Saturday, April 18, 2009

CDS Hangover - Drunks Spilling Wine...

Credit Default Swaps are a very large portion of the Shadow Banking System that was created without regulation and has gone largely untracked.

People get how Mortgage Backed Securities (MBS) work as derivatives, but going beyond those and into CDS or even into interest rate swaps eludes most people’s understanding. While these derivatives are complex in their scheme, they are actually quite simple when boiled down to their Ponzi essence.

Credit Default Swaps in essence are “insurance” that pay the purchaser of a contract money in the event of a default in the company or whatever entity underlies the swap.

Normal insurance requires the company writing the insurance policy to carry reserves in the event they have to pay. But in the unregulated world of CDS, no such regulations exist.

Companies like AIG sold Credit Default Swaps with no intent to ever pay in the case of a large series of defaults. They never had the money to do so, and they knew it. Still, they sold the “insurance” to companies, took their money and spent it, partied with it, and paid themselves big bonuses. The lack of reserves meant that any payouts pretty much had to come from new income – this is what made them Ponzi.

Then come the defaults… Oops, money’s not there. So in steps Paulson who controls OUR Taxpayer money and hands billions to them to payoff their Ponzi scheme, much of the money going to Goldman Sachs who Hank Paulson (former Goldman CEO) holds over $600 million in investments in!

BEFORE the blow up, companies that purchased this “insurance” from AIG thought they were protected. They took larger risks and levered their businesses to extreme levels without doing what ordinarily would be their due diligence job. In this regard, CDS actually INCREASED system risk instead of decreasing it like the “geniuses” who sold it told everyone.

The sellers of CDS got drunk on the money, now the hangover is beginning…

Credit-Swaps Sellers Take Beating on Latest Auction

By Shannon D. Harrington and Pierre Paulden [Nate’s comments in the brackets]

April 17 (Bloomberg) -- Credit-default swaps traders set a value of 3.25 cents on the dollar for bonds of an AbitibiBowater Inc. unit to settle derivatives linked to the newsprint maker that’s now in bankruptcy protection.

The price means sellers of credit swaps guaranteeing as much as $1.1 billion against a default by the Abitibi- Consolidated unit would pay 96.75 cents on the dollar to settle the contracts. Eleven dealers, including JPMorgan Chase & Co., Barclays Plc and Morgan Stanley, bid in the auction, which was administered by Markit Group Ltd. and broker Creditex Group Inc.

A combination of rising defaults and shrinking recoveries that are set through the auctions mean credit-protection sellers since the collapse of Lehman Brothers Holdings Inc. in September have lost as much as 70 percentage points more than rating services estimate the debt is worth.

“Clearly, if you’re a seller of credit-default swaps in an auction, you are getting your head handed to you,”
Janet Tavakoli, president of Tavakoli Structured Finance Inc. in Chicago, said in an interview before today’s auction. The potential for losses because of low recoveries “was underestimated, particularly on highly leveraged companies,” she said.

Losses on these derivatives, which insure a net $2.6 trillion of debt, may mount as the recession that started in December 2007 causes defaults on high-yield bonds to reach 14.6 percent by the fourth quarter, from 4.1 percent at the end of 2008, according to Moody’s Investors Service.

Face Value
Sellers of credit-default swaps earn fees from banks, hedge funds and other investors by agreeing to make another firm whole on a company’s debt if it defaults.

Following a default, the seller pays the face value of the debt protected, minus the recovery value determined during an auction among as many as 15 banks, including JPMorgan, Barclays and Deutsche Bank AG. Swaps sellers also have the option of receiving the debt.

Firms that sold credit protection on Lyondell Chemical Co. two years ago would have been paid about $178,000 a year in exchange for a guarantee on $10 million of the company’s debt, according to prices from London-based CMA DataVision.

After Houston-based Lyondell filed for bankruptcy protection Jan. 6 as the global recession sapped demand for plastics and commodities, traders held a debt auction that set a value of 15.5 cents on the dollar for the company’s senior unsecured bonds and 20.75 cents for its secured loans, according to Markit Group and Creditex.

Projected Loss
That means swaps sellers who agreed to settle in cash locked in losses of 84.5 cents on the dollar for guaranteeing Lyondell bonds, or $8.45 million for every $10 million of protection sold, and 79.25 cents for the loans.

Standard & Poor’s estimated on Jan. 7 that creditors should expect to lose less than 10 cents on the dollar for Lyondell loans [Just a little off… AGAIN]. The ratings company said losses on Lyondell’s debt could increase because of terms of the bankruptcy financing, which took priority over existing creditors.

Other auctions have yielded similar results, from Lehman to Aleris International Inc., the producer of aluminum for aircraft and automobiles.

Sellers of credit-default swaps on 22 defaulted companies in the past seven months had to pay an average of 70 cents on the dollar for loans and 84.7 cents for bonds to buyers of protection, data from Markit and Creditex show. That compares to losses of 13 cents on the dollar for loans and 30 cents for bonds in all of 2008, Moody’s data show.

Faster Payout
“We don’t believe that CDS trading prices are necessarily good predictors of ultimate recovery,” William Chew, managing director at S&P in New York, said in a statement. “Our recovery ratings, which employ fundamental analysis, are designed to capture the range of ultimate recovery an investor might expect if an issuer defaults.” [Hope that strategy works for ya!]

That makes little difference to derivative traders, said Henry Hu, a law professor at the University of Texas in Austin. Unlike bankruptcy, which can take years of courtroom negotiations to increase the value of a creditor claim, derivatives pay out within a couple of months of a default.

“It’s no hassle, no whining, versus trying to work things out with the company,” Hu said.
Credit-swaps sellers can receive the loan or bond during an auction and then take their chances during bankruptcy. Of the five defaults last year on which Bermuda-based Primus Guaranty Ltd. had to make payments, it opted to get the actual underlying bonds in only one of them, according to a regulatory filing.

‘Fundamental Problem’
While derivative auctions may not show the amount debt holders will ultimately recover when companies emerge from bankruptcy, they provide an early prediction by drawing together buyers and sellers, said Kevin Starke, an analyst at CRT Capital Group LLC in Stamford, Connecticut. “It’s essentially like calling everybody to the starting line,” he said.

“The market is saying recovery values will be very low, and that’s a fundamental problem facing every financial institution carrying these assets,” said Christopher Garman, chief executive officer of Garman Research LLC in Orinda, California. [No kidding…]

After Lehman blew up, the world thought they had escaped the wrath of CDS as the entire system didn’t implode immediately. The reality, of course, is that it did. AIG had no money to pay and it only survived on Paulson’s back door deal (with our money). But in the drunken Pigman world of banking and derivatives, not everybody gets saved, a little bit of wine gets spilled now and again…

CDS blamed for role in bankruptcy filings

By Henny Sender in New York

FT - Published: April 17 2009 00:57 Last updated: April 17 2009 00:57

Credit default swaps, the derivatives instruments that have figured prominently in the global financial crisis, are now being blamed for playing a role in two bankruptcy filings this week.

Bankers and lawyers involved in restructuring efforts say they are concerned some lenders to troubled companies, such as newsprint producer AbitibiBowater and mall owner General Growth Properties, stand to benefit from a default because they also hold default swaps, which entitle them to payments in such events.

“We have seen CDS becoming a significant factor” when negotiations on out-of-court restructurings fail, said Alan Kornberg, the partner in charge of the bankruptcy practice at Paul, Weiss, Rifkind, Wharton & Rice, speaking generally. “We used to talk about the practice theoretically but now we see cases where it is hard to get lenders to agree to tender or to compromise and then you find out that these holdouts had significant CDS protection.”

Abitibi , which filed for bankruptcy protection on Thursday, ran into trouble as the dire state of the newspaper industry eroded its cash flow and left it unable to service its debt load. It sought to persuade debt holders to exchange bonds due in August for new debt with longer dated maturity and higher yields, but failed to do so as creditors squabbled.
Such exchange offers require the support of a significant number of lenders, 97 per cent in the case of bondholders in this case. But those who withhold support often have powerful incentives to do so, either because they hope to be made whole or because they are seeking to force a filing that would trigger payments under their credit protection agreements, bankers and lawyers say.

Some creditors, including Citigroup, which held a small exposure to AbitibiBowater, hedged themselves in the CDS market, meaning their economic interest in the deal was different to lenders who had not bought credit insurance, according to people familiar with the matter. Citigroup declined to comment.

Lawyers say CDS holdings were also a factor in the default and filing for Chapter 11 protection of General Growth Properties this week. Restructuring advisers expect many more such cases involving so-called fallen angels, or firms originally investment grade, since CDS was widely sold on such names.

CDS placed pressure on the company to fail? Hardly. GGP is way overextended and possesses far too much debt. I listened to their CEO state that their "only problem was being unable to role over their debt." What baloney. They can't roll their debt over because their business model can't support it when consumers themselves are saturated with debt. They built too many malls and didn't see the collapse of the bubble coming.

In regards to CDS, what this last article doesn’t state is who sold the swaps? While the people who buy protection receive payouts, that money has to come from somewhere. Where? As corporate defaults like GGP begin to increase we’re going to find out who can hold their liquor and who is spilling their wine…

Eric Burdon (The Animals) and War - Spill the Wine (1970):