Tuesday, February 19, 2008

Clear your mind of questions

Its time to play ask the internet, because I honestly don't know the answer to this. With FGIC looking to break in two, and Ambac probably thinking the same, there is a question about what happens to their CDS. In other words, if we have a "good bank/bad bank" resolution, what happens to those who have bought protection against the whole bank?

Now I have not personally combed through a CDS contract, but I've got to think there are provisions for what happens in the event of various corporate actions. I mean, its not unheard of for companies to sell-off units so there has to be some established way of dealing with this. My guess it would depend on what the reference item is. My understanding is that under CDS contracts, an "event of default" is defined as the reference item defaulting. So if you have a CDS contract on Ambac, and the reference item is Ambac's 9.375 bonds due 8/1/11, the contract comes into force if that particular bond defaults.

If I'm right about that, it stands to reason that how the CDS would be treated given a split of Ambac depends on what happens to the reference items. I don't happen to know what the common reference item is for MBIA, FGIC or Ambac's well-traded CDS contracts. I also know there is a market for CDS on the insurance sub of these three companies. I have no idea what those reference items might be.

But if anyone out there (CDS Trader, I'm looking at you) knows the answers to any of these questions, please enlighten the group.

16 comments:

Anonymous said...

Monoline CDS Face Succession



Credit-default swaps on monolines that choose to split their businesses in half will face a succession event, causing a significant re-pricing of the contracts.



Both Financial Guaranty Insurance Company and Ambac announced tentative plans last week to split their municipal bond business from their structured finance business.

Lawyers said if the plans go through, CDS on the names should tighten significantly because CDS would probably reference only the municipal division, which would hold a stronger credit rating. If 75% or more of financial-guaranteed obligations are transferred to a new division, then the original reference entity would be deleted entirely and replaced with the new muni-based division.



Succession is generally based on the transfer of debt and not assets which would make it more likely the companies would transfer the majority of insured debt to the muni side, as muni insurance makes up the bulk of their business.



There is also a small possibility that CDS will be split down the middle with half referencing the old entity and half referencing the new one. If between 25% and 75% of financial-guaranteed obligations are transferred to a new division, then existing CDS contracts would split 50/50 notional between the original entity and the new entity. A USD10 million notional contract referencing MBIA would split into two contracts of USD5 million notional each, one referencing the municipals division and one referencing the structured finance division. A lawyer on Friday said that he did not believe that was likely, however.



CDS on FGIC tightened about six basis points from 1141 bps to 1135 bps between Friday and Tuesday while Ambac remained unchanged at 468 bps.

Anonymous said...

I am not sure what lawyer you are referring to but it is definitely not clear as to how succession will work on either the AA or AAA ref entities.
The way monoline spreads shifted today was much more driven by shorts-covering than by a solid sentiment on the outcome (i.e. if the Muni-based good bank gets all the debt then spreads should be in at around 50-100bps - massively tighter).
On a generally light volume day, with unwinds and rehdging programs pushing indices wider in spreads, the monolines rally was nothing if not uncertain. For my $0.02 worth, I suspect that between the regulators, investors, and banks there will be some work out along the lines of the 50-50 succession-based split and in that case we will see net spreads wider (as bad bank will be very bad - compare to RESCAP at 2600bps ish).
This is definitely one for the lawyers to devour and handicapping this is pretty tough as I suspect that there will be some serious litigation coming from the holders of the wraps (based on the entire entity behind them) when the split happens and there is not much behind the bad bank...
I don't expect any short-term resolution here and if there is then there will likely be a lot of pain if the succession shifts CDS all to the Muni business (protection sellers would get hosed and probably would lead to some forced unwinds on margin calls). Watch out Ackman if so as we all know he has a short position in CDS (unless he unwound it today).
Wow that went longer than I though t when I started...

Anonymous said...

You are both correct. The succession rules are well explained by the first comment and the market's reaction is better described by the latter.

The tricky thing is picking what deliverables are in fact deliverable under each contract and which will be transferred to each entity. An important point is that it is all about the debt and not the assets - the CDS follows the debt (following the 25-75% rule described).

I tend to agree with the latter comments as today's moves in monolines were 50-60bps tighter in the AAAs and 100bps or so tighter in the AAs which feels more like uncertainty and covering rather than conviction on the eventual outcome.

For now, its a handicappers nightmare and I am staying away.

Josh said...

On the existing bonds, how do they decide which entity assumes the debt?

cak said...

How would overseas committments be handled? Ambac insures UK, European public and private debt - utilities, etc?

the cds trader said...

actually i am no expert on the monoline CDS...I'd have to go do some work to learn the dets.

on a bigger picture theme, can any company just walk away from debt it doesn't want? take a regular corporate, can it just decide to split in two, and stick the debt into one company to die, and stick all the other assets into a company that will keep operating? if not, why can the monolines do this?

and if I had bought protection on some sh*tty CDO and then found out that actually I don't have the full strength of the insurance company behind me any more, I'd be sueing the "good" new company to get paid out. surely that would be an easy case to win?

sorry for all the questions but no answers.

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Anonymous said...

This is a very noobish question, but when the more experienced among us quote CDS spreads, like the first commenters statement "CDS on FGIC tightened about 6 bps" - where do you get those quotes? I have access to Bloomberg and can look up FGIC, then see an option to look at "Par CDS spreads" - but it then asks me for contributor sourcing, user-defined spreads, etc... I also noticed there appears to be varying maturities of CDS (FGIC shows 6m to 10y) - can someone direct me to the "standard" way to look at CDS spreads on Bloomberg? Sorry if this is lowering the bar for this blog a bit - just trying to keep up!

Accrued Interest said...

On how CDS work... try this: http://tinyurl.com/28kqfk

On FGIC specifically, Bloomberg doesn't quote their CDS spreads. I think they only really do public companies.

PNL4LYFE said...

To answer AI's question regarding reference obligations, I believe monolines will be subject to the same type of auction process that happens for normal companies when there is an event of default. Rather than physical settlement, holders can participate in an auction where the market sets the expected recovery rate. Exisiting CDS contracts are then torn up and cash settled based on that price. There was an auction of this type on Monday for IQWCN. See www.creditfixings.com for details.

PNL4LYFE said...

One other thing that's worth pointing out is the difference between opco and holdco CDS. ABK and MBI have active CDS on both. The opco (AAA insurance subsidiary) is the AAA entity while the holding companies are AA. Historically, the AAA subsidiary pays dividends to the holdco out of premiums it receives. Currently, AAA subsudiary CDS is trading around 380 and holdco CDS is around 800.

The entity that matters to policyholders is the AAA subsidiary. This is the one that will be split or bailed out or whatever ends up happening. The holdco exists only to receive dividends from the AAA sub and pay them out to it's equity shareholders. Ackman is involved in holdco CDS in the hopes that any bailout will save the insurance subsidiary and it's policyholders but will not save equityholders/creditors of the holding company.

Anonymous said...

So, I'm assuming CDS is not a product Joe Schmoe (i.e., me) can purchase on the open market? I mean, I have brokers I can go to if I want to buy stocks, bonds, funds, commodities, forex, etc... - but I've never seen CDS offered anywhere. Am I not looking under the right rocks, or is this something that is simply out of reach of the individual investor? It seems like a great tool to have as an option, and I'm hoping there is a way for the informed little guy to participate.

the cds trader said...

anonyomous #5 (guys it would really help if you used a name of some sort...), the only decent way to get CDS prices is to be involved directly in the credit markets, and get live prices from a dealer (ie. Goldman/JP/Lehman/MS etc etc)...if you don't have that, and it's something liquid, i recommend using the 5y point that Bloomberg provides in the section you were describing. the 5y is where most trades happen, and if someone describes a spread without specifying maturity, you can be pretty sure it is the 5y.

anonymous #6, correct, "Joe Schmoe" cannot participate in CDS (there was a push from Eurex to get CDS listed as futures, but it never took off as OTC is much simpler). CDS basically needs 2 market counterparties to enter into a mutliple-year (5y is common) contract, so both counterparties need to be comfortable taking credit risk to each other, and generally have collateral lines in place. So retail investors don't get a look in. You can trade corporate bonds as a proxy (if they exist in the same form as CDS). There are some differences, especially in distressed situations, but essentially both CDS and corporate bonds allow you to get long or short credit risk (although I guess a retail investor would struggle to short bonds).

Personally, I think the trade of the moment is to be long credit spreads and short equities, credit has priced in a ton of risk, yet equities haven't done much. Credit spreads implying recession/defaults, equities still seem overly concerned about inflation and also are overly optimistic on future earnings, IMHO.

the cds trader said...

oh and pln4lyfe, you didn't actually answer AI's question...he had asked what would happen to the CDS if the company split up, you answered more generally about using the auction process to settle a defaulted CDS contract. To do that in this case though, you need to know the reference entity/obligation that follows from a split of the companies. Just fyi (and I don't know the answer myself just yet).

Anonymous said...

ISDA has indicated that there would prob not be an auction to determine the price for delivery given the wide range of bonds that are deliverable.

Apolitical said...

Accrued, Citi had a note on CDS succession in one of their research reports a week or two ago in structured credit strategy. According to them it's a succession event under ISDA. I don't have it but your sales coverage at Citi could probably grab it for you.