The Amherst Trade

This is a geeky post about the CDS market.

The newswires have been buzzing recently with news of a 'daring' CDS trade by Amherst Holdings. I didn't comment on it at first as I didn't understand the trade from the initial news items, but I now think it is possible to work out what's going on.

Let's start with the bonds this trade refers to. They are subprime MBS. Like most MBS, these are amortising, prepayable bonds. The fact that these are amortising bonds means that the face value of the security is irrelevant: what counts is the principal balance at the time the trade was done. [Quite a lot of the stories were confused about this point, so it is worth pointing out.]

So, let's say we have some bonds with $100M left to repay.

The next bit that is tricky is the nature of the CDS protection sold. Everyone agrees Amherst sold protection and some banks bought it. But what protection exactly? It is most common for CDS on MBS to be pay as you go, meaning that the protection sellers compensates the protection buyer for principal deficiencies as and when they occur. There is no event of default as such, unlike corporate CDS. [To be strictly honest, there may be an event of default as well, such as bankruptcy of the issuing SPV, but that is irrelevant for our purposes.]

Let's suppose then that Amherst sold pay as you go protection on $100M of bonds.

Since the bonds were thought likely to repay little to nothing of the outstanding principal balance, the banks paid Amherst, say, $80M up front for their protection. [There may have been an ongoing coupon as well, but we'll ignore that.]

Amherst then paid the servicer to buy out the underlying mortgages and pay off the bonds. Thus the bond holders got their $100M. The servicer could do this because the bonds had a 10% clean up call, meaning that if more than 90% of the face had amortised, they could repay the remaining principal balance at any time. [So to keep with the example, the face amount was more than $1B.] 10% cleanup calls are common in ABS, and they are what makes Amherst's trade work*.

Now, here's the confusing part. Who won and who lost?

First the banks. If they had held the bonds, then they would be about flat. $80M for CDS protection paid out, but $100M paid back is a $20M profit, from which subtract the (few cents) cost of the bonds. So the only way the banks could have lost massively on the trade, as reported, would have been if they had been net short the bonds. That is, they did not own the bonds, and bought protection, betting that total losses would be more than $80M. The losers, then, were parties who did not own the bonds and who did not realise the significance of the cleanup call to their short.

[The WSJ story suggests that JP Morgan lost money but that RBS and BofA didn't. This would be consistent with JP being net short, while RBS and BofA had a negative basis trade on, i.e. owned the bonds and bought CDS on them. The presence of net shorts is also consistent with the WSJ's suggestion that more protection had been traded than the notional of bonds outstanding.]

Next Amherst. They had the $80M of CDS premium. But how much did they have to pay to get the bonds repaid? Clearly a logical answer would be about $80M. Therefore the only way that Amherst could have made money would have been if they had sold more protection than there were bonds - $200M say rather than $100M. Say they sold $50M to JPM, $50M to RBS and $50M to BofA. Then they would have had to pay $80M, roughly, to buy back the mortgages behind the RBS and BofA CDS, but the JPM CDS was not backed by any bonds and so the $40M premium from JPM would be straight profit.

In other words, the only way Amherst could have made a lot of money on this trade would have been if it sold more protection than there were bonds. The only way that the banks could have lost money would have been if they bought more protection than there were bonds. In a situation like this someone was always going to be squeezed. It's just that this time, that party wasn't an investment bank.

The lesson of this amusing little situation? Nothing more than read the small print. The buyers of protection -- and in particular naked shorts -- should have understood that arbitrary action by servicers is possible, and that in particular the 10% clean up call could be exercised. This is a much bigger risk late in the amortisation profile of a bond than early, but it is there for most ABS. Caveat emptor.

* Contrary to what Willem Buiter writes in his blog, if you own 100% of a bond, you cannot necessarily control whether it defaults or not. A default on a public security is a default, regardless of who is affected.

Another mistake Buiter makes is assuming that centralising CDS trading would not have helped in this situation. It would certainly have helped the banks to avoid their losses, in that the size of Amherst's long vs. the cash would have been obvious thanks to trade reporting. Personally I don't particularly feel the need to help the CDS trading desks of investment banks, mind you.

MAC make believe

From Ken Lewis' testimony to the House:

In mid December... I became aware of significant, accelerating losses at Merrill Lynch, and we contacted officials at the Treasury and Federal Reserve to inform them that we had concerns about closing the transaction. At that time, we considered declaring a 'material adverse change'... Treasury and Federal Reserve representatives asked us to delay any such action, and expressed significant concerns about the systemic consequences and risk to Bank of America of pursuing such a course.

No one would expect a CEO to tell less than the full truth in a setting like this. But this must surely add fuel to the fire of shareholder litigation burning under BofA.

Update. More (unhelpful to Ken) docs here.

When you want to come bottom of the list

Bruce Krasting has an interesting story on sub-prime related litigation in Massachusetts:

Goldman has agreed to pay the state of Massachusetts $60 million to settle a dispute regarding Goldman’s “predatory lending” practices in and around Boston. $50 million will be made available to reduce the loan principle on 714 individual mortgages... In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today.

As Bruce says, this is not a big deal for Goldman -- but it might set a nasty precedent for those higher up the subprime ABS underwriting tables, notably BoA (labouring under both Countrywide and Merrill) and Citi. You can expect this story, like Enron-related litigation, to run and run.

Update. A different account of the case from Jonathan Weil at Bloomberg is here. His take is that Goldman paid greenmail to Mass, perhaps to avoid the disclosure associated with a full hearing. His article certainly makes interesting reading.

Entirely expected lawsuit of the day

From Bloomberg:

MBIA Inc. was sued by Third Avenue Management LLC... over claims the insurer’s split of its bond-insurance businesses hurts debt holders.

Three mutual funds managed by Third Avenue bought notes issued by MBIA Insurance Corp. in February 2008 based on assurances that the company was recapitalizing following losses in its structured finance insurance business...

MBIA, the largest bond insurer by outstanding guarantees, said in February it was transferring $5 billion in cash and its public finance business to another entity that has no obligation to the notes, Third Avenue said in its statement.

Legal risk, FX risk, and big moves

Suppose a bank buys an option written by a corporate. It ends up in the money. The bank hopes that the corporate will pay out.

But what if lots of other banks have bought the same type of option from lots of corporates. Very few of them hedged, and all the options are far in the money.

Now the banks have a systemic problem. Perhaps many of the corporates cannot afford to pay. In any case, their losses may be sufficient to cause government intervention. The banks may be caught in a storm of protectionism.

It seems, according to FT alphaville, that this is possible for the counterparties to Eastern European corporates on FX options. The corporates, in many cases I am sure with full understanding of the risks, sold zloty, koruna and forint downside as a Euro convergence play. All three of these currencies have fallen: the corporates have taken significant losses. And now, of course, the lawyers are getting involved.

The lesson, then, is that it is good to be right when selling options. Being a little bit wrong is bad. But if you are really really wrong, and lots of other people are too, that's fine, because the government will probably bail you out.

MBIA sues Countrywide

Confirming the insurance industry habit of substituting claims adjustment for underwriting diligence, MBIA is suing Countrywide according to Housing Wire:

The breach-of-contract lawsuit, filed in New York State’s Supreme Court, suggested that Countrywide developed a “systematic pattern and practice of abandoning its own guidelines for loan origination,” in effort to inflate its market share during the mortgage-lending boom. MBIA accused Countrywide of knowingly negotiating riskier loans “no matter the cost to borrowers, investors or guarantors like MBIA.”...

Overall, the case involves 10 residential mortgage-backed securitizations of more than $14B in mortgage loans.

This is going to be interesting. On the one hand, it seems obvious that mortgage quality did decline in the last years of the Greenspan boom. But can MBIA really prove that Countrywide abandoned its own loan underwriting standards - rather than simply changing them to adjust to `market conditions' - and that that was a breach of contract of the financial guarantees? If it can, we are going to see a lot more wriggling from the wrappers, and the lesson from Hollywood Funding - that insurers can't always be trusted to pay when you think they have written protection - will be driven home to a lot more people.

AIG and Credit Support Default

It is reasonably well known in the derivatives markets that a lot of AIG FP's CSAs have collateral on downgrade clauses. Specifically AIG FP has to post more if the AIG parent company is downgraded. The parent is on downgrade watch. Market gossip has it that the amount of collateral required is substantial, probably (irresponsible rumour has it) more than $10B. So AIG will borrow from the FED (or as FT alphaville has it, give a bridge loan to itself) and pledge it straight back to, err, the FED's clients and their peers. Seen that way it makes complete sense for the FED to lend...

Cheyne Pain

Ah, the lawyers may be slow, but they are remorseless. Like the slugs in my friend's garden, there is little you can do to stop them. From the FT:

Abu Dhabi Commercial Bank’s class action lawsuit for fraud, negligent misrepresentation and unjust enrichment over its investment in a complex fund is a fascinating collection of details and allegations that cut to the heart of the credit boom and messy aftermath...

ADCB bought mezz notes paying Libor plus 150 and rated single A: these are now worth squat. Back to the FT:

ADCB’s suit accuses Morgan Stanley, Bank of New York Mellon, Moody’s Investors Service and Standard & Poor’s of misleading investors about the quality of assets the Cheyne vehicle bought and held from its inception in 2005 to its collapse just two years later.

This will be dramatic, even if it is the slow moving drama of a test match. I look forward to the show.

F&F: It is a Credit Event

From Bloomberg:

Thirteen ``major'' dealers of credit-default swaps agreed ``unanimously'' that the rescue constitutes a credit event triggering payment or delivery of the companies' bonds, the International Swaps and Derivatives Association said in a memo obtained by Bloomberg News today.

So the CDS are triggered. What I urgently want to know is is this a termination event on the enormous portfolio of IRD that Fannie and Freddie have as hedges against prepayment risk. Remember these two are amongst the largest players in the interest rate derivatives market, mostly as buyers of convexity. I can't believe many people want an unwind so the situation should be manageable.

Update. Just in case you are not a regular reader of the components of the major credit indices, it is worth point out that Fannie and Freddie are both in the CDX.

Good insurer bad insurer

Lawyers to your keyboards. Ambac is pushing ahead with the good insurer/bad insurer model. From Bloomberg:

Ambac rose as much as 15 percent in late trading as Wisconsin regulators, which have jurisdiction over the New York-based company, approved a plan to move $850M out of Ambac Assurance Corp. into the new business, according to a statement today. Ambac is seeking to obtain an AAA credit rating ... for Connie Lee.

Apart from the obvious questions -- who gets the capital, who gets the muni derivatives, and why anyone thinks structured finance counterparties might be remotely comfortable with all this -- don't we have a bad enough history with two syllable first name one syllable second name companies? I mean, Indy Mac, Fannie Mae, Freddie Mac, ... Connie Lee -- it is not encouraging, is it?

Defusing Journalistic Hyperbole

Sometimes I wonder if the FT is sponsored by Euronext or the CBOT. Today there is an article by Aline van Duyn on derivatives and termination events. She points out, quite reasonably, that Fannie and Freddie are amongst the largest dollar interest rate derivatives counterparties - because they are hedging the prepayment risk of their mortgage books. Conservatorship is a termination event so any restructuring of the GSEs will need to be mindful of that.

Bizarrely, then, she uses this as the platform for an anti-derivatives screed. She moves seamlessly to credit derivatives - without any logical connection of course other than the D word - and starts talking about derivatives timebombs. Why does no one ever talk about bond market timebombs? Could it be that it is easy to pick on the derivatives markets? Perhaps journalists - like the government official van Duyn imagines in her article - need to spend more time learning about derivatives before blaming all the markets worries on them.

Quid pro CDO

No, I don't have anything to say. I just like FT Alphaville's coinage.

Oh all right there, I will say something relevant... Here's a nice article in the FT about Tranche Warfare. You will of course be astonished, especially if you have read this, but:

Some of the CDO and CDS documents leave a lot to be desired, and contain basic errors. The fear is that, as the courts get involved, we are going to have some unpleasant surprises.

Default and CDS written by or referencing monolines

Recent articles (see for instance here, here, here, and here) have spurred a concern that I confess should have occurred to me earlier. What can cause an event of default by a monoline, and what happens next.

The first issue concerns the effective recovery for ISDA claims against a monoline. Here the crux is the relationship between the holding company and the insurer. As I understand it, most monolines are structured with a listed holding company and a regulated insurance sub. Obviously insurance contracts, including financial guarantee policies (whether transformed into CDS or not), are written by the insurance company, and so the insurance company has most (but not all) of the group's capital to support this risk.

Which group company writes CDS? My suspicion is that it has often been the holding company. If the regulator seizes the insurer, it is almost certainly (but check your docs) an event of default on the CDS. But in that case the regulator will almost certainly not permit CDS counterparties to be paid at the expense of claims paying ability for the insurance business - they won't let the money out of the insurer. The holding company will be left with a whole lot of liabilities and essentially no assets beyond a worthless stake in an insurer the regulator has taken over.

This is of course also an issue if you have debt issued by the holding company, or if you have transacted CDS referencing that debt. As Linklaters pointed out a few months ago, credit events can include quite minor regulatory intervention. I suspect that after such an event recoveries might be very low even if the operating sub is still perfectly capable of paying insurance claims.

Update. FT alphaville has additional reporting on FSA, CIFG and FGIC here, following their earlier story on MBIA. What I can't see in the material I have read so far is whether a breach of regulatory capital requirement of the insurance sub is likely to be credit event on (a) CDS written by the parent and/or (b) CDS referencing the parent.

Merrill vs. XLCA

In an important case for the structured finance market, Merrill has won a court ruling in its favour in a case against XL. Reuters reports:

Security Capital Assurance had said it severed seven credit guarantee contracts with a Merrill unit because the investment bank had given key rights promised to SCA under the contracts to at least one other party.

SCA said its XL Capital Assurance unit was promised control rights on the $3.1 billion of portfolios it had guaranteed for Merrill Lynch International, but Merrill Lynch had given those same rights to one or more third parties.

By terminating the contract, SCA was hoping to get out from under an obligation that could cost it hundreds of millions of dollars.

Basically the case was about who in the tranche structure controls voting rights on the underlying collateral: it appears that SCA was insuring a mezz tranche while MBIA was above it. SCA seems to have argued that the MBIA contract had voting rights that belonged to them. According to Bloomberg:

Merrill argued that, even though Armonk, New York-based MBIA was covering CDO tiers more senior to those insured by XLCA, the bank could still vote the shares according to XLCA's directions.

The case is important because if the assignment of voting rights is unclear, or subject to later litigation despite the provisions of the documentation, any writer of protection on a tranche potentially has wiggle room to avoid payment. I just hope for the sake of the broader structured finance market that the docs here hold up to further legal scrutiny.

CDS suits

Bloomberg reports:

Citigroup Inc. and Wachovia Corp. were sued by a hedge fund claiming the banks wrongly forced it to pay more than necessary on insurance derivatives contracts.

VCG Special Opportunities Master Fund Ltd., an Isle of Jersey, U.K.-registered fund, claimed Citigroup asked it to deposit additional sums as collateral for the contracts, eventually costing it about $18 million, according to a lawsuit filed Feb. 14 in Manhattan federal court. The hedge fund, previously called CDO Plus Master Fund Ltd., made similar claims against Wachovia in an earlier complaint.

This is the tightrope prime brokers are walking at the moment. Be too generous on margin, and you don't have enough collateral if the fund fails. Be too tight, and they sue you. In ordinary markets at least if you are within the bid/offer you have some protection. But in current markets, there is no bid or offer, often, which makes life rather more difficult.