Tuesday, October 21, 2008

CDS could be fair and simple

On Friday, Jim Cramer lamented that a fair credit-default swap clearinghouse will be difficult to implement. But I'd argue that a simplified version of CDS could be easily created and listed on existing exchanges. (Click here for the basics of how CDS work...)

The first thing that's needed is homogenization. Currently CDS are liquid so long as there remains 5-years to termination. But as soon as a contract rolls to "off the run" liquidity disappears. That's a major reason why CDS contracts have ballooned to over $60 trillion in notional outstanding. No one actually terminates the contracts, they just buy offsetting contracts.

In addition, CDS are currently struck with various initial spreads. So one person might own Morgan Stanley CDS with a deal spread of 100bps, and someone else with 200bps, and another at 300bps. This also lends itself to illiquidity and poor price transparency.

Then there is the problem of defaults. When an issue defaults, the buyer of protection may deliver a bond to the seller of protection in exchange for par. Except when there are large-scale defaults, like in the case of Lehman or the GSEs, actual delivery of bonds is impractical. So they hold an auction to determine a theoretical value for all outstanding bonds, and that amount of cash is exchanged between sellers and buyers of CDS protection. The problem is that whole process creates a huge degree of uncertainty, and only lends to the feeling that CDS are too easily gamed.

But CDS wouldn't be hard to boil down to a very basic tradable contract. First you set all contracts with a 5% coupon paid quarterly. Second, the contracts have 5-year maturities, with new contracts created each year. Third, in the event of default, the seller of the contract pays the buyer 60 cents on the dollar. No actual bonds change hands. That's it.

The contract would trade based on the present value of the 5% coupons vs. the expected default probability of the referenced company. This may result in either the buyer or seller of protection making an initial cash payment to the other party. For those familiar with the vulgarities of CDS, it would be similar to how up-front contracts work now, except that it could cut both ways.

For example, take a relatively low risk company, say Johnson & Johnson. Let's say that you estimate the proper default spread given J&J's default risk is 0.6%. Since the contract stipulates a 5% annualized payment, the recipient of the 5% coupon (seller of protection)must make an initial payment to the buyer of protection. The opposite would be true for higher-risk companies, like General Motors or MBIA.

Perhaps the best part of this is that a simplier product could be more widely adopted. Sellers of protection would have a defined set of gain/loss scenarios if held to maturity. Currently CDS trade only among large institutions, but wider distribution would certainly improve liquidity and price transparency.

And contracts of this sort could be implemented by exchanges tomorrow. And we wouldn't need some massive new regulatory scheme for CDS. Just simplify the contracts and put it all on an exchange, and all kinds of problems just float away.

Now yes, we want to start winding down the massive number of CDS contracts outstanding, if for no other reason than to eliminate the systemic risk. That's easy enough. Tell banks that any non-exchange traded CDS contract has an additional risk weighting to account for counter-party risk. Banks will immediately start pairing off their CDS exposure and looking to replace it in the exchange-traded market. That would go a very long way to reducing current CDS notional outstanding in a very short period of time.

It can be done. Let's see if anyone actually wants to solve this problem or not.


1EKbbKENtczzW5A9QbbxTB4TZCOY said...

These are excellent ideas!

Moving CDS trading to an exchange has many many benefits.

Reducing the counterparty risk: Exchange trading of CDS would reduce the counterparty risk significantly. The risk traded through CDS is a tiny fraction of the huge notionals mentioned because the market participants use offsetting contracts rather than terminatining them. However, this fact would be clear to everyone only when we move CDS trading to an exchange so that outstanding contracts can be netted.

Transparency: Having CDS traded in exchange, all trades can be traced and monitored by regulators. It would also be very easy to know each participants exposure.

Liquidity: Homogeneous CDS proposed above would be more liquid than the current quarterly CDS. This would reduce the liquidity premium charged and as a result, the price discovery would be easier. This would be good for all investors.

rallip2 said...

I have been trying to understand the Lehman CDS settlement: a financial company that is leveraged 30 times can get into trouble very quickly, but the speed should surely also limit the loss severity: A loss of 4 times the capital of the firm would still leave 26/30 of the total debt being repaid, though of course senior and secured creditors would do better than unsecured.
This October, no-one can know when or how much Lehman bonds will eventually pay out as a result of the wind up proceedings. If it turns out that some bonds pay say 30 cents on the dollar, can the sellers of CDS protection revisit the recent settlement of under 10 cents? Or would it be the case that those who hold onto their bonds get 90 cents CDS settlement PLUS 30 cents liquidation dividend?

kristof said...

This starts looking a lot like intrade. They've been having troubles getting their tail distributions working right, I'm not sure whether it's an issue with the fee structure, not enough volume, or something wrong with their interest-rate model.

David Merkel said...

AI -- this could work. I've been a skeptic on this, but it is worth a try.

That said, perhaps we could experiment by moving interest rate swaps to an exchange first. They are far more generic.


Don said...

"Just simplify the contracts and put it all on an exchange, and all kinds of problems just float away."

Wouldn't this lessen the risk and possible reward and make the investment too bland. I'm assuming that there are a myriad of investments a person could make, and, if in the case of CDS's they have not been simplified and clarified, it's because it would hinder the possible returns, making them less desirable.

In other words, by taming them, are you taking away their reason for existing.

Information Arbitrage said...

i think putting a straw man out there is great. if the precise suggestions you make aren't perfect, the concept is spot on. i have been clamoring for moving cds to exchanges, and simplification is obviously a necessary part of the shift. one of the commenters suggested starting with vanilla swaps and then migrating to more complex products. i think this is a good idea, but i'm not sure it is a precondition for establishing an exchange-based cds contract. really good post. thanks. roger

dolores said...

Perhaps it is possible but it may be the vanilla trades are tiered on custom trades that function as tax and regulatory "arbitrage" with both parties preferring privacy.
Always have found bond insurance rather curious as the risk ought be priced in the instrument. Why would bond investors give up return to CDS and priority in bankruptcy to CDS counterparties with netting capability?
End result is CDS make vanilla bond investing very unattractive.

asterix said...

funnily enough i was interested in doing something similar a couple of years ago after delphi and ahead of dana and there was broad resistance because dealers feel they are in the business of warehousing this risk in a 'sophisticated manner' (i.e thats what i get paid for) and too many credit hedgers have problems classifying this structure as a hedge because of the recovery rate risk. I agree with fixing the recovery at 50 though or at zero (as this would solve the hedger's problem though; again there is another argument the moment you suggest levels for recovery to IG vs HY traders. I would also suggest one maturity a year as opposed to semi/quarterly rolls. Creating liquidity focal points again to enhance transparency and efficiency. Interest rates are very different from credit swaps and thats why there really isnt as much urgency to create a clearing exchange.

jck said...

What you are proposing is a binary CDS, there is no market for this because it has no value as a hedging vehicle. But if you want to be hero, something similar (with a zero coupon) already exists and has been listed on the CBOE for over a year with total volume of zilch.

Amicus said...

What was Jim's argument? Is he worried that it would be too much transparency for hedge funds?

In your example, if I own a bond and would like to hedge, what do I do for the risk that a recovery is below 40% (60% payout).

asterix said...

jck writes "What you are proposing is a binary CDS, there is no market for this because it has no value as a hedging vehicle."

jck raises an interesting point that i hear often but do not understand, and yet it is this flip attitude that prevents us from making changes that we need. To say there is no value in binary cds as a hedging vehicle is nonsense; there may be no hedging treatment from a regulatory pov but that is a different argument. You are clearly able to hedge your risk to the extent you are able to determine what you think the recovery rate should be. There is recovery risk clearly, but that is no different from the recovery risk traders take all the time trading cds; the only difference is that this time one accepts as opposed to ignores it upon initiation of the trade. Every cds trade has an implicit or explicit recovery rate assumption attached - just because no one mentions it does not mean its not there. Dealers and their counterparties both have an incentive to declare this upfront or fix the level. The problem is that like most trades, people would rather ignore the risks they are taking.. esp if its just easier to ignore. With regard to the CBOE effort there has been a consistent effort to undermine this one by dealers. Heaven forbid there be an accurate market and they are forced to admit their folly in warehousing this risk.

Accrued Interest said...

The $40 recovery is what the CDX assumes. So I take exception to those that say the $40 ruins the hedging aspect of CDS, because if that's true, then the CDX is worthless as well.

And besides, CDS only paid you the recovery value immediately after default, not the ultimate recovery which could be wildly different. For example, I know WaMu's CDS are going to be settled in the next couple days. There remains considerable debate about certain assets held at the holding company, which may pass down to the bank (i.e. the FDIC) or be passed on to senior bond holders. So the WaMu ultimate recovery will almost certainly be considerably different than where bonds are currently trading.

So to claim that the CDS hedged the ultimate recovery is BS.


Jim C. was saying that the regulators would likely f' up the creation of a central clearing house. I was countering that you can create a relatively simple contract that any exchange could go ahead and set up right now.

The only thing we need from regulators, and this is really important, is that banks are given a capital/accounting incentive to use exchange-traded CDS over private CDS.

PNL4LYFE said...

Fixed recovery CDS is far from useless, but it is inferior to floating recovery CDS. While the indices assume 40, they aren't truly hedges in the same sense that single name is. If I own a bond and buy protection on it, I need the recovery to be floating for the hedge to work. AI is correct that the ultimate recovery value of the bonds may not be the same as the auction settlement price, but that is beside the point. By participating in the auction and electing to physically settle, I can guarantee that the I will be made whole. In this case the hedge works perfectly. If you elect to cash settle the CDS in the auction and hold on to your bonds, it breaks down because you are taking a view that eventual recovery will be higher than that in the auction. But that does not mean the auction can't work for true hedgers.

Asterix, single name CDS does not necessarily have an implied recovery rate. The only time you need to assume one is when you are unwinding an old trade, and this variable can also be negotiated as part of the unwind price (although 40 is by far the most common assumption).

asterix said...

ahh a response. 40 is the assumed recovery because no one can be bothered to take the time to actually figure out what the recovery should be. Its a moving target; so we all agree on 40 so that you will just keep trading, oh and then when things blow up we'll start debating what the recovery should be on that unwind or on all those positions warehoused via market making. You have to recognize the risk dealers are inherently taking trading a position assuming it has 40 recovery only to find out the recovery is 80. It would simpler and safer for dealers to fix the recovery, and easier for clients so that they dont have to negotiate the recovery rate on unwind. I guarantee you when you really need it, the recovery is no longer 40. My point in any case is that the dirty spread traded is a combination of two important inputs (recovery and prob of def) and fixing one or seperating the two factors would actually create more transparency and provide clearer information.
If you are simply hitting me on word choice - 'implied recovery rate' - there clearly is an implicit assumption of recovery rate when trading; you are clearly making the assumption that it will be 40. Like I said there is little to suggest that it will be 40 when you need it unless you are trading index. Index trading is actually pretty similar to what accint is suggesting since the coupon and recovery are essentially fixed and upfront are exchanged on the initiation of a trade. Now if only we could do this for everything else and the market would be more liquid

PNL4LYFE said...

My point was that the purpose of index trading is very different from single name. Indices are good for taking a macro view, making an imperfect hedge when the appropriate single name is unavailable, or if you want a highly liquid short-term trading vehicle. A lot of single name CDS is put on as a long term hedge for a specific position. Fundamentally, I don't buy the argument that a product should be altered just to make life easier for market makers. Any improvement in liquidity would be offset by the fact that the product no longer meets the needs of a large number of clients.

There is already a recovery swap market in some of the larger CDS names such as the autos, but it has largely disappeared since all those credits trade points up front. For what it's worth, I don't trade that much volume in CDS, but over the last year, there have been several unwinds I've done with lower recovery and/or non-flat curves. It never made nearly as big a difference as the off-market strike.

Amicus said...

AI, thanks for your reply.

Here is, perhaps, another way to frame your proposal.

The contract(s) that you propose would probably be useful to the speculators in credit, not to the hedgers, right?

What's more, an exchange format is probably more conducive to protecting speculators anyway, despite what they may give up in terms of *complete* anonymity.

Thinking aloud, the regulatory incentive for exchange trading might be to give favorable hedge-accounting for CDS. Unhedged positions, whatever those conceptually amount to anyway, would be forced to an exchange or face capital requirements assessed at the *peak* credit exposure of the instrument or something.

Still, there is no getting around the theoretical difficulties with these instruments, *maybe*.

For instance, what do the exchanges currently propose would be the margining requirements for a single-name CDS? An ABS CDS? An index-referenced CDS?

What's more, in the event of multiple, simultaneous defaults or rapidly sequential defaults, what are the margining requirements? Is it a just-in-time capital approach, like the one we have now that appears to be creating a vicious cycle of induced downgrades, leading to capital / collateral needs precisely at the time when those things are the hardest to come by?

Anyway, may the force be with you.

shittingalpha said...

Amicus: margining for something like this shouldn't be significantly more complex than for naked short puts on equities

Accrued Interest said...

I agree with Alpha. Naked stock option margining is far more complicated than the CDS product I'm describing.

On the value of this thing as a hedge... the alternative may be that there is no CDS market at all. This thing wouldn't be useless as a hedge, just imperfect.

Another point to remember is that banks that use CDS are often hedging loans, not bonds. And therefore they are already taking recovery risk, as the loan itself may not be deliverable.

appler said...

Dear Accrued, why does CDS have to trade with running coupon? wouldn't it be simpler if we get rid of it?
And to your point of fixing recovery, would that make CDS less useful for hedging loss given default of cash securities?