Hedge Funds and the Credit Crisis

The RAND Group published a paper examining the role of hedge funds during the credit crisis of 2008.  The question was whether or not funds create or contribute to the systemic risk that caused it.  This was triggered when Lehman Brothers declared bankruptcy and caused the financial markets to melt down globally.  The researchers reviewed that crisis and the 1998 private bailout of Long Term Capital Management orchestrated by the Federal Reserve.  They found six areas of concern:

• Lack of information on hedge funds
• Lack of appropriate margin in derivative trades
• Runs of prime brokers
• Short selling
• Compromised risk management incentives
• Lack of portfolio liquidity and excessive leverage

Dodd-Frank legislation was passed to handle these issues to avoid new crises in the future.  To create more transparency on hedge funds, the reform was to require funds with $150 million in assets under management to register with the SEC.  However, there is a loophole as non-US hedge funds with no offices in the US and less than $25 million invested from US investors were exempt from the reporting requirement.  There is pending legislation from Europe that would affect those hedge funds but no reform in Asia is anticipated.  Funds are to submit the following data points:  assets under management, total leverage, counterparty credit risk exposure, trading and investment positions, asset valuation processes, asset types, side arrangements or letters with investors and trading practices.  Additionally, the SEC would have periodic inspections of the fund.  Since derivative trades were at the center of the crisis, swap trades need to be registered in a central repository. 

The CFTC and SEC would impose minimum capital restrictions on these trades and the funds must trade them on an exchange if possible.  To prevent funds from closing their prime brokerage accounts, their accounts would be segregated from the prime broker’s funds and rehypothecation of assets would not be allowed.  Rehypothecation is when the prime broker uses the hedge fund’s assets for its own business such as securities lending or as collateral. 

Short selling rules will be enforced to prevent bear raids on a stock.  When a stock falls 10% or more in price from the prior day’s close, then the uptick rule will be triggered.  This rule restricts short sales to when the stock price is above the last sale or the best bid price.   In a short sale, the stock must be borrowed first.  These shares must be delivered by the settlement date (within three days) of the trade.  There must be monthly disclosure of short positions aggregated by stock. 

Dodd-Frank also limits bank investment in hedge funds to three percent of the fund’s assets and three percent of the fund’s tier 1 capital.  Hopefully, this will prevent banks from bailing out their funds.  This is true from a financial perspective but banks may be motivated to bail them out to mitigate reputational risk.  These restrictions are only applicable to US entities.

To address the liquidity and leverage concerns, large hedge funds with $50 billion or more of assets under management are candidates to be regulated by the Federal Reserve Bank.  These funds are determined by the Financial Stability Oversight Council who assesses them based on a wide range of factors; quantitative and qualitative, industry and firm-based and the Department of the Treasury.  If two thirds of the council plus Treasury agree, then the fund will be regulated.  There will be position limits on futures and options for physical commodities and annual stress tests for funds with $10 billion in assets under three scenarios – baseline, adverse and severely adverse.  Regulating the prime brokers of hedge funds indirectly addresses leverage.  They will have higher capital requirements and have less credit to extend to funds, limiting their available leverage.

The reforms are changing the way hedge funds operate.  This is ironic as they did not cause the credit crisis.  The gap is in the potential lack of portfolio liquidity and excessive leverage.   There is too long a time delay before reporting positions.  The number of funds covered are few.  Prime brokers and regulators will have incomplete data as funds use multiple brokers and home countries.   Of the other points, lack of information, lack of margin on derivative trades and runs on prime brokers are strongly addressed and short selling and risk management incentives are moderately addressed.  Regulators should continue analyzing the hedge fund universe to better understand and monitor their risk.

The source for this article can be accessed here.

New Opportunities in Collateral Management for Banks

Starting next year, derivative trades such as interest rate swaps will be traded over central clearing houses.  They are currently done as private transactions between two counterparties.  To protect themselves from losses if a counterparty should not pay out their revenue responsibilities, the clearing houses will demand collateral.  It is estimated that the collateral needed to cover these trades will increase by $2 trillion or 50% because many of these transactions are long term in nature.  Several banks are poised to take advantage of the new business - JP Morgan, Northern Trust, State Street and BNP Paribas.  There could be $2 billion in revenue at stake.

Already, there are several partnerships being agreed on to allow counterparties access to new assets and to optimize collateral at different firms.  BNP Paribas Securities Services and Euroclear, the European securities warehouse that settles trades, are allowing their clients to use collateral at BNP to finance trades on Euroclear.

The source for this article can be accessed here.

Uneasiness in the Credit Markets

The credit markets are pricing in the uncertainty caused by fear of a European debt crisis which will cascade into banking failures.  Some of the market reactions are:

Spreads Up/Prices Down

• In the credit default swaps (CDS) market, the bid-ask spread has risen to 5.4% from 3.0% of the annual cost of the contracts on the 15 most traded CDSs on US investment grade companies.  The 3.0% figure is from August 1, 2011.
• The Bank of America Merrill Lynch Global Broad Market Index has reported that spreads on bonds have increased from 170 basis points at the end of July to 231 basis points.
• The Barclays Capital Global Aggregate Corporate Index has an absolute yield of 3.82%, up from 3.67% on August 19th.
• The Markit CDX North America Investment Grade Index has risen to 122 basis points from 96.3 basis points in August.  This index increases as investor confidence improves.
• The Barcap CMBS Super Duper Index has a relative yield of 3.03% compared to 2.13% on July 25th.
• The Standard & Poor's/LSTA US Leveraged Loan 100 index is down 4.7% in 2011.

Investors have de-risked their portfolios by moving out of the leveraged loans and distressed debt.  Banks are continuing to close down their proprietary trading desks and lowering their exposure to corporate debt.  They are not committing capital to facilitate trades or acting as a principal.  There is less liquidity in the market because of these factors.

The source for this article can be accessed here.

Credit Derivatives: Some Basic Information

In prior posts, we have looked at credit default swaps.  Let's take step back and look at credit derivatives as a whole.  They are financial contracts such as options, forwards, futures, swaps and credit linked notes that are used used by fixed income managers to hedge positions (credit protection) or to enhance portfolio returns (credit exposure).  Through credit derivatives, portfolio managers are able to isolate and transfer credit risk, get liquidity in the market and have transparent pricing by trading the underlying credit.  Previously, they would have to hold the underlying assets in their portfolio which is capital intensive.  To manage risk using this method, the manager would have to look at each company's financial statement and balance sheet to rate their soundness.  He would also look at the industries of the portfolio companies and diversify loans to companies in different industries or sectors.

What is credit risk?  There are three components:  default, downgrade and credit spread.  Default risk is the risk that the bond issuer or loan borrower will not pay the bond or loan in full.  A loan is in default if a scheduled payment is not made.  Downgrade risk is when a rating agency such as Standard & Poor's, Moody's or Fitch's lowers the credit rating of the debt.  Credit spread risk is when the market spread between the underlying bond or loan increases for the remaining debt.  Credit risk is usually measured by rating agencies or using the credit spread.

What are the underlying / reference assets that credit derivatives are used for?  They are high yield bonds, leveraged loans, distressed debt and emerging markets bonds.  These assets have low to medium correlation with US equities and low or negative correlation with US Treasuries.  They have a high exposure to large declines in prices.  High yield bonds a.k.a. junk bonds are rated below investment grade by the agencies (either below BBB by Standard & Poor's or Baa by Moody's).  Leveraged loans are bank loans made to companies of credit ratings below investment grade or with a spread of 150 basis points over LIBOR (London Interbank Offer Rate).  LIBOR is the interest rate at which banks borrow from other banks in London.  In addition to the three credit risks listed above, the borrower can pre-pay the loan by re-financing or pre-paying the balance.  This is call risk.  There are to types of loans - revolvers and term loans.  Revolvers are committed lines of credit that also back commercial paper loans of companies with high credit ratings.  Term loans are given to companies with lower credit ratings, are funded commitments with fixed amortization schedules and are based on floating interest rates.  In addition to credit risk, emerging markets debt is exposed to political risk.  Distressed debt is composed of bonds of companies that are in default because of a missed payment, bonds going through Chapter 11 re-organization, the company having cash flow problems or have low credit ratings.

Options, futures and forwards are known as binary options.  They are similar to equity options.  If an event occurs as dictated by the terms of the contract, then the option seller pays money to the holder.  A credit-linked note is a bond with an embedded credit option.  These notes have a higher interest rate than regular bonds but the holder of the note provides the issuer with some credit hedge.  The referenced asset is either a corporation or a basket of credit risks.

A total return credit swap allows an investor to rent a balance sheet.  The investor trades the return of an asset for a guaranteed rate of return, usually LIBOR plus a spread.    The seller of the swap retains ownership of the asset.  For example, an investor could be positive on Apple bonds.  A swap can be bought on the returns of Apple bonds.  The buyer would receive that return and pay the seller LIBOR plus a spread.  The seller has hedged his position in Apple bonds and is now receiving payments of LIBOR plus a spread.

Risks in Credit Default Swaps

There are four types of risk in trading credit default swaps:  operational, counterparty, liquidity and pricing.  Operational risk occurs when traders use swaps to mislead investors about their balance sheet i.e. assets versus liabilities.  A counterparty may default on its payments.  Buyers of CDSs may not pay the monthly premiums.  Sellers may be unable to pay the notional amount in case of a default of the reference entity or the sellers themselves may declare bankruptcy and not have to pay the notional amount.   CDSs are traded as bespoke contracts between two counterparties.  If an investor wishes to exit the position, finding another investor to take over the contact, known as novation, may be difficult.  Pricing may be inaccurate as it may be based on the wrong mathematical models.

Credit Default Swaps: Some Basics

A credit default swap (CDS) is a contract associated with a company where the credit buyer pays the seller a fixed rate for the duration of the contract.  In return, the seller pays the buyer if certain credit events happen and the contract is closed.  Within it is listed a number of trigger events that will result in a payout to the buyer.  The payout is delivered usually in the form of the company bond at par (i.e. full price).  It is similar to any insurance product.  The other type of settlement is cash.  This is used for swaps on indices or structured finance tranches.

CDS contracts contain the reference entity's bond, the notional amount (i.e. the amount being insured), CDS spread (i.e. annual payment in basis points) and time of maturity.  The maturity is usually on March 20, June 20, September 20 and December 20.  Some contracts are based on more than one company.  These are called basket CDSs  If the contract is based on more than ten companies, it can be called a portfolio product.

The trigger events are bankruptcy, missed payment, re-structuring, obligation acceleration, obligation default and repudiation/moratorium.  Bankruptcy and missed payment are a company's failure to pay its debt.  Re-structuring debt is any change that adversely affects the buyer.  Obligation acceleration is when a loan is re-paid early and obligation default is when the borrower violates any condition in the agreement.  Repudiation/moratorium is a refusal to pay debt.  Bankruptcy, missed payment, obligation acceleration and repudiation/moratorium are defined as hard events and trigger the entire bond to be immediately due and payable.  Soft events, such as re-structuring, are changes in the agreement between the reference entities.  Some of them are reduction of interest/principal, postpone payment of interest or principal and a change of currency or contractual subordination.

CDSs provide a way to separate risks in complex securities such as convertibles.  They allow investors to hedge credit risk by shorting credit.  Investors can customize their risk profile by buying contracts on bonds of different companies and maturity dates, buying contracts on baskets and buying contracts to bet on the price direction of the reference entity.  CDSs may link different markets and provide liquidity in the credits markets.  Transactions are confidential.

New Rules for Swap Dealers

The Securities and Exchange Commission (SEC) is proposing new rules for swap dealers and their clients.  The SEC, which was asleep during the credit crisis of 2008, is trying to oversee a swap business of $600 trillion in notional trades.  The transactions that will apply the new rules are security-based swaps and some credit default swaps.  The former are swaps that are derived from the performance of a stock, bond or index.  The latter are insurance against a default for a corporation or government's bonds.  Some of the rules are:

• The security-based swap dealers would have to act in the best interests of the state or local government or pension fund, recommending suitable swaps.  
• They would have to disclose information about the trade's risks and any conflicts of interest.
• They would have to verify that their customer is financially sound.  
• The dealers would also have to know that a qualified independent adviser was representing the fund for a transaction.  
• They would have to build a compliance department for oversight.

Swap execution facilities are being set up by thirty to forty dealers such as Bloomberg and Tradeweb.  Banks, hedge funds, insurance companies and other institutional investors are prepared to trade on these facilities.  They are waiting for the SEC rules to be approved and finalized.

Here are the sources for this article:

• New York Time Dealbook
• Washington Post
• Bondbuyer.com
• Wall Street Journal