CDS Money 'Waiting Around' For Auto Rescue Closure?
A: For anyone late to the credit crisis party, or I should say funeral, credit default swaps (CDS) have played a large role in the shadow banking system taking this crisis from bad to worse! When Bear Stearns was rescued via a fed sponsored merger to JP Morgan, CDS counterparty risk played a large role in not allowing Bear to fail. When AIG, a large issuer of credit default swaps on the other side of the trade, got into trouble the gov't had to step in and rescue that company from failure. Allowing AIG to fail would have hit the global CDS market likely leading to a large disruption or even systemic failure of the worldwide financial system. Now, it seems the CDS nuclear war games are playing a role again; this time in the auto rescue talks. One additional reason (besides deteriorating fundamentals and credit quality) why banks aren't lending? It could easily be they are waiting to see how the auto game plays out and how many billions they may or may not have to pay out should a credit event occur.
Back in March, Bear Stearns was rescued from failure and a credit event did not occur. As a result, tens of billions that would have been paid out by CDS issuers were saved at the expense of CDS purchasers of credit protection. Contraryinvestor.com explained the market movements the week after the Bear-JPM deal was announced, as those CDS holders of protection went from being largely in-the-money on the Friday before the announcement, to big time out-of-the-money when the markets re-opened the following Monday (via, 'Derivatives Tail Wagging The Financial Market Dog'):
"Now put yourself in the position of a meaningfully levered hedge fund who had purchased CDS contracts against Bear credit vehicles. You had levered up against what was continually becoming very profitable CDS positions or credits as Bear was heading nose first into the tarmac. Who knows, you might have even increased the position prior to the weekend based on info your fellow good buddy hedgies were feeding you about Bear's imminent demise. When those long CDS contracts against Bear credits/positions went to zero virtually the Monday after the JPM acquisition announcement, all you were left with was massively deflated CDS asset values relative to the prior Friday and still in place leverage. So what do you do when you get up in the morning on Monday after the Bear acquisition announcement (assuming you slept Sunday night, that is)? You start delevering. You start unwinding in place inflation themed trade positions to raise liquidity. You sell what assets you can (gold, oil, commod's, etc.) and get less short those sectors you have heavily shorted (financials, brokers, consumer, etc.) to raise liquidity and decrease total leverage against a now immediately diminished asset base."Fast forward to today and the ongoing talks that TARP may be used to keep the Big 3 autos alive until the next administration takes office. The TARP, originally designed for distressed asset purchases, has only been used so for to fortify the banks balance sheets (by injection of capital directly into the banks) in an environment where capital raising from the private sector & share dilution is almost impossible. Should a credit event occur for the Big 3, there will be payouts by the firms that issued CDS against a GM/F default. Below is the gross notional value of GM's & F's CDS contracts, net notional, and contracts outstanding as provided by DTCC:
The payout is not as big as you would think because of daily mark-to-market collateral posting of CDS contracts, via Reuters:
If payments on GM's swaps are triggered, they are unlikely to have systemic consequences as most of the losses have already been taken as the securities weakened.Okay, so it won't cause any systemic problems if these guys fail; but what does it mean for the big banks lending capacity?
"CDS contracts require daily posting of mark-to-market collateral posting," Taksler said. "Given that auto company bonds already trade in the $20s, the additional collateral posting prompted by a potential bankruptcy should be fairly small."
By contrast, if GM looks like it will avoid bankruptcy, CDS on the company could rally significantly, leading to the need for large adjustments in the value of the contracts by buyers of protection, he added.
Masacchio, over at Oxdown Gazette, has a very interesting piece titled, "Paying off on Credit Default Swaps is So Important", that is a worthy read:
The current gross notional amount of credit default swaps with GM as the reference entity is $44bn*. This is down from $65bn just three weeks ago. The net notional amount is $3.4bn, up bit since then. According to the DTTC, the notional amount is the maximum amount of money that will change hands on the occurrence of an event of default, after netting and application of collateral.One thing is for sure, the CDS market is proving to play a big role in this credit crisis. It is no longer as simple as, "...do we save the autos for fear of losing American jobs?". No! Part of the formula for whether an entity lives or dies is now a function of things like counterparty risk and systemic attachment to the financial system. Its the sad reality of the complex system of finance that we designed, marveled at, few profited greatly from, powered the housing boom, and ultimately helped to cause the current crisis.
This implies that a large additional amount of collateral has been posted. That money is gone from the banking and investment sector, and isn’t available to be loaned out or otherwise put to good use. It is merely sitting in vaults, waiting around to see what happens to GM.
Meanwhile, the price of GM CDSs has gone way up. The rapid increase in the price of GM CDSs this year, coupled with the decrease in notional amount outstanding, implies that sellers of protection have been buying up protection in the over-the-counter market, presumably to set off against their sales of protection. The AIGs and Citigroups of the world are the sellers of protection, and they’re busy sending money to the buyers of protection, both directly through purchases of gambling CDSs and indirectly through posting collateral for their sins. And we all know where that money is coming from: Henry Paulson and Ben Bernanke. If the bailout comes, and the bankruptcy doesn’t, the prices of GM CDSs will fall quickly. The recent purchasers will be hurt, and maybe that will include AIG and Citi.
This shadow question can’t be ignored. It infects every aspect of the whole bailout situation. Take Citigroup, with its $3tn plus in credit default swaps. Taxpayers are pouring money and guarantees into their treasury. Are they pouring money onto hedge funds and other buyers of protection, trying to prop up their swaps, or solving their exposure to GM and the other failing entities?
As this system unwinds, the complexities are revealed and the truth is that firms like AIG, Citi, Bear were deemed to connected to fail while firms like Lehman were not. Now, I'm no expert on the OTC CDS market, trading CDS, or even contractual terms that kick in on a credit event; but I do know that this market is tied to the current crisis and the counterparty risk and potential damage done by a triggered credit event is something discussed in any bailout/rescue talks. Has to be. We must be asking the right questions here.
Oh what a tangled web we weave!
Posted by lars
Sun Dec 14th, 2008 01:43 PM
To look to CDS risk as the reason for a bailout of the auto industry is to misunderstand the playing field IMHO.
The auto industry will not be allowed to fail by Washington (just look at Bush's quick reversal when the chips were down) because to do so, by either Party (though the Repub Senators are trying hard against this reality) is to write off the White House for decades to come. The electorial importance of Ohio, Mich, Il, PA etc is simply to great.
It is not about CDS financial risk to the system (or what is in the best interests of the US in the long run) and all about political risk for politicains.
There has never been a shred of doubt in my mind that Washington would allow the auto industry to fail. (Now watch, next week Bush will screw things up as only he can do and prove me an idiot!)
Posted by Noah
Sun Dec 14th, 2008 02:19 PM
well I never said cds counterparty was the only reason for the bailout. The piece was meant to bring up whether banks are hoarding a portion of cash in anticiopation for closure to this situation, as payouts will have to be made if GM/F enter into bankruptcy. GM is clearly in more dire need of cash than F.
If at the very least, I think CDS counterparty exposure is being discussed, since the TARP was originally used to help the banking sector. We have many bankruptcies ahead of us in 2009 and who knows how the CDS trades will pan out but this is a big reason to worry for many in addition to the already toxic holdings of these banking institutions.
Autos come a distant 2nd. But if auto failure would have really hurt say a CITI, because Citi had $4 bln of CDS exposure to issued CDS on a GM/F defaults, that this had to be discussed as Citi just had to be rescued and this could result in Citi being even more stressed? And citi was already deemed to big to fail?
The problem is the connection of this financial system to failing institutions and why Buffet viewed CDS as financial weapons of mass destruction. I think this is now an integral aspect of any big failing entity, the connection to the financial system that the fed/treasury is so desperately trying to keep standing
Posted by lars
Sun Dec 14th, 2008 02:41 PM
Noah,
I do not disagree that CDSs are a financial nightmare (and yet another example of where regulators have failed), and that the collapse of the auto industry would negatively affect the financial markets. However, I do not believe this enters materially into the politics of the situation.
From the perspective of those making the decision, the politicians, this is all about the votes and not about the financial repercussions of an auto industry failure on the CDS market.
AIG and Bear Stearns was a different case. The people spearheading those rescues were not the politicians (they only ratified), but financial types (the Fed and Treasury). Their interest was avoiding financial Armageddon and not the nuances of Electoral College strategies.
Posted by Dale
Sun Dec 14th, 2008 06:19 PM
Noah,
Thank you for bringing attention to the CDS market and the role that it now plays in the global financial markets. I have been searching the web for the past three weeks trying to get more information with regards to how the CDS market would potentially cause a domino effect among our banking system. When I first did my investigation and found more than $65 billion in CDSs against GM alone it caused some shock. I feel a little more comforted in the fact that the net outlay would only be about $4 billion if GM went bankrupt. Although I must say that I am confused as to how the DTCC can come up with that number. If there is no defined reserve amount that an issuer of a CDS must keep on the books in order to issue a CDS and the market for a CDS is so secretive then how does the DTCC know these numbers?
Also, if you really think about the rising housing market a case can be made that CDSs and CDOs are the primary reason for the housing bubble. The purchasers of mortgages believed that they could package their mortgages into CDOs as sell them to the market. The purchasers of CDOs bought CDSs to insure the CDOs and thus everyone in the mortgage game felt that they had little or no risk. So mortgages were not scrutinized as much because the risk was always being handled by someone farther down the credit line. Home buyers trusted rising housing prices and the expertise of the financial institutions loaning them the money, mortgage companies could pass the risk on to other financial institutions that were purchasing mortgages on the secondary market in the form of CDOs and finally the purchasers of CDOs passed the risk of CDO failure to whomever they could buy a CDS to back the CDO. Everyone thought they were passing risk to someone else further up the food chain. In reality no one really knew the level of risk involved.
Great point in discussing the fact that the banks are slowing lending because of their own risk in the CDS market.
Posted by Query1
Mon Dec 15th, 2008 07:28 PM
I'm not sure it is right to attribute the difference in expected payout and the notional amount to money sitting around in a vault. The head of ISDA, which is the trade association for the CDS sector said in the Lehman case that the difference between the $400B notional amount of the CDS relating to them and the pay out to settle the contracts at $8-$9 billion is that the dealers offset the risk when they sell protection. Somebody said trading in CDS is like picking up nickles in front of a moving steam-roller. I think they were referring to how much the potential net gain is reduced by the offset transactionso that goes with selling these things. Anyway, the actual cash payout on Lehman according to this person was the loss set at auction of 91 cents x the netted positions. Since the GM notional amount is so much less than Lehman and Lehman settled I would guess the parties and counterparties involving CDS on the auto companies know how they will come out either way. I would guess it is more accurate to say the continuing credit crunch still has more to do with the bad housing credits than the evolving auto story although the latter certainly makes the former worse.
Posted by Noah
Mon Dec 15th, 2008 09:24 PM
Lars - Im glad you brought that up.
Yes, your right, politically its suicide to want to let the autos fail and bring on the job destruction that would result...okay, maybe not suicide.
You know what, Im going to take a few minutes here and take the other side. I know it will be painful. I know it will disrupt the supply chain. I know it will distrupt global economies. But maybe this is what we need. Maybe the housing + auto sector were the biggest consumer driven bubbles out there, whose general model and perception of an asset class, at least in wall street terms here, was just way out of sync; inefficient.
The industry and the model need to die. What about the homebuilders? Are they next? Why not bailout them? And the Lowes & Homedepot's of the world. They are connected aren't they? Where does it end?
I say, dammit, we are in pain now and these inefficient markets with inefficient models need to go down and be restructured or else this problem is not going to go away and be cleansed in the manner that an old fashion sever slowdown can accomplish!
This is how I really feel. I feel very bad for the victims, I really do, but to stop the natural process of market forces, is to try to shape the future by our culture and our values and this is not good for us in the longer term. It is bad policy and bad vision. Some things should be done, and some things shouldnt.
There is plenty of blame for what happened, and failure of many cogs in the overall engineering of the financial system that failed. But that is done. We are at now now. heavy regulation will come and it should take time and it should be designed by mistakes learned during this crisis. But bad businesses need to die too. It has to happen NOW! While the cycle is in the depths of its ills.
now, if they come up with a way to do the dirty work, yet avoid bankruptcy, if there even is a way, great! But I have a bad feeling they will save this industry and years will go by, billions wasted, and we will be at the same spot we are today!
That, is bad vision