Sunday, 15 July 2018

The need for CDS and honesty in bond messaging

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  • Anthony Peters columnist format

I am worried this morning. I am worried by an article in the pink’un titled “Investors pour back into crisis-era credit products”. The article highlights a rise in investor interest in bespoke tranches, a bundle of risks expressed through credit default swaps.

My worrying does not emanate from the re-emergence of synthetic structured credit products but from a response similar to the one which sees North Korea with a nuclear capacity and with the ability to fly a ballistic missile and immediately concluding that that it has nuclear missile capacity.

Please let me explain.

In the run-up to the global financial crisis, the use of credit default swaps got out of hand – of which more later – but they are of themselves not at all toxic. They are, expressed as an insurance contract, an agreement that against a payment of an annual premium by the buyer of protection, the seller will make whole the buyer in the event of the insured credit risk defaulting.

So if I buy US$10m of five-year protection on Daimler Benz at 50bp, I pay you US$50,000 per year for 5 years and you promise to pay me up to US$10m (depending on the result of the credit event auction) if Daimler were to default on its debt at any time during the five-year period. I do not need to actually hold any Daimler debt in order to make good my claim. Thus a CDS is not a guarantee in the traditional sense but an insurance against an event, priced on the likelihood of it occurring.

Of itself, the CDS is a brilliant invention. As I have often argued when slamming the blunt instrument of regulation, liquidity in stocks and in bonds cannot be compared. If anybody in the world trades a Daimler share they are all talking of only one security, irrespective of what currency they settle the trade in. Daimler Benz, however, has 164 bonds outstanding in 11 different currencies and for eight different borrowing entities. Finding a buyer and a seller of the same bond in the same currency for the same borrowing entity at the same maturity and on the same day is a very different prospect and where market makers took on the risk of finding the other side of the trade in time. The price for bridging that time difference, known as liquidity in the bond space, was the bid-ask spread. The more likely to find the other side soon, the smaller the bid-ask spread, the harder it would be, the wider the spread. This, in bond markets, is known as the liquidity premium.

Credit default swaps are generically priced on a generic entity for a generic maturity, thus offering credit investors something not dissimilar to the risk traded by equity people. The difference is that equities are cash securities while CDS is a derivative which means that the risk is not only on the credit but also on the counterparty who might not be able to meet their obligation if called upon. In many cases during the GFC it was the counterparty, such as Lehman Brothers, which ended up defaulting and not the underlying credit. So if I had bought protection on Daimler from Lehmans….I’m sure you get the message.

Let’s move on.

One of the great problems in the run up to 2007 was the way in which transactions were structured. Assume a portfolio of black and white risks. Together they are grey and that is how the ratings agencies assessed the portfolios. So if I bunch a stack of AAA rated risks with a bunch of BB rated ones, I can end up with a BBB rated portfolio and the investor believes he has a BBB rated bond. He doesn’t. If one credit at the bottom end of the spectrum were to deteriorate, then something at the top end would have to improve in equal measure in order to maintain ratings equilibrium.

This doesn’t happen and most certainly not in a declining credit environment. Thus a fall in the overall rating of the market begins to really hurt once investors start to look for the door and they find themselves in a long and lengthening queue. Market leverage only goes to enhance the panic and a crisis rapidly turns into a disaster. The credit crisis was driven by toxic sub-prime risk, leveraged up to the ying-yangs. Corporate risk CLOs and CDOs, many of the latter of which admittedly were not of the finest silk brocade, were amongst the babies which found themselves being poured out with the bath water.

Many bank boards – I’m especially thinking Landesbanks and other less sophisticated regional lenders – insisted on their investment books only buying AAA rated structures. There is, however, a big difference between a World Bank AAA and a AAA rated structure which just made it over the line and where a single downgrade could push the rating south at the blink of an eye. It was in this area of squeezed marginal ratings that the worst single credit arbitrages were taking place. That said, as often as not the buyers only ever saw what they wanted to see which is why many of the more sophisticated structured credit investment companies came though the crisis with the odd black eye but without losing a leg or worse and are still in business and making money to this day.

As a gun owner myself, I know that guns don’t kill, people kill. But the NRA’s rather asinine assertion forgets that one must tightly control which people can lay their hands on those guns. In the same way, there is nothing endemically toxic about either a CDS or any structured credit product. The toxicity emerges when competition breaks out between asset managers as to who can demonstrate the highest risk-adjusted returns and when buyers and sellers begin to con themselves and each other as to how much risk is actually embedded in any given structure and what the correct return should be on that risk. Competition tightens spreads, which in turn creates a false image as to how high or low the risk actually is.

The FT article loosely infers that single tranches are of themselves dangerous. They are not. Apart from that the wholesale demonisation of CDS has done just as much damage to the underlying liquidity of credit markets as have enhanced capital reserve requirements and the control of information exchange. Knowing where prices are is one thing; knowing why they are where they are is another entirely. The ability to hedge credit risk in a cheap, liquid and generic form is invaluable.

The article also suggests that things are not that bad as it is so far only hedge funds which are currently in the tranche game and not pension funds and other “real money” investors. And whose money does the writer think the hedgies are managing?

Meanwhile, did anyone else catch the bond launch yesterday for ISS Global, the Danish facilities management company? In the morning a deal was announced, €500m at 10 years with guidance at mid-swaps + 90 area. At 12pm an update was given that the book was at €2bn and guidance was revised down to +70 to +75, will price within range. At 12:20pm the deal came at €600 million at +70 with the added info that the book had been at €1bn. So at noon the book was 4 times oversubscribed but at launch 20 minutes later it was only 1.66 times subscribed, a detail which only became known post-factum.

Should it not be incumbent on the lead management team to make such a material change in the status of the transaction known to subscribers before the transaction is priced? Please don’t get me wrong; I’m not in favour of padding orders, but everybody does it - though many deny it - and leaving interested parties with the impression that the book is 4 times over when, after drops, it isn’t at all is highly questionable. Partial and biased information, even if correct, is just as unacceptable as false information. I rest my case.

Today this is a Jackson Hole free zone; what I had to say on the subject I said earlier in the week. It is, however, an irony that on the day before Janet Yellen is going to speak on financial stability I should be reviewing the rise in structured synthetic credit products.


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