Recent Average CDS Auction Recovery Rate: 10%

Today's RH Donnelley CDS auction closed at an abysmal 4.875 final price (on top of the IMM). When will DTCC/JPM change the default recovery on bonds for the CDSW calc from 40 to 10? Why 10% - because, as the chart below demonstrates, that is what the weighted average CDS auction recovery has been for the past 8 months. Granted it is weighted a little low due to Lehman's significant weight in determining this outcome, but even excluding Lehman, the average recovery is still grossly atrocious (not sure if that is an ISDA-accepted technical term). Hopefully all hedge funds, foaming in the mouth for high yield bonds as the hot potato game shifts from equities to HY, soon realize that it is safe to say that within 2 years this is exactly the kind of recoveries they will be looking at (and at best 3-4 coupon payments). Maybe take advantage of those greater fools while they are still willing to pay par-plus for 10x leverage monstrosities.

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Collateral Use Increases By 86% to $4 Trillion

In a release last week, the International Swaps and Derivatives Association has determined that collateral in circulation has essentially doubled from its 2008 estimate of $2.1 Trillion to $4 Trillion. Not surprisingly most of this collateral is in cash.

Cash continues to grow in importance among most firms, and now stands at over 84 percent of collateral received and 83 percent of collateral delivered.

“Recent market events underscore the importance of collateralization as a risk mitigation tool," said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. "ISDA’s 2009 Margin Survey indicates that, amidst the volatility in the financial markets, collateral management programs continue to expand, covering increased trade volumes and credit exposures."

The 2009 Survey reports that collateral agreements in place now number over 150,000. Among firms that responded both in 2008 and 2009, collateral agreements grew by nine percent. Respondents forecast further growth of 26 percent during 2009. This reflects a long-term trend toward increased collateral coverage.

Additionally more than half of the respondents stated that they engage in some form of systematic portfolio reconciliation, many on a daily basis. Portfolio reconciliation is the process by which market participants verify the existence and salient details of outstanding trades.

This significant sum not only can be used to estimate net exposure from derivatives (although it is unclear if this accounts mostly for CDS contracts or all swaps), but also to indicate the dramatic drop of leverage used to position derivative exposure. As DTCC discloses that gross CDS notional has declined from roughly $65 trillion to less than half, and stood at a tad over $28 trillion in the last week, while collateral has doubled into this number, the contraction in leverage used for CDS and other derivatives is likely material.

Another interesting tangent is where all this money is invested, with Treasuries (especially one month and other near maturities) likely being an easy conclusion. Any endogenous risk events will likely have a shakeout not only in the derivative collateral market but also in their downstream investment, and could potentially be yet another shock to treasury holdings, especially if a wholesale unwind forces the accelerated sale of Tsys by collateral counterparties. Inevitably, market optimists will say all possible black swans have been successfully priced in in perpetuity at this point, although remarks like the one today from the ever evasive Sheila Bair may present a contrarian view:

The FDIC’s resolution powers are extremely effective when a smaller bank fails. But they fall short when it comes to very large financial organizations. Why? The main problem is that we don’t have the ability to resolve bank holding companies. We can only resolve the insured depository institution within the holding company.

Although this shouldn't be a problem: the dynamic duo of Bernanke and Geithner will simply hold a corner conversation behing closed doors to convince any BHC CEO not to default and that will be that. Sphere: Related Content

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ISDA Open Sources CDS Model, Issues Challenge To White Hats Everywhere

In a historic event that went largely unnoticed, last night ISDA disclosed it is open sourcing JP Morgan's legendary CDS Standard Model which it got ownerships of on January 29, thereby issuing a challenge to the global community of financial white hats to decompile the code and figure out just what the voodoo is the wizards in JP Morgan's Quantitative Research group have put together over the ages.

The premise for open sourcing is "is to enhance transparency and to optimize use of standard technology for CDS pricing, thereby helping promote the development of the credit derivatives industry as a whole. We are very pleased to be able to provide this service freely to the entire industry." This occurs on the back of the decision to appoint Markit as administrator of the code, several weeks ahead of the March 20 transition of CDS trading as a standardized contract (i.e. pts upfront on every trade). ISDA has announced it will also disclose model inputs such as recovery value and yield curves in due course. Curiously, ISDA will also launch an "online discussion form, which will provide for community input."

That last bit should make people very, very nervous. ISDA is in effect disclosing the CDS model is imperfect, and likely has inaccuracies and inefficiencies. That would make sense: after all it was initially the rushed product of a few finance/math Ph.D. who with the input of a few credit traders had to cobble up something that they could use to give to accounts, who would in turn use it to trade CDS and pay JPM the bid/offer spread. Over time, overcaffeinated analysts had to make adjustments on the fly, likely with no second set of eyes supervising, due to the escalating complexity of the code. And as any first year IBanking analyst knows, taking a complex model and layering more complexity to it increases the likelihood of terminal errors in output delivery to a near certainty.

So white hats the world over are (or if they are not, should be) decompiling the code and trying to find where JPM goofed, in order to claim a stake in the financial hacker pantheon. After all the incentive to do so is huge - the most recent indication of the total gross notional size of CDS outstanding was roughly $25 trillion. Discovering an error that would lead to even a 1% mistake in CDS model output would imply a $250 billion correction to global P&Ls! And being all too aware of subconscious optimism bias, it is likely that the mistake will not be in the P category.

All those who can't wait to start going thru the code line by line can find it here.

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Smurfit CDS Auction Yet Another Opportunity For Free Money

Smurfit Stone's CDS Auction concluded at 2pm today with a final clearing price of 8.875, a whole 100 bps over the Inside Market Midpoint of 7.875. Whoever got hit - congratulations as the bonds were bid 9.5 post auction, an 7% immediate pick up.

The auction's final closing price was curious as this was the first time in ISDA auction history where the midpoint was lower than the final clearing price. The high final price was a factor of several significant bids at 8.875, most notably $100 million by Barclays which scooped up almost 80% of the entire $128 million auction. As the auction was relatively smaller than Nortel and of course Lehman, it may be not truly indicative of trending datapoints, nonetheless here are the conclusions. Barclays, JP Morgan, and Goldman are still the only truly active desks (and/or B/D with legitimate hedge funds clients that have the liquidity to put in limit bids). Deutsche Bank, Citi, UBS, BofA and Credit Suisse continue posturing, unable to provide any even remotely relevant bids and merely bidding for the sake of bidding, which is due either to lack of trade desk capital or no hedge fund accounts who they could convince to bid in context. Most amusing is Citi 100 million bid at 0.5 which doesn't even deserve a comment.

Final clearing price: 8.875

Weighted average limit price based on indicated notional and levels: 5.67
Sell limit orders total notional: $128.68 million
Total broker expressed bid notional interest: $1.1 billion
Bid Interest to Sell order ratio: 11.6%
Brokers expressing notional interest and limits (sorted by proposed limit price):

Bank of America: $2 @ 7.00
Barclays: $265 @ 8.31
Morgan Stanley: $122 @ 7.34
RBS: $27 @ 7.81
BNP Paribas: $2 @ 7
Goldman Sachs: $248 @ 4.45
JP Morgan: $158 @ 7.92
Credit Suisse: $2 @ 6.25
Deutsche Bank: $131 @ 2.63
UBS: $7 @ 7
Citigroup: $174 @ 1.23 Sphere: Related Content

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The ISDA CDS Settlement Auction is A Hidden Goldmine for Cash-Rich Accounts

When I discussed the basis trade opportunity, the conclusion was that arbitrage in the secondary (and by extension primary) market exists due to significant dislocations in liquidity. Sure, one can argue that immediate culprits for the arbitrage have to do with counterparty risk and funding costs, which makes sense, but those are merely derivatives of the liquidity disconnects between different brokers, their accounts, and any permutations thereof.

The problem with the basis trade, as Merrill and many others experienced, is that in the period of time before its par unwind, a lot of crazy stuff can happen that can force stop losses triggers, significant margin calls, and the overall liquidation of your business.

In the CDS realm a comparable "risk-free" strategy is participating in ISDA-mediated physically settled credit default swap auctions. These occur roughly a month after the ISDA council determines there has been a "credit event" in a given corporate name (most usually filing of bankruptcy, or some other default variations). As there will be many bankruptcies this year, and numerous physical settlement auctions, accounts that have liquidity can generate quick, practically riskless returns arising from a liquidity-fundamental value disconnect. In fact the most recent ISDA calendar indicates there are quite a few auctions coming up:

• Millennium America, February 3
• Lyondell, February 3
• Equistar, February 3
• Sanitec, February 5
• British Vita, February 9
• Nortel, February 10
• Smurfit-Stone, TBD

One thing to note is that virtually any account which trades fixed income can participate in the auction, it is not limited to parties which have preexisting CDS relationships with the defaulted entity.

So in terms of a chronological summary (for the full chronolgy in the Lehman case, click here. Also props for whoever finds the rather big mistake ISDA made in compiling this schedule, hint: Tembec)

• A few days before the auction ISDA prints the list of deliverable obligations that will be allowed to settle physically - many times these are most of the corporate bonds of an issuer, but in some very complex cases (Lehman and FNM/FRE most notably) only a certain percentage of bonds are selected.
• The day before the auction, ISDA publishes the full list of participating bidders which will serve as the clearing agents to make sure all offers are exhausted.
• On the day of the auction many things happen in rapid succession. The key items to keep track of are the submission of the amount of bonds one is willing to purchase and at what price, the determination of open interest (amount of bonds that have to be purchased in the auction by various dealers), and the final price, which Creditex posts at 2 pm on the auction date, which is also the close of the auction. It is important to understand that physical settlements are Dutch auctions: i.e. clearance occurs at the lowest price at which all net sell interest is absorbed. Therefore, a bidder does not stand to lose by placing a low ball bid as it may very well end up the critical one, and result in the final price.

Due to the significant residual overhang of protection sellers in the 2003-2007 period, most auctions end up with a net open sell interest. Let's take the case of Lehman:

After dealers submit preliminary inside bid indications, they are allowed to participate in the auction. The final bid price is based not on the inside bids but the actual limit orders (a combination of broker and customer orders) at which the Dutch auction clears.

The next important step is determining the Net Buy/Sell interest. As noted, most auctions are entered into with a net open sell interest due to excessive protection selling which is one of the main reason for the arbitrage. As presented, in the Lehman case, despite nearly $150 billion of defaulted unsecured debt, there was only $4.9 billion in net open interest (offered), proving all doomsayers of the CDS market wrong, as at its core it is a fundamentally very efficient market, regardless if it trades OTC or on an exchange.

After the net open interest is calculated, bidders submit limit bids which is where the liquidity arbitrage truly comes into play. The Lehman auction is probably not the best example of the arbitrage as two of the bidders had market-conflicting interests, although it will still demonstrate the point (Barclays which had legacy interests from its Lehman broker/dealer acquisition, and JPM which had the government's backstop at this point and likely other derivative interests in clearing bonds at a certain price). The chart below shows the cumulative total bid interest by pricing bucket (again for the full backup check out the Creditex link above).

Notable here is that the preponderance of bids are at ridiculously low levels, with the average of the total $132 billion notional in submitted bids (which is surprisingly close to the total amount of outstanding debt - perhaps dealers and accounts had assumed that as much as the total unsecured debt may be open to physical settlement) in the 2-3 cent range. Obviously many bidders were focused on the Dutch aspect of the auction, trying to aggressively lowball the market. As the final net sell interest was relatively low in comparison with the total bid interest, $4.9 Bn vs. $132 Bn, the clearing price was higher than the average. However, as mentioned above, JPM and Barclays, which likely had other motives in terms of procuring Lehman securities, alone accounted for $2.5 billion of the $4.9 billion in effective bids. Without these the final price would have had a 7 handle.

The key aspect of the ISDA auction, is that it significantly reprices the secondary market of the existing securities (which at least in theory is determined by fundamentals) based on an exercise in liquidity. It is feasible that with much larger open interest the ISDA auction may have cleared at 5, even 4. Why is this important? Because Lehmans' bonds in the days before the auction traded at markedly higher prices. As an example, let's take the 6.625% Notes due 1/2012, which in the three day prior to the auction closed with an average price of 12.5. (Chart below)

As representative Lehman bonds had been trading in low teens (in this example the 6.625% Notes closed at 13 on October 9, the day before the auction, according to TRACE) the highest bid bucket will almost certainly be below the market price. And this is where the arbitrage comes into play. Managers who wish to enter a specific bankrupt security don't have to buy it in the open market if there is an ISDA auction approaching - they merely have to submit a reasonably discounted bid in the ISDA auction in order to be able to purchase the security, by taking advantage of the liquidity dislocations in the market. Here, the ISDA clearing price of 8.625 was about 35% lower than the prior closing price (13) for an indicative Lehman issue which was a deliverable. This is also sometimes called the cheapest to deliver phenomenon as the clearing price will very likely always be lower than the market price of the cheapest trading security in the secondary market that is part of the deliverable schedule per ISDA.

The liquidity part of the equation comes into play when one considers that fewer and fewer dealers and funds have lots of spare cash lying around to participate in these kinds of auctions. Once an account submits a formal bid (bid and notional), it is binding. Which is why in many of the upcoming ISDA auctions (Lyondell will likely be the most anticipated one) a buysider may make off like a bandit merely by submitting a large, substantially out of the money big which gets triggered when the Dutch auction doesn't find filling bids on the way down.

Admittedly, there are many more nuances to the physical settlement process (could discuss offline time permitting), but in a nutshell it is a great opportunity for still liquid accounts to purchase bonds in bankrupt entities at a significant discount to market values. If one chooses so, these may be flipped immediately in the open market which still trades substantially higher than the auction results (in Lehman's case on the day after the auction, the 6.625% bonds closed at 9.6% allowing for a 10% return in one day).

There are odd exceptions: the Fannie/Freddie physical settlement auction ended up in some surprising results, where due to technical considerations, the subs ended up with a higher clearing price than the seniors (there is good literature out on the net as to why this happened). Additionally the final auction Creditex document provides some very good insight into which broker/dealers may have liquidity constraints. The Lehman auction specifically demonstrated that Morgan Stanley is severely strapped for cash: despite their inside bid/offer levels of 8.25/10.25, they indicated firm limit orders only below 5 cents. The upcoming auction results will provide a rare glimpse into just how cash limited (or not) broker dealers are currently: I would keep an eye out on Goldman, Morgan Stanley, Merrill and RBS. If the liquidity malaise is indeed spreading, funds will be able to take advantage of the brokers' troubles, and purchase securities at some very significant discounts to prevailing market rates.

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