Tuesday, December 02, 2008

Splitting Bond Default Risk with a Maul

Last night, while reading some of the news of the day I came across this article about CDS (credit-default swap) prices on US Treasury debt hitting a record. "There's a funny story," I thought to myself, "maybe tomorrow I'll write about how silly it is to buy default insurance on an institution that can legally dilute infinitely."

Note: a Credit Default Swap is a contract which pays the buyer of the swap an agreed sum of money in the event of a "credit event" such as a default, as the Lehman collapse generated.

So here I sit, beginning at 5:30AM, jotting down notes and doing some research- turning an idea into an essay. It's a laborious but enjoyable process, interrupted by breakfast, home-schooling my son, and, these days, cutting, splitting and stacking wood- nothing like slamming a maul into a big piece of oak to work out a few "turns of phrase."

I enjoy the process of writing mainly because I can rarely see how it will end with clarity- i.e. it's a learning process. Sometimes the finished product is close to the original idea. More often what began as a central idea becomes peripheral upon reflection, and a few whacks of the splitting maul.

"Whack, whack, whack (it's a big piece of oak- probably have to cut it into 8 segments), whack"

"Where was I?" ............right, credit default swaps on US Treasuries.

The starting point (or un-cut log, if you will) was the foolish-ness of buying credit default swaps on US Treasury Debt. After all, the Treasury won't default, they'll just print money, as Greenspan said a few years back.

"Whack!"..."bff".."bff" (that's the two, now-split halfs hitting the ground)

Let me check my research.

CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event.

In the event of a restructuring of sovereign, in this case, US, debt, the CDS would be worth owning, assuming it was cheap. Many Sovereign Debt Restructuring deals often include a shift in duration (an extension) and given the extremely short duration of US Federal Debt, such a restructuring could occur.

So buying these CDSs might not be silly after all.

"Whack!, Whack!"....now I have 4 pieces from the original log.

Credit Default Swaps were introduced during my last years as a professional (by which I mean back when people used to pay to read my views-interestingly I think my non-professional stuff is far more valuable than the pabulum I used to churn out. Of course, free (zero denominator) is a great way to increase value) and their rapidly increased usage certainly changes the bond trading game.

When I was trading you sold bonds you feared might default. Now you might actually buy them, driving the price higher, then buy the CDS with the (paper) profits (50 basis points goes a long way). Bond speculators can arbitrage default risk in very different ways- yet another reason why the Bond Vigilante of old is no longer effecting prices.

"Whack!, Whack!"....finally, eight pieces, ready to stack.

Derivatives, as a general proposition, split risk in different ways. Mortgage Bonds can be split into interest and principal only payment streams, risk of discontinuous price action is FX and Commodity markets can be hedged with options, and, as we have seen, the risk of a sovereign credit "event" can be hedged using CDSs.

Of course, as I was wont to argue years ago, the assumption that a combination of a derivative(s) with an underlying position(s) "collapses" (i.e. has identical payment streams) to a simple position in the underlying is not always valid. Being long, for instance (and from experience) A$ and A$ puts is not the same as having no position in A$ or being short. Indeed, the sense that one can hedge the risk of a sudden turn lower is often enough to allow the rise to continue far beyond what would have happened if "insurance" was not available in much the same way that earthquake or flood insurance allows for the financing of buildings that would not be financed without.

In some events, the availability of insurance, which is often marketed as a means of reducing volatility, actually increases it.

Ben Bernanke is currently grappling with the idea of buying Treasury paper outright as "quantitative easing," or in layman's terms, "printing money." I wonder if he would have this problem if US Treasury CDSs were not available (alternatively, the Treasury and the Fed could just announce as policy that US Federal Debt would never be restructured or defaulted, Federal Reserve Notes would be issued in any necessary amounts to fulfill obligations to bond holders- yes this is implied but so was (and is) the GSE guarantee and that is still a mess).

It is as if the Fed Chairman needs to hit the market over the head with a stick, saying, you are valuing Federal Reserve Notes (FRNs), and the Bonds which pay them, too highly. The market, foreign Central Banks in particular, is driving Treasury prices to an extreme which would likely have been arbitraged much differently 20 years ago. At some point, Ben will get his message through, FRNs are worth much less than foreign CBs think....and then things will change fast.

When burning wood, splitting a log into much smaller pieces increases heating efficiency in my wood stove. Yet, I'd much rather sit on the big old log than the eight pieces I split.

Splitting risks in the Sovereign Bond market has changed the behavior of that market, particularly in the US. Along with our open capital account, the availability of CDS, in my view, contributes to the very anomalous behavior in US Bonds of late. 20 years ago a fiscal expansion of this magnitude would have Treasury Yields soaring as the only "insurance" was to not own paper the US was issuing like mad.

I liked the old Bond market better, which might not be a surprise given that I like to split my wood the old fashioned way.

I suspect, in the end, splitting risk into parts will increase volatility, and further hamper the trade flows finance is designed to facilitate.


cprouty said...

Good point on insurance (in all forms) pushing risk/value further than it would have gone without insurance. I agree with you that Treasuries (and by extension, the dollar) are valued too highly these days (flight to quality and all that). In your opinion, what event/events could alter this valuation by the FCBs? I agree the change, when it comes, will be quite sudden. Which has all sorts of implications in our tightly coupled systems. Thanks.

GoldenHind said...

Dude- could you PM me- GoldenHind- at bearchat? I think we exchanged a few Emails years ago but I'm not sure its you.