How you can go bust investing in sound companies: CDEs

[raylopez99]

I lost some money in AEL and learned a lesson, repeated below, that
CDEs are like an unregulated insurance market. CDEs are where a
company pays a premium to another company to assume responsibility if
a third party goes bust. But no loss reserves need be set aside by
the company accepting the premium--this is not sound finance but just
a casino bet--"always bet on black" (that a company will not go
bust). So a company like AEL, relatively small, can assume a lot of
financial responsibility bigger than it is (and is warranted).

So shareholders essentially can lose their shirts, akin to betting the
roulette wheel in Monte Carlo will come up black and it comes up red.

Gambling, not investing.

Caveat emptor.

RL


The Next Dominos: Junk Bond And Counterparty Risk
By Ted Seides, CFA[i]



Financial history doesn't repeat itself, but it often rhymes. Earlier
this year, losses from subprime mortgages revealed that the financial
markets had taken to excess a good idea in the real economy. A perfect
economic environment allowed the alchemists in structured finance to
apply massive amounts of leverage on low quality, securitized
mortgages.[ii] When the first signs of softening in real estate
prices surfaced, we learned that investors had taken on far more risk
than anyone realized, and losses could not be contained.

The severity of the subprime debacle may be only a prologue to the
main act, a tragedy on the grand stage in the corporate credit
markets. Over the past decade, the exponential growth of credit
derivatives has created unprecedented amounts of financial leverage on
corporate credit. Similar to the growth of subprime mortgages, the
rapid rise of credit products required ideal economic conditions and
disconnected the assessors of risk from those bearing it.

The amount of outstanding corporate credit and leverage applied to it
dwarfs the market for subprime mortgages. As such, the consequences of
a problem in this arena may be far more severe than what happened in
subprime. If we are going to experience the downside of another
economic cycle, we may be in for a painful ride.

The evils that lurk from our creations epitomize Peter Bernstein's
definition of risk - we don't know what will happen. By thinking
through the evolution of the credit derivatives market and the storm
clouds on the horizon, I hope to heighten awareness while there is
still time to act.
Credit Default Swaps: A Brief Introduction

Just a decade ago, the corporate credit market was comparatively
simple. Companies seeking to fund their operations and expansion plans
tapped commercial banks for loans and financial markets for bonds.
Commercial banks carried these senior secured loans directly on their
balance sheet. Subordinated lenders - primarily banks, mutual funds,
and pension funds - evaluated the credit worthiness of the issuer and
determined an appropriate compensation for the risk that the issuer
might fail to meet its obligations. When the borrower offered
sufficient compensation and legal protection, the company received
financing. Since many bondholders owned assets to defray long-term
liabilities, the corporate bond markets had relatively low turnover.
Investment banks served primarily as intermediaries between
corporations and capital providers to place new issues and refinance
paper.

While these arrangements served most participants upon initial offer,
bank loans did not exchange hands in secondary markets, and hedge fund
shied away from shorting credit because of expensive borrowing costs.
[iii] More cynically and perhaps more accurately, the absence of loan
trading and "bond loan" departments left holes in the investment
banks' playbook that they could fill with a more fluid trading
vehicle. In order to meet these needs, in the mid-1990s Wall Street
gave birth to the credit default swap ("CDS"), the basic contract from
which all credit derivatives emanated.

The CDS was an innovative financial technology that revolutionized the
way credit changes hands. A CDS is a financial agreement between two
parties to exchange the credit risk of a reference entity or issuer.
The buyer of CDS pays a periodic premium for which it purchases credit
protection on a specified, notional amount of exposure. In the event
the reference entity faces a credit event - typically a bankruptcy,
failure to pay, or restructuring - the owner of credit protection
receives a windfall profit. In terms of exposure, a buyer of CDS is
short the credit risk of the reference issuer. Conversely, the seller
of protection assumes a risk comparable to owning the reference bond;
the seller receives a premium for taking risk but suffers large losses
in an event of default. Thus, the CDS market is a zero sum game
between the buyers and sellers of protection.

While new to the credit markets a decade ago, CDS has roots in
generations of related financial contracts. A CDS closely resembles an
insurance contract in which the seller receives a premium and suffers
losses of up to the notional amount in the event a low probability
default occurs within the term of the agreement. If the market
properly handicaps the probability of default, the premium on CDS
should equal the yield spread of a corporate issue over Treasuries
after taking into account funding costs.

CDS also share characteristics with put options. Buyers of put options
pay a small premium and have the opportunity to make a large sum
should the underlying stock fall precipitously. However, unlike
options that trade on organized exchanges, CDS transact only between
two counterparties, carrying an additional counterparty risk absent in
listed options markets.
Credit Default Swaps in Practice

CDS loosened the reigns on the rigid credit markets and introduced a
dizzying array of new applications to trade credit. For the first
time, bank loans traded actively in the secondary market, and
investors shorted debt across the credit spectrum for a modest cost.
[iv] Investment banks created a host of indexes to replicate broad
exposure to the loan and bond markets, further augmenting the menu of
hedging alternatives. CDS are commonly used to reference single-name
credits, indexes of credit baskets, and synthetic exposure in other
financial technologies such as collateralized debt obligations
("CDOs") and collateralized loan obligations ("CLOs"). Each of these
broad categories comprises roughly one-third of the total notional
amount of outstanding CDS.[v]

The introduction of CDS coincided with a favorable economic climate
for creditors and debtors. Since the nadir of the last credit cycle in
2002, creditors had a uniformly positive lending experience with
virtually no defaults. The CDS market blossomed and the issuance of
credit expanded, untethered by considerations of risk. From a modest
infancy, the notional value of CDS today surpasses the amount of
underlying cash bonds by an order of magnitude.[vi] CDS contracts now
total $45.5 trillion of outstanding credit risk, growing an amazing
nine-fold in the last three years alone. Putting such a large number
in some perspective, $45 trillion is almost five times the U.S.
national debt and more than three times U.S. GDP.

An Insurance Market with No Loss Reserves

One way of thinking about the CDS market is that of a huge, new
insurance industry whose providers reserve nothing for future losses.
Imagine what would happen if $45 trillion worth of insurance policies
experienced an actuarial average of 5% losses and no one had $2.25
trillion sitting around to foot the bill![vii]

This woefully undercapitalized market may be a frightening reality.
Sellers of credit protection post margin for marked-to-market moves,
but CDS contracts are generally uncollateralized. Further, investment
banks that hold one side of each CDS transaction claim to be hedged,
but their financial statements show neither loss reserves nor bad debt
reserves for potential counterparty failure. The absence of collateral
and significance of counterparty risk have important implications
discussed below.

For a number of years, credit spreads have tightened to historical
lows. During this time, CDS took over cash bonds as the primary form
of trading in credit markets. Is it too much of a stretch to consider
that spreads have been abnormally tight in part because sellers failed
to price in a reserve for future losses and thus systematically
underpriced risk?
The Second Domino: "High"-Yield Bonds[viii]

The economic climate that enabled a transformation in the credit
markets over the last five years simultaneously prevented the system
from being tested. The machine hummed at ever increasing velocity as
long as companies received cheap financing, borrowers repaid lenders,
and expectations remained cheerful. A downturn in the real economy, or
just expectations of pending credit problems, needed to arise before
the imbedded leverage in the system could cause harm. As soon as
either occurred, however, the machine would screech to a halt.

Given their subordination in the capital structure, junk bonds (or,
euphemistically, high-yield bonds) are a logical place to look for the
first signs of trouble. Statistics of high-yield issuance reveal
relaxed lending standards in a marketplace determined to ignore risk.
In each year since 2004, more than 40% of all new debt held ratings
below investment grade. For perspective, the proportion of new paper
of such poor quality issued in each of the last four years far
exceeded the proportion of such issuances in any year since the late
1980s.


High-yield bonds are dubbed junk for good reason. Corporate mortality
tables indicate that defaults of high-yield bonds within five years of
issuance occur 28% of the time for those just below investment grade
and 47% of the time for those with the lowest ratings. Past instances
of high default rates lagged periods of strong junk issuance by 4 to 5
years, coinciding with recessionary periods in the economy.[ix] In
good times, issuance is high, underwriting standards are low, and
investors forget that risky credits may actually default. A few years
later, the economic cycle turns and junk bonds reveal their flawed
character.

A disproportional amount of low-grade paper hit the market in recent
years, but that was not all. Investors also received meager
compensation for taking risk. High-yield spreads over Treasury yields
have hovered around historical lows for nearly four years, indicating
that investors have paid little attention to the real possibility of
loss.[x]


Making matters worse, approximately one-third of all outstanding,
single-name CDS are derivatives of credits with ratings below
investment grade.[xi] When investors have insatiable appetites for
yield, the food stinks, compensation for it comes in small portions,
and customers still can't get enough.
Subprime Revisited in High-Yield: A System with Faulty Design

The anatomy of the high-yield bubble started with a virtuous cycle.
When both the markets and the economy were strong, investors paid
little attention to risk. The more investors assumed risk, the more
they received rewards. Companies seized the opportunity to obtain
inexpensive financing and issued paper to the market on attractive
terms. As leverage increased, private equity buyers drove up asset
values. Higher asset values enhanced collateral and allowed companies
to borrow more or refinance their way out of trouble. Without
defaults, creditors were willing to lend on ever more egregious terms.
As the cycle grew stronger, buyers received less compensation for the
risks they assumed.

Hidden leverage and conciliatory lending standards should be a sign of
caution, and this particular cycle looks familiar. The recent history
and current state of the high-yield market shares a close resemblance
to the ascendance and positioning of the subprime mortgage market
prior to the pricking of its bubble earlier this year.

First, subprime mortgages and high-yield bonds were successful
financial innovations that served an unmet need, but both good ideas
rode a wave to excess on the crest of strong economic conditions.
Initially, subprime mortgages made housing available for those just
beyond its reach. Later, the confluence of rising home prices, low
interest rates, abundant liquidity, and creative structures fueled an
unprecedented growth of mortgage issuance with deteriorating
underwriting standards. Similarly, while investors once accepted the
high risk-high reward proposition of junk bonds only on occasion, over
the last five years low interest rates, a strong economy, and minimal
market volatility combined to foster massive issuance of high-yield
paper with poor promised returns and weak protections for lenders.

Second, investors bid for structured products at remarkably low
yields, accompanied by paltry lending standards. In order to meet
client demands, investment banks created CDOs to deliver investments
that maximized yield for a given credit rating.[xii] Through the
magic of financial engineering, CDOs turned low quality assets - many
of which contained subprime mortgages, leveraged loans, and high-yield
debt - into a blend of high- and low-rated paper. In contrast to the
zero sum nature of CDS, CDOs became a positive sum game in which
increasing securitization provided additional capital to companies
while adding leverage in the system. In the process, banks, rating
agencies, and CDO managers were agents with collective economic
incentives to deliver quantity over quality.

Third, CDOs brought the unwelcome side-effect of segregating the risk-
takers from the risk-assessors. Mortgage originators found every way
possible to increase their production volume, and mortgage companies
sold off the loans to investment banks. The banks securitized loans
into mortgage-backed securities ("MBS"), which they then sold to
investors. Banks also arranged for CDOs to pool a group of MBS into a
portfolio that had sufficient statistical diversification to receive
the imprimatur of the rating agencies. By the time investment banks
sold the CDO to clients, the ultimate risk takers were three or four
degrees of separation from an opaque pool of underlying assets.
Employing the financial "innovation" of statistical default analysis,
leveraged pools of credit with customized risk and reward profiles for
each investor replaced good, old-fashioned credit analysis. In the
high-yield market, the passing of the baton from issuer to investment
bank to CDO to ultimate principal and the corresponding shift in
credit risk from those with the best ability to analyze it to those
with the least are identical to what transpired in the subprime
sector.

Fourth, as long as the economic environment was robust, the complicit
players in the game cooked up increasingly dubious ways to offer more
risk without adequate compensation. The subprime mortgage market is
now notorious for extending no documentation, "liar loans" and
negative amortizing mortgages. In the last year, the high-yield market
welcomed covenant light and PIK-toggle notes.[xiii] Both cases
reached extremes of weakening protections and lowering interest
payments. Investment banks even created a host of products with
acronyms like CDO-squared, CPDO, and SIV that accompanied the CDO
structure itself. Each new vehicle offered a greater degree of
leverage, less transparency, and another degree of separation from the
underlying credit risk.

Finally, when the real economy no longer cooperated, the music stopped
in the markets for subprime mortgages, and financial institutions
throughout the world were left holding the bag. As subprime mortgage
pools created in 2006 and 2007 manifested high rates of early
delinquent payers, the expectation of losses and subsequent rating
agency downgrades triggered widespread sales. The resulting collapse
in CDO valuations threatened to provoke a forced unwind of leveraged
structures whose stability depended on a mortgage payment experience
that resembled those of the past. The unraveling of leverage in CDO
structures has yet to see its bottom in subprime, and financial
observers cannot measure the depth of the abyss. As described by Orin
Kramer, Chairman of the New Jersey State Investment Council, "We
simply don't know how the enormous growing role that credit derivative
products play in the global financial architecture has altered the
fundamental correlation assumptions upon which the entire edifice is
built."[xiv]

Should a recession expose weakness in credit fundamentals, high-yield
bonds may suffer a similar fate. As much as the situation has been set
in motion by the financial economy, the tipping point will be a
fundamental deterioration in the real economy. With current default
rates around 1% and the lowest since 1981, a consumer recession or
business slowdown thus far are little more than the prognostications
of bearish economists. When the cycle turns and defaults rise,
however, falling prices of CDOs backed by high-yield collateral and
forced sales of CDOs could mimic the catastrophic declines of subprime
CDO prices. A large amount of high-yield paper at low rates with weak
covenants is already out in the marketplace and worth a good deal less
than the values at which it may be carried on investors' books today.
So the stage is set for the drama to unfold, as the positive sum game
reverses and becomes a negative sum game for all participants.
The Third Domino: Counterparty Risk

As derivative markets replaced cash markets in the trading of debt,
another novel form of risk entered the fray - counterparty risk. Each
CDS is a swap between two counterparties, and a broker-dealer is on
one side of every transaction. In the cash markets, the performance of
the debtor is the creditor's only concern. In the derivative markets,
the lender must also be concerned with the performance of the
counterparty.

Counterparty risk in the CDS market lies with the sellers of
protection, or the insurers of risk. Banks are the primary sellers of
CDS, totaling 40% of all written CDS and representing notional
exposure of $18.2 trillion.[xv] Banks claim to run hedged books,
effectively serving as a market-maker in the CDS market. As should be
evident from the events in subprime, even the most sophisticated
systems are often unable to fully hedge risks of this size and degree
of complexity. If printed materials are any indication, banks may be
asleep at the switch. The "Counterparty Considerations" section in the
Credit Derivatives Primer of market share leader JP Morgan is a single
paragraph on the last page of the volume, which proclaims "the
likelihood of suffering (counterparty default) is remote."[xvi]
(italics added)

Hedge funds appear to be in over their heads as well. According to
printed statistics and consistent with anecdotal evidence, hedge funds
are sellers of 32% of all CDS, insuring exposure of $14.5 trillion.
[xvii] Recent estimates indicate that the entire hedge fund market is
approximately $2.5 trillion in net assets under management. Thus,
hedge funds are bearing risk in excess of their ability to pay the
piper if anything goes wrong.

Jeremy Grantham of GMO recently predicted that a major bank will fail
in the next five years.[xviii] I would take his vision a step further
and offer two ways that outcome might occur. First, a bank could
simply collapse under the weight of its written CDS obligations. This
event would not be the first time that massive high-yield issuance
followed by a change in credit cycle induced bank failure - remember
Drexel Burnham? Second, imagine what would happen in the unlikely
event that banks have perfectly hedged CDS exposure on paper. In a
wave of defaults, banks would be obliged to pay where they are long
credit and may experience counterparty defaults from hedge funds or
others sellers where they are short. Losses would shift to the bank's
balance sheet, and sufficient losses could wipe out their equity
capital.

It seems logical that a market of this size with expected defaults
should be housed on an exchange, obviating the need for counterparty
involvement. The issuance of CDS today falls under standards set forth
by the International Swap Derivative Association (ISDA), which is a
big step forward from the early days when no two contracts looked
alike. Nevertheless, the CDS market remains over-the-counter, so
perhaps banks earn a pretty penny coming in between buyers and sellers
and would rather maintain the revenue stream than be concerned with
the risk of a fat tail event.

Counterparty risk management supposedly ensures that sellers of
protection post adequate collateral and do not exceed safe limits.
Even if we make the bold assumption that risk management is effective,
the implementation of such techniques could cause a violent downward
spiral. In a volatile market, the vast amounts of leverage created by
CDS would be withdrawn from the market suddenly and simultaneously,
leading to a market paralysis comparable to or worse than the crisis
of last August.
Who's Holding the Bag?

One of the uncertainties about risk in this complex system results
from the unprecedented degree of financial leverage placed on real
economy capital structures. Never before have we entered a downturn of
an economic cycle with so much paper riding on the fortunes of
companies known to have such poor credit quality. Those left holding
the bag will be the sellers of CDS (the insurers), owners of CDOs,
financial guarantors of CDOs, and may include another link in the food
chain.[xix] Regardless, in the aftermath of the subprime mess, no one
will fess up to holding politically toxic securities before they must.
In short, the separation of risk production and risk taking makes any
definitive assessment of risk in this market unattainable.

When subprime mortgage losses surfaced in February and again over the
summer, the success of structured finance in dispersing risk was more
than offset by the exceedingly high degree of risk taken across the
globe. Not only did direct participants like subprime mortgage
originators meet their demise, but also U.S. investment banks,
European insurance companies, Chinese state-owned institutions, hedge
funds promising a low risk profile, and even money market mutual funds
suffered write-downs on their balance sheets.

Unfortunately for our financial system, the magnitude of risk in
corporate credit is a multiple of that in subprime mortgages. Each
written CDS exchanges a risk that cannot be eradicated no matter how
broadly aggregate risk is dispersed. Sinking valuations of CDOs and a
commensurate leverage unwind could trigger a vicious cycle of
financial losses. By implication, the problems that might ensue could
make the subprime mortgage problem look like a walk in the park.

I cannot be sure these assertions are true, but I suspect that it
would be just as difficult to provide evidence that they are not. I
have listened to arguments against systemic risk, suggesting that the
double counting of CDS, matched books of investment banks, and
increasing sophistication of risk management techniques make the eye-
popping numbers of notional risky debt larger than they seem.
Nevertheless, I remain skeptical. We've seen similar movies before,
and they don't end well.
Only Time Will Tell

Earlier this summer, we saw the first tremors of change in the credit
markets, as liquidity dried up, spreads widened, volatility returned,
CDO issuance all but disappeared, and the private equity markets took
a pause. The continued absence of liquidity in the commercial paper
markets makes us wonder what might come around the next corner.
Though Wall Street may have witnessed the beginning of the end of the
good times, Main Street has yet to encounter problems. Sure enough, in
the months following Chairman Bernanke's intervention, spreads
tightened as if everything was good again.

So long as we no longer have economic cycles and defaults do not
occur, we can all shrug off the possibility of a calamity and go on
our merry way. But the tide will go out - it's not a question of if,
but when. And when it does, we may experience the harrowing affects of
real financial hardship.

Footnotes:

[i] Ted Seides is the Director of Investments at Protégé Partners,
LLC, a hybrid fund of funds that invests in and seeds small,
specialized hedge funds.

[ii] By alchemists I am referring to the financial engineers who,
complicit with the rating agencies, turned over 85% of asset pools
comprised of BBB-rated subprime mortgages into AAA-rated paper.

[iii] An investor with a short position in bonds must borrow the
security and pay out the coupon to the lender. Since coupons are a
significant component of bond returns, shorting the securities can be
an expensive proposition.

[iv] Buyers of CDS pay out only the yield spread of the bond over
Treasuries.

[v] British Bankers' Association, "Credit Derivatives Report 2006," pg
6.

[vi] JPMorgan Corporate Quantitative Research, "Credit Derivatives
Handbook," December 2006, pg 6.

[vii] Assuming recovery rates on defaulted debt of forty cents on the
dollar, the tab to the insurers would still run $1.35 trillion, far
surpassing the amount of capital available to pay.

[viii] I use the adjectives "high-yield" and "junk" interchangeably to
describe less-than-investment-grade debt. It pains me to use "high" to
describe bonds that offer single-digit yields to maturity. The
nomenclature reminds me of my disappointment in seeing the size of
London's legendary clock tower for the first time, after which I
referred to the monument as either "Medium Ben" or "Big Benji."

[ix] Presentation by Dr. Edward I. Altman, "Current Conditions in
Global Credit Markets," October 2007.

[x] Ibid.

[xi] BBA Credit Derivatives Report 2006, pg 23.

[xii] CDOs are effectively financial service companies whose assets
are debt issues and liabilities are parsed into a capital structure
and sold to investors. Relying on historical correlation analysis of
defaults, rating agencies mark senior paper with a rating of AAA,
senior subordinated rated AA, and so forth down to below investment
grade and equity. The ratings provided investors with paper with a
range of ratings quality independent of the quality of the underlying
assets held by the CDO.

[xiii] A "PIK-toggle" note gives a borrower an option to defer cash
interest payments on bonds, toggling from a cash pay instrument to a
pay-in-kind indenture. The fancy instrument was a recent example of
clever structuring employed by private equity firms to finance
leveraged buyouts.

[xiv] Orin Kramer, "Speech on Credit Derivatives," April 23, 2007. The
statement is another example of physicist Werner Heisenberg's
contention that you cannot measure something and observe its movements
at the same time, because the act of measurement alters the character
of the motion. See Peter L. Bernstein, "Can We Measure Risk with a
Number?," EPS, June 15, 2007.

[xv] BBA Credit Derivatives Report, pg 18.

[xvi] JPMorgan Credit Derivatives and Quantitative Research, "Credit
Derivatives: A Primer," January 2005, pg 25.

[xvii] BBA, pg 18.

[xviii] Jeremy Grantham, "The Blackstone Peak and the Turning of the
Worms (The Slow Motion Train Wreck Continues)," GMO Quarterly Letter,
July 2007.

[xix] For example, should sellers of CDS default, the buyers of CDS
would find their alleged protection worth substantially less than was
promised.