I am delighted to welcome my friend Rory Laughna back as a guest author with a wonderfully lucid piece regarding the return of the Financial Swamp Monster, AKA the Credit Derivative Swap –CDS. I hope that you enjoy this blog as much as I did.
Musings of a Roaming Buffalo
Derivatives Abuse and Old Time Hockey
July 7, 2013
Synthetic CDOs (Collateralized Debt Obligations) were enjoying renewed attention this year, triggering alarm bells in a June 4 Wall Street Journal article (“One of Wall Street’s Riskiest Bets Returns”), followed by a rant the next day by Jim Cramer, CNBC’s modern day answer to Eddie Shack (fondly remembered by old time hockey fans as one of the great characters from the 50s/60s era, affectionately known as “The Entertainer”). Possibly, these and other rebukes induced prospective investors to withdraw their plans and banish the financial engineers to a neutral corner. But why did it cause Cramer’s migraine? Did the investor retreat avoid violent retaliation akin to a Shack vintage cowboy ride? Possibly unanswerable questions, but some simple concepts are worth exploring.
Eddie Shack & Old School Hockey
Synthetic CDOs consist of financial derivatives, specifically Credit Default Swaps (CDS). Just as the name implies, financial derivatives are financial instruments which derive their value from another financial instrument. They come in wide varieties. The foundation for financial derivatives was inspired by risk control objectives. Futures contracts to buy or sell agricultural commodities at a specified point in time are among the oldest. Neither farmers nor distributors of agricultural produce could control the weather so they effectively agreed share the risk by locking in prices prior to the harvest season. Over time these contracts came to be traded on structured exchanges with rules addressing participants’ responsibilities, minimizing concerns of settlement failure.
Financial market instability and the consequent volatility fostered similar motivation for parties in offsetting positions to share risks. This enhanced businesses’ ability to focus on their core operations. The Interest Rate Swap provided my first derivative experience over 30 years ago. An interest rate swap is an agreement for one party to pay a floating rate of interest referencing one type of debt instrument, in exchange for receiving a fixed interest rate referencing another type of debt instrument, while the reverse obligations are assumed by the other party to the agreement (“counterparty”). For instance, a financial institution may pay a floating rate based on LIBOR (the London Interbank Offer Rate which is the reference for large banks’ cost of floating rate funds) and receive a fixed rate based on a specific 10 year U.S. Treasury bond from a corporation. In practice, the obligations are netted at designated settlement dates.
This instrument was developed in the wake of a period of double digit interest rates, while corporate treasurers were highly sensitive to the consequences of precipitous interest rate spikes. Conveniently, there were parties who had excess capacity for raising long term fixed rate debt, with a desire to invest in floating rate instruments (for example, large Japanese banks strategically expanding in the U.S. market). Therefore there was mutual benefit for parties to exchange floating and fixed rate positions, reducing risk in the process. It was a beautiful world, as the interest rate swap moderated interest rate risk concerns and supported the recovery from severe recessionary conditions.
Interest rate swaps have been traded “over the counter”, meaning agreements are arranged directly between parties and not through an exchange. Their activity supports by far the largest over the counter derivative market, with notional amount outstanding (face amount of referenced securities) of $370 trillion at year end 2012, with gross market value of $17 trillion (an estimate of actual risk exposure). The size of the market reflects a broad range of reference instruments subject to swaps and corresponding applications to control risks, and consequently continues to be a critical risk control tool for the corporate treasurer. The sheer size of the market likewise reflects the products’ significant contribution to trading revenues for banks and certain fund investors. This prompts questions of the degree of speculation that may be leading to systemic risks. This is an elusive question for a variety of reasons, and in a sustained low interest rate environment consequences are limited. However, I note that a managed low interest rate policy creates incentives to speculate on both sides of swaps. Even if the gambling “wins” and “losses” are muted by the environment, the instrument seems to have come full circle to the extent it may divert business attention away from core operations.
Swap Cash Flows
The Special Case of Credit Default Swaps
A CDS is a derivative that is a de facto insurance policy. The structure is that a “protection buyer” (bank lender, commercial finance company, bond buyer, etc.) contracts with a counterparty (“protection seller”) who agrees to compensate the lender if a specified borrower defaults on its debt obligations, in exchange for the protection seller sharing a portion of the interest payments paid from time to time by the borrower/issuer (insurance “premium”). If a default occurs, the protection buyer typically delivers the defaulted instrument to the protection seller in order to receive compensation. The CDS genesis was motivated by multiple productive purposes. For instance, commercial banks confront a conflict between prudently limiting risk and fully meeting customer needs. By insuring a portion of specific customer risk exposure, a bank may meet that customer’s loan requirements without taking excessive risk. Beyond the risk sharing benefit, an effective protection seller validates valuable information to the protection buyer and the market generally. By simply focusing on assessing and pricing default risk without the distraction of other market risk and customer relationship elements, credit price discovery is enhanced. Like interest rate swaps, CDS are traded “over the counter”, whereby contracts are executed directly between parties. Although the industry has adopted procedures intending to standardize contracts and mitigate risk, more comprehensive regulatory structures are being pursued, prominently Dodd Frank Title VII which among other provisions requires substantially all derivatives trading to move to regulated exchanges. For now, participants assume counterparty settlement risk.
CDS Cash Flows
AIG’s failure during the 2008 credit crisis provided a prime exhibit of CDS abuse, particularly when basic derivative risk sharing motivations are disregarded. A constructive purpose for AIG entering the CDS market would have been enhancing industry credit underwriting experts with its superior actuarial discipline, particularly in determining proper loss reserve and capitalization levels. Unfortunately, the exact opposite seems to have been the case as AIG pursued a gambling strategy, apparently believing their underwriting capabilities could “beat the house” and realize outsized profits by selling credit protection. They were likely lured by the interest rate sharing with a contingent funding commitment (funds advanced only when and if defaults occur), but misunderstood the nature of credit risk: highly infrequent loss events, but large losses when such events occur. They were further enabled by very “sophisticated” counterparties (large financial institutions including Goldman Sachs) that accepted AIG performance risk as if their trades enjoyed all the protection of a regulated exchange. An embarrassing abdication by all of their intermediary currency integrity responsibilities. AIG temporarily enjoyed a frothy stock price while it collected it share of interest payments, and the firm’s value approximated $200 billion at the end of 2006 on the cusp of the credit crisis. Once defaults commenced while AIG had failed to accumulate appropriate reserves, an incredible dissolution of perceived value unfolded. The US Treasury and Fed concluded that AIG’s inability to meet its credit “insurance” obligations further endangered its systemically important counterparties to such an extent the entire financial system was in jeopardy of meltdown, and therefore exposed taxpayers by extending bailout support aggregating approximately $180 billion.
As efforts to create exchanges proceed deliberately, smaller control steps have been undertaken. One example, the Bank for International Settlements (BIS) collects data from central banks in the G-10 plus Switzerland, Spain and Australia. This is one of the post credit crisis action steps intended to improve risk control by improving transparency for regulators and investors. The BIS reported that the notional amount of credit default swaps outstanding as of year-end 2012 exceeded $25 trillion, while the gross market value, an estimate of credit exposure, approached $850 billion. These figures compare to 2010 figures of $29.9 trillion and $1.35 trillion respectively. The market remains very large with a favorable risk trend. Many observations can be made about CDS, so here are just a few:
–Successful credit risk underwriters navigate a very narrow path between competing successfully and incurring excessive losses. CDS magnify the impact so an intrepid CDS underwriter must be brutally honest about its risk assessment and pricing capabilities;
–The market has integrity only if the CDS underwriters hold adequate reserves and capital to cover the infrequent losses when they occur;
–The loan or bond interest payments compensate the investor for assuming credit risk, but also for committing capital and assuming interest rate and market risks. Competitively pricing a debt instrument, then further allocating a share to a protection seller in a manner that satisfies all parties is highly challenging. Sound like a good instrument to further layer compensation for “financial engineers” to magically convert it into a golden goose?
–The market is very large, suggesting many credit protection buyers may lack an insurable interest in an underlying instrument. Advocates argue this enhances liquidity and enhances price discovery. Opponents grumble this is pure gambling, and cite moral hazard (AIG’s life insurance subsidiaries do not sell strangers insurance policies on your life). Maybe it is sufficient to note wariness of participants lacking basic risk sharing motivations and/or deep risk underwriting expertise.
Collateralized Debt Obligations With a Turbocharger To Boot
A CDO is a security created by aggregating debt instruments into a pool, and the investor realizes a return from the distribution of the underlying principal and interest cash flows. The original theory was valuable risk diversification resulted from the pooling, and further benefit realized by dividing up the future cash flows and assigning them to different investor classes based on a prioritization scheme. This was intended to maximize investor demand by meeting various risk/return preferences. As demonstrated by the subprime debacle, it only works if underwriting integrity survives complex structuring and distribution steps. Misrepresentations combined with sloppy analysis impaired risk recognition, leading to catastrophic losses. The causes and remedies have been widely debated, but just bear in mind many of the structuring and distribution parties were motivated by fees without risking capital.
A synthetic CDO applies the same basic concepts, but is created when CDS, instead of debt instruments, are aggregated into a pool and sold to investors. Very alluring for investors to get a diversified stream of cash flows with only a contingent funding commitment, particularly when the contingency is disregarded because it is “obvious” the pool will be sufficiently diversified to eliminate default risk. Turbocharged returns indeed. Varied arguments supported the case for synthetic CDOs, my favorite being that one could acquire pure credit exposure and avoid other risks of bonds such as market and interest rate risks. In other words, a lower risk than bonds. Just consider the perverse mix of motivations; advisers structuring the instrument without capital at risk, distributors bent on simplifying transaction descriptions of a complex product, and investors rationalizing infinite returns, all battling over a thin slice of interest coupon pie. No wonder Cramer had a migraine.
Buffalo off the Range and Definition of Insanity
So why is this buffalo hoofing up old dirt and kicking dead horses? Dodd-Frank will certainly prevent these ills from re-surfacing! Did he wander off the range and drink from toxic streams? Indeed, prospective investors backed off, Cramer’s migraine was cured, and there was no need to clear the track for Shack bounding over the boards. Far be it for the simple buffalo to challenge brilliant financial engineers, but there are some dots to connect:
–Recall Wes Chapman’s June 11, 2012 entry regarding the folly of an 8% projected return on pension assets. Unrealistic expectations for investment returns, particularly fixed income returns relied on by retirees, are deeply imbedded in investor expectations and pension administration;
–Theoretically, fixed income investments provide low risk steady returns from interest income. However, except for bond fund managers of a vintage comparable to this old buffalo, that fraternity has been conditioned over the past 30 years to expect compensation packages stoked by recurring equity-type returns including capital gains. Without even considering Chairman Bernanke’s alerts that “tapering” will eventually happen, simple math suggests rates close to zero mean the 30 year bond rally and the capital gain party are over. Certainly alternatives will be found to support your friendly neighborhood Goldman asset manager’s divine right to the newest Tesla Model S.
–Just peruse a few bond fund annual reports. Plenty of alerts that derivative investments will be pursued to “sustain” recent performance;
–Canaries in the coal mine: Chairman Bernanke made a modest suggestion tapering could start by the end of the year if the economy improves, and the bond and equity markets sell off. Did equities really find an improving economy revolting? Or just a sneak preview of the magnified impact of speculative derivatives? Pimco’s Total Return Fund, which very transparently invests significantly in credit default swaps, lost close to 4% in June. Be wary of others that may be less transparent.
The march back into the synthetic CDOs may have hit resistance given their high profile, but use of speculative derivatives used to enhance returns is evident. The exit path from the zero interest rate policy will be lined with unknown hazards. Does it make sense to amplify those risks, or reduce return expectations and minimize the risks? Remember the definition of insanity: doing the same thing over and over again and expecting different results.
Global regulators are addressing derivatives risk, and in the U.S. Title VII of Dodd Frank is providing new powers to the SEC and CFTC to regulate derivatives markets. This is a massive undertaking primarily tackling 3 areas: registration and oversight of participants; central clearing including recording keeping and reporting requirements; and margin requirements. On its face, increased transparency and risk scrutiny enable oversight bodies and regulators to more quickly identify and react to excessive risks. Hopefully, unintended consequences are avoided such as complexity discouraging constructive risk hedging, or speculative arbitrage frequently spawned by detailed rules applied to complex markets. Further, the more basic issues of establishing risk tolerance (risk appetite), and the tactical use of derivatives remain a function of effective management planning. Title VII’s success prospects depend on government and intermediaries embracing supportive cultural principles. Examples of key elements include the following:
—Government policies minimizing volatility. Once again, fiscal rectitude is the most significant support mechanism congress can provide. I further contend that the Fed’s continuing dual mandate accentuates volatility while enabling profligacy by proffering a convenient excuse for avoiding discipline. In any case, policy makers should recognize when speculative motivations are minimized, financial derivatives will be much more naturally concentrated on prudent risk hedging;
–Business (and personal) management realistically recognizing the environment and plan appropriately for the corresponding returns. Recognition must be made that derivatives do not alter the environment, only magnify or diminish its effects. Simple procedures should be taken to identify the economic or insurable interest protected by derivatives.
—Effective corporate board oversight that employs Title VII tools to enhance risk comprehension. Title VII requires boards through responsible committees, in specified circumstances, will have increased responsibility including personal liability. The intent of raising the risk scrutiny is understood, but mandating board control of customary management responsibilities creates risks of its own. Supportive culture includes board oversight approving risk appetite, critically reviewing risk dynamics, and being satisfied with management execution. Methods of discharging the new responsibilities are likely to include applying packaged consulting models that are very prone to “check box” procedures. The desired culture could be undermined if board attention is diverted from broad strategic focus, or management execution is disrupted;
—Regulatory field examiners empowered to apply safety and soundness judgment. Field examiners are dedicated professionals but are always at an information disadvantage relative to supervised management’s working knowledge. The examiners’ unique perspective of reviewing risk control practices and assessing management of multiple institutions supports excellent qualitative assessment skills. It is critical that examiners be allowed to do what they do best and apply the Title VII reports and procedures as tools supporting qualitative judgment, as opposed to assessing against inflexible standards.