Credit instruments

Derivatives, margins and reform (hot off the press, 5 years later).

In 427 class the other day, we talked about transparency and exchange trading of OTC derivatives. In this piece, you get an update on OTC derivatives reform for the G-20 meetings from the Financial Stabiility Board. If you want more details on the nitty-gritty of margins for OTC derivatives, go here. The paper is long, at least read the executive summary. The procedures and processes described in these documents are European in origin, but similar concerns pervade our markets as well,







The return of credit products

Synthetic CDO’s are back say these pieces (here and here). Some of you may recall the BISTRO template, where the cash flows from selling CDS are packaged into tranches and sold to investors. This time, it appears that these are more of the “bespoke” variety, where the products are customized for presumably savvy investors and do not go through a ratings process where senior tranches used to get AAA ratings in years past. Regardless, Citi apparently sold $2 billion last year and has already done $1 billion this year alone.

Somewhat more ominous is this plan by ProShares to create and market ETF’s that are based on CDS. The thinking behind this is that in a post Dodd-Frank world, CDS trading is moving to exchanges, is becoming more transparent, so retail investors can participate in these products.

Keeping track.

1. Many of you know my penchant for keeping track of investment vehicles with a derivatives twist (wrinkle, wrapper, whatever).  The market linked CD (MCLD) is another incarnation of the same, where FDIC protects your principal investment, a DEATH put makes sure that your heirs get that principal if you are gone.  You get interest as well,  which is the greater of a) a minimum flat percentage or b) returns to some index of equity market performance.  This latter is upside capped just in case the market takes off, so that the bank does not have to pay all of that gain. There is no such limit on the downside.  All this holds if you hold to maturity.  If you don’t (hold to maturity) the fine print legalese in the agreement (that you never read) will tell you what you don’t get –after all, there is no secondary market for these things.  One of these days I need to figure out exactly how they go about setting interest rates and caps on these instruments.

2. More Gold titbits (courtesy this piece).


Today’s poor new home sales data prompted me to catch up on news relating to housing, mortgages and the residential mortgage backed securities (RMBS) markets. This press release by a well-known firm talks about more write-downs ahead in the coming months and makes me want to get short the banks.  Essentially they claim that many of the losses in the loans underlying the securities have not been allocated to the bonds directly and their estimate of $300 billion in losses on a $1.42 trillion in securities is quite ominous. Perhaps why the banks are down today?  Remember the lowest tranches of these securities are the ones that get hit the worst. These are private label RMBS, not those from the GSE’s that the Fed has been buying and will continue to buy. One wonders.  Without securitization to provide funding and with the continuing issues dogging the credit quality of borrowers, can the housing market be close to a bottom?

In a related story, the Financial Crimes Unit mentioned in the President’s State of the Union address the other day can go back over 10 years to identify mortgage fraud. This as the banks are negotiating a $25 billion settlement with protection against future liability with various state AG’s. More indication that the story is far from over.

CDS protection and sovereign debt default.

This story says that Greek debt restructuring may not trigger debt default provisions in a CDS and therefore Greek bondholders owning them may not get a payout.  Credit default swaps pay when the ISDA determines that a  “credit event”  has occurred.  A credit event that is binding on all bondholders would trigger this insurance payout.  The 50% haircut for Greek bondholders which was part of the bailout proposal for Greece  is voluntary and therefore may not trigger a payout– so says the ISDA. What kind of insurance is this?

Many US banks, GS and MS in particular, have said that they are hedged against sovereign debt.  Obviously markets are asking what that hedge is worth especially if no payout is coming.  You have to wonder if those who opt out of the  haircut can keep carrying these assets on the books at mark-to-myth valuations?  You would think that regulators should be able to look at the security holdings of the banks and their associated hedges and determine what the exposure is. This is what the stress tests that keep happening are supposed to do.  Like in some business schools no one gets a failing grade.

And St. Lous Fed President Bullard was just on CNBC saying that US banks do not have much exposure to European debt.  Who can you believe?

That same CNBC has now begun to flash Spanish and French bond yields on the screen as the Euroland auction I referred to in the earlier morning post presumably terminates. Talk about real-time alerts. And, responding to every tick, equity futures are now turning positive. Come and play suckers.

Jefferson County files for bankruptcy.

This story of the largest municipal failure is another case of floating interest rate security investments gone wrong.  In 2001, with rates at historic lows, Jefferson County, AL  got talked into reducing their borrowing costs by issuing floating rather than fixed rate loans.  Part of these were swaps and the bulk were “auction rate securities.”  These are basically bonds whose interest rates are reset by monthly dutch auctions. In 2008 this market fails and many of the securities have been frozen every since. Municipal bond insurers were failing in 2008 and couldn’t guarantee these loans, so the banks that served as bidders of last resort in these securities declined to participate.  The whole story is complicated by the fact that the county was also messing about in swaptions (yes these are options on swaps) market.  The 2008 story is here. I remember talking about it in a 427 class at that time.

And of course you read the story of LCH-Clearnet raising margin requirements on Italian bonds and their derivatives, many of which were in the MF global portfolio. They serve as the clearing house and that one move was sufficient to trigger a 400 point drop in the Dow and similar moves in world market indexes.

Can you say EFSF-SPV=CDO?

1. Here come the CDS stories.  This is the one about US banks selling CDS to European banks, just like AIG did a few years ago.  The banks assert that these holdings are hedged, that counterparty risk is less now and better understood, but the market does not appear to be buying this argument.

2. The European Financial Stability Fund (EFSF) is funded by member states with Germany and France together guaranteeing about 50%. Italy and Spain guarantee about 30%.  Since the latter two may need bailouts eventually, there is a circular logic to this. Forget the circularity for the moment.  The EFSF can issue bonds, make loans to distressed countries, finance recapitalizations and intervene as needed in financial markets.  All this is well known as is the fact that they have about 250 billion euros in the pot which will be leveraged up.

I want to bring your attention to the SPV (Special Purpose Vehicle) portion of the recent initiative.  How do you get the Chinese and other investors to buy the bonds the EFSF will issue to accomplish its goals? You provide guarantees against first losses (the skin in the game idea). In other words the EFSF will be the equity holder and the Chinese the debt holders in a CDO-type structured finance product. This is bringing out doomsayers in droves. The thinking is: such leveraged structured finance may have brought Enron down in the 1990s. Such leveraged structured finance may have brought down the global banking system in the late 2000s. And now governments are getting into this game?