Friday, October 17, 2008

CDO, CDO-squared and CDS in pictures

If you already know what a CDO is, this is too elementary, but it might be helpful for explaining to your friends...

Crisis explainer: Uncorking CDOs from Marketplace on Vimeo.

Here's one for CDS (thanks to MFA for the pointer):

Untangling credit default swaps from Marketplace on Vimeo.


Anonymous said...

Great video (and the other on CDS on vimeo).



Anonymous said...

Credit derivatives will also bring about greater efficiency of pricing and greater liquidity of all credit risks. Institutions benefiting from this development will include a broad range of financial institutions, institutional investors and also corporates, in their capacity both as borrowers and as takers of trade credit and receivable exposures.

Just as the rapidly growing asset-backed securitization market is bringing investors new sources of credit assets, the credit derivatives market will strip out and repackage credit exposures from the vastly greater pool of risks that do not naturally lend themselves to securitization, either because the risks are unfunded (off balance sheet), or because they are not intrinsically transferable. By enhancing liquidity, credit derivatives achieve the financial equivalent of a free lunch, whereby both buyers and sellers of risk benefit from the associated efficiency gains.

--- Blythe Masters, 1997 (now CFO, J. P. Morgan, at age 36; then head of credit derivatives)

(from N. C. Painter)

Anonymous said...

Correction: "Blythe Masters [age 38] is currently Chief Financial Officer for Investment Banking at J.P. Morgan Chase & Co."

Unknown said...

My favorite quote:

>>``We refused to touch credit default swaps,'' Taleb said. ``It would be like buying insurance on the Titanic from someone on the Titanic.''


Anonymous said...

Our Government was constructed to allow citizens Life, Liberty and the pursuit of Happiness. Systemic risk in the relatively new form of financial derivative, Credit Default Swap threatens that very promise.
Capital positions in banks are at risk as never before.
CDS: “Weapons of financial mass destruction”.
Warren Buffett
The size and breath of which the world has never experienced, CDS may pose not only a significant risk to free world capital markets but also must be called what it has become at present:
An unsafe and unsound practice as it operates.
Example: A small Bank ($500M in total assets), with $12M in capital and 39 employees, has a $7 Billion CDS trading book. The 39yr old Trader recently bought the home next to mine for $2.1M. He is not concerned about counterparty risk, since he has been assured that all positions are “cash secured” by such parties.
The use of the term “swap” allowed exemption from insurance and gaming regulation. Easy entry, with little or even borrowed capital requirements, has allowed a 1920’s type of “bucket shop” speculation to develop within the Trading Desks of the most sophisticated Wall Street and world banks.
The unregulated CDS market has not only expanded over the years but has also become riskier. The preference has been more for multi-name instruments, longer duration, and below investment grade companies. As economies weaken or de-leverage, the prospect that default events occurring greatly increases. Such proceedings will directly relate to increasing the volume of CDS “payout” settlements which will test the Risk Management practices of the Banks acting as dealers.
Liquidity risk, Credit risk, Operational risk and Market risk and management practices, design and attention to procedures of process, authority and responsibility will be tested as never before for sellers of CDS, namely Banks. Weakness identified by market force rather than over-site can be catastrophic, the “abyss” as termed by the U.S. Federal Reserve Chairman.
As a recent business segment, it will process inherent systemic risk due, but not limited to:
 Structural issues related to its’ immature development, reliance upon econometric computer models of unknown ability to produce desired results with wide fluctuations of market data.
 Managers and Traders directly involved experiencing conflicts of interest, unknown authority levels and scope of responsibility.
 Being deficient in involvement of external examination, review by regulatory authority of control processes.
 Easy market entry and transfer of participants of questionable equity capacity.
Credit Default Swap positions should be immediately frozen, all future trading action stopped until world regulatory bodies can gather the information necessary to review, understand and control the systemic risk which exists throughout this business practice as it has developed during the last few years.
NY Federal Reserve President Geithner stated in regard to CDS:
“The potential for squeezes in cash markets and greater volatility across instruments in the event of defaults, magnify the risk of adverse market dynamics.”
Meaning: The potential for a Global scale degrade of the Banking financial sector as the essential conversion of assets to cash is driven by requirements to cover ever increasing amounts of default events of referenced entities and the side bets upon them. “Rush to Cash”
This scenario, which had been avoided in the recent past, has presently caused central banks to intervene and infuse substantial liquidity into the world banking system. The CDS spreads had widened but have declined post central bank intervention only to widen again. Direct capital injection into the Banks themselves is being considered/required by those same authorities at present.
We do not know how the crisis will fare in the future. The camp is divided, as one-half believes the worse is over and the other half believes it is yet to come. If the latter comes true, the CDS market will be tested yet again and there might be defaults by banks on the payments. The result could be uncorrectable for central banks and their “tool kits”.
Even if the former is true, policymakers should make the over-site of the CDS market the top priority and understand the counterparty positions and liabilities. Developments in CDS have been termed, by those associated with it, as a “ticking time bomb”.
Credit risk management is central to the functioning of financial markets. Traditional measures have evolved from direct accountability for the provision of lent facilities, attaching risk weights and holding reserves for identified risk. Responsibility for this Process, supervision and granting of extensions of credit with FDIC deposits as it develops over our countries financial life time, should not be allowed to be evaded by the participants by use of terminology; The “SWAP” looks, acts, and is sold as insurance, positions are placed/posted as in gaming, the conduct is preformed by Banks.
Progression in financial systems moved from bank-based to market-based systems, permitting world wide investment in dollar based cash flows. New measures to manage credit risks evolved, namely; securitization and credit derivatives (CD).
The traditional measures were deemed inefficient, as they make less capital available for business operations and make banks more conservative. Studies reflected that debt default risk lowered with diversity and size. Bank portfolios were shown to require large size and to be spread across vast bases in order to lower risk of loss. The use of derivatives were/are seen as a method to achieve these goals without the expenditure of infrastructure to accommodate direct, accountable/supervised lending.
Within the group of off-balance sheet derivative instruments, there exists the Credit Default Swap (CDS); standardized (by market participants) contracts whereby entities looking to protect against risk of default or bankruptcy of any referenced party can transfer risk via cash payments. As a hedge, this risk can be transferred from the seller (a bank) to the buyer (another bank, dealer, etc).
The Credit Default Swap (CDS) market is vast. It consists of several complicated types, requires the use of complex computer models and provides a means for the outflow of bank capital in amounts never seen before in the history of finance. Rational banking thought and perhaps function, the idea that banks are to lend money to borrowers in order to provide fuel for growth of the economy, seemingly has given way to allure of fee income during a time of generous monetary policy.
There are various types of credit swaps, credit linked notes, total return swaps, etc. within which, credit default swaps (CDS) constitute the majority. The Comptroller of Currency reports (Q4 2007) that CDS constitute 98% of total credit derivatives in the US, estimated to be $60 Trillion outstanding by 6-30-2008.
Single name CDS are still the larger category, multi name CDS are growing at a much higher rate. The latter basket type are more complex and difficult to price and about 45% of CDS are of that variety. Within single name CDS; the trend has been towards longer maturity (1 to 5 years). Majority of CDS issued are to manage non-sovereign or corporate risks (95% of total). Within the non-sovereign category, the CDS issued below investment grade is about 35% and increasing.
The reasons for the growth and preference for higher risk trajectory reflect banks desire to use regulated capital better. CDS is easier to create and is less costly than making actual loans or their securitization, and easy economic conditions (also called ‘great moderation’) have allowed them to flourish.
There are, and should be real concerns over the growth of this market. Hedging has taken a backseat to parties betting on reference entities without being required to own the underlying obligation. Such activity has been encouraged so as to increase the number of participants in the CDS market, with the thought that it adds liquidity to trading the CDS contracts themselves. The assumption that increasing the number of side players reduces risk seems to understate the history of market psychology wherein participants can concentrate in a single direction and intention as a group. Systemic risk is present here.
Settlements had to be changed from physical delivery of the obligations to “cash”, since the amounts covered are in large excess over the amount of the referenced obligation. Example: $20 million bond covered by $60 or even $100 million in swaps. In one case, the amount was 28 times the face amount of the bond.
Policymakers are worried and Timothy Geithner, President of New York Federal Reserve has raised his concerns as have many others. The real test of any financial market or instrument is its performance in times of stress and CDS markets have been largely untested until the present. The explosive growth in these markets is a recent phenomenon and there had been few major prior crises. Though, there was a one-off case of Delphi Corporation in 2002, it has been ignored, as economic volatility has been low ever since, due to the growth of “easy” money.
Initially, the sub-prime crisis started in housing markets as house prices softened. But now because of the effect spilling to other assets and a large number of foreclosures, the housing crisis has taken the shape of a credit crisis. This market segment employed CDS to cover collateralized debt/mortgage obligations (CDOs) in order to obtain higher credit ratings and thus pricing upon their sale to investors. However, what is surprising is there has been no public news of any concern on the credit derivative markets. The counterparties in the credit derivative market are mostly financial firms, as non-financial firms constitute smaller market segment. The pressure of CDS has forced certain well known Investment banks to disintegrate, others to merge or seek central bank assistance or face a similar fate.
The CDS market is largely dominated by financial firms (Banks, Finance companies and Hedge Funds) as either buyers or sellers. The risk of settling the derivatives stays within the financial sector. In a credit crisis, one should see credit events triggering against a large number of financial firms. This will lead to buyers of the CDS asking the sellers (other financial firms) to honor their commitments.
There are four main areas of concern, apart from lack of regulatory over-site.
1. Credit Risk: CDS are traded amidst financial entities where the buyer might be in a position, due to novation, where he has difficulty finding who holds the transferred CDS as of date of payment. The entity holding the CDS might be in a much worse position financial condition than the original seller and might not be able to pay up. Novations were 40 % of the market in 2005 and growing. Who and what quality of capital backs CDS out standings ($60 Trillion) is in serious question. Only predetermined margin (by buyer and seller) is required to enter into a CDS arrangement and in some cases it is lent to “qualify” (known as buying the balance sheet). Borrowing margin makes bucket shops look conservative.

2. Liquidity Risk: The credit crisis puts the entire financial sector under stress. It will not be possible for all parties to honor their commitments. As trade amounts require settlement in cash (greatly exceeding the defaulting bond amount), cash must be acquired to make settlement. The selling of assets to convert to cash will cause large deep decline surges in asset prices, requiring even more selling to obtain cash balances required. Prices of assets continue to drop as market psychology changes and normal buyers refrain from entry to markets.

3. Market Risk: CDS issuances are much higher than corporate bonds and loans referenced leading to difficulty in settling the dues. Hedge positions, like collecting the insured amount, may be covered, but difficultly will be experienced with collection and settlement of the “side bets”, or some naked positions. Undoubtedly counterparty risk is difficult to quantify in this closed book, off balance sheet, non-regulated or firm internally only overviewed business. A large portion of the USD $60 Trillion market is concentrated at many of the world largest financial institutions, a collapse of any one of which will most clearly have far-reaching implications.

4. Operational Risk: The participants in this market have experienced operation risk in the recent past with what has been called “backlogs”. Failure to follow procedures set by the ISDA (dealers association) allowed Novation (transfer of positions to another party) to become a serious issue. Since most participants were banks, the credit risk exposure was not to pose a significant problem. However, the market has grown to almost twice in size since these issues were first raised, and unknown participants (leveraged hedge funds) have been entering though Novation. Is the “self” supervised management of banks and hedge funds keeping track of the credit risk, transferred via such Novation, in a controlled manner wherein operational procedures can expose credit risk?
A BNP Paribas report estimates about $1.3 trillion is at risk or an amount is equal to the entire US Bank capital position as of 30 June 2008. These are not small numbers (though hundreds billions have lost to date) and the size of the exposure itself can, and quite possibility has, lead to further erosion of the confidence in the free worlds financial markets.
Two examples follow which may highlight the CDS risk.
1. You own a house, and want carry insurance in case of fire. You wish to hedge your risk of loss. Do you pick a well know insurer or just send premiums to a no name off shore Acme Inc?
2. Someone, with little money, is allowed to also insure your house, the house on both sides and front and back maybe the entire subdivision. If they all burn down, he gets all the insurance. He has no relationship to you or the houses what so ever. Is it in his interest to show you fire prevention or toss matches in your direction?
3. You are a commander of an air wing of jet aircraft. The chief of maintenance brings to your attention that the fan blades on the turbines are showing serious signs of early metal fatigue and is sure some will fail very soon. You are at peace time status. Do you let your pilots to continue to fly daily missions in those aircraft?
Recent review of data provided by Markit, reveals interesting information. The number of trades, the trend of dollar volumes involved and the amount of trades that are confirmed later than 30 days (while reduced) leads this former risk manager to have his “radar” up.
There is a tremendous amount of information to absorb concerning this quickly developing and expanding world wide market. People outside of the business, who have a fair view, are very alarmed. Two dear friends, also retired early, are former managers of well known trading concerns. They see the same dangers and for the first time in their lives, want regulation. OCC capital market examiners many need to have an educational course, prior to conducting their reviews, so as to encompass examination of the risk issues involved.
The financial progression towards the securitization of assets and the entire process involved, from originator to investor, should be reviewed in a coordinated manner by the representatives of the OCC, SEC, and Federal Reserve with FDIC involvement. Teams should be assembled, trained and assigned to exams. The members of each over-site organization will greatly benefit from the sharing of the individuals perspective, (hopefully without the standard agency infighting and bias) as they come to fully understand the complex procedures involved in this practice. Insight gained by these members must be shared within their prospective organizations to promote expansion of effective regulatory guidance. International regulatory participation should be not only be encouraged, but also adapted as a standard practice.
The size and scope of the financial progression of banking “product” expansion, must be addressed with a world coordinated examination conducted by external over-site bodies, as may be realistic, to assure that activity occurs in a safe and sound manner.
Former National Bank Examiner, Commercial Banker and Investment Banker, 25 years (now retired, age 52)

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