NuclearPhynance Archive

I don't think you can make a complete argument about the state of global economic affairs by looking at the equity market.



1) DJIA recently gave back all of 2007 gains, 10% fall from peak

2) Certain sectors have indeed been nailed - i.e. financial-related stocks

3) Rate cuts mean higher PV, and likelihood of fed funds with a 3-handle in early 08 is proven out by the rates markets

4) Volatility has increased, which represents a net transfer of value away from debt and into equity - i.e. positive for limited-liability claimants

5) Shortage of equity investments in countries where SWFs are large due to commodity and trade trends of the recent past (not necessarily future) is creating additional 'idiosyncratic' demand (i.e. think Citigroup)



The fact is, any market counterparty that can buy bonds and trade CDS can earn a virtually risk-free premium of over 75bps for 5y right now by offering their liquidity to the market. That is the highest it has been in the recollections of pretty much everybody I know. Usually the number is NEGATIVE rather than positive - i.e. benefit should be accruing to the risk-taker rather than the liquidity provider.



Hate to say it, lads, but Jim Cramer was, and still is, correct.

Virtually risk-free? It carries funding risk - the risk at some point that you cannot get leverage on the asset or only at highly punitive terms such as hc and L +xx (xxx?), and mark to market risk. If you are highly leveraged, with say 30x assets to equity ratio and suppose you are undiversified (ala SIV/NRK) and just own basis, 10y basis only has to fly 35bps in your face before to mk to mkt ur equity to 0 and to stop people wanting to lend to you. Taking on this package requires balance sheet room, and faith that you can always access funding. I believe using the FED comes with a haircut which gives leverage less than most banks balance sheet, and i think only deposit taking insitutions can access the fed - no investment banking co's can directly access the fed (wuld need to check precise details, and obv most can back to back it thru their other co's).



Im not dissing it, i buy some at these levels, but ultimately one is a leveraged instrument with limited funding need and one is unlevered. One can trade at true default expectations, the other trades at the rate of return required for unlevered cash

no, the premise is that if you have term cash, you can buy bonds and hedge w/ CDS, reducing your risk to 2nd-loss (i.e. both the bond AND your CDS counterparty blow up), and get paid +75. I don't see any leverage here at all, or MTM triggers. If anything, the basis will also tighten and you will get paid to unwind the transaction. I am not talking about bank people doing this, I am talking insurance or other people (SWFs) who are long cash for cash's sake - i.e. b/c there is nothing better to do.

Obviously there is no leverage issue if you are real with term cash, but i think most real dont trade derivs, and there are plenty of good ops to buy bonds outright at current levs, since ig cash and long cash bonds are historically very cheap, but i dont see much of a bid right now. SWF seem to be more interested in buying equties. I completely agree that if you only have a choice between buying treasuries/agencies or ig corps with CSA'd cds at L+75 then the latter is a much better use of term cash. But the guys positioned to do the trade, and who have historically done this, banks/leveraged insitutions would not be doing a virtually riskless trade to buy more.

Part of the issue we are running into is that counterparty risk is now being overstated versus almost completely ignored as it was before. One thing that is making it even more difficult is that the counterparties (lets say a CDPC) are really just set up to achieve a high rating and everyone is skeptical of the RAs ability to get credit right. I'm now working people through posting requirements, trust me it will be cool is not good enough anymore.

true AAA CDPCs do not post collateral under ANY circumstances, not sure what you mean by your comments on working through collateral postings...

that's right.  we were approached by a AAA CDPC who wanted to sell us supa senya. we started the ISDA negotiations and were told that the RATING agencies wouldn't allow any counterparties to call for collateral. IN fact, that's one of the conditions for BEING AAA CDPC.  It's stupid if you ask me. we said thanks but no thanks (thank god).



I think the cross default may be an issue, but the much higher probability problem would be CDS CP defaults...then what? then you have to replace a CDS probably in a shitty market.  why would a CDS counterparty default in such a case? probably because of some real phucked up event in credit space in general. I suppose at that point the "arber" would be in a phucked up situation of having full capital treatment of the super senior on balance sheet with no protection, and if he replaced the CDS it could now be way under water.  on funding risk, I suppose having term cash would be the only way to do this these days; could you imagine doing this at XYZ bank and just getting 3M funding and then XYZ is downgraded (leaving aside the current obvious problems of liquidity)?

Re not posting collat, that is sort of the same thing as avoiding MTM triggers in the structure. I would argue a good part of the mess on our hands now comes exactly from people who thought they were making life BETTER by adding MTM triggers. Instead, collateral got flushed BEFORE the ratings downgrades. On a macro level I think this led to a bad outcome.



If you don't like that, then you can find somebody to intermediate - i.e. face the CDPC on one side under a gtee-type contract, and face you under a CSA. That of course brings the counterparty risk back into the picture, b/c anybody who would intermediate generally has a higher prob of failing to post collateral than the prob of default of either the asset, or the monoline. But, I don't think it HAS to be this way, it's just that the market for liquidity is almost inherently attached to the market for credit.



I am not an expert on ISDAs - not sure who bears the cost of counterparty substitution but I would think it's the counterparty, i.e. not your own problem. Same with funding commitments that draw upon downgrade - in that case anyhow it's clear that the problem is with the counterparty.

yeah, but we never trusted Moodys in the first place on CDPC ratings anyway.  my colleague likened the rating to this:  guy has an ice cream truck and he sells insurance against a house being hit by a meteor.  guy has very little capital, and in fact can barely pay out one claim.  he's AAA, simple because the event itself is deemed to be AAA risk.  



Plus, the no collateral calls was just the beginning.  there were a bunch of other restrictions Moodys put on dealing with counterparties. can't remember all of them, but I thought it was sort of paradoxical to disallow CPs from mitigating against risk because it would put the AAA at risk.  There's a school of thought that Subprime crisis followed by general systemic liquidity shock was due to the domino effect of CPs making margin calls, which led to fire sales of not only illiquid assets but also liquid assets (hence knock on effect in equities in August etc).  However, I'm not just going to trust a rating agency and an ice cream truck and ridiculously restrictive covenants.



by the way, remember back in the day when you, Stork, and I were scratching our heads on why there was this nice arb of buying the whole lot of senior tranche and then just buying CDS?  anyway, I think the price of the CP risk itself is probably only a fraction (if CP were not correlated, it'd be on the order of the price of a CDS swaption times  the CDS spread of the CDS counterparty).  In retrospect (20/20 thing), it was the funding risk.  Guess that's obvious.

ok, that's fine, I would definitely say that the rating agencies have proven their incompetence in all things of a mkt value nature - which would include sivs and cpdos. But really, when you think of failed financial instutions, usually you think of banks and not insurance companies. It's something I want to look at a bit more - but the idea of not allowing acceleration of claims is a sound structural concept. If you can't model the correlation, you might as well have some control over it. Beyond that, CDPCs are just risk aggregators like banks, and you take ratings volatility (AAA one day, CCC the next) as the tradeoff for getting AAA today and not A-/BBB+. That too is a bit like funding risk.