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Friday, 21 December 2007

A Christmas Special - An Occasional Letter From The Collection Agency

A Beginners Guide To Credit Default Swaps

We hear and see the alphabet of the derivatives world thrown around with gay abandon, like so much confetti at the Brides third (and definitely for the last time, she insists) wedding. Often the word "bond" is thrown into the mix, just to spice up the play, not unlike the bridesmaids, who at 2 and 0 for successful marital bliss, scrum down for the prize of catching that bouquet one more time to hope for a third attempt.

For some people though the world of derivatives is not a wedding made in heaven. So for those readers lets take a condensed walk through what is a Credit Default Swap. (CDS)

What is a CDS?

First and foremost a CDS is not a bond. It is a derivative based on a bond or basket of bonds as the underlying asset. (think CFD and Shares). The CDS is used to transfer credit risk to another party and because its a derivative the original underlying asset is kept by the owner. The bond paper stays in the vault and on the balance sheets.

How does it work?

An agreement is drawn up by 2 parties where the first is seeking to buy protection against a credit event that would adversely affect the underlying asset (lets say bond from now on) and the second party who is willing to sell that protection. Just like insurance, the buyer has to pay a premium to the seller, whilst the seller has to cover losses in case of an event. Again, like insurance, those events that could qualify for a payout are drawn up in the agreement.

What is a credit event?

As mentioned above its a list of circumstances, agreed by both parties, that would invoke a loss to the protection buyer. That loss of course is on the bond, held in the vaults, that was issued by a third party, the bond originator. An event could include debt restructuring whilst in administration or, in the US under bankruptcy laws, insolvency, debt default, failure to service the debt, non payment or even a change in credit rating of the bond.

Why are CDS used?

As well as straight forward insurance on the bond, the CDS can also be used reduce exposure to an adverse turn in credit market conditions, to enhance performance of a basket of bonds or to trade on events that may happen to bonds that the buyer of protection doesn't own. Of course for every buyer there has to be a seller of protection who will want a premium that reflects the risk of insurance. This also opens up the possibility of arbitrage trades and allow the trading of differing spreads and ratings on bonds.

What are the risks?

Like all trading the most apparent risk is over-exposure to a particular event for the protection sellers and not enough coverage for the bonds held (partial hedge) for the buyer. Other risks include a lack of research on the bond issuer where the risk is not reflected in the bond rating, including a reliance on mathematical models that do not reflect the probability of an event accurately. Another risk to the protection buyer is his exposure to the possible bankruptcy of the protection seller, leading to a default in cover.

What happens if the bond issuer defaults or goes bankrupt?

As long as the event is covered in the agreement the protection seller has to pay the amount agreed to the protection buyer, who has to deliver the bonds covered. In an orderly market or a market where cover of the bonds is equal to the amount of bonds that exist then the transaction is straightforward. However if the cover purchased exceeds the amount of bonds that were issued then the protection buyer will either have to buy more bonds or pay cash to the market value of the outstanding bonds for delivery to the protection seller. This is what happened with Delphi in the US last year and why the bond prices rose after Delphi sought protection under bankruptcy.

The original idea of Credit Default Swaps was sound. A two way contract taken out to cover a third party liability. The complications arise when the CDS is used in ways that have not been stress tested in theoretical or actual market conditions. With that test now upon us it is a good thing that as many people as possible understand what may or may not occur.

Although not a comprehensive and in-depth brief, I hope the above has helped with the understanding of CDS.

Market Snippets

As quoted:

2008 AFP Business Outlook Survey finds: financial professionals do not expect a recession in 2008 but do predict a slowing in the economy - with GDP growth projected at a median of 2.5%. The worst of the credit crisis is not over (66%) but most corporations expect to weather the storm with little impact. 64% of financial professionals expect the growth rate in inflation to increase slightly over recent trends and 59% believe that interest rates will continue to drop during 2008.

From Challenger: "Ongoing troubles in the housing market threaten to greatly weaken the 2008 job market, according to Challenger outlook, which not only foresees a significant slowdown in job creation but warns that next year could see an increase in job-cut announcements. If that occurs, it would mark just the second rise in annual job cuts since 2001. Outlook noted concerns about the economy triggered by the housing downturn and the subsequent collapse in the credit markets are already causing employers to postpone expansion plans and delay hiring."

Economist Chris Low at FTN says NAHB index is stuck at a record low 19 for a third month. "Housing starts have recently fallen to levels not seen since the early 1990s, which has resulted in almost a year of falling new home inventories. The high-water-mark was 570k in August 2006. Inventories have since fallen to 520k. Still, there's a long way to go before it's a seller's market again. At the end of the last cycle, inventories fell to 320k."

Credit Default Swaps – An Example In Real Time

In that almost mystical way in which co-incidence happens, a real time occurrence of the risks I outlined in A Beginners Guide To Credit Default Swaps has appeared. With excellent timing S&P downgraded the rating of ACA Capital Holdings Inc to CCC or, as it is known, junk. Whilst not a happy occurrence, it does give us the chance to walk through the consequences.

ACA Capital Holdings Inc. provides financial guaranty insurance on municipal obligations, asset-backed and corporate financings, bank certificates of deposit and surety risks through its insurance subsidiary, according to Bloomberg. The downgrading of ACA means that the insurance given to municipal bonds and derivatives is also downgraded, effectively downgrading the assets themselves. This has consequences to those who bought the protection from ACA.

It works like this. ACA are in trouble, big trouble. They look unlikely to survive the credit crunch and with liabilities already higher than assets, any call made on the insurance they issued will cause a default. That default means the assets insured by the protection buyers become fully exposed to the market and therefore become riskier to hold. As with any risky asset, the price falls / yields rise because potential buyers of the assets would need a higher risk premium.

The fall in asset prices is also reflected in the same assets held by other institutions and banks and downward pressure on the asset type as a whole appears. This causes the risk exposure on the holding company to increase, putting its ratings under review, normally with a negative bias. Some Institutions have to sell any asset of derivative they hold if it falls below a certain grade or price, increasing selling pressure and lowering prices. Buyers meanwhile lower their offers in a falling market.

As can be seen above, the effect of a single default can have widespread and very damaging consequences, not just to derivative and asset prices but to the gradings of the banks and institutions that hold such paper.

In fact the risk was so great that as it appeared inevitable that ACA would be downgraded to junk, Merrill Lynch and Bear Stearns tried to launch a rescue package to postpone the event. S&P went ahead anyway.

You will notice in the diagram I have used CIBC, Canadian Imperial Bank of Commerce , as an example. For a very good reason too. Within hours of the downgrade of ACA, CIBC announced that it " believes there is a reasonably high probability that it will incur a large charge in its financial results for the first quarter''. The fifth largest bank in Canada said that ACA insured about $3.5Bn of US subprime investments.

Unfortunately, S&P didn't just look at ACA, they also placed AAA rated Financial Guaranty Insurance Co. on negative credit watch meaning there is a 1 in 2 chance of a rating downgrade in the next 13 weeks.

They also placed Ambac, MBIA and XL Capital Assurance on a negative outlook. This means the chances of a downgrade in the next 24 months is 1 in 3.

The importance of this move cannot be understated. If ML and BS felt threatened enough to attempt a rescue on ACA then everyone should take note. The fallout has only just begun. The tipping point may well be in the municipal bond markets. Municipal bonds gain the same rating as the Insurer who sells protection (a CDS on a MB) and that rating is oft transferred to the local government too.

If the rating on the Insurer is downgraded, so is the rating on the CDS, MB and the local government. Not only will yields rise on current issues but with the local government also "downgraded" future debt issues by them will have to be at a higher yield. This would require higher taxes and lower spending to service the higher debt payments.

In an economy already showing signs of stress, further burdens on the consumer and businesses would guarantee a recession.

Market Snippets

Morgan Stanley is the latest bank to receive a cash infusion from a foreign investor. MS said Wednesday it sold part of the company to China Investment Corp., for $5 billion to raise capital after taking $9.4 billion in writedowns on mortgage-related investments. In October, Bear Stearns Cos. agreed to a $1 billion cross-investment from Citic Securities Co.of China, while Citigroup received a $7.5 billion infusion from Abu Dhabi government last month.

Richmond Fed Pres Lacker in a speech in North Carolina, said "I am uncomfortable with the inflation picture" as November core PCE prices will accelerate; he added GDP is to be 'very weak' for several monthss before improving. He also said that financial markets will find ways to work through their problems and tighter credit may restrict spending, but if oil prices stay high monetary policy will be more difficult.

Edit. Here is a copy of an article I wrote for Livecharts about the Term Auction Facility:

Term Auction Facility

December 13, 2007

With credit markets extremely tight due to the continuing unavailability of short term commercial paper (CP), The Federal Reserve, The Bank of Japan, The Bank of England, The European Central Bank, The Bank of Canada and The Swiss National Bank have decided to experiment with the monetary system.Let me say straight away, the risk involved in this new venture is high, not only to the whole credit based monetary system but to the Central Banks themselves. That said, if it succeeds then the pressures in the credit markets should be lifted, allowing conditions to become conducive to further lending. The stakes are very high indeed.

So what exactly is the TAF designed to do? There appear to be 2 functions.

The first is to allow dollar swaps from the Federal Reserve to the other Central Banks to help alleviate dollar based liquidity problems outside the US.

The second function is more complicated, co-ordinated and risker.

As the CP market froze and then contracted, due to the lack of confidence Banks had in each other and other Institutions to repay (or service) the short term debt, the Central Banks offered funds through discount windows of one form or another, usually at rates higher than base but lower than commercial rates. After the Northern Rock debacle, borrowing from such avenues was not thought to be a wise move.

Time however, is against those who had borrowed using CP. As maturity dates approach it has become apparent that the CP market has not recovered to its pre-summer liquidity, indeed the CP market appears to be closed to new issuance. The short term loans used to purchase longer term assets or to fuel carry trades (selling low yield currency to buy high yield other denominated assets) will have to be repaid. This has now come to a climax as year end rolling of positions has been placed under threat or become non-viable.This was not part of the original plan when the lending had been entered into. Indeed, like Northern Rock the plan was to keep rolling the short term debt into new short term loans allowing the long term positions to continue.
With the facility withdrawn the plan became unstuck and the repayment of the loans would require sale of the assets bought. If the assets had appreciated then the position could be unwound without a capital loss. On the other hand if the asset had dropped in price then the amount owed would have to be made up using the Bank or Institution own reserves. As most of the borrowing had been used to bolster leverage (margin) then losses would be amplified, threatening their solvency. This also amplified the lack of lending, as Banks etc hoarded their reserves.

Back in September The Federal Reserve drew up the TAF as an answer to a US-centric problem. The idea was not implemented as it appeared credit markets were stabilizing. However that stabilization was fleeting and as conditions worsened the TAF plan was dusted off and put forward to other Central Banks as a solution.

That solution is to replace the traditional CP market, allowing the Central Banks to replace the previous participants. This is a full test of the Lender of Last Resort Theory where Governments or their Agencies are allowed to interfere in a capitalist structure.

At first glance the plan seems workable. There are however weaknesses which could become exposed, leading to further problems.

Firstly, the action must be co-ordinated between all participants, including the Bank of Japan, who appear not to be part of the TAF but are required to allow currency markets to flow freely. As much of the carry trade is funded by the Yen they are an integral part of the system. This could lead to political pressures building if the Yen is strengthened, hurting the Japanese export dominated economy.

Secondly, previous attempted international multi-agency intervention has not done well in financial markets. The attempts to keep Wiemar Germany afloat and the ERM regulated spring to mind as these efforts resulted in conditions that either worsened the problem or allowed speculation to destroy a framework. The risk to TAF would be the latter, where speculation in forex markets could endanger stability. More likely though is a stress test of the carry trade. It appears that the forex markets have already identified which assets are at risk, albeit not intentionally. When the TAF announcement was made gains in emerging market currencies and carry trade favourites, such as the NZD, AUD, TRY, BRL MEX and GBP were seen in expectation of continued risk taking in carry trades.

If the Central Bank intervention is to allow either an orderly unwinding of Emerging Market carry trades or a continuation of general carry trade conditions then speculative attack on TAF is a real possibility, not unlike Soros Vs Sterling. Shorting Emerging Markets, thus pressuring assets lower would force those in the carry trade to liquidate (costing capital reserves) or to approach TAF for higher borrowing, pressuring forex levels. Systemic risk would increase, either through a viscous circle of liquidations forcing prices of assets lower (along with other sellers heading for the exits) or a destabilization of forex levels requiring Central Bank intervention in interest rate markets.

On the plus side TAF has some flexibility, when initial lending operations were announced it was made clear that others could follow as required. TAF does not seem to have a lifespan either, possibly removing the bottleneck of the year end / Jan 08 roll over requirements. Of greater importance are the amounts of funding available, which should be enormous and the lack of a penalty rate on the interest charged. This should make TAF a much more attractive alternative than the higher interest rate required at discount window facilities..

Although the risks to TAF are high, the risks to the reputation of Central Banks are even higher. If this experiment fails then confidence in the system as a whole would collapse. Central Banks themselves are in danger of becoming victims, whose role and function could be radically altered or even removed in the event of failure.

An experiment of this nature has never been seen before and its unclear as to what the outcome will be. What is known is that stock markets hate uncertainty and that may well drive market direction into 2008 and beyond.

Sunday, 16 December 2007

Edwin Coppock, Fed Fund Rates and The Dow.

Aha there you are readers, I couldn't see you, hidden behind all that steam rising from the cups of mulled wine. A warm welcome to the last letter for 2007 - did I hear cheers and whoops of delight? Well its to be expected I suppose, I have been a rather grizzly writer over the past 2 years and I know you would prefer to see a more positive outlook.

However, a positive outlook requires positive action to happen now that will help further ahead on the economic road. Alas, I am not seeing too much that gives me cause for hope.

I hope you found time to visit and read the articles posted. As well as shorter articles covering topical subjects by myself you will find articles written by others too. Its well worth a visit.

As you know I try to peer into the future and divine what the economic outlook has in store for us. Readers had been well briefed about the credit crunch or as I see it the outright deflation of credit and it effects on the economy. Whilst I don't like to keep repeating the same theme, credit deflation is with us and will be around for some time to come. In this letter though I want to look at what the outcome of the current economic situation may do to stocks. I only rarely look at stock markets and try to see where they may be heading, not because I don't think its important but because there are plenty of other writers and systems out there who do just that, I prefer not to join a crowded play.

Edwin Coppock developed an indicator that helped to spot bull markets. Its a slow moving indicator and is usually late although, since 1996, it has become somewhat more timely. I think there is a very good reason for that. In 1995/6 Alan Greenspan changed his rate setting methodology, instead of following gold, he broke the link, allowing a period of steady rates in a more relaxed credit regime - enabled by the virtual abolishment of Bank reserve requirements.

The chart below shows that relationship and where it decoupled (with thanks to and Aaron Krowne, the chart is part of a great article) :

We can clearly see that he was attempting to rein in credit growth as he warned about "irrational exuberance" by keeping Fed Funds higher. As we now know the relaxation of reserve requirements had a much greater effect than he envisaged, probably due to his inability to see what the outcome of allowing unfettered credit creation and leverage would do, even with a Fed on an inflation fighting stance. Thus was born the beginning of the stock market surge in a newly revitalised Bull market, the building blocks for the housing boom and the acceleration of the credit derivative creation and application. I suspect the increase in the use of leverage and margin made the Coppock Indicator (CI) more sensitive to market conditions.

In decades to come, 1995/6 will be seen as a pivotal event, the enabling of what was to come. It was after this event that the CI became much more timely in showing Bull market conditions. Although the CI is a Bull indicator it can, if used carefully and by applying the new gold/Fed Funds relationship supply us with a longer term view of what may happen.

The next chart shows 2 things. The first is my dire attempt to display what I consider to be the best chart of the year. If only I was better at this graphics stuff eh? Ah well readers, you can't have everything..... The second is the chart itself. I have overlaid a chart of the Fed Fund Rates from 1986 to present with a monthly chart of the Dow from 1986 with its CI. Its clear to see the CI before 1996 did indeed lag and post '96 its a much better tool. Although the CI is used to indicate a bull market on a rise through zero it can be seen that in either half of the chart CI did give a lower high before stocks broke lower (marked by faint red lines). Whats more those lower highs were divergent when compared to the Dow which made higher highs.

Now before you run off and short every stock in the markets, remember, the CI wasn't designed for this use and the timescales involved increase the need for caution. Think of this more as a warning of a possible change of longer term trend, after all that's what I look for.

Lets look a little more at the CI before I discuss the Fed Funds Rate. Its use as a bull market indicator seems valid to me, it crossed up through the zero line twice, in late 1988 and 2003. By any count, that's not a bad indicator. Going long on those 2 dates would have been very profitable. When the day comes and the CI crosses zero to the upside again, I will be happy to look for good value long positions. Two other zero line crosses also appear, both to the downside. here is were I think the CI has changed. Notice the turn down in early 1988 would have to be judged as a failed signal, the Dow didn't retrace lower. In 2001 though the down signal was very useful especially when combined with the retest of the zero line and the turn back down. I suspect the difference between the the 2 signals was the way Fed Fund Rates were applied at the time.

The FFR in the late '80s was rising in an effort to control inflation (aha gold!) and even with the crash of '87 when rates dropped slightly, overall FFR continued to climb. As did stocks. There can be little argument that in modern times, rising FFR and rising stocks are not uncommon. For the long term, buying stocks when FFR is raised from a low is no bad thing. It also shows us that buying stocks when FFR is falling from a peak is a bad idea and since 1996, buying stocks with falling FFR and a divergence in the Dow/CI is not clever at all. Its noticeable too that if the CI is falling, even with FFR rising, stocks tend to tread water, a warning that conditions are not ripe for major stock gains. Its seen in the Dow returns in 1994, 1997-8, 2000 and 2004-5.

So, what are the Coppock, Fed Fund Rates and the Dow trying to tell us now? Firstly a rider. Although Fed Fund Rates are falling, other rates, especially LIBOR are not. We should keep this in mind. Firstly, we have a falling CI, with a divergent lower high when compared to the Dow. The Dow itself is beginning to resemble the 1999/2000 top, without a lower low as yet. Fed Funds are dropping and if consensus (a warning in itself) is correct, FFR will be much lower next year.

With the CI acting in a much more timely fashion, the minimum we can expect is for a flat return on stocks whilst FFR has ongoing cuts and the downward direction of the CI is maintained. A lower low on the Dow would make the flat return scenario seem less likely and open up expectations of a larger fall in 2008.

I do have one caveat to the above forecast. As can be seen in the next chart (below) Asset Backed Commercial Paper is still plunging but we can also see the beginning of an upturn in financial and non-financial Commercial Paper (CP).

Is liquidity beginning to return to the higher quality end of the market? Its probably too early to tell and the move higher could be connected with year end liquidity but a trend has to start somewhere. If CP has stabilized and issuance is increasing then confidence may begin to creep back into the markets.

I have no doubt it is connected to this:Term Auction Facility.

Finally, an old friend has been speaking, I refer of course to Alan Greenspan. (with thanks to Sarah for highlighting the article) A quick reminder of what I see ahead:

A recap of the scenario: bubble, easy money, inflation in fiat money supply, inflation in commodities and hard assets, inflation, fear of inflation, rising rates, YC inverting, flattening, rising and inverting again, tightening, withdrawal of liquidity, corrections, crashes, talk of stagflation, FEAR, withdrawal of speculative funds, further corrections and crashes, demand collapse.......Deflation.

"In an interview on ABC's "This Week with George Stephanopoulos," Greenspan said low inflation was a major contributor to economic growth and prices must be held in check.

"We are beginning to get not stagflation, but the early symptoms of it," Greenspan said.

"Fundamentally, inflation must be suppressed," he added. "It's critically important that the Federal Reserve is allowed politically to do what it has to do to suppress the inflation rates that I see emerging, not immediately, but clearly over the intermediate and longer-term period."

That readers, is Alan Greenspan asking for rate rises. It makes sense if you think about what he did to the FFR / gold link. Remember, as the architect of this financial monster he has now to support it. As he sees it, rising rates and rising stocks go hand in hand. I still think he fails to see the effects that credit creation had in the making of bubbles. Even with a small increase in CP, credit is still being destroyed at a greater rate, confidence is still missing. I leave it to the reader to check where his remarks fit into the scenario.

The interview with Greenspan went on with this:

"Greenspan repeated his assessment that the probability of a U.S. recession had moved up toward 50 percent but noted that corporate America's debt levels were in good shape, which should help cushion the blow from tightening credit terms.

"The real story is, with the extraordinary credit problems we're confronting, why the probabilities (of recession) are not 60 percent or 70 percent," he said.

Maybe someone should remind him that only a few months ago, he thought the chances of recession were about 30%.

I hope you found this letter helpful and enjoyable. More importantly, I hope that you and your loved ones have a Christmas to remember for all the right reasons. Gifts and presents are nice but the warm glow from a smiling face is worth much more.

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