Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults
By David Evans
It's Friday, March 14, and hedge fund adviser Tim Backshall is trying to stave off panic. Backshall sits in the
Bear Stearns Cos. shares have plunged 50 percent since trading began today, and his fund manager clients, some of whom have their cash and other accounts at Bear, worry that the bank is on the verge of bankruptcy. They're unsure whether they should protect their assets by purchasing credit-default swaps, a type of insurance that's supposed to pay them face value if Bear's debt goes under.
Backshall, 37, tells them there are two rubs: The price of the swaps is skyrocketing by the minute, and the banks selling the insurance are also at risk of collapsing. If Bear goes down, he tells them, it may take other banks with it.
‘‘There's always the danger the bank selling you the protection on Bear will fail,'' Backshall says. If that were to happen, his clients could spend millions of dollars for worthless insurance.
Investors can't tell whether the people selling the swaps - - known as counterparties -- have the money to honor their promises, Backshall says between phone calls.
‘‘It's clearly a combination of absolute fear and investors really not knowing,'' he says.
On this day, a CDS-market meltdown doesn't happen. In a frenzy of weekend activity, the Federal Reserve and JPMorgan Chase & Co. rescue Bear Stearns from bankruptcy -- removing the need for the sellers of credit-default protection to pay up on their contracts.
Backshall and his clients aren't the only ones spooked by the prospect of a CDS catastrophe. Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis.
CDSs, which were devised by J.P. Morgan & Co. bankers in the early 1990s to hedge their loan risks, now constitute a sprawling, rapidly growing market that includes contracts protecting $62 trillion in debt.
The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb.
‘‘It is a Damocles sword waiting to fall,'' says Soros, 77, whose new book is called ‘‘The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means'' (PublicAffairs).
‘‘To allow a market of that size to develop without regulatory supervision is really unacceptable,'' Soros says.
The Fed bailout of Bear Stearns on March 17 was motivated, in part, by a desire to keep that sword from falling, says Joseph Mason, a former U.S. Treasury Department economist who's now chair of the banking department at Louisiana State University's E.J. Ourso College of Business.
The Fed was concerned that banks might not have the money to pay CDS counterparties if there were large debt defaults, Mason says.
‘‘The Fed's fear was that they didn't adequately monitor counterparty risk in credit-default swaps -- so they had no idea of where to lend nor where significant lumpy exposures may lie,'' he says.
Those counterparties include none other than JPMorgan itself, the largest seller and buyer of CDSs known to the Office of the Comptroller of the Currency, or OCC.
The Fed negotiated the deal to bail out Bear Stearns by allowing JPMorgan to buy it for $10 a share. The Fed pledged $29 billion to JPMorgan to cover any Bear debts.
‘‘The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets,'' Fed Chairman Ben S. Bernanke told Congress on April 2. ‘‘It could also have cast doubt on the financial positions of some of Bear Stearns's thousands of counterparties.''
The Fed was worried about the biggest players in the CDS market, Mason says. ‘‘It was a JPMorgan bailout, not a bailout of Bear,'' he says.
JPMorgan spokesman Brian Marchiony declined to comment for this article.
Credit-default swaps are derivatives, meaning they're financial contracts that don't contain any actual assets. Their value is based on the worth of underlying loans and bonds. Swaps are similar to insurance policies -- with two key differences.
Unlike with traditional insurance, no agency monitors the seller of a swap contract to be certain it has the money to cover debt defaults. In addition, swap buyers don't need to actually own the asset they want to protect.
It's as if many investors could buy insurance on the same multimillion-dollar home they didn't own and then collect on its full value if the house burned down.
Bigger Than NYSE
When traders buy swap protection, they're speculating a loan or bond will fail; when they sell swaps, they're betting that a borrower's ability to pay will improve.
The market, which has doubled in size every year since 2000 and is larger in dollar value than the New York Stock Exchange, is controlled by banks like JPMorgan, which act as dealers for buyers and sellers. Swap prices and trade volume aren't publicly posted, so investors have to rely on bids and offers by banks.
Most of the traders are banks; hedge funds, which are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall; and insurance companies. Mutual and pension funds also buy and sell the swaps.
Proponents of CDSs say the devices have been successful because they allow banks to spread the risk of default and enable hedge funds to efficiently speculate on the creditworthiness of companies.
‘Seeing the Logic'
The market has grown so large so fast because swaps are often based on an index that includes the debt of scores of companies, says Robert Pickel, chief executive officer of the International Swaps and Derivatives Association.
‘‘Whether you're a hedge fund, bank or some other user, you're increasingly seeing the logic of using these instruments,'' Pickel says, adding he doesn't worry about counterparty risk because banks carefully monitor the strength of investors. ‘‘There have been a very limited number of disputes. The parties understand these products and know how to use them.''
Banks are the largest buyers and sellers of CDSs. New York- based JPMorgan trades the most, with swaps betting on future credit quality of $7.9 trillion in debt, according to the OCC. Citigroup Inc., also in New York, is second, with $3.2 trillion in CDSs.
Goldman Sachs Group Inc. and Morgan Stanley, two New York- based firms whose swap trading isn't tracked by the OCC because they're not commercial banks, are the largest swap counterparties, according to New York-based Fitch Ratings, which doesn't provide dollar amounts.
Untested Until Now
The credit-default-swap market has been untested until now because there's been a steady decline in global default rates in high-yield debt since 2002. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody's Investors Service.
Since then, defaults globally have dropped to 1.5 percent, as of March. The rating companies say the tide is turning on defaults.
Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002. On May 7, Moody's wrote that as the economy weakened, high-yield-debt defaults by companies worldwide would increase fourfold in one year to 6.1 percent by April 2009.
The pressure is building. On May 5, for example, Tropicana Entertainment LLC filed for bankruptcy after the casino owner defaulted on $1.32 billion in debt.
‘Complicate the Crisis'
A surge in corporate defaults may leave swap buyers scrambling, many unsuccessfully, to collect hundreds of billions of dollars from their counterparties, says Satyajit Das, a former Citigroup derivatives trader and author of ‘‘Credit Derivatives: CDOs & Structured Credit Products'' (Wiley Finance, 2005).
‘‘This is going to complicate the financial crisis,'' Das says. He expects numerous disputes and lawsuits, as protection buyers battle sellers over the technical definition of default - - this requires proving which bond or loan holders weren't paid -- and the amount of payments due.
‘‘It's going to become extremely messy,'' he says. ‘‘I'm really scared this is going to freeze up the financial system.''
Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, has researched counterparty risk and says it's only a matter of time before the sword begins falling. He says the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $35 billion in defaults.
$150 Billion Loss Estimate
‘‘That's a very conservative estimate,'' he says, adding that his study finds that losses resulting from hedge funds that can't pay their counterparties for defaults could exceed $150 billion.
Hedge funds have sold 31 percent of all CDS protection, according to a February 2007 report by Charlotte, North Carolina-based Bank of America Corp.
Cicione says banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That may not work, he says. Many of the funds won't have the cash to meet the banks' requests, he says.
Sellers of protection aren't required by law to set aside reserves in the CDS market. While banks ask protection sellers to put up some money when making the trade, there are no industry standards, Cicione says.
JPMorgan, in its annual report released in February, said it held $22 billion of credit swap counterparty risk not protected by collateral as of Dec. 31.
‘A Major Risk'
‘‘I think there's a major risk of counterparty default from hedge funds,'' Cicione says. ‘‘It's inconceivable that the Fed or any central bank will bail out the hedge funds. If you have a systemic crisis in the hedge fund industry, then of course their banks will take the hit.''
The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.
‘‘It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred,'' the report said. ‘‘It can be difficult even to quantify the amount of risk that has been transferred.''
Counterparty risk can become complicated in a hurry, Das says. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle, Das says.
‘Daisy Chain Vortex'
The original purpose of swaps -- to spread a bank's loan risk among a large group of companies -- may be circumvented, he says.
‘‘It creates a huge concentration of risk,'' Das says. ‘‘The risk keeps spinning around and around in this daisy chain like a vortex. There are only six to 10 dealers who sit in the middle of all this. I don't think the regulators have the information that they need to work that out.''
And traders, even the banks that serve as dealers, don't always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDSs, some far more complex than others.
More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company's debt or collateralized debt obligations.
A CDO is an opaque bundle of debt that can be filled with junk bonds, auto loans, credit card liabilities and home mortgages, including subprime debt. Some swaps are made up of even murkier bank inventions -- so-called synthetic CDOs, which are packages of credit-default swaps.
AIG $9.1 Billion Writedown
On May 8, American International Group Inc. wrote down $9.1 billion on the value of its CDS holdings. The world's largest insurer by assets sold credit protection on CDOs that declined in value. In 2007, New York-based AIG reported $11.5 billion in writedowns on CDO credit default swaps.
Michael Greenberger, director of trading and markets at the Commodity Futures Trading Commission from 1997 to 1999, says the Fed is fully aware of the risk banks and the global economy face if CDS holders can't cover their losses.
‘‘Oh, absolutely, there's no doubt about it,'' says Greenberger, who's now a professor at the University of Maryland School of Law in Baltimore. He says swaps were very much on the Fed's mind when Bear Stearns started sliding toward bankruptcy.
‘‘People who were relying on Bear for their own solvency would've started defaulting,'' he says. ‘‘That would've triggered a series of counterparty failures. It was a house of cards.''
It's concerns about that house of cards that have kept Backshall, the California fund adviser, up at night. His worries about a nightmare scenario started in early March. The details of what happened are still fresh in his mind.
It's Monday, March 10, and the market is rife with rumors that Bear Stearns will run out of cash. Some of Backshall's clients have pulled their accounts from Bear; others are considering leaving the bank. Backshall's clients are exposed to Bear in multiple ways: They keep their cash and other accounts at the firm, and they use the bank as their broker for trades. Backshall advises them to spread their assets among various banks.
That same day, Bear CEO Alan Schwartz says publicly, ‘‘There is absolutely no truth to the rumors of liquidity problems.''
Backshall's clients are suspicious. They see other hedge funds pulling their accounts from Bear. In the afternoon after Schwartz's remarks, the cost of protection soars past 600 basis points from 450 before Schwartz's statement.
CEO Didn't Calm Fears
Swaps are priced in basis points, or hundredths of a percentage point. At 600 basis points, a trader would pay $6,000 a year to insure $100,000 of Bear Stearns bonds.
‘‘I don't think his comments did anything to calm fears,'' Backshall says.
‘‘We have a good deal of comfort about the capital cushions at these firms at the moment,'' he says.
Cox's comments are overshadowed by rumors that European financial firms had stopped doing fixed-income trades with Bear, Backshall says.
‘‘Nobody has a clue what's going on,'' he says. Bear swap costs are gyrating between 540 and 665.
For most investors, just getting default-swap prices is a chore. Unlike stock prices, which are readily available because they trade on a public exchange, swap prices are hard to find. Traders looking up prices on the Internet or on private trading systems see information that is hours or days old.
Banks send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, Backshall says. For many investors, this system is a headache.
To find the price of a swap on Ford Motor Co. debt, for example, even sophisticated investors might have to search through all of their daily e-mails, he says.
‘‘It's terribly primitive,'' Backshall says. ‘‘The only way you and I could get a level of prices is searching for Ford in our inbox. This is no joke.''
In the past three years, at least two companies have developed software programs that automatically parse an investor's incoming messages, yank out CDS prices and build them into real-time price displays.
The charts show the highest bids and lowest offering prices for hundreds of swaps. Backshall tracks prices he gets from banks using the new software.
‘It's Very Hard'
Backshall has been talking with hedge fund managers in New York all week.
‘‘We'd quite frankly been warning them and giving them advice on how to hedge,'' he says of the Bear Stearns crisis and banks overall. ‘‘It's very hard to hedge the counterparty risk. These institutions are thinly capitalized in the best of times.''
The night of Thursday, March 13, Backshall can't sleep. He lies awake worrying about Bear and counterparty risk. The next morning, he arrives at work at 5 a.m., two and a half hours before sunrise.
Through the window of his ninth-floor corner office, he takes a moment to watch the distant flickers of light in the rolling foothills of Mount Diablo. Across the street, he sees the still-dark Walnut Creek train station, about 30 miles (48 kilometers) east of San Francisco.
Backshall, wearing jeans and a blue, button-down shirt, sits at his desk, staring at a pair of the 27-inch (68.6- centimeter) monitors that display swap costs. CDS prices jumped by more than 10-fold in just a year. The numbers show rising fear, he says.
Until early in 2007, the typical price of a credit-default swap tied to the debt of an investment bank like Merrill Lynch & Co., Bear Stearns or Morgan Stanley was 25 basis points.
‘Unknowns Are Out There'
If a swap buyer wanted to protect $10 million of assets in the event of a company default, the contract would cost about 0.25 percent of $10 million, or $25,000 a year for a five-year protection contract.
Backshall's screens tell him the cost of buying protection on Bear Stearns debt in the past 24 hours has been moving in a range between 680 and 755 basis points.
‘‘The unknowns are out there,'' Backshall says.
He advises his clients not to buy CDS protection on Bear because the price is too high and the time is wrong. It's too late to buy swaps now, he says.
At 9:13 Friday morning in New York, JPMorgan announces it will loan money to Bear using funds provided by the Federal Reserve. The JPMorgan statement doesn't say how much it will lend; it says it will ‘‘provide secured funding to Bear Stearns, as necessary.''
Bear CEO Schwartz says his firm's liquidity has ‘‘significantly deteriorated'' during the past 24 hours. Protection quotes drop immediately into the low 500s, as some dealers think a rescue has begun.
That doesn't last long.
‘‘Very quickly, the trading action is swinging violently wider,'' Backshall says. Bear's swap cost jumps to 850 basis points that afternoon, his screen shows. ‘‘When fear gets hold, fundamental analysis goes out the window,'' he says.
In the calmest of times, making reasoned decisions about swap prices is a challenge. Now, it's impossible. Traders don't have access to any company data more recent than Bear's February annual report. Sharp-eyed investors looking through that filing might have spotted a paragraph that's strangely prescient.
‘‘As a result of the global credit crises and the increasingly large numbers of credit defaults, there is a risk that counterparties could fail, shut down, file for bankruptcy or be unable to pay out contracts,'' Bear wrote.
‘Material Adverse Effect'
‘‘The failure of a significant number of counterparties or a counterparty that holds a significant amount of credit-default swaps could have a material adverse effect on the broader financial markets,'' the bank wrote.
Even after JPMorgan's Friday morning announcement, the market is alive with rumors. Backshall's clients tell him they've heard some investment banks have stopped accepting trades with Bear Stearns and some money market funds have reduced their short-term holdings of Bear-issued debt.
On Sunday, March 16, the Federal Reserve effectively lifts the sellers of Bear Stearns protection out of their misery. JPMorgan agrees to buy Bear for $2 a share.
While that's devastating news for Bear shareholders -- the stock had traded at $62.30 just a week earlier -- it's the best news imaginable for owners of Bear debt. That's because JPMorgan agreed to cover Bear's liabilities, with the Fed pledging $29 billion to cover Bear's loan obligations.
Turned to Dust
For traders who sold protection on Bear's debt, the bailout is a godsend. Faced with the prospect of having to hand over untold millions to their counterparties just three days earlier, they now have to pay out nothing.
For traders who bought protection swaps just a few days earlier -- when prices were in the 600s to 800s -- the Fed bailout is crushing. Their investments have turned to dust.
On Monday morning, the cost of default protection on Bear plunges to 280. Backshall sits back in his chair and for the first time in two weeks, he can breathe easier.
‘‘No wonder I look so tired all the time,'' he says, finally showing a bit of a smile.
When it bailed out Bear Stearns, the Federal Reserve effectively deputized JPMorgan to monitor the credit-default- swap market, says Edward Kane, a finance professor at Boston College. Because regulators don't know where the risks lie, they're helpless, Kane says.
Default swaps shift the risk from a company's credit to the possibility that a counterparty might fail, says Kane, who's a senior fellow at the Federal Deposit Insurance Corporation's Center for financial Research.
‘Off Balance Sheet'
‘‘You've really disguised traditional credit risk, pushed it off balance sheet to its counterparties,'' Kane says. ‘‘And this is not visible to the regulators.''
BNP analyst Cicione says regulators will be hard-pressed to prevent the next potential breakdown in the swaps market.
‘‘Apart from JPMorgan, there aren't many other banks out there capable of doing this,'' he says. ‘‘That's what's worrying us. If there were to be more Bear Stearnses, who would step in and give a helping hand? You can't expect the Fed to run a broker, so someone has to take on assets and obligations.''
Banks have a vested interest in keeping the swaps market opaque, says Das, the former Citigroup banker. As dealers, the banks see a high volume of transactions, giving them an edge over other buyers and sellers.
‘‘Dealers get higher profitability through lack of transparency,'' Das says. ‘‘Since customers don't necessarily know where the market is, you can charge them much wider margins.''
Banks Try to Hedge
Banks try to balance the protection they've sold with credit-default swaps they purchase from others, either on the same companies or indexes. They can also create synthetic CDOs, which are packages of credit-default swaps the banks sell to investors to get themselves protection.
The idea for the banks is to make a profit on each trade and avoid taking on the swap's risk.
‘‘Dealers are just like bookies,'' Kane says. ‘‘Bookies don't want to bet on games. Bookies just want to balance their books. That's why they're called bookies.''
The banks played the role of dealers in the CDO market as well, and the breakdown in that market holds lessons for what could go wrong with CDSs. The CDO market zoomed to $500 billion in sales in 2006, up fivefold from 2001.
Banks found a hungry market for CDOs because they offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating.
CDO Market Dried Up
By the middle of 2007, mortgage defaults in the U.S. began reaching record highs each month. Banks and other companies realized they were holding hundreds of billions in toxic debt. By August 2007, no one would buy CDOs. That newly devised debt market dried up in a matter of months.
In the past year, banks have written off $323 billion from debt, mostly from investments they created.
Now, if corporate defaults increase, as Moody's predicts, another market recently invented by banks -- credit-default swaps -- could come unstuck. Arturo Cifuentes, managing director of R.W. Pressprich & Co., a New York firm that trades derivatives, says he expects a rash of counterparty failures resulting in losses and lawsuits.
‘‘There's a high probability that many people who bought swap protection will wind up in court trying to get their payouts,'' he says. ‘‘If things are collapsing left and right, people will use any trick they can.''
Frank Partnoy, a former derivatives trader and now a securities law professor at the University of San Diego School of Law, says it's high time for the market to let in some sunshine.
‘‘There should be a centralized pricing service for credit-default swaps,'' he says. Companies should disclose their swaps holdings, he adds.
‘‘For example, a bank might disclose the nature of its lending exposure based on its use of credit-default swaps as a hedge,'' he says.
Last year, the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn't worked. It's been boycotted by banks, which prefer to continue their trading privately.
Leo Melamed, 76, chairman emeritus of Chicago Mercantile Exchange Holdings Inc., says there aren't any easy solutions.
‘‘Plus we're not sure the banks want us to be in this business because they do make a good deal of money, and we might narrow the spreads considerably,'' he says.
‘Central Clearing House'
For now and for some time in the future, CDSs will remain unregulated and their trades will be done in the secrecy of Wall Street's biggest securities firms. That means counterparty risk will stay out of the sight of the public and regulators.
‘‘In order for us to get away from worries about counterparty risk, in order for us to encourage more trading and more transparency, there's got to be some way to bring all the price data together with exchange trading or a central clearinghouse,'' Backshall says.
Until that happens, the sword of Damocles will remain poised to fall, as banks, hedge funds and insurance companies can only guess whether their trillions of dollars in swaps are covered by anything other than darkness.