Friday, May 15, 2009

why would anyone buy protection from a reference entity on itself since the entity in question will be unable to honor its obligation?

TO BE NOTED: From A Credit Trader:

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Milan, MBIA – Mamma Mia! The Wild and Crazy World of Self-Referenced Credit

Bloomberg is out with an article describing how Milan city officials used derivatives to bet on the default of the Italian government. While we wait for the sounds of knee caps being broken, let’s take a deep breath and think about what may be going on here.

The article states that “The city council sold credit-default swaps that protected the banks against a decline in the value of Italian Republic securities”. The immediate thought that comes to mind is that were Italy to default on its debt, Milan would very likely not be able to deliver on its contract. This is far from an original insight – in fact, everyone from Janet Tavakoli (buying protection on Korea from a Korean bank) to Nassim Taleb (buying insurance on the Titanic from someone on the Titanic) have made this exact point. So, what’s going on? Are the banks that are buying Italy protection from Milan just plain dumb?

There are two important things to keep in mind whenever you read any piece of financial news in the press:

  1. though often the broader fundamental point may be correct, the actual phrasing is often misleading if not downright wrong,
  2. we should not always rush to brand the traders behind these deals as unaware of potential risks

For the ADD-afflicted, my take on what’s going on is in the section entitled: Self-Referenced CDS/CLN

Some Background

At first glance, the article suggests that Milan has ventured close to the world of self-referenced credit derivatives, just the kind of market that would endear itself to those who hate the concept of plain vanilla CDS in the first place.

The question is why would anyone buy protection from a reference entity on itself since the entity in question will be unable to honor its obligation? Or in other words, how can we possibly trust an entity to guarantee its own debt?

To take a step back, we have to ask whether entities are allowed to buy or sell derivatives on their own securities.

Self-Referenced Equity Structures

Employee Options

The most obvious instance of entities trading derivatives on themselves can be found in stock options offered to employees as part of their compensation packages. Outside of backdating scandals and the ongoing accounting treatment issues, these products have been adopted as an accepted part of the market economy. In fact, they are likely to gain popularity, especially in the financial sector, where cash bonuses are likely to give way to options with long vesting periods.

Selling Equity Puts

Many companies, such as Microsoft, have sold equity puts on their own stock as a way to cheapen the cost of stock buy-back programs or lock in their cost. Since the 1992 SEC ruling, these trades have been attractive to corporates, driven partly by the tax-free treatment of the put premia received by the companies. The basic motivation behind the trade is that if the stock price rises, the puts expire worthless and the company offsets the higher stock price it pays on the repurchase (if it decides to go ahead with the repurchase anyway) with the premia it received on the puts. If the stock price falls, the company is essentially delivered its own stock at the strike price – thus having locked in the stock repurchase cost at the time of the sale of the puts.

Self-Referenced Debt Structures

Synthetic Debt Repurchase

Stock repurchase programs are fairly common and well-established. In the fixed income world, the debt equivalent of a stock repurchase plan is a Debt Repurchase which can take the form of either Cash or Synthetic programs. Though less flexible than their synthetic counterparts, cash debt repurchases can be executed via open market debt purchases (which is more common for a buyback of a fraction of the outstanding debt) or via public debt tender offers (which is geared toward buying back all or a significant portion of an outstanding debt security).

Synthetic debt repurchase seeks to replicate the economics of its cash cousin with enhanced flexibility and reduced execution costs. Here, the issuer enters into a Total Return Swap with a bank with a particular issuer’s debt security as the underlying asset. The bank will pay the issuer interest and principal payments made on the underlying security and, to the extent the maturity of the TRS is shorter than the security, settle the price difference at maturity. Similar to the cash outlay on the cash repurchase, the issuer will post collateral on the TRS to the arranging bank.

Self-Referenced CDS/CLN

Here, the company sells protection on itself. Though they are, in effect, identical, there are two flavors of the trade: 1) collateralized CDS or 2) Credit-linked Note. A fully collateralized CDS is essentially a CLN (i.e. a bond)., while a partially collateralized CDS (say, 50%) is a called a leveraged CLN. Such trades usually have embedded spread or MTM triggers that are tied to the either the level of the CDS or the MTM of the trade.

This trade may be appealing to a company if its bond/CDS basis is positive i.e. it earns a higher yield by executing the trade via CDS rather than cash bonds. Also, if the company believes the widening in its credit spreads is overdone, it can sell CDS on itself and unwind at tighter levels, though it would then be open to insider and/or market manipulation charges. Finally, as a funding trade, it may make sense for a corporate to buy its own short-dated CLN at L+x, rather than put cash on deposit or buy Tbills that offer sub-Libor yields.

In fact, this is what MBIA did in 2002 when it bought CLNs linked to its subsidiary. Bill Ackman has talked about this trade in his broader criticism of the company. Effectively, by purchasing its own CLN’s MBIA benefitted publicly by improving the weighted-average rating on its portfolio and causing its CDS spreads to tighten, while at the same time, hurting its liquidity (by having to post cash for the CLNs) and leveraging itself up on its own creditworthiness - two issues that were not disclosed.

As far as the Milan trade, the story looks pretty simple – Milan had some cash that it needed to put to work. Rather than go to the market and buy Italy bonds (which I’m sure is well within the mandate of Italian municipalities just as buying US Treasury bonds is well within the investment mandates of US muni’s), it chose to structure the trade in a synthetic fashion – either to match a particular maturity/target yield/notional schedule etc.

So, a tad overblown if you ask me.

Collateral Enhancement

Though potentially a red flag, a company can, in some cases, increase its credit line with a lender by assigning a long protection trade as collateral, though the increase will not likely be 1:1 for the amount of protection given increased counterparty exposure to the lender on the CDS trade.

Improving Recovery/Funding

A neat trick that improves recovery prospects for subordinated debt holders while providing senior-level funding for the issuer without increasing the outstanding amount of senior debt involves selling sub debt to an investor and at the same time entering into a TRS where the investor pays the total return on the sub debt in exchange for L+x.

This achieves the following benefits in some jurisdictions:

  • The senior noteholders see an improved position in the capital structure with the sale of subordinated debt.
  • The investor sees an improved recovery profile on the net trade. Say, sub and senior recoveries are 20% and 50% respectively. The investor receives the 20% on his sub debt plus 50% x (1-20%) on the TRS, which beats the recovery of the senior noteholders.
  • The issuer obtains senior-level funding, without showing any increase in the outstanding amount of senior debt

Improving Credit Ratios

A way for a bank to improve its credit ratios is to do the following. Find a bank (investor) to put up $100 for issuer’s subordinated debt. This $100 is then roundtripped back to the bank in exchange for a zero-recovery CLN linked to the issuer. So, in case of a default the bank will find itself with a liability worth zero and an asset worth the subordinated recovery, a net of greater than zero. The issuer will be required to hold some $8 of capital against the CLN, with a net capital increase of $92.

Clean Asset Swaps

Let’s say you’re an Emerging Market corporate or a sovereign that would like to issue a sizable amount of debt. You have two choices: you can issue in your local currency or you can issue in a foreign currency, let’s say a major currency like USD. The benefit of issuing in the local currency is that you are not taking any FX risk i.e. your revenue/taxes are in your local currency – the same currency which you will use to pay interest to investors. The downside, however, is that the market for locally-denominated debt may not be large enough to digest the issuance, at least at levels that are attractive to you. On the other hand, issuing in USD taps a much larger market, however you will now have pretty serious FX risk as the size of your debt will grow if the local currency depreciates relative to the USD. This is the problem of “original sin” that all emerging market issuers are keen to avoid.

So, what’s an enterprising Emerging Market issuer to do? The obvious solution is to hedge the FX risk with a cross-currency swap. You issue debt in USD and then enter into a swap where you receive USD from a bank and pay the local currency, thus hedging your exposure. Feeling pretty good about yourself and about to pull the trigger, you get a call from a credit marketer of the same bank who tells you that he can pay you 50bps more on the swap than the rates desk. What’s the catch? The catch is that in the event of default by you, the cross-currency swap is extinguished.

This is not much of a catch – who cares what happens in the event of default, especially if you have one less trade to worry about during the workout/restructure process. An important caveat is that this trick can only work when local currency rates exceed foreign currency (USD in our example) rates. Why? If local currency rates are higher, that means the currency is expected to depreciate relative to USD throughout the trade, which means that while the earlier cashflows are expected to be a net positive for the bank (+ve carry), later cashflows, including the large principal payment, are expected to be worth little for the bank. Adding credit risk to the structure means the scenarios when the bank is receiving cashflows that are worth less than what it is paying are less likely, hence the bank can afford to pay more to the issuer on day one.

This trade has been very popular, for instance, with Latin American sovereigns but less so with corporates, largely due to the lack of liquidity on corporate CDS. In fact, a good guage of whether corporates/sovereigns are doing this trade can be found in the quanto CDS market where banks will go to hedge the local-ccy denominated CDS risk they are taking on via this trade.

Kangaroo Bonds

This structure involves a higher recovery in case of default for the investor in exchange for better financing to the issuer. Say, an investor buys a $100 issuance and at the same time buys $200 of CDS from the issuer. In case of default and 50% recovery, he will recover $50 on the bond and will have a claim of $100 against the client, on which it will recover an addition $50, this making him whole. He will consequently pass on this benefit to the issuer via significantly better funding."

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