Friday, July 4, 2008

CDS flaws exposed by tough conditions

(FT) Credit derivatives were hailed as one of the most impressive innovations in the pre-credit crunch world. Since the end of 2000, when statistics were first gathered, the market has grown from $631bn to $62,000bn, an eye-popping 10,000 per cent, according to the International Swaps and Derivatives Association.

The beauty of these instruments, which act as a kind of insurance against bond defaults, were their liquidity, which made them far more valuable as a proxy for risk and a reference point for pricing debt. Volumes were more than 10-times that of cash bonds, which were considered less responsive to market sentiment.

But this year, as the markets came under increasing strain because of the financial problems, liquidity in the credit default swaps markets began to dry up too, raising doubts over their value as an indicator of risk and funding costs. In the good times, CDS had thrived, but as the markets turned ugly their flaws had been exposed.

One notable critic was Geir Haarde, the Icelandic prime minister, who questioned the quality of CDS as the spreads of his country's three leading banks rose to unprecedented levels in March, as high as 1,000 basis points, compared with only 30bp in July last year. The cost to insure against these banks defaulting had risen by €100m ($157m) annually for €10m of debt.

Mr Haarde insisted that these spreads were artificially wide because a lack of liquidity had exaggerated trades by speculators and hedge funds that increasingly viewed Iceland's banks as dangerously over-leveraged.

Critically, this spread-widening potentially posed problems for Iceland's ability to raise money or roll over debt in the capital markets as investors were, in consequence, demanding much higher interest rates to buy the banks' bonds or loans.

With more problems surfacing last week over the Icelandic economy and its ability to combat inflation, the three banks' CDS prices came under further pressure. Kaupthing's CDS price has jumped to 820bp from 680bp on June 23, Glitnir's to 814bp from 660bp and Landsbanki to 569bp from 400bp over the same period.

Yet, in spite of this, Kaupthing still managed last month to sell €275m in loans for just 200bp over market rates, underlining the wide discrepancy between CDS prices, which were more than 500bp wider at the time, and actual funding costs. In theory, these rates should be roughly the same.

The fact that Kaupthing could price a loan at much lower rates suggested some investors were doubting the worth of CDS.

Bankers also started to use existing cash bonds and government paper as a reference to price new debt rather than CDS because they believed the physical market was providing a fairer reflection of funding costs.

These same bankers insist that the flaws in CDS since the credit crunch should not take away from how valuable they have become as an indicator, even in the most stressed and volatile markets.

CDS flows may have slowed sharply this year, particularly in the second quarter, but they are still much higher than the cash markets, where many bonds are not traded.

The value of CDS for market participants also depends on what company is trying to raise money. For example, the big investment-grade names such as British Telecom or BMW are fairly actively traded, meaning their prices are of relevance in contrast to an Icelandic bank.

Terence Shanahan, global head of debt capital market syndicate at SG CIB, said: "Some companies may have very illiquid CDS, which means they are less useful for pricing bonds. For these deals, where the CDS price is erratic or illiquid, you may wish to price a bond off the cash market instead. But for the big names, such as British Telecom, the CDS is still relevant."

A number of payment disputes on CDS contracts in the courts have also raised questions on the product's credibility. One high-profile case involves UBS, which is fighting Paramax Capital International, a hedge fund, for compensation on a $1.3bn contract in which it had bought protection.

Paramax claims it cannot fully compensate UBS for any meaningful losses because it had only $200m under management and its agreements with investors limited it to commit no more than $40m to any single deal.

Yet, in spite of litigation, the lack of liquidity and attacks from Nordic prime ministers, bankers insist that CDS is one innovation that is here to stay.

Ivor Dunbar, co-head of global capital markets at Deutsche Bank, said: "CDS are not perfect. They work best with high-grade names, which are more liquid and provide more reliable prices. But CDS is still more dependable than the cash markets and provides a reliable benchmark. It is also a useful hedging tool and a way for investors to get exposure to certain credits."

Jim Reid, credit strategist at Deutsche Bank, added: "CDS is still very useful in many ways, whether it is providing an ability to go short [by buying protection against a bond defaulting], or as a reference for pricing. More real-money investors are looking to use CDS as well as the banks and the hedge funds. Activity in the market is still growing and is likely to stay strong."

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