Several Auctions in October: How Does A CDS Settlement Work?
The FT reports that the $62 trillion credit derivatives (CDS) market faces its biggest test in October as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual are settled. Here is how a cash settlement works and what the public information available is so far.
General Procedure in a CDS Credit Event (Robert Bliss and George Kaufman)
1) Upon default or any agreed credit event that can consist in a downgrade below a certain level (which is what triggered the run on AIG) all derivatives contracts are immediately terminated or accelerated (i.e. payouts promised in the future come due now). This is called ‘close-out’. Termination cancels the contract and creates a claim for compensation, usually the cost of reestablishing the contract on identical terms with another solvent counterparty. Different from other collateralized transactions where the collateral remains under the control of the bankruptcy trustee, “most collateral posted against derivatives positions is under the control of the counterparty and may be liquidated immediately upon a covered “event of default”.
2) After seizing the collateral immediately, all bilateral contracts are netted until one single payment remains to be made form one party to the other. “If the solvent counterparty is a net creditor the solvent counterparty becomes a general creditor for the net amount. If the solvent counterparty is a net debtor the full payment is made to the insolvent counterparty or their trustee.”
3) At the beginning of 2004, 50% of the net exposures were covered by collateral arrangements. In numerical terms, total collateral was just over $1 trillion. The large majority of the collateral is cash (79 percent; 51 percent in USD, 23 percent in EUR). Important: Collateral frequently is re-hypothecated, that is collateral received from one counterparty is then used to satisfy demands for collateral by another counterparty. The ISDA estimates of collateral usage (gross values) account for this effect.
–> Satyajit Das: In a cash settlement the bond recovery value is established through auction of defaulted bonds. The protection buyer has a claim of insured face value minus recovery value of underlying bonds. If the seller of protection is unable to perform then the buyer obtains no protection.
Converting the $62 trillion (BIS)/ $54 trillion (ISDA) gross exposure into net exposure:In the words of Robert Pickel, CEO of the International Swaps and Derivatives Associaion (ISDA) back in January 2008:“First, the $50,000bn “notional” or nominal amount is just that; a nominal figure that references the “underlying” bonds and loans being protected by use of credit derivatives. Focus on the net exposure of these transactions, many of which hedge or offset one another. A recent Fitch Ratings survey estimates net exposure at less than $1,000bn.”
–> going forward, we will assume a conversion factor of 50 from gross to net exposure where multiple bilateral trades cancel out.
1. GSEs (Auction date October 6)
FT, Sep 10: “Michael Hampden-Turner, credit strategist at Citigroup in London, estimates there are $200bn-$500bn of outstanding CDS and other credit derivatives referencing Fannie and Freddie–> This would make their default the biggest the market has encountered. The previous record was held by Delphi, the US carparts maker that went bankrupt in 2005 and which had about $25bn of CDS.”
“Currently, the recovery value of the Fannie Mae and Freddie Mac bonds is expected to beabout 95 cents in the dollar, leading to a potential 5 per cent loss for insurance companies or banks who offered protection against a default. On CDS worth $200bn-$500bn, losses would come to $10bn-$25bn (gross exposure).” More recent estimates see a recovery value of 85 cents on the dollar which implies payouts in the amount of $75bn.
“GSE protection sellers are mainly insurance companies and banks. However, hedge funds will also likely take a hit from previously nice CDS premium income that falls away.”
naked capitalism: Although the payment per contract is comparatively small (5% of face value), the amount of contracts outstanding is so large that the collective hit will be significant.
2. Lehman (Auction date October 10)
Lehman’s default has 2 separate effects in the CDS markets:
1) Lehman is one of the largest counterparties for CDS investors that took a position referencing a third party. All of these contracts need to be either terminated (leads to claim for compensation, usually the cost of reestablishing the contract on identical terms with another solvent counterparty), or assigned to another counterparty (occurs at a higher premium) which is called ‘novation’.
See the following summaries:
Would Lehman’s Default Be a Systemic CDS Event?
Back-of-the-Envelope Estimate Of Counterparties’ Net CDS Exposure
Source:Credit Derivatives: An Overview, ISDA (2007)
Source: Robert Bliss and George Kaufman, Chicago Fed (2005)
2) Unspecified amount of CDS bought and sold on Lehman’s own bonds. These will be settled October 10
FT: Lehman listed $613bn of debt and $639bn of assets in Chapter 11 petition.Subordinated debt and preferred shareholders may be wiped out. Defaulted bonds currently trade at 18 cents on the dollar and bondholders could lose $120bn but not all CDS contracts have been settled yet: Pieces of 1,889 synthetic CDOs worldwide sold default protection on Lehman (Bloomberg). It might take years to unravel and value these structures.
See here who the creditors are: Lehman Bonds Trade at 18 Cents on the Dollar, Investors Could Lose More Than $110bn
–> The reason why the expected recovery value of bonds is so low is because there are many more creditors (including CDS protection buyers) than underlying bonds. If Lehman bonds recover 18 cents on the dollar, credit protection buyers have a claim on 82 per cent of the par value insured. However, as noted in the beginning: If the seller of protection is unable to perform then the buyer obtains no protection.
3. Washington Mutual (Auction Date October 23)
CreditSights (via Bloomberg): “WaMu has $28.4 billion in outstanding bonds, with Los Angeles-based Capital Research and Management Co. its largest noteholder, according to data compiled by Bloomberg–> Bondholders’ only recourse may be the capital remaining at the holding company, Washington Mutual Inc., which Hendler estimated at $2.8 billion.”
“If the holding company keeps the cash, holders of $4.1 billion of Washington Mutual Inc. senior unsecured debt may see a recovery of more than 50 cents on the dollar and investors in $1.6 billion of subordinated debt may get back as much as 10 cents”
Bloomberg: “The failure of Washington Mutual Inc. will have a “significant” effect on collateralized debt obligations that made bets on the lender’s creditworthiness, Standard & Poor’s said. Pieces of 1,526 synthetic CDOs worldwide sold default protection on Seattle-based WaMu, S&P said in a statement today. Synthetic CDOs already have been roiled by last week’s bankruptcy of Lehman Brothers Holdings Inc., which was included in 1,889 deals globally, and the government’s takeover of American International Group Inc., which was downgraded three grades to A-. S&P said 1,619 CDOs made bets on AIG.”
–>“Of the CDOs that sold WaMu default protection, 514 were in the U.S., 752 were in Europe, 122 were in Japan and 138 were elsewhere in the Asia-Pacific region.”
“Many of the deals also will lose payments and loss cushions from contracts linked to Fannie Mae and Freddie Mac, the mortgage-finance companies seized by the government this month. The takeovers triggered a technical default on the credit swaps.”
No Responses to “Several Auctions in October: How Does A CDS Settlement Work?”
Murph • October 7th, 2008 at 10:11 pm
Ms. Parisi-Capone,You do seem to tackle the trickiest subjects – your technical explanations are always excellent, thank you!
Guest • October 14th, 2008 at 4:48 pm
What happens now that RBS doesn’t exist really anymore?
