Con-tango

A tough spot

I’ll be thinking out loud about the tough spot of a seller of a distressed CDS. I’m trying to figure out how the Lehman auction would transpire.

Let’s see an example of how swaps trade:

ABC Corporation may have its credit default swaps currently trading at 265 basis points.
In other words, the cost to insure 10 million euros of its debt would
be 265,000 euros per annum. If the same CDS had been trading at 170
basis points a year before, it would indicate that markets now view ABC
as facing a greater risk of default on its obligations.

Let me get myself into a seller’s shoes.

If I’m in trouble because I’ve been selling CDS swaps (insuring companies’ debts) like there’s no tomorrow, and collecting the fat annual swap (premium) income, the only way I see that I can extract myself out of the bind I’m in –supposing companies are defaulting on their debt–, is to buy back enough swaps of the same company to cover my fannie.

I also know there are a lot more swaps out there than needed to cover the debt –something like ten times, so there is a good chance I can get my hands into the few that I desperately need to get out of the corner I’m in.

Trouble is buyers are sitting pretty, in what may be a freight-car full of cash, if the company bonds go under –and, they know it.

Trouble for the swap buyer is collecting, if I go under, they collect ‘nada’.

Now, what the heck is the Fed going to do with all my swap contracts?

Ok. My bulb is dim, but beggining to produce the goods. In essence through the price discovery of the swap auction, the Fed will discover how much it will cost to buy the swaps to get me out of trouble. Considering a mix of bad apples and not so bad ones, there will be a final tally of the cost to clear my swap obligations, and I would expect at this point that the Fed will require my soul in exchange –or the same as prefered stock– and will lend me the rest to survive, if the price of my stock is so degraded.

Fair enough.

Fed acts as middleman II

This morning the Fed released the following statement:

The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF).
(…)
The CPFF will provide a liquidity backstop to U.S. issuers of
commercial paper through a special purpose vehicle (SPV) that will
purchase three-month unsecured and asset-backed commercial paper
directly from eligible issuers.
(…)
The commercial paper market has been under considerable strain in
recent weeks as money market mutual funds and other investors,
themselves often facing liquidity pressures, have become increasingly
reluctant to purchase commercial paper, especially at longer-dated
maturities. As a result, the volume of outstanding commercial paper has
shrunk, interest rates on longer-term commercial paper have increased
significantly, and an increasingly high percentage of outstanding paper
must now be refinanced each day. A large share of outstanding
commercial paper is issued or sponsored by financial intermediaries,
and their difficulties placing commercial paper have made it more
difficult for those intermediaries to play their vital role in meeting
the credit needs of businesses and households.

By eliminating much of the risk that eligible issuers will not be
able to repay investors by rolling over their maturing commercial paper
obligations, this facility should encourage investors to once again
engage in term lending in the commercial paper market. Added investor
demand should lower commercial paper rates from their current elevated
levels and foster issuance of longer-term commercial paper. An improved
commercial paper market will enhance the ability of financial
intermediaries to accommodate the credit needs of businesses and
households.

Sounds good to me.

Freddie Krueger’s CDS

Elm Street’s Freddie Krueger

A Credit Default Swap is a very simple financial instrument. But, when I go over its wiki definition I can’t avoid thinking that Freddie Krueger must’ve been involved in the creation of this nightmarish contraption:

A credit default swap (CDS) is a contract in which a
buyer pays a series of payments to a seller, and in exchange receives
the right to a payoff if a credit instrument goes into default or on the occurence of a specified credit event
(such as bankruptcy or restructuring). The associated instrument does
not need to be associated with the buyer or the seller of this contract.^[1]

In other words, there is no requirement on the seller to guarantee and provision his side of the contract in case of a default. I repeat, no requirement, as in nada or none.

Continue reading…