Built to Fail CDOs 101: How Well Do You Know Your CDS Counterparty?

The Abacus CDO story of 2010 brought to the fore a worrisome scenario in which it could be argued that the arranging bank (Goldman Sachs) played two different roles at once, potentially serving one particular client (Paulson) at the expense of other clients (investors in the Abacus CDO). Goldman settled the case with the SEC for $550mm. What could be worse than participating in such a conflicted scenario? We are concerned that in a number of deals the arranging bank may have positioned itself directly against the CDO investors. In other words, the bank, like Paulson, may have been betting against its clients.


But first, let’s take a step back to explain how this all works…

A CDO is called a “synthetic CDO” when the underlying assets are “synthetically” referenced, rather than being held like physical corporate bonds. The underlying assets are often referenced by way of credit default swaps, or CDSs, and are called “reference obligations.” These CDSs may reference several types of asset classes, but in the synthetic CDO setting they typically reference either corporate debt or structured finance securities, such as commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS), or even other CDO tranches. In the Abacus deal, the reference obligations were credit default swaps struck on RMBS.

Instead of buying physical assets that pay coupons (when current), the synthetic CDO sells protection on a portfolio of reference obligations. Much like insurance contracts, the buyers of protection on each underlying CDS make periodic “premium” payments to the CDO in exchange for compensation if and when a default, or credit event, occurs with respect to the obligation being referenced.

The CDO’s immediate counterparty on each CDS – typically the arranging bank – often plays an intermediary role between the CDO and each of its CDS transactions. It buys protection from the CDO and sells protection to the end buyer. This layout allows for the CDO to focus solely on the counterparty risk (i.e., the risk that a party will fail to fulfill its obligations under the CDS agreement) of a single party – in this case the arranging bank – as opposed to that of each end buyer (of protection).



Ideally, this dynamic ought to create an environment in which the immediate CDS counterparty (the arranging bank) is neutral to the performance of the CDO as the bank is fully hedged (as long as end buyers do not default).[1]

The imposition of an intermediary CDS counterparty often masks the identity of the end buyers from those who invest in CDO notes, potentially rendering CDO investors unable to discern which parties are ultimately short their portfolio.

Goldman Sachs’s now famous Abacus CDO illustrates a serious danger that can arise from the above confusion. The argument could be made that had investors known that Paulson was the end buyer of protection on a significant portion of Abacus’ CDS portfolio, they may have reconsidered the prudence of their investment, and potentially shunned it.


Built to Fail, Profitably

But what happens if the arranging bank chooses not to off-load all positions to an end buyer? In other words, what happens if the bank retains some or all of the short exposures to the underlying reference obligations? Here, the end buyer of protection, and the immediate CDS counterparty are one and the same: the arranging bank. The bank is now effectively short the CDO.

For example, the plaintiff in re: Space Coast Credit Union vs. Barclays Capital et al argues that:

“[the] facts here leave no doubt there was clear intent to create a very large short bet through Markov against Mezzanine CDO risk”

and that:

the “Defendants were extraordinarily determined to stuff Markov [CDO] with Mezzanine CDO risk.”

Plaintiff argues that:

“most stunning of all, [the Defendant] was so intent on Mezzanine CDO failure that it custom-built $300 million of built-to-fail Mezzanine CDOs … that [the Defendant], through Markov, could then bet against.”

While we do not seek to verify the accuracy of their contention, we are keenly aware of the material conflict such a scenario would present: the arranging bank is short the securities, meaning it would be financially rewarded if those securities were to plunder. The bank would benefit from selecting poor-quality assets. At the same time, the arranging bank is selling CDO notes, supported by these assets, to its clients. If the assets fail, the bank profits at the expense of the CDO noteholders – its clients. If the assets perform well, the bank would suffer financially.

From a higher level fiduciary perspective, the bank’s financial motive would not be aligned with the well-being of its client. Nor would the bank be even indifferent to the performance of its client. Rather, the bank’s profitability would be in direct opposition to that of its client.


While their clients were losing money on the trade, how much were bank profiting?

Removing the time value of money and the default timing as inputs to the model, we can create a simple model to estimate the bank’s profits from this trade. The model assumes that 100% of the assets are synthetically referenced.

Suppose the total premiums being paid were P, and that a bank held the super senior swap, with attachment point AP. The higher the attachment point, the greater the potential for the bank to make money: if losses exceed AP, the bank's profits are capped, as the profits from its short positions mimic identically the losses from its super-senior position.





In dollar terms, suppose the deal is of size $1bn, with an average 1% credit premium (P) on the reference obligations and a super-senior attachment point (AP) of 50%.

Suppose for simplicity that all losses occur within the first year.

If losses (AL) are lower than 1%, say they’re 0%, the bank loses 1% x $1bn = $10mm. Thus, if the portfolio is well selected, the bank stands to loses up to $10mm.

But if the portfolio is poorly selected, and suffers losses over 1%, the bank cashes in handsomely. At 5% losses, the bank makes 4% of $1bn, or $40mm. At 50% losses, the super senior attachment point, the bank caps out at 49% of $1bn, or $490mm. (Profits are maxed out at the 50% AL level as, in this example, the bank holds the super senior swap.)

A bank can either lose up to $10mm for doing a really good job of diligently selecting good assets, or the bank can make as much as $490mm for selecting really bad assets. Would you expect any bank to do the former?

_________________________________________


[1] If anything, the CDS counterparty ought to have a slight preference for the continued performance of each CDS contract, as a default would cause settlement and thereby cut short any intermediation fees it may be earning as a middle-man.

Christine Richard, on Confidence

Earlier this week, Expect[ed] Loss sat down with Christine Richard, author of Confidence Game. If you haven’t already read the book well firstly shame on you. The paperback’s due out next week so pick it up. It’s a vital story.

Briefly, the book tells of a hedge fund investor’s campaign to bring attention to what he felt to be material shortcomings within a AAA-rated, systemically important insurance company. He’s short their credit default swap, which means he stands to profit if other market participants, authorities, rating agencies or regulators can be convinced to agree with his take. Of course, he walks the line between good and evil: he provides a material public good in a way in warning of a systemic concern, but in doing so his warnings serve to cloud the viability of a systemically important public company, while creating a profit for him.

We’re not here to spoil the book for those of you who haven’t read it yet. But we’re going to provide you with a couple of snippets from our conversation. Any wisdom coming from the interview belongs to Christine. Any errors are ours.


EL: Christine your book describes activist investor Bill Ackman’s crusade, and really it’s quite a lonely crusade isn’t it, against an insurance company he believed to need reforming and perhaps a whole system he felt was broken. Having seen how reform and regulation has transpired since, how the world has moved on, well has it affected your perception of the value of your work. Was the book fulfilling to you?

CR: I'm pleased with the book and the response I've gotten from people who've read it. I think it succeeds in combining a very human story with the larger story about what went wrong on Wall Street. I do find it discouraging that the FCIC left the role of the bond insurers out of its 500-page-plus report. I think that the loss of confidence in the triple-A ratings of companies like MBIA was the beginning of the unraveling of everything. Most of the companies have crept quietly off the stage but still I think the story of their collapse is worth understanding. They were the first, really, to figure out that the triple-A rating was one of the most powerful brands in the world. Before the crisis, their collapse was unthinkable. Even the idea that they might be downgraded to AA from AAA was unimaginable. It shows you just how fragile and delusional the financial system had become.

EL: Companies can fail for all sorts of things, often trace-able to poor communication between management and the board and shareholders. But here that wasn’t really the problem – Ackman, like Harry Markopolos in a way, was all about communication. He went to regulators, to the attorney generals, to the executives at the ratings agencies. He wrote detailed reports, ran extensive analyses, produced an open source model at a time in which analytics were expensive and the market opaque. What can be taken from all his efforts? All these authorities he went to that were deaf to his comments - did they all just have a distortion field around them at the time?

CR: Some of the reasons people wouldn't listen to Bill were obvious. It wasn't in their interest to be critical of a company that could turn any bond into a top-rated security. For a while, the main business of Wall Street was manufacturing triple-A-rated securities. I also think there were psychological reasons that people didn't want to listen. No one wants to be told how to do their job or that they have it all wrong. Plus, Bill had this huge financial motivation to scare people about the bond insurers so that he could make money on his credit default swap position. It was hard to look beyond the self-interest and really think through the argument. Above all, the triple-A credit rating shielded the company from critics.

EL: When we read interviews of Inside Job director Charles Ferguson, they often ask him about the language barrier of finance. Overcoming the barrier might be quite difficult for some reporters who are not too familiar with finance. Now I know you’ve been covering the debt market for many years at Dow Jones from well before you were at Bloomberg. And you’ve written a page turner, you really have, it’s remarkable. But was there a, how do we say it, complexity barrier for you to overcome?

CR: The financial system became so unbelievably complex. And, bond insurance layered more complexity on top of complexity. I didn't want to shy away from writing about credit default swaps or collateralized debt obligations but I was always conscious that I needed to quickly offset the technical explanations with something a human being could relate to. Bill's willingness to share his personal experiences, to let me look through thousands of emails and to interview his friends and colleagues made it possible to write a story that's as much about human nature as it is about bonds or credit default swaps or collapsing mortgage securities. One of my favorite parts of the book is when Moody's finally puts MBIA under review and Bill is at his grandmother's 90th birthday at the Plaza Hotel. He's trying to piece together how a credit rating downgrade might unravel the whole company and how that is going to trigger payments of billions of dollars on his swaps. Meanwhile, the waiter is holding up a cake and his family is singing Happy Birthday and he's trying to sing and to read Bloomberg headlines and communicate with his trader on a Blackberry under the table.

EL: You mention even at Dow Jones that there wasn’t much patience for your investigative tendencies, your interest in digging deeper. And you’ve mentioned to me before the pressures to keep current – how nobody wants you going back and following up on stories of the past. Is this the new normal?

CR: It's a big part of what business journalism aspires to do -- to give people information to trade on, to move stocks, to make profitable predictions. Maybe it explains why the M&A reporters get so much of the attention. I've always enjoyed telling stories more than making forecasts. In the case of MBIA, I found the company's history of covering up losses so fascinating because it revealed its vulnerability. It had to be infallible or it was finished. That made going back and looking at the past important. The past held all the clues about what was going to happen.

EL: Christine before I let you go I want to ask you one thing – does Bill inspire you?

CR: I spoke with Bill for six years before I started writing the book. What I enjoyed most about our interactions was his enthusiasm for the research. He was fanatical about figuring out what made the company tick, and he seemed to have more fun reading financial statements than anyone I've ever met. He also just has this incredible optimism. He'd come back from a meeting with one of the credit rating agencies (back in the days when he was giving two-hour long presentations about why MBIA should be downgraded and he was being ignored) and an employee at Pershing Square would ask how it went. It was always the same response -- "On a scale of one-to-ten, the meeting was definitely a ten." Eventually, people didn't even bother to ask Bill about meetings, they just looked at each as he came through the door: "Ten out of ten?" "Yep, ten out of ten?" It's a great message about believing in yourself and persevering when the world thinks you're wrong.

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To read more about the Confidence Game, click here.

Credit Ratings Reversals

The debate continues over the usefulness of credit default swaps (CDS) spreads as alternatives to ratings.

Today, Moody’s Corporation announced that its Analytics division – separate from its ratings group – has improved the ability of its EDF (expected default frequency) model to estimate default probability as a result of the incorporation of CDS spreads to the platform.

Moody’s Analytics clearly agrees that CDS spreads provide useful predictive content. So did a fellow panelist of ours at a distressed debt conference on Friday.

Jerome Fons, EVP of Kroll Bond Rating Agency, included the following slide in his presentation (click here to download the presentation in its entirety).

Among other things, it shows CDS spreads to be better predictors of default probability (see the higher Accuracy Ratio).

The slide also displays the lower frequency with which credit ratings are reversed by rating analysts, versus the regularity with which CDS spreads can move from one bucket to another as per the market’s whims.

This feature, as displayed by Ratings Reversals and Rating Changes, reminds us of the human nature of rating agency analysts and in particular their psychological predisposition against reversing a prior rating action. The obvious upside is ratings stability – at the expense of volatility -- to the extent we care for it. Would we want our regulatory capital ratios to move on a daily or secondly basis, as a stock price may trade on the news, or on gossip?

For example, consider the case of Arlington CDO tranche A3. Moody’s and S&P both started off at Aa2/AA ratings, respectively, in the year 2000. In 2002, Moody’s downgraded it more aggressively than S&P, a situation which lasted until 2006, at which stage Moody’s upgraded the bond to A3, which was the then-current equivalent of S&P’s rating of A-. 2009 arrives and Moody’s drops to Caa3, before upgrading to B3 in early 2010 and then Ba3 last week. Moody’s is now just short of S&P’s current equivalent rating of BB+.

While certain market participants might benefit from more regular rating actions, others no doubt value ratings stability above all else. But either way, it seems entirely unlikely that rating stability and ratings accuracy go hand-in-hand.



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We remain very interested in the topics of ratings alternatives and the comparison of ratings performance. Let us know if you have a similar interest in these topics.

For more on CDS spreads as alternatives to ratings, click here; to visit our submission to the Fed, OCC, OTS and FDIC on this topic, click here.

Credit Rating Alternatives

At a time of increased tension in and among the larger credit rating agencies, Frank Partnoy, Mark Flannery and Joel Houston have submitted a suitably-titled research piece that addresses "Credit Default Swap Spreads as Viable Substitutes for Credit Ratings."

Inconveniently they have chosen 15 highly liquid financial names for comparison purposes, which unfortunately means their conclusions do not address our concerns that credit default swaps (CDS) spreads remain questionable estimates when the CDS and the rated underlying itself have vastly different trading volumes, or for illiquid or unrated securities (visit our April piece "Credit Ratings vs. Credit Default Swaps").

As the banking regulators consider following the NAIC's lead in finding alternative solutions to relying on credit rating agencies for regulatory capital reserve considerations, another key features to consider is their respective predictive content: do ratings or CDS spreads have any long term opinion associated with them, or are they purely back-looking or point-in-time estimates. The authors attend directly to the search for regulatory scrutiny alternative and the possibility of relying on CDS for this purpose (emphasis added by us):

"More generally, it is apparent that CDS spreads reflect available information, which makes them useful for regulatory and risk management purposes, even if they are not necessarily suitable for forecasting."

...

"At a minimum, our analysis supports the conclusion that CDS spreads reflect information more quickly and accurately than credit ratings. Specifically, we find that as information about the subprime mortgage exposure of financial institutions was disclosed during 2007 and 2008, CDS spreads reflected that information, whereas credit ratings remained relatively unchanged.

If regulators and investors had looked to CDS spreads to assess the riskiness of financial institutions during this period, they would have found as early as April 2007 that such risks were significant and increasing. By early 2008, CDS spreads reflected a significant likelihood of default by one or more investment banks. In contrast, credit ratings reflected little or none of this information."

The Carry Trade from Off-Balance-Sheet Heaven

The Citigroup-structured CDO, Adams Square Funding II, Ltd., closed in March 2007 with the $600mm Class A1 Floating Rate Notes (Due 2047) not being offered by Citi; rather the A1 notes were being insured by a swap counterparty by way of the then-convenient-and-now-infamous negative basis trade.

By insuring this A1 tranche trade (Ambac Assurance was reportedly the ultimate swap counterparty), Citi was able to lock in substantial up-front “profits” on the trade in addition to their significant underwriting fee. FASB’s accounting regime (1) enabled the so-called profits on the trade to be recognized immediately, by way of “sale accounting,” and (2) allowed the trade to disappear into off-balance-sheet oblivion, away from Citigroup shareholder verification.

The negative basis trade was perpetuated by several banks for many reasons, as described more comprehensively here. The forthcoming chart provides what we believe to be a thorough breakdown of the minimum estimated up-front profit -- of approximately $9.8mm -- Citigroup would have been able to achieve in having the A1 wrapped by a monoline guarantor.



Indeed UBS’s shareholder report explains that

[UBS’s] CDO desk viewed retaining the Super Senior tranche of CDOs as an attractive source of profit, with the funded positions yielding a positive carry (i.e. return) above the internal UBS funding rate …

and…

Day1 P&L treatment of many of the transactions meant that employee remuneration (including bonuses) was not directly impacted by the longer term development of positions created…

UBS may have made larger sums on the deals they had wrapped: UBS’s cost of credit default swap (CDS) protection was on average as low as 11 bps, or 0.11%.

The ability to lock in such enormous, fictitious, gains (and potentially distribute some of these gains immediately in the form of bonuses to investment bankers) proved to be a major contributor to the financial crisis. With the under-capitalized monolines – such as ACA, AIG, Ambac, CIFG, FGIC, FSA, MBIA, Radian and XL -- struggling or failing to support the credit protection contracts they had over-sold, several of the TBTF banks were forced to rely on the government’s (and taxpayers’) aid to fund the ultimate return to their balance sheets of what we estimate to be $300 billion of off-balance-sheet negative basis trade securities.

Other resources: a diagram describing the trade more generally, in its context relative to the CDO, can be found here.

Credit Ratings vs. Credit Default Swaps

As an alternative to relying overly on ratings produced by credit rating agencies, several ratings reform proposals offer the usage of bond or credit default swap (CDS) prices or spreads as a more plausible option. Some of these proposals are positively suggestive of the fact that market prices are both more accurate and more predictive than credit ratings.

I’m not convinced.

Firstly, with ratings being so deeply embedded throughout our financial structure, the ratings of the assets themselves become an integral component of the market-implied risk assessment. For example, even when analyzing securitized products Vink and Fabozzi (2009) show credit ratings to be a major factor accounting for the movement of primary market spreads. Thus, for any proposal to be convincing it would have to test the accuracy and reliability of CDS spreads on unrated bonds or companies. Alternatively, a study would need to compare the performance of traded securities whose ratings are not publicly known (also known as shadow ratings) to the performance of those shadow ratings.

Secondly, bond yields (or spreads-to-swaps) and credit default swap premiums are largely incomparable to credit ratings for many reasons. These differences will have to be tackled in a separate piece, but at the very least there’s that non-insignificant concept of liquidity. Both CDS premiums and bond yields include the various risks – not just credit risks – that come with investing in, or buying protection on, a security. Credit ratings speak solely to long-term credit risks.

One may argue that the ratings were far less accurate than CDS spreads during the crisis, and that this (i.e., during a market dislocation) is the only time we depend on accurate default projections and we should therefore abolish rating agencies in general. While I don’t wish to complain of these proposals, I fear that they complain unfairly of the rating agencies.

Yes the CDS spreads may better reflect default probability during a crisis. By definition they’re more adaptive to changing market conditions, versus the ratings which are long-term predictors. But would you want ratings to change in as volatile a fashion as CDS spreads? Would you want ratings to depend on headline news, or on audited (or lightly audited) financial data? Also, one shouldn’t forget that CDS spreads on CDOs and RMBS tranches were just as poor reflections of market-perceived asset quality before the crisis. The crisis could only occur, in part, because the banks were able to buy protection so cheaply from the monolines, by way of being long the CDS -- the infamous negative basis trades.

But even if these proposals made sense and even if their hypotheses were correct, they would be missing at least one crucial point: we need ratings. Meaningful ratings are essential – certainly now. Let me explain why, albeit by way of a long-winded explanation.

For financial reform to be successful it needs ultimately to deal with the flaws in our banks’ risk management procedures – and to deal with them in an environment in which the very serious practice of risk mitigation is left by senior management to risk managers, just as the serious business of growing revenues while attending to shareholder pressure is left by risk managers to upper management.

That these two functions are more adversarial than independent in nature is a concept not to be lost on us. Overly cautious risk management might hinder the implementation of growth opportunities, or the extent thereof. At times, indeed, they may be thought by the skeptic to be mutually exclusive.

Indeed the overpowering pressures that come with business initiatives can influence even the most judicious risk manager’s ability to perform her function in an objective manner, even though her function ought to be both separate from and independent of the business strategies. (See for example “Lehman’s Worst Offense: Risk Management.”)

With both traders and management being compensated for revenue generation, and with prudent risk managers acting only as a hindrance to the initiation and exploitation of growth opportunities, there remains little incentive for senior managers to maintain a healthy risk management environment. Instead of cultivating an environment in which risk managers are educated in monitoring the real risks (which requires expensive resources including personnel, data and systems) they are seen rather as a burden and a cost center, and are therefore starved of the resources necessary to question traders, trades, and trading strategies.

In sum, we remain in the infancy of creating a functioning risk control practice in place at our major banks. We are yet to promote adequate business-peer challenge processes and our price verification processes remain immature. Credit ratings, if created and applied properly, can provide a healthy starting point for internal skepticism; they can provide the independent credit risk assessment that supplements an analysis performed by the front-office or by the back-office.

Conclusion

CDS spreads are untested as a predictor of long-term default probability on unrated securities. Perhaps the reliability of CDS spreads depends on the underlying referenced entity being rated. There’s no doubt that CDS spreads are useful indicators – but I seriously doubt that they’re anywhere near as useful as ratings in predicting long-term default probabilities or losses.

I remain convinced there's an important place in our market for one or more independent agencies to provide their objective opinions in the form of a rating. For ratings reform to be successful, however, requires that the necessary measures be put in place to ensure that rating analysts are unfettered by market share concerns, and are incentivized only by ratings quality and accuracy. If we can achieve these objectives, ratings will return to providing a meaningful utility.

An Investor's Guide to Hedge Fund Leverage (Part 1)

Leverage (more specifically deleveraging) difficulties have caused more than their fair share of pain of late in the hedge fund world.

We're going to explore the concept of leverage by way of an example for now; let's suppose:

1. we're in a simple world (let's call it Wonderland) in which the price of a bond or a loan remains constant at $100 per $100 of par;
2. managers can only buy (go long) assets, and no naked shorting is allowed;
3. AA bonds carry coupons of LIBOR + 90 basis points (i.e., L + 0.9%); and
4. A bonds carry coupons of LIBOR + 125 bps (i.e., L + 1.25%).

Imagine these bonds are fairly illiquid and so the manager's strategy is to buy them and hold them to maturity. Assuming zero defaults, the manager who buys AA bonds will earn L + 90 bps on his/her investment, while the manager who took on more risk with single A bonds will earn L + 125bps.

Let's put aside our feelings about whether LIBOR + 1% or so is a "good" return. One thing we know for certain: unless LIBOR goes crazy and hits the 29% mark, your hedge fund is never going to earn 30% annually by simply buying and holding bonds, even if there are never any defaults. We're not going to invest in a hedge fund that targets L + 1%; to compensate for the limited upside potential of bonds/loans, relative to equity, fixed-income hedge fund managers need a little more zip. To "hit" the big numbers (assuming no shorting for now), they need leverage.

Leverage can be "achieved" in various forms, such as total return swaps and repurchase agreements ("repos"); for now let's examine the essence of the mechanism.

Suppose hedge fund HARRY has $10mm of capital and wishes to buy a $10mm position in that AA bond paying L + 90 bps. HARRY could buy it, after which HARRY is fully invested and yielding L+ 0.90%.

Alternatively HARRY enters an agreement with bank that wants to sell HARRY the bond. The agreement says that bank will LEND HARRY $10mm to buy the bond, subject to the following conditions:

1. HARRY must post the purchased bond to the bank as collateral for the loan;
2. HARRY must pay bank LIBOR + 10 bps on the loan, as long as it's outstanding; and
3. HARRY must post 5% haircut against the AA-rated collateral (to mitigate the bank's risk that the collateral defaults or depreciates in value).

Summary: HARRY's collects L+90 on this bond, pays L+10 to the bank, and has to put down $500K capital (5%) as haircut. Thus, he captures L+ 90- (L+10) = 80 bps on this transaction (of size $10mm). Since he's posting 5% haircut, he can logistically (we're still in Wonderland) perform this operation 20 times (20 x $500K = $10mm = HARRY's total capital). In so doing, he's making:

20 x 80bps x $10mm = a handy 16% return p.a. on capital

Some market terminology for you:

• HARRY is 20 times levered;
• HARRY manages $10mm capital, but has $ 200mm of assets under management (AUM);
• The bank's lending rate to the hedge fund is often termed the "Pricing Rate"; and
• The "haircut" described may also be referred to as initial margin, but bear with me here - we haven't yet breached the topic of "variation margin."

The better the collateral quality, the lower the haircut. Using a 1% haircut in the above example, would allow HARRY to lever up 100 times in Wonderland. Municipal bonds -- historically typically AAA rated and often insured -- are an example of collateral that could be highly leveraged on the back of this strong credit quality.

Now let's have a look at some actual (slightly historical) numbers, while remaining for a while in Wonderland...

(Click on the table to enlarge it)

This concludes Part 1. Part 2 will follow shortly, and will discuss, among other things:

• deleveraging, and its effects
• variation margin - and what happens with 2008 numbers
• leverage facilities: diversification, termination
• and possibly, the cases of Bear Stearns Asset Management (and Merrill Lynch), and the municipal arbitrage deleveraging nightmare

Systemic Risk in the Sovereign Air

Larger-than-life market-perceptions of systemic risk have blown sovereign debt wider and their credit default swap (CDS) levels to epic proportions.

With the US Treasury's 10-year CDS as wide as 40 bps (i.e., 0.4%) -- a 40-fold since early 2007 -- we're being forced to re-evaluate just what is meant by the "risk-free" rate of return (which is traditionally the UST, in fixed-income world).

According to the following chart (click on it to enlarge), perhaps 27 bps should be the minimum credit-related risk-adjustment used in conjunction with discounting by by the "new" risk free rate...
(1 basis point (bp) = 0.01%. In other words, the seller of protection earns a 0.4% annual premium on US debt, versus a 39.5% annual premium on Argentina; but beware that shorting the CDS will require you to post wicked amounts of margin given the volatility.)

Remember: A country's default probability is a measure of both its ability and its willingness to pay its debt.

Holders Steamed Over Lehman CDOs

Link to the Asset-Backed Article (came out last Friday)

Investigating the Eligible Investments

In many ways connected to our earlier piece on "Investigating the GIC," Moody's downgraded various LCDO tranches underwritten by Lehman Brothers. As their name suggests, these CDOs are backed by loan credit default swaps (LCDS). With the underlying being by nature synthetic, funded issuance can be invested in "Eligible Investments," such as a GIC.

For these deals, proceeds of funded issuance was invested (either substantially or completely) in the Lehman Brothers ABS Enhanced LIBOR Fund, which according to Moody's, consists of -- or invested in -- a portfolio of highly-rated asset-backed securities. Moody's remarks confirm the suspicions we describe in our earlier piece on GICs: that the proceeds of liquidation may not be sufficient to repay in full the principal amount of the funded note tranches.

Those notes were downgraded by 3 to 6 rating subcategories across the board. We're admittedly surprised by the mildness of these downgrades, but they remain on watch for further downgrade, so stay tuned.