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To Stabilize Global Banks, First Tame Credit Default Swaps
Janury 21, 2009

To Stabilize Global Banks, First Tame the Credit Default Swap Market

"Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham's current shareholders - and it would also encourage excessive risk-taking in the future. Still, the possibility of such a gift is what's now supporting Gotham's stock price. A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks' debts to make them solvent; and sold the fixed-up banks to new owners."

Paul Krugman
"Wall Street Voodoo"
The New York Times
January 18, 2009

Congratulations to President Barack Hussein Obama on assuming the Presidency of the United States. We wish you and yours Godspeed.

A long-time colleague and IRA reader who works for a mostly nationalized UK bank tells the following tale. Upon arriving at Heathrow Airport several weeks ago, he was pulled out of the line by UK immigration authorities and told to sit in a windowless interview room.  After waiting for quite a while, two plain clothes members of the UK immigration service came into the room, sat down and informed the banker that he had made a false statement on his customs declaration.

"Sir, you are not a banker as you have claimed," said one of the immigration officers. "You are in fact an employee of Her Majesty's Government. In future, please ensure that you form is filled out correctly." And they were deadly serious.

Such is the level of public anger and outrage at the moves by the UK government to rescue the few, large players in that nation's banking sector. And there are similar political trends building in the US. Thus the need to fashion a prompt but effective response to the crisis, as none other than Nobel Laureate Paul Krugman outlines above. Simply buying and/or guaranteeing bank assets, without first passing these banks through a receivership, is pointless.  First the market value of the assets and liabilities must be put back into balance, then and only then the banks may be recapitalized.

In our latest report to our advisory clients, we discussed the likely magnitude of the losses to hit the US banking sector in 2009. We had been pondering this issue with respect to Citigroup (NYSE:C), JPMorganChase (NYSE:JPM) and Bank of America (NYSE:BAC) for some while now, but the reports from FBR and, more recently, a draft paper from our friend Nouriel Roubini, forced us to focus on some hard numbers. Registered investment professionals who want information about IRA's confidential advisory service, please contact us directly.

The bad news is that estimates that put aggregate charge-offs for all US banks over the next 12-18 months above $1 trillion are probably in the right neighborhood. The entire banking industry only has $1.5 trillion in capital, so new equity must obviously be provided by Washington and/or private investors.  This is why the UK, US and other affected nations must soon abandon the bailout model championed by Fed Chairman Ben Bernanke and Treasury Secretary-designate Tim Geithner, and instead embrace the strategy of resolution and restructuring exemplified by Sheila Bair and her colleagues at the FDIC.

The good news is that much of that loss is going to be concentrated among the largest banks, with C accounting for as much as a quarter of the total all by itself. When you see a 40% loss rate vs. total assets for a relatively simple institutions such as IndyMac, tell us why you would not start at that level with C? Impose a conservative 30% loss rate on C's $1.3 trillion in bank assets and you have wiped out the group's $150 billion in Tier One Risk Based Capital several times over.  The common and preferred of C is toast, in our view.  Restructuring is the only rational choice for C and for Washington.  And maybe, just maybe, the C bond holders will see a modest recovery. 

Our long-time estimate of 2x 1990 loss rates for peak charge-offs in 2009 implies that the industry will reach 4% defaults and relatively riskier players like C will be much higher. In 1990-91, Citibank NA peaked around 3.5% charge-offs vs. total loans and leases, almost causing the bank to fail. Some observers believe that had regulators resolved Citibank two decades ago, we would not be facing the same type of financial crisis today.  So now the past is prologue.

But even with all of this red ink in evidence and easily projected, the magnitude of current and prospective charge-offs does not fully explain the crazy, triple-digit volatility of the debt and equity of C and other banks, large and small.  Even the events of the past year, including the failures of Lehman and Bear, do not fully explain why financial names are behaving so erratically, this even after the US government has effectively underwritten the banks' operations. No, the reason for the continued heebie-jeebies in bank equity and debt stems from the unfinished business in the market for credit default swaps or "CDS."

As readers of The IRA know full well, the Fed of New York and the Depository Trust & Clearing Corp have been working for years to address the bank office issues facing CDS, this all the while declaring that there is nothing basically wrong with the CDS market. Strange, then, that as part of the process of rationalizing CDS contracts, nearly half of the outstanding contracts have been torn up in the past year!  This is because, dear friends, when it comes to CDS, clearing is the least of our problems. 

The tension with CDS regarding the money centers in particular and banks generally comes from several basic flaws in the ISDA model for these instruments, including the lack of a central counterparty and the issues that arise from this archaic, bilateral market structure. Most crucially, because the Fed still refuses to enforce any type of credit margin discipline over the CDS markets by raising collateral requirements to realistic levels, the short-selling pressure of C and other wounded money centers is magnified many times above the true pool of investors with hedging needs. Yesterday's trading in US bank names is a case in point.

Unlike a centralized exchange where an impartial counterparty holds the cash, the bilateral relationships in the CDS market lead to gross under-collateralization of CDS trades which are, in turn, governed by separate collateral security agreements. This leads to what one participant calls "a dirty float," where counterparties keep minimal collateral with one another and thus nobody is sure whether their contracts are money good. It is thus possible to run short positions against banks or other names and have virtually no collateral backing these trades, both for dealers and their customers.  Why should the citizens of the industrial nations tolerate the existence of this unsafe and unsound market for another moment longer?

By failing to enforce margin limits on CDS leverage while investing new capital in C, BAC and other large banks via the TARP, the Fed and Treasury are essentially trying to fill up a bucket with a hole in the bottom.  Providing new capital to wounded banks is pointless if you are going to allow the remaining street dealers to short bank stocks with impunity and virtually no collateral. To fix the systemic risk issues with the CDS market permanently and also provide a much need additional buttress to the bank rescue efforts by the Fed and Treasury, here is what we would suggest.

First, the Fed and Treasury should prohibit the writing of new CDS on any financial institutions that is participating in the TARP.  Instead, the Fed and Treasury should interpose themselves as counterparties for these names, writing CDS for any and all counterparties and capturing the revenue for the US Treasury. This change can be accomplished unilaterally, without notice or Congressional authority, pursuant to the safety and soundness provisions of 12CFR.  After all, since the government is already effectively backing the liabilities of these insolvent firms, the taxpayer has first claim on any insurance premiums written against such public support. It is absurd for the government to allow private speculators to profit by trading against public-guaranteed liabilities of banks that participate in the TARP. Unfortunately, Chairman Bernanke and his colleagues at the Fed are still not willing (or able politically) to enforce prudential rules on the CDS casino.

Second, the Fed and Treasury, via legislation if necessary, should propose changes to the legal configuration of the CDS contract that will take it away from the OTC FX/interest rate model used by ISDA over the past decade or more.  Regulators should require that CDS contracts be exchange traded, but with collateral and delivery requirements that mirror not the cash settlement world of OTC FX and interest rate OTC contacts, but instead based on the basic model of the exchange traded world of physical commodities, but priced based upon the risk measures used in the insurance industry.

While it is entirely appropriate for exchange traded instruments like the S&P 500, Eurodollar futures, or OTC interest rate swap and currency contracts to settle in cash, allowing cash settlement in CDS has opened a Pandora's Box for bank managers and investors, who must manage both the market and credit risk of dealing in these contracts as de facto central counterparty, while at the same time being attacked by their clients who are shorting the bank's equity and debt!  Remember, a speculator must only agree to pay for CDS based upon the short-term yields on the underlying bonds -- a price that does not even begin to approximate the true cost of funding a short put position in the underlying basis upon default.

When traders use CDS to build short positions on C, BAC and JPM as part of equity volatility trades and similar short-term strategies, they are increasing the cost of the TARP bailout to the taxpayer while at the same time adding to the overall instability of the financial system. As we've said before, if there were nothing wrong with the basic model for CDS, then there would be no need for the industry to have torn up $30 trillion in notional amount of contracts during the past year!

The basic model for a CDS contract does not really fit the needs of investors or the real economy, who are in the most simplistic terms looking for a practical way to hedge an illiquid corporate bond. Unfortunately, most corporate bonds cannot be borrowed in the securities lending market, WHICH MEANS THAT THERE IS NO TRUE CASH BASIS FOR SINGLE NAME CDS.  Faced with this issue, the happy squirrels at ISDA came up with cash settlement as a way to ensure the astronomical growth of CDS - never realizing that in so doing, they were also magnifying the overall level of risk in the global financial system many times over and above the actual "basis," represented by the bonds specified in each CDS contract.

CDS are a great tool for playing/managing volatility in time of low or no defaults. In the period 2002-2007, when the CDS market was growing many times faster than the underlying real economy and corporate default rates were virtually zero due to the plenitude of credit, using CDS to trade volatility produced huge paper profits to dealers.  But now that all types of default rates are rising and credit spreads are widening, the cost to the system of a CDS contract -- which requires the seller to fund the par value of the underlying security, less recovery value -- is a dead weight around the neck of the global financial system.

As we've noted before, CDS contacts are high-beta risk, that is, highly correlated with the broad financial markets. Unlike natural disasters and other low-beat risks, where the frequency of events is relatively low and uncorrelated to the financial markets, in CDS the high degree of market correlation ensures that most or all of a portfolio of single-name CDS contracts will deteriorate when economic conditions turn negative. There is no way to hedge such risk because it is entirely correlated to the broad market -- unless you happen to be a conservative P&C underwriter!  The yield spread on a bond represents the current cost of renting money for a year, but it does not begin to describe the cost of refunding the entire security upon default!

What a shame the folks at American International Group (NYSE:AIG) forgot the centuries of experience that the insurance industry has with managing different types of risk. The widening sinkhole around AIG provides a case in point of what happens when a low-beta and high-beta portfolio are mixed without adequate capital and, more important, an understanding of the full downside funding risk.  Recall that in the traditional, low beta world of P&C insurance, the assumption is that most coverage will never result in claims. In a broad portfolio of single-name CDS during a recession, by comparison, the assumption must be just the opposite. 

As corporate defaults rise and recovery rates fall, the net funding required to perform on single name CDS must approach 100% of par.  In such an event, the exercise of extant CDS contracts could theoretically consume all of the capital in the global banking system, several times over.  How is this good public policy?   Indeed, viewed from an actuarial perspective, the world of CDS makes no sense at all.  In order for premiums to be high enough to make a high-beta portfolio of CDS contracts profitable in an economic sense, a new pricing methodology based upon true, medium-term default risk need be developed - but such a framework would be very expensive and might not be practical to implement.

So what is the solution? So us, the Fed and Treasury must immediately force the CDS market onto exchanges and go back to the pre-Delphi bankruptcy model to require physical delivery of the underlying bonds in order for purchasers of protection to collect their insurance payments. The Fed should also reinstate higher margin requirement for all securities and include CDS in a newly reformed margin regime. On single name CDS, the margin requirements for sellers of protection should approximate roughly 50% of the amount of the net exposure, roughly half the estimated recovery value less par. By imposing this Draconian requirement, the doubts as to funding of CDS and the related market fear, will disappear.  Admittedly, these changes will have the effect of driving most or all of the speculative players out of the CDS market and make it a hedge-only market, but frankly there are many more liquid alternatives for traders, including exchange traded futures and options, to use to support volatility strategies, including short-sales of bank stocks.  Allowing cash settlement CDS contracts to continue to exist and trade in their current form seems to be contrary to all of the efforts currently underway to stabilize the global financial system.

Unless and until Chairman Bernanke and the other regulator are willing to tame the CDS tiger, there will be no success in bringing stability to the US banking system or foreign banking markets. And the longer Bernanke & Co refuse to say an emphatic "no" to Goldman Sachs (NYSE:GS), JPMorganChase (NYSE:JPM) and the other CDS dealers, the financial crisis affecting global banking institutions will continue to worsen.  Making this change may force GS and other dealers into mergers or liquidations, but such is the cost of reform. The US economy can live without the major Sell Side dealer firms, but we cannot survive without commercial banks, insurance companies and commercial companies, all of which are targets for the CDS Mafia and the unlimited leverage that they use as weapons against us all to generate speculative gains.  We have the power to fix this aspect of the financial crisis immediately, but do our leaders have the courage and the vision to close down this reckless, speculative market before it destroys what remains of our economy?

Questions? Comments? info@institutionalriskanalytics.com




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