracts are as an insurance/barrier option type offering. In plain
> vanilla, single name CDS, we are pricing the obligation to fund par
> less recovery on a corporate bond default, but we price this risk
> vs. short-term spreads and volatility!!!
>
> Then there is the correlation problem. Unlike ship sinkings and earthquakes,
> traditional low-beta insurance risks uncorrelated to the economy/markets
> (and, indeed, were a hedge to the economy/markets!!!!), CDS is high
> beta and thus cannot really be hedged. Even a very broad portfolio
> of such risks will still go to hell in a severe downturn such as
> we see today. CDS does not manage risk, it creates risk in vast amounts
> in order to generate commission income for the CDS dealer community.
>
>
> That is why I believe that clearing is not really the issue when
> it comes to "fixing" CDS. I think we need to abandon the ISDA model,
> which was copied from the IR/FX template, and look at more traditional
> insurance type models and capital/collateral levels before CDS or
> its successor make sense and thus gain investor support

Netting Derivatives: Slippery Slope Marred by Opaqueness

Dear monday1929: I am in the process of assessing the "even if" scenario you talk about. But, whichever way you look at it, the potential losses are staggering indeed. Many thanks - Rakesh


On Jan 07 02:13 PM monday1929 wrote:

> Even if the liars (banks) were acidentally telling the truth here,
> and assuming all counterpaties will make good (an absurd assumption),
> that may leave about 3 trillion in losses for JPM, Citi ie. the U.S.
> taxpayer.