The Real World

There was a great deal of discussion about the difference between the real world and the world of Washington, DC during the recently concluded election season. Implicit in the discussion is an us and them mentality ... right versus left, wealthy versus not and privileged versus not. When one takes the time to analyze recent events in the capital markets within the context of wealthy versus not and its twin, privileged versus not, one can easily come to an understanding of the attitudes that I have tried to articulate in previous posts. I'm getting the same vibe out of Washington now. That is, the folks in Congress are so far removed from the real world, that they are blinded to the absurdity of the course that things have taken since the first bailout last September.

I'll say this one more time - the folks in the banks and the Wall Street firms that have been the beneficiaries of the government's handout really think that they deserve the money. Further, they are blinded to the fact that they caused this mess. Further, the idiots in Congress are way too obtuse to comprehend that giving money to these dopes rankles people in the real world. There has been a ton of blowviating from both houses, but, in the end, the members are NOT in the real world and they would never dream of biting the hand that feeds them.

The following isn't really a good example of the above, but it does show how someone in the ivory tower of an investment bank can, in this case, write a book that is a how to on credit default swaps. If this guy was so good, how come UBS lost billions and billions in credit default swaps? You don't suppose that they knew the risk and went ahead and took the profits, firm in the knowledge that the Fed would come to the rescue? NO, nobody would do that, would they?

So this is a new book on CDS's published by Bloomberg Press. I won't comment on the contents, I think it speaks for itself. The following was lifted from the Bloomberg website:

DESCRIPTION OF BOOK

For traders trying to navigate the increasingly volatile credit default swap market, CDS Delivery Option provides worked-out examples, over 30 charts, a case study of Delphi, and detailed explanations of how the subprime crisis caused the credit crisis and the near collapse of the GSEs. The book includes detailed information on:

--how to value a CDS contract
--how to value the delivery option
--how contract value changes when the yield curve flattens or becomes steeper
--how contract value changes with bullish or bearish market moves
--how to figure out when to buy protection and when to sell protection
--how to hedge CDS risk
--when and how to unwind a contract prior to settlement
--when to hold a trade through delivery
--how to navigate a “squeeze” (when the notional value of contracts going through delivery is larger than the supply of the cheapest-to-deliver issue)
--when buying contracts can make their prices go down
--how to construct a basis trade
--how to find arbitrage opportunities
--how to analyze default probability and corporate debt
--when to settle via auction and when to settle via physical delivery
--which note is the cheapest to deliver

This book is an indispensable resource for all market professionals working in the CDS market.

AUTHOR

David Boberski is executive director and head of exchange-traded derivative strategy within Prime Services at UBS Investment Bank. Institutional Investor has named Boberski to its All-American Fixed-Income Research Team for his work in federal agency debt and interest-rate derivatives. Boberski is also the author of Valuing Fixed Income Futures.

TABLE OF CONTENTS

Part I Markets and Mechanisms
Chapter 1 Interest Rate Policy, Housing Prices, and the Credit Crunch
An Unspoken Assumption
The Music Stops in Home Prices
The Music Stops in Lending
The Music Stops on Wall Street
Fed in a Box

Chapter 2 The Crisis After Subprime
Agencies Born of Crisis
Contradictory Objectives?
The Golden Goose
Losing Focus

Chapter 3 The Link Between Credit Derivatives and Bonds
Caulis Negris
The Music Stops for the Agencies
The End Game for the Government-Sponsored Enterprises

Part II The Delivery Option
Chapter 4 Delivery Option: The Link Between Futures and Credit Derivatives
Assumptions Behind the Credit Default Swap Basis
Default Probability, Corporate Debt, and the Delivery Option
A Review of Treasury Futures Mechanics
Pricing Treasury Futures Delivery Options
The Fair-Value Method for Pricing an Embedded Option

Chapter 5 The Squeeze
Making Mischief
Distorted Economics

Chapter 6 The Cheapest-to-Deliver Option in Credit Default Swaps
Quantifying the Value of the Delivery Option
A Proof by Contradiction
Applying the Fair-Value Analysis
More Lessons from the Futures Market

Chapter 7 Delphi: A Real-World Example
Recent Developments: Destroying Value

Part III Contract Design
Chapter 8 Designing an Agency Credit Derivatives Futures Contract
Chapter 9 Bringing the Index to an Exchange

Part IV A Bear Market Case Study
Chapter 10 The ABX Meltdown
Index

EXCERPT

Chapter 4 Delivery Option: The Link Between Futures and Credit Derivatives

Credit derivatives, which began as a means of hedging the loan exposure of banks, have taken on a life of their own. Now they are used for many purposes for which they were not origi nally designed.

For example, some investors use derivatives to construct syn thetic corporate bonds. As current convention has it, this is done with two instruments: a credit default swap (CDS) and an interest rate swap. The credit default swap is a contract in which one party sells default protection to another. The interest rate swap is a con tract in which one party makes interest payments at a fixed rate and the other makes payments at a floating rate. One would create a basis trade by exchanging a corporate bond with a credit default swap bundled with an interest rate swap. If the credit default swap premium plus the interest rate swap yield are better than or equal to the yield on the underlying corporate bond, then exchanging the cash for the synthetic makes sense.

Assumptions Behind the Credit Default Swap Basis
The important question to ask is: Should a credit default swap spread be added to an interest rate swap when constructing a synthetic corporate bond? When one does so, one assumes that the factors affecting credit spreads will not also affect interest rate swap spreads. In other words, the assumption is one of zero cor relation. If this assumption is violated—in other words, if move ments in credit spreads are correlated with movements in interest rate spreads—then the above construction offers far more risk than is present in the corporate bond. For example, if the credit swap has a spread DV01 (dollar value of 1 basis point) of $450 and the interest rate swap has an interest rate DV01 of $450, then the two better not be correlated, because if they are, the total risk of the position will be greater than $450 for every basis point change in rates. The corporate note in the cash market has a DV01 of only $450, so any correlation between credit spreads and swap rates adds unintended risk. Constructing a basis trade this way makes an interesting assumption about the correlation between the two derivative pieces, considering that one might imagine that an inter est rate swap spread, the residual that’s left from receiving on an interest rate swap and selling a Treasury, is itself a credit spread. If it’s not a Treasury bond, there is a risk of default! However, the going assumption in the credit derivatives market is that the credit risks in interest rate swap spreads are independent of corporate default probabilities. How good is this assumption?

As Figure 4.1 (in the book) illustrates, there are times when it isn’t realistic to assume independence between the derivative legs of a basis trade. Yield changes in a cash corporate note can be attributed to either a change in interest rates or a change in the probability that the bond’s issuer will default. Of course, both risk factors can change at the same time, but each influence can still be consid ered separately, because we can measure the price risk of a note by perturbing its yield by just one basis point. The same may not be true of credit default swap and interest rate swap spreads; there is evidence that during the period illustrated in Figure 4.1 there have been times when the two spreads have moved together. In this case, any positive correlation between the two would lead to a greater price risk in the synthetic bond than is present in the cash note. A true basis trade would swap identical risks to mea sure the pricing differences between each side. One can always make more money by taking more risk, but the point of constructing a basis trade is to take identical risks to discover pricing discrepancies. A first stab at arbitrage is to search for mispricings between risks that, by all rights, should be interchangeable. In order to adjust for correlation, one could measure the historical movement between the sides and then scale up or down the derivative pieces so that the statistical risk is comparable to the cash note. There are several problems with this approach. First, statistical measurements drift. Second, there is the problem of which side should be scaled—the credit or interest-rate swap? On the one hand, it is amazing that such a large market has grown up with such imperfect relative value approaches, but this might also be a testament to how sorely the credit market needed derivatives and how much utility they afford users.

Default Probability, Corporate Debt, and the Delivery Option Before digging into the mechanics of evaluating the delivery option, it is instructive to take a step back and consider the inter-actions we are studying. Accurately evaluating a credit default swap necessitates analyzing two markets: one for default probability and one for the debentures of the company. Rather than being divorced from the cash corporate market, credit derivatives are quite closely linked to this market through the structure of the embedded delivery option. The delivery option is a feature of trillions of dollars worth of outstanding credit derivatives. While the delivery option does have elements that behave like interest rate options, the triggers are very different. Interest rate options go in the money when there is a market move past a certain threshold. The delivery option goes in the money when a credit event occurs. The cash flows of a credit default contract are influenced by changes in the probability that a particular company will default. Presumably, the higher the premium paid in the default swap, the more likely it is that a company will default or the greater the severity of that default will be. (The severity of default refers to the loss incurred by the protection seller after paying par for a note that may be worth less than par. Typically, one considers the probability of default and loss severity to move in lockstep, since it is relatively unusual for a company to be in financial distress but pose little risk of loss to its bondholders. The exception to this could be collateralized debt, a separate situation from evalu ating the unsecured debentures of a company, which constitute the vast majority of credit default swaps.)

Even though default probabilities are the most important fac tors to consider when evaluating the cash flow of a default swap, it is also necessary to evaluate the structure of the market for the underlying debenture to determine the value of the delivery option.

Consider a default by a company with just one note outstanding: there is no delivery option since there are no alternatives for delivery except that one note. What if the company has two notes outstanding? The situation may or may not be very differ ent than it is for the “one note” firm, depending on the differ ences between the two notes. For example, the two notes could be just three months apart in maturity, with the same coupon, in which case price movements would be nearly identical between the two. Although there is technically a choice about which note to deliver, the economic differences between the choices are rela tively small.

But what if a company has two notes with a twenty-nine-year difference in maturities and the long bond is a zero-coupon issue? In this case there would be a great difference between the risks of the two issues, which would make the right to choose which note to deliver upon settlement of the contract quite valu able. Of course, companies rarely finance themselves with such a berserk barbell structure of discount notes and 30-year bonds. In fact, most firms have a fairly orderly structure to their liabilities. However, the point worth making is that the value of a delivery option is tied to the structure of the notes available in the cash bond market.

Inspiring Confidence

This is the new Treasury Secretary, Tim Geinther. Under our present economic circumstances, it really does my old heart good to have our fate in the hands of so capable a man. Doesn't this face inspire confidence? I'm sure that he's just a bit tired, not suffering from depression or any anxiety related to the execution such an important job in the face of the worst set of circumstances the country has faced in a generation. Have I mentioned, that this is the guy who endorsed Paulson's forcing Lehman into bankruptcy? A really brilliant move. By the way Tim, what was your reasoning? Oh, that's right, it was against the rules for the Fed to help Lehman, but not AIG, Morgan Stanley and Goldman (Paulson's former firm).

More on Arrogance

Having fought a few battles with the IRS, I can understand wanting to keep a bigger slice of the income pie. However, not reporting something as obvious as the income value of a limo and driver is something that only the very naive or hubristic or obtuse would dare.

BTW, nice glasses ... the rims are a bit light, but overall, not bad.

Hubris

Hubris, n. arrogant pride or presumption ... it's been a major part of the Street for as long as there has been, The Street. It's really interesting to watch as a bunch of arrogant congress (not the fun kind) people criticize "Wall Street Bankers" for doling out $18 billion in bonuses. If it's happening at Goldman and Morgan Stanley after they waltzed into changing their charters to become national banks and received $10 billion each then, then we taxpayers are really getting taken to the cleaners.

I especially enjoyed the comments of Rudy Giuliani in defending the bank's right to pay whatever they please. Golly, it seems like it was only yesterday when Rudy was a prosecutor and needed a cause, which turned out to be the insider trading scandal, to ride into politics. In those days, the country's mayor was hauling (totally innocent - and he knew it) people away just so that he could get on the evening news. Seems to me that he railed against the fat cats back then. Funny isn't it, now that old Rudy's a fat cat himself, how the worm has turned. That that dope can be taken seriously is way beyond my ability to comprehend.