[A-List] Rumors and News: Credit Derivatives Trigger Near System Meltdown

["Sabri Oncu" <soncu@xxxxxxxxxxx>]

--- FINANCIAL POLICY FORUM ---

Derivatives Study Center
www.financialpolicy.org
1660 L Street, NW, Suite 1200 
Washington, D.C.    20036
 

Special Policy Brief 26
 
Rumors and News: Credit Derivatives Trigger Near System Meltdown

Randall Dodd, Director
Financial Policy Forum

August 5, 2005



Rumors started circulating two months ago concerning the possible failure of
several large hedge funds and massive losses by at least one major global
bank.  The source of the troubles was a free-fall in prices in the credit
derivatives market that was triggered by the downgrading of GM and Ford.
The financial system ended up dodging a systemic meltdown, but without
proper coverage and analysis of the events there will be no lessons for
policy makers to learn.

This Special Policy Brief is an attempt to put these rumors together in
order to tell a coherent story.  The purpose is to show how the events posed
a severe threat to the stability of our financial markets and overall
economy.  The narrative also should help illustrate the market problems with
these non-transparent markets organized around dealers with no commitment to
market participants to maintain orderly and liquid markets.  

During these May events, there were only rumors because this "near-systemic
meltdown" - in the words of a senior representative of the securities
industry - occurred in OTC derivatives markets where there are no reporting
requirements and hence no real transparency.  

Instead of news and facts, it was rumors that circulated.  First the rumors
were of one hedge fund failing, and then another.  As the New York Times
(May 12, 2005) put it, "One firm that was the subject of rumors was
Highbridge Capital Management."  Highbridge, which manages a reported $7
billion in hedge fund investments, had to send out a reassuring letter to
investors denying the rumors.  GLG Partners - a London hedge fund owned by
Lehman Brothers known to have suffered enormous losses - was also the
subject of such rumors.  More alarming were rumors that Deutsche Bank had
lost $500 million on its own account from trading in credit derivatives and
that it faced further losses through a default from its prime broker
relationship with an unnamed hedge fund - its stock slid 3% as a result.
Kim Rupert, analyst at Action Economics, put it this way, "There could be
pretty substantial problems given the size of the moves. At this point we're
trying to figure out whether this is just the tip of the iceberg and how big
this iceberg may be."[1]

A few journalists cautiously reported this, but were constrained by the lack
of factual information and flat denials or refusals to comment by those
targeted by the rumors.  Being long rumors and short facts is not the basis
for sound journalism.  And it is made all the more acute because so few
journalists feel comfortable talking about the intricacies of derivatives
markets and especially credit derivatives.  

*


THE SETUP

The sources for this Brief are several news articles and a series of
conversations with financial professionals at major financial institutions,
trade associations and credit derivatives markets in particular.  So it is
different from previous Special Policy Briefs because it is not built solely
upon data and other official facts.  Given these limitations, it attempts
construct a more complete picture of the near catastrophe.

Two investment strategies created the condition for these market
malfunctions.  The first investment strategy was for hedge funds to sell
credit protection (i.e. insurance against default or downgrade) to major
banks and broker-dealers through credit derivatives.  These major financial
institutions use these derivatives to reduce their capital requirements by
shifting risk onto unregulated hedge funds.  As a Federal Reserve Board
study put it, "In addition, the use of synthetic CDOs has been mainly
motivated by the needs of commercial banks to free up regulatory capital,
rather than to offer investors an alternative to the safety of U.S. Treasury
securities, and indeed, U.S. banks tend to retain the super senior tranches
of synthetic CDOs in their balance sheets."[2]

Of the array of derivatives, credit default swaps and especially synthetic
collateral debt obligations (synthetic CDOs) were the vehicle of choice to
transfer credit risk and income.  (A brief description of both can be found
in Box 1.)   The strategy first involved hedge funds selling protection on
the equity tranche of a synthetic CDO.  The equity or junior segment of a
synthetic CDOs is responsible for the first portion of the corporate names
in the CDO to suffer a credit event.  It offers the highest risk and the
highest return portion of the credit derivative.  This generates income to
hedge funds as the protection buyers - often banks and broker-dealers - pay
an "insurance premium" of sorts in order to move credit risk off their
books.  

It should be added at this point that the proprietary trading desks at major
banks and broker-dealers also took speculative positions through this credit
arbitrage investment strategy.

Hedge funds manage their exposure to this credit risk by shorting the
underlying corporate bonds - when economical - or by shorting the mezzanine
tranche of the synthetic CDO.  The economics of this latter strategy amounts
to selling protection on the riskiest tranche and buying protection on the
second riskiest tranche.  The idea is that corporate credit spreads tend to
move together, i.e. have a high degree of correlation, so that losses on the
equity tranche would be offset in part or whole by gains on the mezzanine
tranche.  Hedge funds capture gains on this long and short credit risk play
because payments they receive on the equity tranche are greater than that
they pay on the mezzanine tranche.

The second investment strategy forming the basis of the market meltdown was
hedge fund investments in convertible arbitrage.  This strategy involves
buying convertible corporate bonds - bonds with an attached call option that
allows the bonds to exchanged or converted into stock at what amounts to a
specified price - and hedging out the value of the call option by
short-selling the stock.  (The amount of stock sold short depends upon the
exercise price or conversion ratio, the sensitivity of the option value with
respect to changes in the stock price (the delta risk), and the sensitivity
of the delta with respect to the stock price (gamma)).  The strategy
generates a low risk income if the options value of the convertible bond is
under-priced in the market and because the practice of hedging the option's
value results in systematically selling the stock when the price is high and
buying when it is low.  Would Adam Smith have made such a high moral purpose
of this buy low and sell high activity?

In sum, the foundation was created by two hedge fund investment strategies
that were long GM and Ford credit risk while proving inadequately hedged
with short positions in mezzanine level credit risk and stock. 
 

THE CATALYST

Some people celebrated the past May the 5th for Mexico's victory over French
invaders in 1862 and others celebrated it as Karl Marx's birthday (his
187th), but the folks at Standard and Poor's apparently saw it as the time
to release some seriously bad news to credit markets.  GM was cut two
notches to BB and Ford one notch to BB+.  

Although this represented just a couple of steps down the credit grade
ladder, it meant that these two corporate giants crossed the threshold from
investment grade to junk status.  Falling from the status of investment
grade meant that pension funds and some other managed funds might be
prevented from investing in their bonds.  As a result, the price effects of
this downgrade were larger than would otherwise result from a single or
double step downgrade.

The downgrade also meant that both GM and Ford bonds might be removed from
the Lehman Brothers and Merrill Lynch bond indices that set the performance
standards for portfolio managers on Wall Street and elsewhere.  Removal from
these indices would likely harm demand because portfolio managers would not
need to buy the bonds in order to match the returns on the index.  

This other reason that this downgrade was atypical is that GM and Ford were
a major share of the corporate debt market.  GM had $290 billion in
outstanding debt and Ford had another $160 for a total of $450 billion -
several times over the size of Argentina's debt which suffered a default a
few ago.

Since the announcement by S&P was widely expected - hints had been
"telegraphed" to markets by S&P for some time - it is all the more telling
about market stability that it ended up having such a profound impact.  As
one wire service put it, "After the downgrade there was a few minutes of
silence, followed by 15 minutes of mayhem."[3]
 

THE DELUGE
 

The downgrades had the following impact on the two investment strategies
that was compounded by their impact on credit derivatives prices and to a
lesser extent GM and Ford bonds.

The credit arbitrage investment strategies were hit hard by the downgrade
because it resulted in an "uncorrelated" event.  The credit rating and
credit spreads of GM and Ford were sharply affected, but there was so
comparable impact on other corporate ratings or spreads and so corporate
credit spreads did not change in a correlated manner.  The result was that
the equity tranche of synthetic CDOs (see box below for description)
underwent a huge price swing (the price of protection reported to have risen
from 16% to 50% of notional principle for the benchmark CDO index) while
that of the mezzanine tranche remained unchanged.  The result was a
breakdown in the hedge component of the investment strategy that left huge
losses on the equity portion with no offsetting gains on short positions in
the mezzanine level.  Hedge funds that tried to buy back their position were
crushed when they had to pay 50% for what they previously sold for 16%.  

And that level of loss was not always available because market liquidity
broke down.  As one newspaper put it, "When these generated losses after the
May turmoil and many investors tried to unload loss-making positions at the
same time, liquidity evaporated."[4]  This appears to have been example of
what Avinash Persaud has described as a "Liquidity Black Hole."[5]

The price impact was very high - movements from 16% to 50% represents a
tripling of prices - and this could be due to the tremendous growth in the
credit derivatives market and the fact that it has outgrown the amount of
underlying cash credit instruments, i.e. bonds, in some areas.  "There are
indications that growth in CDS activity, especially for highly volatile
names such as GM, may have outpaced growth in cash market activity by a
factor of three to one this year, highlighting the greater use of the CDS
market for those who wish to either take on or lay off credit exposure,"
said Jim Batterman of Fitch Ratings.[6] 

Another reason for the price impact can be explained by the market
structure.  Credit derivatives are traded in OTC markets where a few major
financial institutions act as dealers.  Prices are not fully transparent,
and the dealers are under no obligation to act as market makers.  When
certain kinds of trouble emerge, they are free to withdraw from the market.
At other times when market participants have reason to doubt the
creditworthiness of a dealers - such as rumors that they face massive losses
from trading or lending to hedge funds - then the dealer's counterparties
withdraw from the market.  And then sometime both factors happen at once.
The illiquidity that results is in sharp contrast to the behavior of
derivatives exchanges and securities exchanges where liquidity is all but
assured.  It is also in contrast to the OTC market for U.S government
securities where primary dealers are required to maintain bid/ask quotes
through the trading day as a condition for their primary dealer status.

At the same that the credit arbitrage strategy was collapsing and causing
spikes in credit risk protection, the convertible arbitrage strategy was
suffering its own version of the disaster.  While in normal times the
convertible arbitrage strategy generated low risk and high returns, in rare
situations it became very high risk and big trouble.  The downgrade of GM
sent the price of its bonds tumbling, and the short stock position would
normally have provided some protection against this event.  However, Kirk
Kerkorian's bid for GM was not a normal event and it sent the price of
stocks up at the same time the price of the bonds was falling.  Hedge funds
that were long the bond and short the stock lost in both directions -
instead of being hedged they found themselves doubly exposed and with
leveraged positions.

In short, prices were free falling towards a dry lakebed of a market.  Their
fall was arrested, according to the same rumors, only hen previously
uninvolved investors came into the market to seeks gain from what they
perceived to be miss priced derivatives.


CONCLUSION: THE FIRE NEXT TIME?

What is the extent of the fallout?  Exact amounts cannot be known with any
clarity or certainty.  Actual losses at hedge funds and proprietary trading
desks are not reported or at least not reported separately.  The change in
credit derivatives prices can be estimated from the iTraxx index for credit
derivatives, however there is no reported information on the volume of
trades and value of derivative and cash positions.  Thus estimates of gains
and losses to individual firms and the market cannot be determined.

Some anecdotal information can be gleaned from announced hedge fund
closings.  The well-known Marin Capital hedge fund closed doors after big
losses in convertible arbitrage and credit arbitrage; and Aman Capital also
closed shop at the end of the mid-year.  GLG's Neutral Group, which has
credit derivative investments similar to that of Marin Capital, lost $2.5
billion or 17.2% in the first half of the year.  Cheyne Capital's hedge fund
lost 4.8% in May alone.  The huge hedge fund Bailey Coates Cromwell Fund,
after being named Hedge Fund of the Year for 2004, announced in early June
that it would close down.  

What lessons might markets and policy makers have learned?

The financial sector maintained its customary stance.  Either there is no
problem or the limited impact of the problem proves that the system works.
An exception comes from Louise Purtle of CreditSights, who stated "The
combination of leverage, credit deterioration, event risk and illiquidity
now bodes ill for how pervasive a period of weakness the corporate bond
market will face."[7]  And as an unfortunate coincidence in timing, ABN Amro
and AXA Investment Managers chose this time to role out a credit derivatives
fund aimed at attracting retail investors.[8]

Reaction by the official sector varied a great deal.  Of US officials, SEC
Chair Donaldson appeared the most alert and perceptive, stating, "Every week
seems to bring another article in the press about the crowding of hedge
funds into similar investment strategies and the difficulty that this
implies for hedge fund managers eager to post market-beating returns. If
history is any guide, it is just this sort of pressure that can lead
otherwise well-intentioned professionals to pursue practices that can
ultimately result in disaster for the investors they serve."[9]
Unfortunately, this person is no longer helping to regulate financial
markets.

In comparison, U.S. bank regulators appeared to have been drinking something
caffeine free.  Timothy Geithner, president of the New York Federal Reserve,
equivocated with, "The growth of credit derivatives . . . seems to have made
the system more stable" and at the same time these improvements have come
"at the price of increasing uncertainty and potential losses".[10]

This position pretty well mimics the equivocation of Federal Reserve chair
Alan Greenspan's views on derivatives and credit derivatives especially.
Greenspan gave a speech at the Chicago Fed's annual banking conference on
the very day of the downgrade and market panic.  While expressing his
concerns about hedge funds and credit derivatives and concentration amongst
derivatives dealers, he also took the opportunity to restate his view that
these markets should not be regulated.  

This ambiguity about financial contagion and other threats to financial
stability may very well be itself contagious.  The IMF's Global Financial
Stability Report, released before the May events in April of 2005, also
concluded that the role of large, complex financial institutions might or
might not contribute to global financial stability or instability.  

Federal Reserve Board vice-chair Roger Ferguson suffered from neither
equivocation nor concern as he expressed his glowing assessment of the
market.  Speaking to the U.S. Financial Professionals and Global Corporate
Treasurers Forum in San Francisco, he said "Hedge funds are not at this
stage a source of instability, nor likely to become one," he said. "The
market discipline of hedge funds has improved over what we have seen in the
past."  Reporters described him as also saying that the largely unregulated
global hedge fund industry was improving market efficiencies.[11]  

One last important item in the policy sphere deserves special attention.
The Counterparty Risk Management Group II, formed in January of this year,
released a related report entitled, "Towards Greater Financial Stability: A
Private Sector Perspective" on July 27, 2005.  Although the report does not
mention the near-meltdown until page 239 of the 278 page report, it does
address such issues and does provide a thoughtful and coherent analysis of
financial disruptions and threats to financial stability.  (Available at
www.crmpolicygroup.org).

In contrast to its analysis, the report's recommendations are weak.  They
are mostly non-regulatory and amount to an appeal for voluntary compliance
to several trading, settlement, disclosure policies by the major financial
institutions and their hedge fund counterparties.

"Most of the Recommendations and Guiding Principles relate to measures that
are within the control and reach of individual institutions. Others entail
collective actions by institutions and their so-called "trade groups.""

Even these recommendations face the daunting assumption of the role of such
a entirely private, financial sector group: 

It was clearly understood by all at the outset that these individuals were
not representing nor speaking on behalf of their employers [Wall Street
banks, brokers and fund managers] and that neither the individuals nor their
employing agencies were being asked to endorse the Report or any of its
component parts.

Nonetheless, a noteworthy exception is their call for a joint public and
private sector effort to study the potential for a proper framework for
regulating hedge funds.

47. Recommendation, Category II & III (pages 149 to 150)

CRMPG II recommends that the private sector, in close collaboration with the
official sector, convene a high level discussion group to further consider
the feasibility, costs and desirability of creating an effective framework
of large exposure reporting at regulated financial intermediaries that would
extend - directly or indirectly - to hedge funds. Using the indirect method,
regulators would collect and aggregate large exposure data from
traditionally regulated institutions and, through those institutions,
collect data on hedge fund activity. Under the direct approach, hedge funds
would, on a voluntary basis, provide large exposure data directly to the
appropriate regulator.


Rumors are no way to lesson regulatory lessons.


It would be preferable to conclude on a positive note, but there really
isn't one.  Perhaps two negatives ones will do equally well.  The first note
is that the details of the May events will not likely be assembled and made
available to the public for analysis, scrutiny and fuel for good public
policy deliberation.  The second note is that both the public regulatory
authorities in the U.S. (although the situation is different in Europe) and
the powerful financial interests are dead set against taking regulatory
measures to address these concerns.  They cry out about the crushing cost of
regulation, but they ignore the benefits or a more orderly market and they
discount the costs of regulations emerging out of a realized as opposed to a
near systemic meltdown.


*

A better formatted and more easily printed version is available out our
website: http://www.financialpolicy.org/dscbriefs.htm


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[1]     Financial Times and National Post, May 11, 2005
[2]     Antulio N. Bomfim. 2001. "Understanding Credit 
Derivatives and their Potential to Synthesize Riskless 
Assets." Federal Reserve Board, July 11, 2001.
[3]    Dow Jones Newswire, May 5, 2005, quoting Michael 
Fuhrman, product manager at GFI in New York, an 
inter-dealer brokerage in credit derivatives.
[4]     Gillian Trent, India Business Standard, July 6, 2005
[5]    State Street Bank working paper, 2001.
[6]     Quotes in Financial Times, May 12, 2005.
[7]     London Times, May 14, 2005.
[8]     Financial Times, May 6, 2005, "Fund lets retail 
investors bet on CDS A new credit derivatives fund will 
open up to small investors previously unavailable sources 
of risk and reward, writes Ivar Simensen."
[9]    HedgeWorld
[10]     Quotes in FT, May 14 ,2005
[11]     Financial Post, May 13, 2005

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Box 1: CREDIT DERIVATIVES

Credit Derivatives 

A financial contract that transfers the credit risk of a reference asset,
also known as a "name," from one counterparty to the other in exchange for
payment.  The protection buyer or originator makes a periodic payment (think
of an insurance type risk premium) to the protection seller.  In exchange,
the protection buyer has the right, upon the occurrence of a credit event,
to deliver loans or securities to the protection seller in exchange for an
agreed upon amount (typically par) - or to cash settle the claim.  A credit
event is usually defined as the failure to perform on a scheduled payment,
but might also be defined as a downgrade, bankruptcy filing or other such
"event." 



Credit Default Swap (CDS) 

The contract is structured so that one counterparty pays a constant payment
or "insurance premium" to the other counterparty in exchange for protection
from a specified credit event on a particular name or reference asset. 


Synthetic CDOs 

Synthetic CDOs can be thought of a basket or a portfolio of credit default
swaps (CDS).  The term synthetic is used to distinguish them from a class of
credit-linked structured securities called collateral debt obligations
(CDOs). The key difference is that synthetics are pure derivatives and while
the CDOs are securities with an actual (as opposed to a notional) principal
that is attached to a credit derivative structure. 

The risks and payments on these instruments are usually divided into
segments called a "tranche" in order that they might better fit the needs of
investors.  The most junior tranche, known as the equity tranche, covers the
first corporate names to suffer a credit event.  The next level of risk is
the mezzanine or intermediate tranche and covers the portion of names
suffering a credit event after the equity tranche as been exhausted.  The
least risky is the senior tranche and is responsible for the last of such
credit events. 

The premia or protection payments for each tranche are set when the
synthetic CDO is issued.  In subsequent trading in the secondary market the
tranches are priced as a percentage of their notional principle.  As credit
risk rises, the price might rise from say 5% to 10% of principal for the
tranche that pays a fixed number of basis points in exchange for credit
protection on that tranche.

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