CDS = WFMD, An Example Case

I've been catching up to my reading and came across an incredible story in FT which makes a prima facie case for the very strict regulation of credit default swaps. Here's the gist of it:

As the financial crisis virus has swept around the globe in recent months, Kazakhstan’s banking sector has been engulfed in turmoil. This is not just creating a headache for the Kazakh government and Western creditors, but also highlighting issues about the credit derivatives market that extend well beyond those far-flung steppes.

Take the case of Morgan Stanley’s dealings with BTA, Kazakhstan’s largest bank. A few years ago, BTA – like many of its Eastern brethren – was an up-and-coming darling of the capital markets world, with investment bankers furiously competing to float its bonds, provide loans, and much else.

But earlier this year, when funding dried up for Kazakh banks, BTA fell under the control of the government. Initially BTA wanted to keep servicing its loans, and its creditors, such as Morgan Stanley, appeared happy to play along.

But last week Morgan Stanley and another bank suddenly demanded repayment. BTA was unable to comply, and thus tipped into partial default. That sparked fury among some other creditors, and shocked some Kazakhs, who wondered why Morgan Stanley would have taken an action that seemed likely to create losses.

One clue to the US bank’s motives, though, can be seen on the official website of the International Swaps and Derivatives Association. One page reveals that just after calling in the loan, Morgan Stanley also asked ISDA to start formal proceedings to settle credit default swaps contracts written on BTA.

For it transpires that while the US bank has a loan to BTA it also has a big CDS position on BTA, that pays out if – and only if – the Kazakh bank goes into default. Indeed, some of Morgan Stanley’s rivals suspect that notwithstanding its loan, Morgan Stanley is actually net short the Kazakh bank.

As a result speculation is rife that Morgan might have deliberately provoked the default of BTA to profit on its CDS, since a default makes the US bank a net winner, not a loser as logic might suggest.

Morgan Stanley, for its part, refuses to comment on this speculation (although its officials note that the bank does not generally take active “short” positions in its clients.) And I personally have no way of knowing whether Morgan is short or long, since Morgan refuses to disclose details of its CDS holding.

What is crystal clear is that somebody has been placing big bets on whether or not the banking equivalent of Borat will blow up. Right now more than $700m BTA CDS contracts are registered with the Depositary Trust & Clearing Corp in New York. Last year the BTA CDS contract was so liquid that banks and hedge funds were trading it as a proxy for Kazakh governent debt.

Therein lies the crucial reason why the world outside Kazakhstan should note what has happened to BTA. In some respects, the fact that BTA has spawned so much CDS activity has been rather good for Kazakhstan. After all, if banks such as Morgan Stanley had not been able to hedge their positions in recent years, they might never have provided finance on such a scale to BTA - or any other emerging market banks.

Or, to put it another way, if CDS contracts did not exist, Western banks such as Morgan Stanley would now be nursing big losses at BTA, rather than ending up flat (or even making a profit.)

But the rub for regulators and investors is that BTA credit risk has not entirely disappeared: somebody right now is holding the other side of Morgan Stanley’s contracts and unfortunately there is little way for outsiders to know exactly who.

Worse, the presence of those CDS contracts makes it fiendishly hard to work out what the true incentives of any creditors are. In theory, lenders should have an interest in avoiding default. In practice, CDS players do not. The credit world has become a hall of mirrors, where nothing is necessarily as it seems.

At best, this makes it very difficult to tell how corporate defaults will affect banks; at worst, it creates the risk of needless value destruction as creditors tip companies into default. Either way, the key point to grasp is that this is not just a Kazakh tale.

After all, investment banks and hedge funds have written vast volumes of CDS contracts on western names too. And while the corporate default rate has been low in recent years, it is rising fast.

What is playing out at BTA, in other words, is merely a foretaste of what awaits part of the Western corporate scene too. Call it, if you like, the new face of financial globalisation, albeit one that is unlikely to look quite as funny as those Borat jokes, as companies and investors finally wake up to the implications of this deceptive new credit world.

What was the notional value of derivatives worldwide, $600 trillion?

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Outstanding column/post

And what you described above sounds eerily familiar (Lehman Bros., WaMu, General Growth Properties, Inc., Chrysler bankruptcy, Bear Stearns (I seem to recall some involvement of Goldman Sachs, JP Morgan and Deutsche Bank with that one?). And one wonders how many of those hedge funds were interlocked, or owned, perhaps outright, by the banks which signed on to the Chrysler rescue plan which fell through (Goldman Sachs, JP Morgan, Morgan Stanley, perhaps??).

And did Cerberus (private equity owner of Chrysler) also profit from their CDS position? And who would profit from any CFO (Collateralized Fund Obligations) Cerberus might have with regard to Chrysler?

Time for another AIG infusion/bailout???

At some point, with so much

At some point, with so much interconnectedness among the funds and banking institutions, doesn't a line need to be drawn? It's incestuous, to be sure. Bankruptcy aimed at escaping excessive cumbersome debt ultimately ends up screwing the taxpayers, who bailed out some of these creditors. Where does the insanity stop?

just a note on posts

We cannot post entire articles that are subject to copyright. We can quote them and link to them (acknowledge the publication, author, give a link so people can read the original article).

What I try to do is capture that quote which either gives an overview of what the article is about or a quote which is the key piece of info, then link over information on the topic that has been previously written on EP or elsewhere, plus whatever insights (or lack thereof) of it.

Same is true with any media. If there is embedding code, linking code it's fair game, else there might be some copyright restrictions from the content producers/owners that they want.

The real problem with the Internets and sharing to this day is how revenue streams are not bound to the original content....i.e. if someone lifts an author's work, there are no ads attached to it so they can get paid.

correction, quote a paragraph or two from them

We can quote a few paragraphs from someone else's copy protected writing, just not the entire thing.

Paul Craig Roberts' excellent remarks on this subject

Paul Craig Roberts published an outstanding article on this in some time back where he made this excellent point:

"Credit default swaps are a form of unregulated insurance. One danger of the swaps is that they allow speculators to purchase protection against a company defaulting on its bonds, without the speculators having to own the company’s bonds. Speculators can then short the company’s stock, driving down its price and raising questions about the viability of the company’s bonds. This raises the value of the speculators’ swaps which can be sold to holders of the company’s bonds. By ruining a company’s prospects, the speculators make money."

Yes, they can't lose for winning!

The naked CDS's are the root of all evil. They are essentially a very high stakes poker game which essentially amounts to financial extortion through the use of arbitrage. I'm pretty sure the regulators understand this but it will take some prosecutions to bring the practice into the light of day. Maybe Cuomo's investigation will get there. If not, let's hope some European regulator has the guts to expose it. Certainly, this article will reverberate in the EU.

A crazy idea

As everyone may or may not know, the move to a regulated exchange-based CDS market is happening. Now I had a crazy idea, what I propose is a simple three part regulation regarding future Credit Default Swap trading.

1) Allow only a certain type of institution to sell swaps, a new type of financial insurance company of sorts or primary dealers. These companies would meed stringent requirements, like the performance bonds one sees for regulated commodities, where they must have the collateral to back up the claims. They can sell them in a secondary market of qualified purchasers, even in strips, so long as those buyers are able to back up a future claim and are recorded via a clearing house mechanism (this would help in avoiding the "who owns what?" scenario).

2) Any purchasers of CDSes cannot short sell the equity of the company who's debt is linked with those swaps. Also, and maybe this may or may not be an extreme idea, make it a crime akin to insider trading to purposely cause a company to default on their loans to trigger a payout.

3) For those not in the primary dealer circle, say investors who wish to purchase an exchange traded CDS, they must meed the same performance bond requirements. Indeed, perhaps their should be income/asset requirments to get involved in CDS trading. At one time, you had to have a high networth to really invest in the spot currency market, like George Soros, today anyone can.

you might write this up as a blog post

as well as what is happening with regulation generally. I haven't been watching the latest and when it comes to every single derivative, I think you could educate us....

I have a real serious issue with CDSes because they are almost a short and also because they are traded daily, one can kind of "cash in" when one finds out there is a potential default happening on the underlying asset...I mean could it create an incentive to cause a default?

i.e. I'm Hank Paulson and I think Lehman Brothers CEO is an asshat because he jerked my chain 10 years ago...therefore I am going to create this major CDS buy on their MBS and also leak it to the press or ....
(can that create that kind of rumor panic with an actual underlying asset, another unknown, but you get the idea)

I mean if you do your major "new financial insurance company" type deal, what's their incentive and what's really the feature here that regular insurance can't do...
or should there even be insurance here, is this like Blackjack or removing the risk from speculation or ?

Then, my other very serious issue with CDSes is they are not linear, 1:1, bounded, correlated to the underlying assets per say.

At minimum they should be seriously decoupled from any sort of CDO or tranche evaluation.

You can tell me why I'm wrong on this but if I had all of my conditions, they would plain disappear and we would have good old fashioned insurance really.

Just another example of how

Just another example of how corrupt private financial interests hurt U.S. foreign policy. And, another reason why Obama needs to help develop a system that lets us speak with one tongue.