MTM

MTM means for course `mark to me'. It appears that AIG has determined the most reliable source of fair values for some transactions is -- itself. Think of a number. Wow, the number I just thought of was ... the number I was thinking of. I must be right.

I exaggerate of course. Let Bloomberg take up the story:

AIG swaps not covered by the government program include guarantees on $249.9 billion of corporate loans and residential mortgages, most of them made by banks in Europe...
[These swaps] are different because they didn’t insure against losses... they were bought to take advantage of European accounting rules that allow the banks to use the swaps to reduce the capital they’re required to set aside as loss reserves.

The swaps are kept in place only until new accounting rules, known as Basel II, are phased in. Those rules eliminate the ability of financial institutions to reduce the capital they need to set aside by buying swaps.

[AIG has] unwound $95 billion of these regulatory-capital swaps without any losses as of the end of the third quarter. And Gerry Pasciucco, hired from Morgan Stanley on Nov. 12 as interim chief operating officer of AIG’s financial-products subsidiary, said the company continues to “experience early terminations according to our schedule at par.”

As a result, Lewis [AIG risk officer] said, even if the assets underlying the remaining swaps fall in value, AIG isn’t required to mark them to lower market levels.

That’s because, as the insurer said in its third-quarter filing, it “estimates the fair value of these derivatives by considering observable market transactions.” And the only relevant transactions are the swaps AIG has successfully unwound with the European banks, according to the filing.

There is more to trouble an AIG investor, European bank regulators, the SEC, the FED, and AIG's auditors in this, if it's true, than you can shake a stick. Here are a few of the issues.

Firstly you would have thought that the Gen Re case had taught AIG that doing transaction purely for regulatory manipulation without risk transfer is a bad idea.

Secondly, what do European bank regulators think of this? (I'll leave Basel 2 being described as an accounting standard as a signal that this new item may not be entirely reliable. And while we are asking questions, where exactly in Europe hasn't Basel 2 been implemented yet? And what is a default swap that does not transfer losses, and how exactly does it qualify for capital relief?)

Thirdly, if both the transaction and AIG's accounting for it are correctly described, why on earth do their auditors, PWC I think, let them get away with this? Hasn't AIG had enough auditing issues at AIG FP already?

Fourthly does the FED really want an almost 80% state owned company doing this kind of transaction? And accounting for it this way?

The flight to simplicity

Rick Bookstaber has an interesting if flawed post on the neue sachlickeit in derivatives:

Assume we get to the point of standardized swaps and derivatives instruments that are exchange traded and backed by a clearing corporation. These instruments will create a high hurdle for any non-standard OTC product a bank wants to put into the market. The OTC product will have worse counterparty characteristics, will not be as liquid, will have a higher spread (which helps explain why the banks will decry this proposal) and will have inferior price discovery. To overcome these disadvantages, the specialized OTC product will have to demonstrate substantial improvement in meeting the needs of the investor compared to the standardized products.

That would all be true if the list of standardised products stays short. But I am willing to bet quite a bit of money that more and more products will be exchange traded and cleared rather quickly. The sales people - who get paid more for exotic structures - will push hard for this. Soon range accruals and power inverse floaters will go through exactly the same infrastructure as plain vanilla swaps.

Where Bookstaber goes really wrong, though, is a mythologising of the early days of derivatives:

If someone writes a history of innovative products, it will start with the golden era, when options and other derivatives were introduced to help investors better meet their investment objectives, allowing them to mold returns or, in the parlance of academics, to span the space of the states of nature. Then, somewhere along the line... [things went bad].

Oh grow up. I mean, really. Derivatives were always about tax arb and regulatory arb and ratings agency arb and accounting arb/earnings smoothing. There never was a golden age when derivatives were used just to meet risk management needs, and where unicorns lay down with virgins after the market closed. Swaps grew because they allowed the derivatives desk to lend without the credit department finding out. Credit derivatives grew thanks to a massive regulatory arbitrage. It has always been a client facilitiation business, and what the client wanted, the client generally got (albeit at a price).

Consider prime jumbos

Yields are attractive. From the FT:

US mortgage rates soared last week amid a sharp rise in Treasury market yields, as investors started to bet that inflation pressures could prompt the Federal Reserve to raise interest rates later this year.

The sell-off pushed rates on 30-year fixed-rate mortgages to an 11-week high of 6.02 per cent, up from 5.81 per cent a week earlier, according to Bankrate.com. Meanwhile, the so-called “jumbo” mortgages – or those for loans above $417,000 – rose to 7.21 per cent from 7.05 per cent.

A rough duration hedge is 7 year swaps at 4.4%. I'll take more than two and half percent running for prime jumbos vs. swaps.

First Comes the Swap. Then It’s the Bad Journalism

Continuing a long tradition of dissing something you don't understand, Gretchen Morgenson has an ill-informed article in the NYT on a dispute between UBS and a hedge fund over a CDS. Let's start with the errors:

INVESTORS don’t often get a peek inside the vast, opaque and unregulated world of credit default swaps, those privately traded insurance contracts that essentially allow participants to bet on or against a debt issuer’s financial condition. (Remember, these are the same instruments that played such a pivotal role in the collapse of Bear Stearns.)

Plain wrong. Lack of liquidity played a pivotal role in the collapse of the Bear. CDS had little to do with it.

There is no central market where investors can watch credit default swaps trade and see their prices. Each transaction is conducted away from regulators’ prying eyes.

Again wrong. Regulators have the right to look at all transactions, OTC or otherwise. FSA for instance has a legal right to demand any document at any time: the FED is similarly engaged with its firms' OTC deals. If UBS's regulators can't see its CDS exposure that has much more to do with Swiss Banking law than with CDS. As I pointed out earlier, just because something is on exchange does not mean that price discovery are reliable: in many ways CDS levels are more readily available and liquid than most exchange traded single stock options.

The article does then make a not-entirely-terrible job of explaining the dispute between UBS and the fund. It appears an MD at UBS (who I am assuming is a sales person) assured the fund, Paramax, that UBS's collateral calls would not be based on aggressive marks. The court papers apparently claim he:

assured Paramax that mark-to-market risk was low... Paramax contends in the filing, it was informed ... that “UBS set its marks on the basis of ‘subjective’ evaluations that permitted it to keep market fluctuations from impacting its marks.” ... [the salesperson] was responsible for all marks on UBS’s super senior positions and that he could justify ‘subjective’ marks on the Paramax swap because of the unique and bespoke nature of the deal.”

Again, _if_ this is true, it has nothing to do with CDS. It could happen in any market. If it happened, it would be a dramatic failure of segregation of duties, but nothing about CDS makes this more or less likely.

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.

A frightening picture

From the Economist via Immobilienblasen. This long term trend in the UK vs. other retail housing markets certainly sheds some light on the BOE Special Liquidity Scheme, although it is worth noting that the incentives to originate bad loans were never anywhere near as bad in the UK as in the US.

Some very quick thoughts on the Bank's scheme:

• Is it big enough? £50B feels intuitively too small. Probably it needs to be two or three times the size to have a real impact. More experienced hands than mine are also not convinced: see for instance here for Bloomberg on Charles Goodhart's reaction.
  
• Are the haircuts too penal? Probably.
  
• Finally I still believe it would have been most helpful for these swaps to be assignable. That is, once a bank swaps MBS for gilts, it should be able to sell the MBS with the swap still in place, with the buyer having the obligation to repurchase the MBS at the contractual maturity of the swap and deliver gilts. This would help to liquify the MBS market by allowing them to trade with financing in place.

On transaction liquidity

Naked Capitalism has a typically engaging post on transaction liquidity.

One of the arguments apparently being made in Washington by those who oppose regulation of credit default swaps is that it would reduce liquidity and that of course would be a terrible thing.

Fair enough. A priori it is not clear if having transaction liquidity is a good or a bad thing.

One of the comments I have heard from debt market participants in the bubble era was that they were faced with a 'wall of liquidity", tons of money looking for places to park it. And some of that appeared to be the direct result of credit default swaps. CDS allowed banks in Europe to circumvent capital requirements, enabled investment banks to accelerate profits from deals into the current period by (in theory) defeasing risk, allowed banks to extend bigger loans than they would have otherwise by hedging some of the risk.

Let us look at these one by one.

• Capital. That was the regulator's fault and not the banks'. And it had little to do with liquidity. So yes, it was a bad thing, but it has nothing to do with either CDS per se or with transaction liquidity.
  
• Profits. There are arguments in both directions for fair value vs. accrual, but again this has nothing to do with either CDS or liquidity.
  
• Hedging. Here's the nub. A lower cost of capital is good for the economy when it is growing. But if it is created by over-leveraging the financial system, then clearly it is dangerous.

Let us turn back to NC:

Behavioral finance studies have found that even in simple bidding setting, participants create bubbles. Low transaction costs and the appearance of abundant liquidity supports short-term, momentum based trading strategies, with participants believing they can find the exits when they need to... Higher frictional costs lead investors to think twice about adding and exiting positions.

This is also a good point. Transaction liquidity supports the development of crowded trades, but often there is not enough to support their closing. I wonder if we should consider some form of frequency based regulation, whereby more frequent traders require more capital.

Personally, then, I think the case remains tantalisingly unproven. In traditional equity markets, abundant liquidity supports price discovery, permits speedy asset reallocation, and lowers everyone's cost of capital. But patchy liquidity, whereby there are periods of liquidity which can suddenly disappear, as in the ABS market and some other areas of credit, is deeply unhelpful. What we really need is more constant liquidity, so that liquidity assessment is possible for the life of a trade. Perhaps market maker requirements have a place here: obliging firms to provide liquidity in good times and bad - a feature of the equity but the credit markets - could help to even things out. And certainly if we are going to intervene to improve liquidity (as in the TALF), then we need to consider the possible negative effects of too much liquidity.

What is a derivatives pricing model anyway?

I had a conversation about this last night and thought it was worth writing some of it down and extending it a little. So...

Let's begin with the market. For our purposes there are some known current market variables which we assume are correct. This could be a stock price, interest rates, a dividend yield -- and perhaps one or more implied volatilities.

Secondly we have a model. The model is often, but not always, standard, i.e. shared between most market participants. Let's start with standard models. Here the model is first calibrated to the known market variables.

At this point we are ready to use the model. There is a safe form of use and a less safe one. In the safe one we use the model as an interpolator. For instance we know the coupons of the current 2, 3, 5, 7 and 10 year par swaps (plus the interest rate futures prices and deposits) and we want to find the fair value coupon for a 4.3 year swap. Or we know the prices of 1000, 1050 and 1100 strike index options and we want to price a 1040 strike OTC of the same maturity.

The less safe use is when we use the model as an extrapolator. We want a 12 year swap rate, for instance, or the price of a 1200 strike option. That's not too bad provided we don't go too far beyond the available market data, but it is definitely a leap.

(Both of these, by the way, count as FAS 157 level 2.)

Note that there are two ways that we realise P/L in derivatives. Either we trade them or we hedge them. If we are in the flow business then trading is important. We need to use the same model as everyone else simply because we are in the oranges business and we need to kInow what everyone else thinks an orange is worth. We take a spread just like traders of other assets, buying for a dollar and selling for a dollar ten, or whatever. The book might well be hedged while we are waiting to trade, but basically we are in the moving business. Swaps books, index options, short term single stock, FX, interest rate and commodity options, and much plain vanilla options trading falls into this camp.

In the hedging business in contrast we trade things that we do not expect to have flow in. Most exotic option businesses are an example here, as are many long dated OTC options. There is no active market here so instead we have to hedge the product to maturity. Thus here the model hedge ratios are just as important as the model prices. Valuation should reflect the P/L we can capture by hedging using the model greeks over the life of the trade. Thus standard models are more questionable in the hedging business than in the moving business since it is not just their prices -- which are correct by construction -- but also their greeks that matter.

Things start to get really hairy when we move away from standard models. Now we are almost certainly dealing with products where there is no active market (some kinds of FX exotics are a counterexample) and we do not even know that the model prices are correct. There is genuine disagreement across the market as to what some of these things are worth. Different models also produce radically different hedge ratios. How can we judge the correctness of such a model? The answer is evident from the previous paragraph: it is correct if the valuation predicted can genuinely be captured by hedging using the model hedge ratios. [Note that this does not necessarily give a unique 'correct' model.]

In summary then: for flow businesses we need interpolators between known prices and, to a lesser extent, extrapolators. For storage businesses we need models which produce good hedge ratios.

Friday in Fantasy Land with George

I should buck up, I know. The current furore over credit derivatives may well come to nothing. But when I read something like Soros' article in the FT today, my heart sinks. Let's play spot the fallacy.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds.

So how can you explain the growth of CPDCs, who are long risk only CDS investors, or for that matter the long risk portfolios at the monolines and AIG? In reality the fact that CDS allows unfunded risk taking trumps the ability to go short in stimulating demand.

Note too that there can be no asymmetry in the market: you can't sell CDS protection unless someone buys it and vice versa.

...US and UK government bonds... actual price[s are] much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.

No they are not. (I don't believe in the strong form of the efficient market hypothesis either, but this is not evidence for or against it.) CDS spreads include counterparty risk effects and liquidity risk on the possible future margin. Bond spreads include funding premiums. They are literally incommensurate since to have hedged positions (bond plus CDS) you need to be able to fund the bond to term at a fixed cost and to have no counterparty risk on the CDS provider.

I have an unworthy, low conjecture. It is that the age of a commentator is directly related to their hostility to CDS. The older someone is, the later they are likely to have come to the CDS market. And the less likely they are to understand it.

Reflecting Trichet

A speech by Jean-Claude Trichet at the International Capital Market Association’s Annual Conference has received considerable comment - see here for instance for Alea. I'd like to focus on just two aspects in a long speech. First, leverage:

The challenge lies in preventing the system from feeding on itself through a spiralling process of leveraging...

Abundant liquidity, financial complexity [and] financial players’ incentive structures contrived a convergence of mechanisms that resulted in the upward spiralling of asset prices, further leveraging, increasing complexity and shrinking transparency.

The combination of leverage and complexity is a massive concentrator of model risk. Simple leverage is easy to spot: my broker won't let me buy stock on margin with a 1% haircut. But a tranche of a CDO-squared financed via repo could have a much higher leverage than 100:1. Complexity, then, can hide leverage and it can make modeling the true return distribution difficult or impossible: just because you can structure something does not mean that you should, as Bankers' Trust found out with Gibson's Greetings and Libor-squared swaps.

Second, ECB open market operations:

The first response of the Eurosystem during the turmoil was to try to keep very short-term money market rates near policy rates through more active liquidity management. With this objective in mind, the ECB adjusted the distribution of liquidity supply over the course of a maintenance period, by increasing the supply at the beginning of the period and reducing it later in the period (the so-called frontloading). The average supply of liquidity remained unchanged over the whole reserve maintenance period, in line with the Eurosystem’s aim to provide to the banking system over each maintenance period the exact amount of total liquidity it needs to fulfil its liquidity deficit. The average size of the Eurosystem’s refinancing operations for the maintenance periods since August 2007 remained at around €450 billion, as in the first semester of 2007.

This is remarkable -- and it makes the point beautifully that is is not the supply of cash that has been important in central bank financing operations, but rather guaranteed funding for illiquid assets. The ECB has indeed been remarkably liberal (by the standards of other central banks pre Crunch) in the collateral it permits at the window, and so it did not need to explicitly manipulate liquidity premiums the way the FED did.

Dying for Goldman

Goldman has announced that it will publish a mortality index, presumably to stimulate growth in the mortality swap business. Insurance-linked capital markets products have been around the market for a while without really catching on - I remember being told that mortality swaps were the new credit derivatives - but this might stimulate the market a little. All the same, I'd want to be sure I wasn't one of the 46,000 odd individuals in the index just in case. Getting between Goldie and an index fixing might just be bad for your health...

Equity/Credit: Who's Right?

Naked Capitalism has a thought provoking article on the current disconnection between the equity markets and the credit markets, which in turn refers to FT articles by John Authers and John Dizard. Authers describes the issue:

If you believe the credit market, things have worsened sharply in the past few weeks. With spreads widening significantly, recession is a certainty in the US and Europe.

If you believe the equity market, there are grounds for optimism. Stocks are still above the low they hit in January, before the Federal Reserve made its emergency rate cut – betting that this huge monetary stimulus would ensure that any recession is shallow.

[...]

But in the past few weeks, as credit spreads have widened, the shares of those companies the credit market sees as most risky have rallied, and outperformed the rest of the market. Equity investors are making a bet that the credit market has got it wrong.

The credit market may be at levels that cannot be justified by the fundamental outlook for defaults: its investors have difficulty raising liquidity; many need to clean their balance sheets; there are unprecedented worries over various structured credit products, many of which did not exist during the last downturn in the credit cycle; and the problems of the monoline bond insurers create further uncertainty.

One has to sympathise with this last: we are in a situation at the moment where most of many instruments credit spread is compensation for factors other than default, prominent amongst them the cost of financing the position, the possible future volatility of the position, and the liquidity risk of the position.

This leaves some serious issues with equity/credit (aka capital structure arbitrage) models though. The vast majority of these models are based on the assumption that the credit spread is (risk neutral) compensation for the probability of default, and that equity is (some kind of) option on the value of a company struck at the face value of the liabilities. Given these assumptions and a few more besides, a connection between equity prices and credit spreads is established. But if there is a systematic component to credit spreads which varies strongly with time then most of these models are some trouble. And certainly their predictions earlier in the year wouldn't have ensured career success. As Dizard puts it:

Let's say you decided at the beginning of the year, with what was left of your limited partners' capital, to bet that the price of risk in both markets will converge. So, you go short a basket of stocks of investment grade companies, and simultaneously buy the CDX.IG, the index of investment grade credits. However, since, historically, stocks in the form of the S&P 500 are seven times as volatile as the CDX.IG, you levered up the CDX at the multiple required to have a hedged position. Unfortunately for you, in the first week of February, the CDX moved (down) one fourth, not one seventh, as much as equity, as dealers stopped providing liquidity. So your position just died and went to money heaven.

Leaving aside Dizard's hedge ratio calculation - which is far too naive - he is basically right. And remember you need models like these for a range of wacky convertibles, too, so this is not just a matter of interest to the CSA funds. If nothing else this little market episode will result in some improvements to equity/credit models.

Update. There is further comment from the FT, based on a report by Goldman, here. Some of the examples given here are fascinating:

In the first three weeks of February, the shares of Swedish truckmaker Scania rose 11 per cent. But the spread on its credit default swaps (CDSs) rose 60 per cent... Over the period, spreads on the 155 names in the iTraxx main index of European investment-grade companies widened 55 per cent on average. The figure for 103 names not on the index – including, for instance, Scania – was 41 per cent.

I am not brave enough to opine for certain which market is right. But it is clear that one of them is wrong. And if it is the equity market, there is a lot more pain to come.

Short LEH?

Clearly there is a lot of money shorting Lehman, and I won't deny it can't go down further. But honestly, do you think the Americans will let another broker/dealer fail? They had five big ones before the Bear: now it's four. Three feels like too few to me, and I suspect both the FED and the SEC agree. I think I might be a seller of the default swaps.

And by the way, in what possible world are Merill and Lehman A- but Ambac and MBIA still AAA? Admittedly there are signs that Moody's might finally (six months too late) be ready to do the right thing with the monolines, but really, these four ratings taken together make no sense.

New York really wants London to succeed

According to Bloomberg:

New York State will begin to regulate part of the $62 trillion market for credit-default swaps, Governor David Paterson said.

The state will treat contracts in which the buyer also owns the underlying security as insurance, Paterson said today in a news release.

That's it then. London always was ahead of New York in structured credit: now, provided we do not do something similarly stupid, we can own this market.

It is worth pointing out, en passant, how successful treating credit derivatives as just another insurance contract has been so far. The largest two firms to adopt that paradigm were MBIA and Ambac. Unless you count AIG of course. Still, New York will still have better looking trucks. That's something.

Update. The Economist has a nice article, Guilt by suspicion, about the benefits of derivatives and the mud slung at them. I do think it is worth remembering that the cause of all of this mess was not derivatives, it was mortgages.

More awful journalism on credit derivatives

The ignorant journalist's favourite whipping boy, the CDS market, gets another undeserved beating today, this time from Alan Kohler in the Business Spectator. Managing a considerable density of mis-information, Mr. Kohler is rather histrionic:

As the world slips into recession, it is also on the brink of a synthetic CDO cataclysm

Would that be a cataclysm like the Lehman CDS one, or like the Fannie and Freddie one? How would sir like his non-event today?

The triggering of default on the trillions of dollars worth of synthetic CDOs that were sold before 2007 could be a disaster that tips the world from recession into depression. Nobody knows, but it won’t be a small event.

Or just perhaps it will be totally orderly just like all the other CDS settlements so far.

CDOs were invented by Michael Milken’s Drexel Burnham Lambert in the late 1980s

No, CMOs were invented by the Freddie Mac in 1983. The first CBOs were based on that structure.

About a decade later, a team working within JP Morgan Chase invented credit default swaps, which are contractual bets between two parties about whether a third party will default on its debt. In 2000 these were made legal

Again no. They were legal when they were first traded, in the early 1990s. (U.S. law, it may surprise Mr. Kohler to learn, is not the only relevant one.) At this point I have to confess I gave up. Anyone who makes that many basic errors in the first few paragraphs while using over-blown and emotive language does not deserve to be read.

On Black Scholes Hedging

Further to yesterday's post about CB arb, a short note on hedging options.

If you sell an option at an implied vol of v, and the Black-Scholes assumptions hold (in particular the underlying is a diffusion with constant delivered volatility w, and you can trade instantaneously at zero spread) then the expected P/L of a delta hedged position depends only on v and w. In fact, as Dupire amongst others pointed out, it depends on v versus the gamma weighted delivered volatility. Thus, on average, if you sell an option at v, and v > w, you will make a profit. If you buy an option at v and v < w, you similarly expect to profit.

Two things can screw you up. Firstly this result only holds if the underlying is a diffusion. Therefore in the real world, with jumps, you can buy a 'cheap' option (i.e. one whose implied is less than realised) and still lose money on hedging. Secondly all the other imperfections (bid/offer spreads, variable interest rates, stock borrow costs etc.) hurt, so in practice you need at least a 2 vol point difference between realised and implied to have a good chance of a profit.

Thus, to return to yesterday, you will judge a CB to be cheap if the implied vol needed to recover the price of the CB is significantly less than your expectation of future delivered vol of the underlying during its life. If you are right, you can make money delta hedging the embedded option. Before 2004 or so CBs were often cheap - the issuers discounted them a bit to be sure of getting the issue off - and so CB arb could be profitable. The problem is that buying a CB to get the option is inherently deleveraged, since the option is only a fraction of the total (the rest being the bond floor). Hence callable convertible asset swaps. But that is a story for another day.

Thank you Collin Peterson and Tom Harkin

Bloomberg reports:

Credit-default swap clearing would become mandatory under legislation slated to be introduced next month by House of Representatives Agriculture Committee Chairman Collin Peterson.

Not to be outdone,

Peterson’s counterpart in Congress, Senate Agriculture Committee Chairman Tom Harkin, a Democrat from Iowa, last month introduced legislation that would force all over-the-counter trades including credit-default swaps to be traded on an exchange and processed by a clearinghouse.

If this happens, it would be tremendous for London. We will consolidate our lead in credit derivatives, and attract a lot of OTC equity and interest rate derivatives currently traded in the US too. That should cushion Crunch-related job losses a little, at least.

Before the bust: AIG's early collateral postings

AIG's collateral postings after the rescue are well known - essentially the firm was saved so that it could continue to fulfil its obligations to the banking system, notably under the CDS it had written. AIG before the fall has received less attention. But now Bloomberg has done some digging, and the story of the collateral calls that brought AIG down is emerging.

Goldman Sachs Group Inc. and Societe Generale SA extracted about $11.4 billion from American International Group Inc. before the insurer’s collapse as the firms demanded to hold cash against losses on mortgage-linked securities, ... “It was precisely that drain of liquidity to Goldman and SocGen that put AIG in a position of illiquidity and ultimately threw them into the government’s arms,” said Charles Calomiris, a finance professor.

Including collateral from before and after the rescue and payments made by Maiden Lane III, a vehicle created by the Fed to retire the swaps, Goldman Sachs received about $14 billion from AIG, Societe Generale got $16.5 billion, and Deutsche Bank AG received $8.5 billion.

Credit protection sanity

I have made a bit of a sideline in highlighting some of the less helpful comments on the CDS market. It pains me to include a man I generally respect, Paul Krugman, in the list of people who have got the wrong end of the stick.

He first quotes marketwatch:

The spreads on credit-default swaps for U.S. government debt jumped to 97 basis points Tuesday, nearly seven times higher than a year ago and 60% higher than the end of last year, to a level roughly in line with those of France, according to data supplied by Markit.

Then he opines:

Has the risk of a US government default risen? Probably. Nonetheless, the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?

The answer is that it does not matter (much). Most CDS trading is about views on the spread, not views on default. People buy CDS on the US government because they think the spread will widen and they can close out at a profit, not because they think that default is likely. Therefore the CDS market often tells you rather little about default: what it tells you about is market participants expectations of spread movements. CDS spreads go out when there are more buyers of protection than sellers. That is the only reason spreads move. Any connection between CDS spread movements and expectations of default is a modeling assumption, and one that is particularly dubious at the moment.

CPDO: Endgame

The end of some of the CPDOs nears. I did hint earlier that a yield of Libor + 200 implied that they were not AAA securities, and indeed it turns out that, once again, straightforward beta rather than alpha was the cause of the return. Anyway, Bloomberg reports:

ABN Amro Holding NV clients face 90 percent losses on two credit derivative products totaling 120 million euros ($176 million), according to Moody's Investors Service.

The so-called constant proportion debt obligations have seen their net asset value fall to 10 percent, meaning they will have to unwind, or ``cash-out,'' Moody's said in an e-mailed statement today.

Leveraging up as spreads widened didn't turn out to be such a good idea after all then. Of course, investors in the ABN product were unlucky with the size of the moves experienced:

Credit-default swaps on the Markit iTraxx Financial index of 25 European banks and insurers soared to a high of 84 basis points this week on concern credit rating downgrades at bond insurers including Ambac Financial Group Inc. and MBIA Inc. will cause bank losses to surge. The index traded as low as 20 basis points in November.

Still, given that a number of commentators thought the CPDO was a really bad idea when it launched (see for instance here or here), you can't say no one said I told you so.

Finally, perhaps in the bolting the door after the horse has run away category, I leave you with a link to a paper on Rating Criteria for CPDO Structures. It may be that this is of purely historical interest.