When Credit Derivatives Go Bad

Wow… This past week has been full of exciting news. Some smart cookie has finally realized that maybe it would be worth revisiting the credit ratings of bond insurers. (At this point, I sincerely hope that no-one reading this is foolish enough to have given any credence to those ratings.) M-LEC, a sort of financial Superfund site, appears dead at birth, and FASB’s rule 157 will soon take effect to force more mark-to-market of dubiously-valued assets. Citigroup, just like Merrill Lynch a few weeks before, tossed its CEO and wrote down ~$11 billion in assets.

While I’d love to rant about the abomination that was M-LEC, I’m going to instead provide a quick introduction to two phrases: “counterparty default” and “acceleration event”. I think we’ll be seeing much more of them in news articles over the coming months.

One common method of hedging against credit risk is the purchase of credit default swaps. You can think of it as buying insurance for your investments. Credit derivatives are used to repackage and transfer risk, and CDSs are the most widely traded form of them. This isn’t necessarily a bad thing, but derivatives can also act to amplify losses while creating a false sense of security. Here’s the basic definition:

A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).

– Wikipedia, “Credit default swap”

Warren Buffet wrote in Berkshire Hathaway’s 2002 annual report that the “ultimate value [of derivatives contracts] also depends on the creditworthiness of the counterparties to them”. Should a counterparty default, the risk that had been thought safely packaged and sold off comes cascading back. In a highly-leveraged company, “counterparty default” also represents significant damage to the balance sheet. Now let’s look at the other phrase:

You want to know what will force “Mark To Market” on all those CDOs? Here’s a hint – whisper “Acceleration Event” to a CDO manager and see how white his face turns.

What’s an “Acceleration Event”? It is a deterioration in the underlying credit quality that causes all of the subordinate tranche coupon payments (the “regular” interest payments) to be cut off. This is usually an incurable event; once it happens only the “super senior” tranches – which typically are NOT traded – get interest payments. Everything else, including the so-called “AAA” tranches DO NOT.

– Genesis, on market-ticker.denninger.net

Remember that the coupon payments are prioritized according to the rating of the tranches. This can create a situation where the lower-rated equity tranches are no longer receiving payments but the senior tranches are, but the value of the CDO itself continues to fall. An acceleration event is a circuit breaker that says “OK, stop, things are so bad that even though the AAA-holders are still getting paid, everyone else is getting hosed and it’s time to cut losses and liquidate the thing”.

The cutting off of payments isn’t so bad, relatively speaking. It might hurt some pension funds or other naive buyers, but it’s… manageable. The problem is that it forces the sale of assets on the open market, and at prices significantly lower than what the models or balance sheets say they’re worth. (This is exactly the sort of situation that M-LEC was intended to prevent.)

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