As we have noted, the DTCC finally started releasing somewhat detailed data in November about the CDS market. Unfortunately it was too late, and it seems only 3 people in the entire world follow what is says. So let us summarize it simply: 1) the market is already on a death spiral in terms of gross notional, and 2) the net notional of outstanding CDS is woefully inadequate to protect from the upcoming default onslaught in cash bonds.
What is the difference between gross and net notional? The gross number indicates the total notional of CDS contracts without taking into consideration offsetting trades. As the bulk of CDS notional holdings are at broker dealers who (aside from now defunct prop desks) take little principal risk, most of the CDS contracts they hold are offset. This means that for any $10 million CDS in a single name or index a B/D sells to counterparty X, the B/D has to purchase an offsetting $10 million from a different counterparty Y in order to be risk neutral. And so while the two transactions result in gross notional of $20 million outstanding, the net impact is 0. As the CDS data that had been previously available (which was never that much to begin with), was all on a gross basis, it tended to substantially exaggerate the total risk exposure in the market, and might have misled financial titans such as Mr. Soros himself. And as the charts below will show, the size of the net notional CDS market is troubling - in that it may in fact be too little.
While the gross notional size of the CDS market did grow significantly in recent years, there has been a very troubling decline recently in gross amounts. From a peak size of $62 trillion in 2007, gross notional CDS size has dropped to $28 trillion, with a run-rate weekly decline of almost $1 trillion, if DTCC is to be trusted. Interestingly, the gross notional on single names is for the first time on par with the size of the comparable cash bond market, both at about $14 trillion. If one actually were to delta hedge all bonds per the agriculture department's proposal, the argument would go that the market now is in equilibrium... at least based on a gross exposure.
The decline in the gross size is troubling: the overshoot to the downside over the past 6 months is almost as large as the ramp up during the peaking of the credit bubble. Data indicates the bulk of the change is in the index and tranche components of total gross, with single name gross size declining less acutely.
Which leads to the net CDS market exposure. Another way to think of net is how the general public thinks of gross: it is the total amount of cash that would change hands if every single reference entity were to suffer an event of default with a 0% recovery. And the total amount is a paltry $2.6 trillion, at least when juxtaposed to such previous hyperbole as $50 + trillion. Additionally, as the total cash bond market is $14 trillion, one could argue that the net notional does not nearly hedge enough of the cash market in the case of spreading defaults. ZH has shown before how market values of Investment Grade and High Yield indices imply there is a blended cumulative default risk of up to 40% over the next 5 years (assuming a high 40% recovery rate), the (simplified) argument would go that of the $14 trillion in cash bonds, up to $5-6 trillion could default. This number is therefore underhedged by up to 75%: there is a total of $2.6 trillion in total net, but only $1.4 trillion net in singe name CDS (excluding indices and index tranches which are used by index correlation trading desks as trading vehicles, not hedging instruments, and would promptly collapse when defaults start to really pick up).
Zero Hedge argues that CDS has been probably the most efficient way to hedge credit risks in the past 3 years. The fact the insurance companies took Buffett's example 10 steps too far, and just kept on selling and selling protection (kinda analogous to how the U.S. is printing and printing $$$ now) assuming six sigma events would never occur, thereby exposing the entire financial system to systemic risk, is solely their mistake and the appropriate punishment should have been default. An efficient market would have eventually picked up the pieces from AIG's failure, so the course that Paulson departed on when he bailed AIG out just takes that mistake even further as it merely leverages the faulty disbelief in fat tail events. The argument goes that CDS and equity markets are self referential when gossip picks up and companies like Bear and Lehman get shorted to death as fear is rampant. There are many more pieces to this argument, but we think it is totally meritless (in Lehman's case CDS traders would not purchase protection blindly as they were worried a Bear Stearns bail-out type event would reoccur making all CDS contracts virtually worthless; the government is as much to blame for being unable to hold a consistent policy course w/r/t how to deal with bank failures). The flipside is that CDS provide the only mechanism to hedge credit risk, which at implied 40% default probabilities, will need to be hedged even more so in the future.
So what is in store? Granted the death of CDS is an exaggeration, CDS will soon move from trading Over The Counter to a centralized Clearinghouse exchange, maybe in as little as 3 months. Initially this market will support indices (HY and IG) and subsequently move to index tranches and single name CDS. The clearinghouse will eliminate counterparty risk as contracts will be netted multilaterally, not just between two entities. Dealers would face a centralized cash-rich entity: The Clearing Corp (TCC), which would be funded through initial and daily collateral postings and cash flow sweeps on mark-to-market CDS margins. The biggest benefit from this would be the sharing of losses by all counterparties in case of a systemic failure.
Once counterparty risk is removed two things will happen: basis trades will collapse and the overall CDS levels will likely spike dramatically (wider). Due to aforementioned liquidity constraints (here and here), true risk levels are captured by spreads on cash bonds, not CDS. The counterparty premium is manifested by an artificial tightening in single-name CDS vis-a-vis matched maturity bonds (the negative basis trade phenomenon), and represents anywhere between 200 and 500 bps in any reference entity. Thus once a clearinghouse is established, as long as economic fundamentals maintain their scary downward trajectory and defaults are expected to keep rising, CDS will move steadily wider until they catch up with the true risk levels as currently expressed by Z Spreads (or interpolated recovery levels on highly convex names). Bottom line: we recommend purchasing CDS outright in any name that has a marked negative basis as counterparty risk becomes a negligible issue.
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5 comments:
"Another way to think of net is how the general public thinks of gross: it is the total amount of cash that would change hands if every single reference entity were to suffer an event of default with a 0% recovery. And the total amount is a paltry $2.6 trillion, at least when juxtaposed to such previously hyperbole as $50 + trillion."
In the case of AIG, I view the chain of events as follows:
1) Tsunami of foreclosures begins, leading to gross uncertainty as to how many foreclosures there would be and how much housing prices would fall. If I'm correct, that meant that there was uncertainty in both:
A: The number of defaults
B: The amount which would be paid in the event of a default. The lower housing prices go, the more insurance there is to be paid on a foreclosure.
2) AIG was downgraded because of the uncertainty of A and B.
3) AIG had a capital call, and needed to raise money.
4) They went to the government for a bridge loan, to avoid selling assets at fire sale prices. This is what Liddy actually said in November. He did not say that he couldn't sell the assets.
The CDS and CDO problems are part of a larger Calling Run. That is, anyone who had investments with the lenders on these poor mortgages started demanding cash if they could, worrying that at some point the money might run out. The TARP plan actually hindered everything by raising the price of Toxic Assets and giving the owners of these investments the hope that the government might, somehow, provide a better deal than John Paulson. This is somewhat like the difference between the terms Buffet got and the government got on similar investments. Underneath everything, is the foreclosure tsunami, which is a Calling Run ( Debt-Deflation ). This problem will lead to some real and very large losses, no matter what insurance there is on these foreclosures. Since the foreclosures must, to some degree, offset the losses on the mortgages, it's hard for me to see them, qua insurance, as the problem. Where third parties are concerned, my understanding is that those have been working since they were marked-to-market. In that case, I'm still wondering how CDSs are causing the problem. To the extent that CDOs are, that seems a problem of liquidity, which I believe is largely induced by the holders unwillingness to absorb huge losses. My view, but I'm not an expert.
Don the libertarian Democrat
I've been thinking about how outstanding CDS will be affected if (when?) majority of trading moves to a clearing house. First, is it safe to assume that outstanding net will be moved to the clearing house? This seems to be pretty unfair to protection sellers. Second, if outstanding stays OTC without central clearing, does the creation of a clearing house and a large percentage of trade moving there reduce systematic risk enough that it would reduce counterparty risk on the previous outstanding CDS? I think this is what you're implying will happen, thereby resulting in reduced basis in outstanding.
from what i have heard existing contracts will have the option of moving from OTCC, but any new contracts will have to be on the TCC (by participating dealers, so in theory a dealer has an opt out clause, which will likely be frowned upon). and yes you are right about the second part - counterparty (liquidity as I like to call it) risk would be gone in TCC, which would make the cash-cds basis market much more realistic.
Btw, i saw your comment about neg basis as caused by bond repos. I respectfully disagree. You are right the repos are scarce in general, but the issue here is the CDS repo side, not the cash side. If the latter were the case, you would see overbought bonds (due to inability to short cash) resulting in tighter spreads to FV and to synthetics (and a resulting + basis). I am convinced basis still has to do with scarce liquidity provided to accounts by PBs and B/Ds, who are unable to put on enough CDS to where implied risk matches, i.e. artifical lack of demand pushing yield/risk tighter to FV.
Tyler, Thank you for the article. I have a few follow up observations/questions to your article. I look forward to your comments.
1. What accounts for the huge decline in outstanding CDS? Given well documented operational issues, and that both buyers and sellers would need to agree to close out an existing contract, and that huge losses/gains would have been crystallized, this drop seems odd. Why would buyers of protection want to close out contracts ahead of a spike in corporate default rates (whether via index or single name exposure)? As you point out, they would be less hedged as a result.
2. The "net" exposure probably understates the risk much as the "gross" exposure overstates it. To accept the net exposure as an appropriate risk measurement is to accept that all counterparties are equally credit worthy. Yet, already some of the largest intermediaries (US and Euro commercial banks) are on life support. The failure of a large intermediary would be instantly devastating. The failure of a smaller counterparty would pass risk to these intermediaries as their exposure would move from "hedged" to "naked". CSAs have probably worked well to mitigate risk in a relatively benign default environment (5% defaults in 2008) but what happens when defaults move above 10% per annum?
3. Government support is hardly a cure to counterparty risk. Essentially the weakest countries (Iceland, Ireland, Belgium, etc.) would just be passing on the risk of their government guarantees to the "healthier" countries and their taxpayers. What is JPM's exposure to Allied Irish, Glitnir, Fortis, etc.? Why would any countries taxpayers accept the risk of other countries banks via CDS contracts?
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