Traders Sowing Seeds of Destruction Prompt Crackdown

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Traders Sowing Seeds of Destruction Prompt Crackdown (Update1)
By Shannon D. Harrington, Caroline Salas and Pierre Paulden
Sept. 24 (Bloomberg) -- The $62 trillion market for credit- default swaps, created to protect banks from loan losses, helped fuel a near-meltdown in the financial system and now may be regulated for the first time.
The derivatives precipitated plunges in the shares and debt of Wall Street firms, accelerating the collapse of Lehman Brothers Holdings Inc. and the U.S. takeover of American International Group Inc., the biggest U.S. insurer. Now, regulators want to bring oversight to a part of the credit market that may be more susceptible to manipulation than selling stocks short, according to U.S. Securities and Exchange Commission Chairman Christopher Cox.
Banks ``are suffering the consequences of their own actions,'' said Thomas Priore, chief executive officer of Institutional Credit Partners, LLC, a New York-based hedge fund with $13 billion in assets. ``They created a mechanism through default swaps to reflect a view on credit that has taken on a life of its own.''
The swaps became one-way bets on the demise of financial institutions as traders hedged the risk that their partners might implode, said Gary Kelly, a strategist at broker Tradition Asiel Securities Inc. in New York. The wagers sent distorted signals about credit risk, he said.
The resulting run on shares of financial companies prompted Cox yesterday to seek enforcement powers over the market. New York State will also start regulating some sales of the derivatives, according to Governor David Paterson.
Loan Protection
``The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing,'' Paterson said in a statement Sept. 22.
Banks started buying and selling credit derivatives in the mid-1990s to protect loan portfolios, Andy Brindle, the former head of JPMorgan Chase & Co.'s credit-derivatives group, said in 2003. The International Swaps and Derivatives Association started reporting credit-derivative volumes in 2001, when volume stood at $919 billion.
The contracts trade in over-the-counter deals, leaving each side exposed to the risk their partner will default. There's no exchange or clearinghouse for the swaps and no system for publicly reporting trades.
Credit-default swaps aren't issued or repaid by the companies referred to in contracts. The instruments pay the holder the face value of the amount protected in exchange for the underlying securities if a borrower fails to adhere to debt agreements.
Death Spiral
The market helped set off a death spiral for Lehman and AIG as a jump in the cost of protecting debt, or credit spreads, pushed down their shares. That eroded capital and prompted credit-rating companies to threaten downgrades. Bear Stearns Cos. met a similar fate in March before JPMorgan took the bank over in a rescue orchestrated by the Federal Reserve and Treasury.
Credit spreads were exaggerated as banks and investors hedging the risk of their trading partners defaulting rushed to buy swaps. That sent the price of protection soaring.
``The risk concerns became massively overblown,'' said Tradition's Kelly, who for the past three years made recommendations on stocks based on signals from credit-default swaps. ``Now, the time that the equity market starts heavily focusing on the CDS market, it's probably a period where its reliability is the most questionable.''

 

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`Nonsense' Trades
The difference between the cost at which dealers sell and buy protection on Merrill Lynch & Co., AIG, Morgan Stanley, Goldman Sachs Group Inc. and Wachovia Corp. widened last week to an average of about 63 basis points, compared with 10 basis points the previous week, according to quotes from London-based CMA Datavision. A basis point is 0.01 percentage point.
Trading in the derivatives became ``nonsense,'' Morgan Stanley Chief Financial Officer Colm Kelleher, 51, told investors after reporting third-quarter earnings Sept. 16.
The New York-based securities firm had net income of $1.43 billion in the quarter and reported $175 billion of cash and available equivalents, up from an average of $135 billion the prior quarter. Credit swaps showed a higher risk of default for the broker than homebuilder Lennar Corp., which reported losses in each of the last six quarters.
Credit-default sellers on Sept. 17 demanded as much as $2.1 million upfront and $513,000 a year to protect $10 million in Morgan Stanley bonds from default for five years. The price implied a 65 percent chance the company would go bust within five years, based on a valuation model created by JPMorgan. The cost has since dropped to $500,000 a year, implying it has a more than one-in-three chance of failing.
`No Rational Basis'
The price moves had ``no rational basis,'' and helped touch off a 66 percent slump in his firm's stock last week, said CEO John Mack, 63.
``Why should CDS spreads be having such a big impact on the stocks?'' Glenn Schorr, a UBS AG analyst in New York, wrote in a Sept. 17 report. ``Isn't this a bit disconcerting that the illiquid CDS market, or the rating agencies, can have so much influence on the fate of these companies and alter the landscape of the brokerage industry?''
Merrill Lynch, seeking to prevent itself from being the market's next target, agreed to be bought by Bank of America Corp. last week after credit-default swaps implied a one-in-three chance of default in five years and the shares plunged 31 percent in four days.
`Default Risks'
Morgan Stanley and Goldman Sachs, the last of the five big U.S. investment banks, sought approval to become bank holding companies, allowing them to build deposit bases and move away from a business model that investors had deemed too dependent on borrowed money, or leverage.
Credit-default swap traders shouldn't be blamed for pushing Lehman into its grave, said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California.
``A company that relies on short-term funding and high leverage is destined to face higher default risks,'' he said.
Lehman spokesman Mark Lane in New York didn't return calls for comment.
Credit-default swap buyers and sellers don't need to own bonds or other debt of the company referred to in a contract. This leads to ``outsized incentives'' for investors to bet on an issuer defaulting, Cox said in Congressional testimony yesterday.
``We are looking at the effects of short-selling'' of shares, he said. ``Greater opportunities for manipulation exist in the CDS market.''
`Ill-Fitting' Regulation
Short sellers borrow shares and attempt to profit by repurchasing the securities later at a lower price and returning them to the holder.
``Proposals which would seek to treat privately negotiated contracts as securities, or otherwise apply ill-fitting regulatory regimes to these agreements, are likely to deter healthy economic activity,'' Robert Pickel, ISDA's CEO, said in a statement yesterday.
Banks face pressure from regulators to create a clearinghouse by the year-end that would back trades between dealers and absorb the failure of a market-maker. New York State also plans to regulate some credit-default swaps as insurance policies after AIG sold protection on more than $400 billion of debt that led to $18 billion of losses in three quarters. New York said its new rules will take effect in January.
``I hope that by then there is maybe even a more holistic solution that we can discuss,'' New York Insurance Superintendent Eric Dinallo said in a Bloomberg Television interview today.
Collateral Demand
The surge in AIG's credit spreads and slump in the shares prompted Moody's Investors Service and Standard & Poor's to cut the insurer's ratings on Sept. 15. That allowed counterparties to demand more than $13 billion in collateral on swap trades and forced the company to cede control to the government in exchange for an $85 billion loan.
``A major part of AIG's problems were created when credit- default swaps were issued by a non-insurance unit that did not hold sufficient reserves,'' the statement from Paterson's office said.
Goldman Sachs, which reported $4.9 billion of writedowns and credit losses the past year, saw credit-default swaps widen to a record 685 basis points on Sept. 17 from 148 at the end of August, suggesting a 45 percent chance of default in five years. The contracts were trading at about 332 basis points today after billionaire Warren Buffett said yesterday his Berkshire Hathaway Inc. is buying a $5 billion stake in the company.
Goldman shares fell to as low as $85.88 on Sept. 18 in New York Stock Exchange composite trading, and have since risen back to $129.98 as of 10:53 a.m. in New York. They're down 40 percent this year. Spokesman Michael Duvally declined to comment.
Taking Cues
Stock investors began taking cues from the derivatives in 2005, when the contracts moved before leveraged buyouts and other transactions were announced, said Tradition's Kelly. When a surge in Bear Stearns's credit swaps preceded its collapse, investors began looking to the market for early signs of stress in other financial companies.
``It's become suddenly a huge focus of the market,'' Tradition's Kelly said. ``Credit issues have really begun to start driving the equity market.''
Lost Trust
Frank Glaser, 75, a retired Hughes Aircraft executive in Los Angeles dumped Wachovia preferred shares he bought in December after asking his broker at UBS where credit-default swaps on the Charlotte, North Carolina, based-company were trading. The derivatives implied a 47 percent chance of default in five years on Sept. 17, the day Glaser sold the shares at a loss, based on the JPMorgan valuation model.
Wachovia is managing through the pressure in the credit markets and is financially sound, spokeswoman Christy Phillips- Brown said. The shares fell to as low as $8.50 last week and was trading at $14.90 today.
``We don't trust the rating agencies,'' Glaser said last week. ``Lehman was A2 the day before it went bust, so what have I got to go on? I listen to the president of Wachovia. He sounded like he really knew what he was doing, and I'm reasonably sure he's going to come out of it. But the market doesn't believe him because the credit-default swaps are huge.''
To contact the reporters on this story: Shannon D. Harrington in New York at [email protected]; Caroline Salas in New York at [email protected]; Pierre Paulden in New York at [email protected]
Last Updated: September 24, 2008 10:55 EDT