There is widespread recognition that the benign conditions of recent years encouraged a sharp increase in the leverage within the financial system. The build-up of leverage this time around entails a number of surprises. New financial techniques have supplanted lending as the primary source of liquidity and leverage creation reflecting Will Rogers’ droll observation: “You can't say that civilization don't advance; for in every war they kill you a new way.”

Traditional leverage, in the form of borrowings, remains important. A major area of growth has been collateralised lending where holders sell assets against the agreement to re-purchase it at a future date. Growth of hedge funds and prime brokers has fueled explosive growth in collateral and expanded the range of assets against which funding can be raised. Substantial sums can be raised against any type of security or instrument, complementing the long established government bond repo markets.

The borrower posts an initial margin or “haircut” (a small amount of his money) and promises to post more cash if the value of the asset declines. Favourable regulatory rules, optimistic views of liquidity (the collateral must be sold if the borrower fails to pay) and faith in the models used to set the initial margin are driving aggressive use of collateral increasing available liquidity and leverage.

Derivatives have contributed to the sharp rise in leverage. Derivative structures have increased leverage in two ways.

The first is the “derivatisation” of lending. For example, the purchase of $10 million of shares requires commitment of cash. The trader can instead enter a total return swap (“TRS”). Under the terms of the swap (see Diagram below) he receives the return on the share (dividends and increases in price) in return for paying the cost of holding the shares (decreases in price and the funding cost of the dealer). The TRS requires no funding other than any collateral required by the dealer; this is substantially less than the $10 million required to buy the shares. The trader acquires the same exposure as buying the shares but increases its return through leverage. In effect, the loan to the investor secured over the asset has been repackaged as a derivative transaction enhancing the leverage.

The second way in which derivatives can be used is to create embedded loss leverage. For a given event, you increase your potential gain or loss. Two examples – digital options (a common form of exotic derivative) and credit leverage in collateralised debt obligations (“CDOs”) – illustrate the idea.

Under a normal option to buy shares at $100 (the strike), if the shares at expiry of the option are above $100, the gain is equal to the share price minus $100; if the share price is $110, then the purchaser of the option makes and the seller loses $10. In a digital or binary option, the parties can agree that if the share price is above $100, then the option payoff is $25. If the option is in-the-money (above the strike price of $100) then the gain to the buyer and loss to the seller is the fixed $25, irrespective of whether the share price is $100.01 or $200. In effect, for a relatively small move in the share price (from $100 to $100.01), the option buyer gains and the option seller losses $25 (25% of the value of the share) effectively embedding tremendous sensitivity (i.e. leverage) to price movements.

Digital options enable traders to nominate large payouts to take leveraged positions on price movements. Declining market volatility in recent years has meant that traders generate larger premiums by increasing the size of their wagers.

The equity tranche of collateralised debt obligations (“CDOs”) is an example of loss leverage in credit markets. A typical CDO consists of a $1,000 million portfolio made up of $10 million exposure to 100 corporations. The equity investor assumes the first 2% ($20 million) of losses on the portfolio. Assuming a loss of $6 million if any corporation defaults (recovery rates are 40% of $10 million), the equity investor is taking the risk of the first three defaults. In contrast, if the investor invested $20 million in the entire portfolio ($200,000 per corporation), then three defaults in the portfolio would result in the investor losing $0.36 million (loss of $120,000 per company ($200,00 adjusted for 40% recovery rates) times 3). For three losses the equity tranche investor’s leverage to defaults is 56 times (if there were 3 losses then the investors loses the entire $20 million invested in the CDO equity against $0.36 million in the diversified portfolio). By reducing the “tranche width” (the size of the equity tranche) the credit leverage can be increased to over 83 times!

Increasing the amount of potential gain or loss for a given event is now routinely used to create leverage. The use of these techniques is poorly understood. It does not show up in traditional leverage measurements that are focused on the level of borrowings. The additional liquidity and leverage creates complex chains of risk and moral hazard in markets that may prove problematic when prices correct. It is another unknown unknown of modern markets.

As Wells Fargo CEO John Stumpf observed: “It’s puzzling why bankers have come up with these new ways to lose money when the old ways were working so well.”

© Satyajit 2008

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

In May 2006, Alan Greenspan, the former Chairman of the Fed, noted: “The CDS is probably the most important instrument in finance. … What CDS (credit default swaps) did is lay-off all the risk of highly leveraged institutions – and that’s what banks are, highly leveraged – on stable American and international institutions.” It will be interesting to see whether reality proves to be different.

The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who for a fee indemnifies the protection buyer against credit losses.

The CDS contract and the entire Structured Credit Market originally was predicated on hedging of credit risk. Over time the market changed focus – in Mae West’s words: “I used to be Snow White, but I drifted.” The ability to short credit, leverage positions and trade credit unrestricted by the size of the underlying debt market have become the dominant drivers of growth in the market for these instruments.

The CDS market has grown exponentially to current outstandings of around US$ 50 trillion. Even eliminating double counting in the volumes, the figures are impressive, especially when you considered that the market was less than US$1 trillion as at 2001. However, the size of the market (which has attracted much attention) is not the major issue.

Banks have used CDS contracts extensively to hedge credit risk on bonds and loans. The key issue is will the contracts protect the banks from the underlying credit risk being hedged. As Mae West noted: “An ounce of performance is worth pounds of promises.” Documentation and counterparty risk means that the market may not function as participants and regulators hope if actual defaults occur.

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought. In fairness, all financial hedges display some degree of mismatch or “basis” risk.

The CDS contract is triggered by a “credit event”, broadly default by the reference entity. The buyer of protection is not protected against “all” defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan. Some credit events like “restructuring” are complex. There are different versions – R (restructuring); NR (no restructuring); MR (modified restructuring); MMR (modified modified restructuring). Different contracts use different versions.

“PAI” (publicly available information) must generally be used to trigger the CDS contract. Recent credit events have been straightforward Chapter 11 filings and bankruptcy. For other credit events (failure to pay or restructuring), there may be problems in establishing that the credit event took place.

This has a systemic dimension. A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. This may exacerbate losses in case of defaults.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, the volume of CDS outstanding was estimated at US$28 billion against US$5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called “auction system”. The auction is designed to be robust and free of the risk of manipulation.

In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100% - 63.38%) or US$3.662 million per US$10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi’s senior unsecured obligation equating to a 0-10% recovery band - far below the price established through the protocol [see James Batterman and Eric Rosenthal Special Report: Delphi, Credit Derivatives, and Bond Trading Behavior After a Bankruptcy Filing (28 November 2005); www.fitchratings.com].

The buyer of protection depending on what was being hedged may have potentially received a payment on its hedge well below its actual losses – effectively it would not have been fully hedged.

The settlement mechanics may cause problems even where there is no default. One company refinanced its debt using commercial mortgage backed securities (“CMBS”). The company was downgraded by rating agencies. A shortage of deliverable obligations (the company used the funds from the CMBS to repay its bond and loans) meant that the CDS fee for the company fell sharply (indicative of an improvement in credit quality). This resulted in mark-to-market losses for bemused hedgers. This is known in the trade as an “orphaned CDS”.

In the case of actual defaults the CDS market may provide significant employment to a whole galaxy of lawyers trying to figure out whether and how the contract should work. There is the risk that contract may not always provide buyers of protection with the hedge against loss that they assumed they would receive.

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. If the seller of protection is unable to perform then the buyer obtains no protection.

Currently, a significant proportion of protection sellers is financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented. Recently, a number of banks took charges against counterparty risk on hedges with financial guarantors including Merrill Lynch (US$ 3.1 billion) Canadian Imperial Bank of Commerce (“CIBC”) (US$2 billion) and Calyon (US$1.7 billion).

For hedge funds, the CDS is marked-to-market daily and any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. In practice, banks may not be willing or able to close out positions where collateral isn’t posted.

ACA Financial Guaranty sold protection totaling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement. The banks have agreed to a “forbearance agreement” whereby the buyer of protection waived the right to collateral temporarily. ACA subsequently has been downgraded to “CCC” reducing the value of the CDS contract and the protection offered. The problems at ACA are not unique.

A critical element is the level of over-collateralisation. The buyer of protection will want an initial margin to cover the risk of a change in the value of the contract and the failure by the seller of protection to meet a margin call. The seller of protection wants to increase leverage by reducing the amount of cash it must post as initial margin. It is possible that the level of initial collateral may prove be too low. Collateral models use historical volatility and correlation that may underestimate the risk. The entire process also assumes liquidity in the underlying CDS market that may be absent in a crisis.

CDS contracts entail significant operational risks. Delays in documenting CDS contracts forced regulators to step in requiring banks to confirm trades more promptly. Where collateral is used, there are additional challenges of the accuracy of mark-to-market of CDS and monitoring of collateral.

If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between US$33 billion and US$158 billion [Andrea Cicione “Counterparty Risk: A Growing Cause of Concern” (25 January 2008) Credit Portfolio Strategy - BNP Paribas Corporate & Investment Banking]. This compares to the around US$110 billion that banks have written off to date. While it may be unlikely that the CDS market will fail entirely it is possible that losses on the hedges will add to the losses that the banks have already incurred.

The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of Lloyds. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance premiums are received up front. In both cases the risks are both potentially significant and “long tail” – they do not emerge immediately and may take some time to be fully quantified. As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Defaults may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.

The impact of a bankruptcy filing by Bear Stearns on the OTC Derivatives market, including the CDS, was probably one of the factors that influenced the Federal Reserve and US Treasury’s decision to support the rescue of the investment bank. Barclays Capital recently estimated that the failure of a dealer with $2 trillion in CDS contracts outstanding could potentially lead to losses of between $36 billion and $47 billion for counterparties. This underlines the potential concentration risks that are present.

Over the last year, securitisation and the CDO (collateralised debt obligation) market have become dysfunctional. As the credit crisis deepens, the risk of actual defaults becomes real. Analysts expect the level of defaults to increase. The CDS market is about to be tested. While there have been a few defaults, the market has not had to cope with a large number of defaults at the same time. CDS contracts may experience problems and may be found wanting.

CDS contracts may not actually improve the overall stability and security of the financial system but create additional risks.

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At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

© 2008 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).