Finance
CDS Insanity
Lest you be lulled to sleep by the daily 400+ point swings in the DJIA, word comes yesterday of new insanity in the capital markets. Bloomberg is reporting that Credit Suisse and Citi are now using credit default swap rates to determine rates on corporate loans. Yes, there were reports of unidentified pigs flying over NYC last night. So now future loan agreements will have rates decided not as a spread to LIBOR based on a firms credit rating and a thorough analysis of its balance sheet by bank loan officers but on the whims of an illiquid derivative market which is prone to bouts of extreme panic.How does this all work? Cited in the Bloomberg report is the case of FirstEnergy:
FirstEnergy, with utilities in Ohio, Pennsylvania and New Jersey, agreed this month to link interest rates on a $300 million credit line to the cost of Libor as well as the sum of the spread on its default swaps and those of Credit Suisse, according to a regulatory filing. Loans from the Zurich-based bank would require total interest payments of about 6 percentage points over Libor if the power company draws on the bank line, according to regulatory filings and Bloomberg data. That's almost 14 times the spread on a $2.75 billion credit line the company negotiated in 2006.So not only is the rate dependent upon their own 'rating' in the CDS market, it is also dependent upon how the market views the default risk of Credit Suisse. What kind of nonsense is this? The borrower should pay more because the market thinks the lender more likely to default?
The utility would pay Libor plus 3 percentage points to draw on the line, according to company filings. Based on yesterday's levels, FirstEnergy would be charged an additional 1.70 percentage points, reflecting the levels of its credit- default swaps, and another 1.35 percent to account for the bank's own spread, according to Scilla. Pricing on the loan will change as Libor and the swap spreads on Credit Suisse or FirstEnergy move. Source: Bloomberg.com
The game here seems to be the banks wanting to appear to provide a credit facility, while in fact, offering nothing. As the only time most firms need these lines are in times of economic or market turmoil, CDS spreads are likely to have increased dramatically for both the borrower and lender. As an example of the former, consider what happened to many insurance companies at the beginning of October. Not only did the CDS rates for Hartford, Metlife and Lincoln National blow up to 500 bp, they went to trading on an upfront basis requiring prepayment of from 500 to 1100 bp. Those rates are now down dramatically, though still at elevated levels of 300-400 bp. "Normal" might be measured in the 10s of basis points. Would any of these companies have been able to draw on these lines at the start of October? This realization has led a number of companies, such as Nestle, to demand caps be in place in exchange for accepting these new terms.
This move to using CDS as the basis for loan terms will also open another Pandora's box of speculation in CDS contracts. There is already a perception that CDS have been misused by speculators who were short equity to help force bankruptcies by driving up the cost of funding for a company to impossible levels. Having revolving loan agreements also tied to CDS will remove the last fire wall against this type of activity, perhaps even opening the door for another company to push a competitor under. It really is shocking that after the near meltdown of the capital markets this fall that we should move deeper into the unknown while the original fires are not yet out.
How Low Can It Go?
The sigh of relief which the world equity markets breathed earlier this week just became a gale force wind pushing prices back near last week's lows. Most technicians look at variants of bar charts or candle charts of various durations for guidance on market direction. Less so the point and figure chart and even rarer the percentage change point and figure chart. The beauty of pf charts are the clarity they bring by consolidating market movements. Below are a few charts we made at StockCharts.com tonight of both the Dow Jones Industrial Average as well as the S&P 500 index. Each box represents a move of 3 ⅓% and reversals occur when direction changes by three boxes (10%). The first two charts include the daily high and low to determine how many up (X) and down (O) boxes to draw. The latter charts use only the daily closing price and the change from day to day to calculate which, if any, boxes to draw.It looks to us that a break of DJIA 8100 again should see a test of 7500-7500 area (these days perhaps within hours). Looking at a longer dated chart, this is a very key level and provided support in 1997 and 1998. A break would open up significant more downside, with 5700-5800 looking to be the objective. Eeek! The serious break level in the S&P is about 790.
A Solution To The Credit Crisis
No matter which way you turn, somebody has serious problems with the Paulson 'bailout' plan as proposed and amended by the house and senate. Our own view is that the situation is too far gone to just let the chips fall where they may. But we also agree that the Paulson proposal has serious flaws and may not work at all. We would like to propose a far simpler plan which addresses the immediate problem while also attempting to protect the taxpayers.The Financial Gedanken Experiment
- Immediate elimination of mark to market accounting for those assets which were originally booked as 'hold to maturity'.
- Immediate formation of a Mortgage Trust to purchase, at historical cost, up to $1.5 trillion of mortgage securities and associated securitizations such as CDOs
- If purchases by the trust fund are oversubscribed, it shall fill orders uniformly based on the largest percentage of total assets which absorbs the fund and no single firm placing more than $100B until all others have had their entire request fulfilled.
- The Mortgage Trust will hold to maturity for the benefit of each institution the securities tendered.
- Each institution shall be responsible for any net loss, accounting for recoveries, on securities sold to the Mortgage Trust.
- Each institution will pay back any net loss amortized over a period of 20 years, payable in full at any time.
- Each institution participating in the program agrees they will not pay any dividend on common stock or new preferred shares until such a time as their account with the Mortgage Trust is cleared and any losses are repaid.
- Each institution agrees no top managers will be paid more than $500,000 in salary per year and any bonus shall be in equity with a value of no more than $1 million at the date of the award with 50% of any shares restricted until the account with the Mortgage Trust is cleared and fully settled.
- Each institution shall pledge its remaining assets against its obligation to the Mortgage Trust.
So what does this plan accomplish? First off, it recapitalizes the financial institutions by allowing them to book their non-impaired hold to maturity securities at historic cost as was done pre-Enron. Second, it allows them to remove from their books impaired securities or those which are not yet impaired but likely to be in the near future. But it is not a free ride. Unlike the Paulson plan(s), the taxpayer is not on the hook for the losses. Instead, each firm participating will be required to make good on the net losses over a 20 year period. By allowing a lengthy period, the government enables the firms to continue their normal operations without a gun to their head of a single large payment due in a short time. However, to accelerate the process, no dividends will be paid to shareholders thus preserving cash which can be used to pay off these debts. Likewise, the mega bonuses of the past will be eliminated. It would be in the institutions best interest to clear these obligations as soon as they are financially able so as to once again pay their shareholders dividends as well as have more flexibility with executive compensation. As a backstop, the government will have first claim on the assets of any firm unable to meet its obligation to pay the ultimate losses on the securities sold to the Mortgage Trust.
This, to our thinking, is a far better way to proceed. It frees up significant capital immediately, allows firms flexibility in whch assets to sell, allows firms to spread potential losses out over a long period of time if need be, allows the government to receive any income paid on the securities, puts the firms on the hook for any future losses, and places some constraints on the institutions to prevent 'rewarding' bad management. All these combined will allow firms to go back to normal operations (lending) and eliminate much of the counter party fear gripping the credit markets.
Beyond this initial proposal, which we see as the most pressing, we would enact a follow on which looks to some of the other problems. We wouldn't dally too long here either:
- Restore the uptick rule.
- Complete ban of naked shorting except by a market maker providing liquidity to facilitate an investor purchase.
- Institutions selling total return swaps are not exempt from the uptick or naked shorting restrictions.
- No shorting of any stock with a price under $15.
- A complete investigation and review of the credit ratings agencies.
What remains is the issue of credit default swaps. This is a bit more tricky. The most significant problem with CDS are counter party capitalization and pure speculation. As CDS are at their heart insurance, institutions selling these contracts should be regulated in a manner similar to existing insurance operations. This would prevent a holding company taking excessive risk underwriting CDS contracts without commensurate capital in place. Likewise, it would also prevent hedge funds from being a writer of CDS as few, if any, have sufficient capital to make good on any contract which is exercised.
Speculation in CDS must also be addressed. The current notional outstanding far exceeds the debt they are written against. Simply put, too many people have an economic interest in seeing companies fail and thus default on their debt obligations. Going forward, restrictions can be put in place which required the buyer of CDS to own the underlying security and in the same amount. That, however, does not eliminate the looming present day problem. With no better solution at hand, we are inclined to suggest the nullification of all contracts where the purchaser does not own the underlying. Contracts would be settled at original cost with all periodic and up front payments returned to the buyers, with interest. This is preferable to allowing the sellers of the CDS contracts the opportunity to cherry pick those contracts they wish to negate. It is hardly a beautiful solution but we see no other practical way of eliminating this very large ticking time bomb.
