Santelli On CDS Regulation And Why Bank Analysts Failed
It would seem, just as during the crisis in 2008/9, that now might be an opportune time to push for 'improvement' in how banks are regulated (and more importantly how the instruments they trade in colossal size are priced and marked-to-market). Rick Santelli believes now has never been a better time but as his guest Tim Backshall of Capital Context notes, regulation of the CDS market can be summed up in one sentence "Get Them On Exchange". Something we have been saying for years (and has been tried before) but with dealers holding all the keys (to market-making) and exchanges cowering for fear of losing clients, we remain less optimistic. Santelli and Backshall critically address the complicity of banks, regulators, analysts, and The Fed in giving 'banks the benefit of the doubt' with regard their use of the bottomless pit of capital they implicitly have but what is more important is for the hordes of sell-side analysts and buy-side sheeple to understand just what this JPM debacle exposes about bank risk (VaR is useless), bank transparency (mark-to-model or worse is widespread), and bank valuation (traditional Price/Book metrics have no merit anymore).
Tim sent over some notes from the call (note they are notes and not clear prose)...
Margin/Collateral – CDS is margined but generally large lines of credit will cover a ton of sins. The problem with these positions is that they are more complex and mark-to-model – so until one side really presses for some margin or collateral – there is no real reckoning – I suspect that is what recently happened.
Regulatory change is simple – exchange trade CDS (some details here on the more complex markets and inability to exchange trade but the largest segment of the CDS market could be on exchange in weeks – it already trades electronically with a number of dealers).
Credit markets have been far less excited about JPM and the big US banks for a couple of months now – post stress tests – equities seemed to believe the hype and momentum did the rest but CDS on JPM, MS, BAC etc did very little and in fact started to deteriorate – JPM at one point was over $5 expensive in stock relative to where its credit market price suggested – today has brought that gap back to zero.
Main lesson from JPM fiasco: banks, regulators and Fed are all complicit in their belief in the ‘benefit of the doubt’ that JPM would not use its risk models in vain – or more simply not take advantage of a bottomless pit of capital to press positions that would otherwise seem untenable.
VaR - since JPM admitted its VaR is meaningless, how long until MS, GS and BAC admit theirs too – VaR simply does not give any useful information on positions that are so levered and non-linear as these tranche positions – things get worse in a hurry.
CDS market in general should be on exchange – at a minimum the major credit indices – only thing holding it back is dealers who make the markets and exchanges who are afraid to upset the dealers.
Synthetic CDO market is likely to be dead now. The whole market is premised on illiquidity and mark to model unrealities that at times mean both sides of a trade can be winners (or losers). I suspect this is what happened here – the other side of the trade Iksil had on started to press their position and forced JPM to realize a mark to market change.
Noone knows how big the hole is – today was worst day in IG9 10Y (the credit index that hinged a lot of the position for JPM) in 6 months. And at $200mm DV01 – this could have been a $1-2bn more loss for JPM – the position is too big to unwind (we know that from the changes in net notionals that DTCC provide) and so they will have to hedge their ‘hedge’ somehow – or face a hedge fund community who smells blood – as it clearly did today. The losses could be huge if we merely get back to pre-LTRO levels of risk
Analysts like Dick Bove who come on and push long positions in banks on the back of earnings, or balance sheet dissection are simply out of their minds – this episode (as we have always known) clearly shows that banks income and balance sheets remain (especially for the biggest banks) opaque at best and manipulated at worst as mark to model, Level 3 assets, and prop trades hidden under the auspice of hedges can flare at any time (ask Boaz Weinstein at Deutsche Bank).
Price to book is irrelevant as an indicator since the book has no value because so little of the real assets are marked to market (or even near) – hence the market discounts them
Also – chatter over gross and net positions in CDS (which we heard so much about from Morgan Stanley) are irrelevant as there is no transparency on the haircut on ‘netting’ means we have no way of knowing how ‘netted’ they are
Bottom line is that anyone estimating an EPS impact of this trade has no idea realistically, there are some huge positions that will run off into year-end (but ithers that remain considerably longer-dated - IG9 10Y) or be hedged and we suspect will create significant gaps (up or down) in various credit markets – but certainly less liquidity and more volatility, and if there was ever a time for regulators/market participants to press for exchange trading of CDS, it is now (though this more complex JPM position would be largely untenable on exchange – and perhaps therein lies the problem)