Regulators and practitioners alike have spent much of 2008 fretting about how the CDS market would perform in the event of a big counterparty default (see Credit default swaps: On dangerous ground Euromoney, August 2008). Last month the system was more than put to the test when credit events triggered the unwind of not one but three big CDS counterparties. The "conservatorship" of mortgage agencies Fannie Mae and Freddie Mac rapidly followed by the bankruptcy of Lehman Brothers has placed more of a strain on the infrastructure of the CDS market than anyone – even its harshest critics – could have expected it to deal with.
According to Citi analysts there is roughly $200 billion of index CDS outstanding that references Fannie and Freddie and $300 billion in single-name exposure. They also estimate $200 billion in tranche exposure for Lehman, which gives a ballpark estimate of $700 billion in gross notional to be settled. And that is before the implications of JPMorgan’s Washington Mutual takeover are factored in.
Opinions are divided as to just how the market is functioning with this processing challenge. "There are a lot of outstanding contracts for which value must be established [each non-defaulting party has the right to establish the value of the contract through the Isda auction process]. There are a lot of processes that need to take place that do not take place every day. There will be some grinding and points of friction but essentially the process is working," says Mark Brickell, former chairman of Isda and chief executive of Blackbird Holding, a hybrid trading platform for swaps. His view is shared by Isda’s present head, Robert Pickel. "During the current market volatility the credit derivatives market has performed very well," he stated in late September. "It has allowed companies and investors to manage their risks in a time of higher than usual rates of default, and the credit events that have occurred thus far are being settled in an orderly fashion."
The Citi analysts estimate that Lehman is in 70% of all reference portfolios in the market, so losses will be substantial. They put recovery rates at no more than around double digits for senior debt and low single digits for subordinated debt. Recovery rates for Fannie and Freddie will be determined once disputes about eligible deliverables have been resolved – as Isda auction protocol sets cash recovery at the lowest price on physical assets at the auction. Calls that government support for AIG should constitute a restructuring and therefore amount to a credit event are likely to fall on deaf ears. An AIG credit event would have far more serious repercussions in the market than Lehman has had. "The majority of investors would have had both long and short exposure to Lehman. The result is that its net credit exposure was limited, although the operational headache of rebalancing the books is massive," says Michael Hampden-Turner, structured credit strategist at Citi in London. "AIG has been much more of a risk taker. It was a big seller of protection into the market."
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Default fear spurs volatility |
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$ 5yr CDS spread |
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Source: Markit |
But not everyone is as upbeat about how the CDS market is coping with the huge pressures being placed on it. "We are hearing from clients that the novation process continues to be slow and painful (and broken in many cases) for their Lehman CDS positions," notes Tim Backshall at research firm CDR. "The process whereby one credit derivative counterparty can essentially move a trade from one counterparty to another by assignment, or monetize a winning trade by tearing up the contract with the existing counterparty, is apparently broken." Certainly participants away from the big dealers seem to have a less optimistic view of how the market is coping. "The big counterparties have coped well because they reconcile their positions every day," says Jos Stoop, general manager at Interwoven’s Global Capital Markets division. "The problems are at those second-tier and buy-side institutions that do not have a daily picture of where they stand. They cannot get access to information so have been left in the dust." Interwoven specializes in OTC derivative trade processing and runs a connectivity platform to the DTCC Deriv/SERV trade information warehouse.
The incredible shrinking market
| "The problems are at those second-tier and buy-side institutions that do not have a daily picture of where they stand"
Jos Stoop, Interwoven |
Conscious of the criticism that the volume of notional outstanding CDS was attracting, the industry has devoted much time and energy to reducing the number of trades outstanding. This is something that credit events of this magnitude will certainly help with. According to Isda, the notional amount of CDS outstanding decreased for the first time in the market’s history by 12% in the first six months of the year to $54.6 trillion, from the famed $62.2 trillion figure that has caused such concern among the regulators. The figures only run until June 30, so do not reflect the impact of the GSE and Lehman events. Growth has also been checked by trade compressions (see Credit default swaps: Monolines face litigious and costly endgame Euromoney, August 2008): TriOptima has revealed that during the first half of 2008 its compression platform terminated $17.4 trillion in CDS notional principal outstanding. "As the sole provider of portfolio compression services in the first half of 2008, we can confirm that tear-ups were a positive factor in stabilizing the growth in notional principal levels that had attracted the attention of regulators," says Brian Meese, group chief executive of TriOptima. "We have long believed that aggressive use of tear-ups is one of the most effective ways to manage risk, and a vital complement to central counterparty activities. We include all dealer counterparties, not just a few, and we eliminate, rather than mitigate, the risk associated with those trades." Creditex and Markit launched their tear-up system in September.Despite the industry’s best efforts, however, regulators have lost little time in demanding additional oversight for the CDS market. New York State governor David Patterson announced plans in mid-September to redefine CDS as insurance contracts and thus subject them to state regulation. Under the plan, only entities licensed to conduct insurance business would be permitted to issue CDS. The proposal also attacks "naked" CDS (buying protection on a company in which the protection buyer does not hold debt), casting it in the same light as the politicians’ other new bogeyman – short selling. "Many phrases within the circular show a lack of understanding of the CDS markets, their underlyings, and how CDOs work," says Backshall at CDR. The governor also fails to point out that some of the most active participants in the CDS market – the monoline guarantors – have been regulated since the late 1990s but have been among the biggest casualties of the market downturn.
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