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The Bond-CDS Basis and a Fixed Income Conjecture (pdf)
Submitted by JM
I don't trust any investment vehicle that depends on subprime governments
Thanks for the interesting ideas.
Why should the derivatives get settled first? And with swaps, how do these affect the underlying?
It would seem that the counter-party would be the one to pay the difference, regardless of what happened to the underlying instrument. I thought CDSs were basically just insurance that someone wrote against an occurrence or situation to hedge their bet and taken on by someone who felt the risk of that happening was minimal enough to take the other side of the trade. How, then, would that affect the holders of the actual value?
Still trying to wrap my skull around bonds...
This is due to the fucked up Bankruptcy Reform bill of 2005, of course lobbied by the banks. It says in case of bankruptcy, derivatives counterparties owed money by the defaulting entity can force liquidation REGARDLESS of Chapter 11 protection and court proceedings. This makes derivatives counterparties the supreme creditor. It also makes Chapter 11 menaingless for anyone heavily into derivatives. It has huge impact on the capital markets, yet got little attention.
Ironically, this also means recovery rate on big banks will be 0, because they all by definition are buried to the eyeballs in derivatives and, when shit happens, their derivatives counterparties would have cashed out everything before the bond holders get their turn. It's either survive or CLEAN KILL. Poetic justice?
Now you understand why buying corp bonds is stupid in general, and financials in particular. Recover my ass.
Hmmm. So you know, I am somewhat of a conspiracy theorist...
Could it have been inserted into the bill that way on purpose to create an insulation around banks and financial institutions because they knew the big shit-storm was coming and the only way to protect their ill-gotten gains, create an "emergency," and rape the middle class yet again was to make sure that everything would fall apart if it weren't done? I mean Hammerin' Hank and his martial law threat, for instance.
On its face, it doesn't make any sense to do it that way anyway. To me, they are seperate intruments- the insurance and the actual- and shouldn't be considered as one entity anyway. The insurance on my house is not my house.
If someone were to take a CDS against my insurance and my house burned down (or they burned it down for me...), why would they be owed for the house and not the insurance costs?
I think I hear you saying that the dominoes were beginning to roll and that led to a bunch of crazy shenanigans going on. But if the counter-party were to just be entitled to the risk of insuring the instrument, then he would have no incentive to burn my house down at all.
This sounds quite fishy to me...
Sorry, I try not to be a conspiracy theorist. :) The rationale behind the reform bill was that Chapter 11 protection would cause a lot of damage to the banking system because banks would be locked out for years, which is true. The real question is whether it's wise to change the effective capital structure and effectively throw away Chapter 11 protection mechanism and create perverse incentives (derivatives counterparties prefer quick banruptcy rather than saving it through debtor financing). Derivatives got a lot of breaks, like this and the off-balancesheet status. Yeah, it's really fucked up.
Your analogy of house is flawed. Bond is not your house, but more like your mortgage if you insist on the analogy. Selling insurance on your mortgage is roughly equivalent to borrowing money and lending you the mortgage.
Interesting and very informative. Thanks.
One more thing, what does it mean, "locked out?"
Say GM owed GS $10B in derivatives before it went down. If Chapter 11 applied to derivatives, GS would not be able to get the money until GM exits Chapter 11. This would be very painful to GS, possibly fatal, because as a bank/hedge fund/trading house, all the money in the world doesn't mean shit if you can't churn it. It's all about cashflow and liquidity (well to a point). In retrospect, the right thing to do would be to counter-argue that "ok then you'd better be careful getting into big derivatives positions, but I ain't gonna screw up the capital structure and throw away Chapter 11 for your convenience."
Yes, MSM never talks about it but it was a top fuckup in legislation, right up there with the abandonment of Glass-Steagall.
"...but it was a top fuckup in legislation, right up there with the abandonment of Glass-Steagall...."
Rhetorically, then, how can you not be a conspiracy theorist? Everything fits.
Thanks very much for everything.
fascinating. the reason "derivatives get settled first" is because "cash itself is a market." You think of "cash" as "money in your wallet" but in fact "it's been worthless for decades" and "only has value through the lens of buy low/sell high or sell high/buy low." We know for a fact "an equity can sell for less than the cash on the balance sheet" and indeed even "the cash value of the company." Talk about "breaking the buck"! It happens all the time. This time? "You're fighting the money printer"! vis a vis equities. Now "if you're talking debt" well....HAHAHAHAHAHA. "It didn't even used to be a market" so "shorting debt markets was well nigh impossible..." until...THE MIGHTY CDS. Remember..."Warren Buffet called them financial weapons of mass destruction." We've already "dropped the bomb on Greece." Talk about "making a fortune." So of course the question "as Warren Buffet asks it" is "why shouldn't I make a fortune wiping San Franscisco off the map." He is a Democrat is he not? And of course "so are they"!
The chart is CDS premium - bond yield. During most of the crisis CDS premium was lower than bond yield. If people prefer CDS over bond, then both CDS premium and bond yield would go up and it'd be mostly a wash on the basis.
What the author said about derivatives having a higher effective seniority than senior bonds is true. But this was not an overwriting factor during stress times. Rather, it's mostly due to
1. Funding cost. Cash requires funding and funding is hard to come by during crisis, driving up bond yield.
2. CDS counterparty (dealer, big banks) risk. When a big shit storm hits and the reference credit defaults, there's a chance the CDS seller gets dominoed and can't pay. This drives down CDS premium.
3. Liquidity. During crisis, risk-off means people want to sell the most liquid position, which is usually high quality corps. This results in the "strange" phenomenon of the best quality bonds getting hammered more -- more negative CDS-bond basis.
Another factor, and probably much more interesting one, is CDS sellers deleverage. When crisis looms, CDS dealers begin to realize they'll be hit by the shit storm (AIG) and may get into panic unwinding of their short-CDS positions. This would drive the basis positive, and was probably why ML did the massive basis trade. But expectation of bailout stopped dealer from doing it. They basically said "oh fuck it, why realize the loss now, gov will make use whole." Such is the unintended consequences of gov fucking around the mkt -- gov ended up bailing out both sides of the trade.
What the author said about derivatives having a higher effective seniority than senior bonds is true.
What the author said about derivatives having a higher effective seniority than senior bonds is true.
A little misleading since the issuer of the bond is not the issuer of the CDS
It seems the way the law was written that if you default for any reason, you have to pay the derivatives first. What's left can pay everyone else. Of course, there's nothing left.
Hmm, this is starting to sound like the biggest banking scam of all time...
Yes, it is.
Dispersion and stacking the synthetics contained loads of pure, premeditated fraud over quite a timeline too.
The fraud reached from the synthetic, backwards, to the loan origination, for example, on MBS. I don't mean only in the aggregate either and obviously not just MBS. I mean specific and detailed decisions aimed like a gun at potentially productive money.
This infected thinking and financialization of America will motivate a LOT MORE unbelievable and complicated fraud that so reliant on different contingents (like government regs) that it will not be prosecutable. We've just seen the start. This has the power to change human nature exponentially, because the incentives are exponential for controlled fraud, not production.
Was kiwi fruit banned from New Zealand (see news) or a virus planted on those kiwi properties because someone insured a security or created synthetics (or even shorted the NZ dollar?). If so, who? A few government workers in NZ making $35K/yr take a bribe from a banker like the interest rate swap bribes in Mississippi? Infiltration in the kiwi farms? FDA lying or overreacting to make a market?
I'm not suggesting ANY of this, and it may seem a ridiculous example, but people will start suggesting all of this soon. The more ridiculous it seems the more invisible it will be.
Let me guess, we can thank Bobby Rubin for most of this?
Yes, good point.
you're a phucking wack ball.
Either this author is very confused or has presented only half of his theory.
Let's go back to basics. Credit default swaps are not issued by the company that the derivative relates to, they are issued by an unrelated 3rd party. This is why it's called a synthetic exposure.
So if Ford defaults on it's debt, Ford has nothing to do with settling the CDS contracts which may exist between buyers and sellers of credit protection on Ford's debt. These contracts may be settled in cash or physically, in which case the buyer of protection has the right to sell the defaulting bond to the seller of protection at par. The seller then takes their bond and gets in line with all the other bondholders and creditors.
So the fact that derivatives rank higher in the credit structure than senior debt does not support your theory, because you are talking about positions in the credit structure of two different companies, namely the issuer of the debt and the CDS counterparty.
Thanks for the input. I know that this capital structure stuff isn't the end-all, be-all.
When a funded bond position is unwound, there are costs. When parties trade for an unwind there may be disagreement in NPV. There is a difference in the seniority of the positions with respect to recovery/MTM. I believe this makes a difference.
I'm just trying to think through how it feeds into that illiquidity headline, which is hard to define.
Punter- You have probably seen this story that Chris is commenting on from the NYT. Not sure if you follow IRA, but what are your thoughts on CDS holders getting paid out over RMBS insurance policy holders?
Just for anyone who is interested in the actual reason that the bond-CDS basis moved the way it did, here it is.
It is mainly related to funding costs on holding the physical bond.
The CDS bond basis is usually considered to be the difference between the CDS rate and the spread of the yield of the bond over the risk-free rate. The theory suggests that these two numbers should be roughly equal because otherwise there would be an arbitrage opportunity. For example, if the bond spread is higher than the CDS rate, just borrow (at the risk-free rate) and buy the bond. So you are receiving the bond spread. Now buy protection for which you pay the CDS rate. You are totally hedged and are pocketing the difference between the bond spread and CDS rate.
But to do this you have to be able to borrow money at the risk-free rate (whatever you have defined it to be). This is normally the swap rate (ie LIBOR). Therefore when the CDS-bond basis is negative it is saying that banks (who would normally arb this away) are not able to borrow at LIBOR in order to invest in corporate bonds. There is no arb, it is simply that the "risk-free borrowing rate" is not being defined correctly in the calculation for current market conditions.
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