'Heads We Win, Tails We Rescind'

There are a number of so-called experts -- some of them are bloggers for established mainstream media sites -- who've long been arguing that worries over derivatives are overblown -- the product of an overactive imagination.

In their view, even though the "notional" or face value of outstanding obligations is extraordinarily large, the "net" exposure is substantially less. That is because many of these over-the-counter contracts can supposedly be offset against one another, or reflect contingencies related to future cash flows rather than the underlying principal amounts.

While that is true in general terms, those views don't really take counterparty (and, to a lesser extent, operational) risks into account. These include the fact that firms that are on one side of a trade may not have the wherewithal (or even be in business) when it comes time to honor those commitments. Or they may decide to use every trick in the book (e.g., the legal system) to disavow those commitments, as a matter of survival or out of pure greed.

Making matters worse, of course, is the fact that these contracts are not standardized (though organizations like the ISDA have tried to tackle this issue) and, like many legal agreements, they have mistakes, omissions, or ambiguities that can cause lawyers to lick their chops in anticipation.

Under the circumstances, many counterparties who've taken on exposure in the credit default swap and other OTC derivatives markets are poised to learn the hard way -- and, most likely, at the very worst time -- that they are not positioned or "hedged" like they thought they were.

The result? A panicky scramble and even greater chaos than we've seen lately as more firms invariably end up in the same sticky mess as Bear Stearns did.

In "FGIC Sees No Need to Honor Agreement With IKB, Calyon" Bloomberg gives us a taste of things to come.

FGIC Corp. said it's walking away from an agreement to provide $1.9 billion in guarantees on mortgage-linked securities because Credit Agricole SA and IKB Deutsche Industriebank didn't live up to their side of the deal.

FGIC "has no further obligation" because certain responsibilities weren't met and IKB, the German bank that's had to be bailed out four times since July, misrepresented its condition, the insurer said in a statement today. The three companies are fighting the matter in courts. If FGIC wins, the benefit "could be material," the New York-based company said.

Bond insurers are seeking ways to relieve themselves of guarantees on collateralized debt obligations to temper their losses amid surging mortgage defaults. Security Capital Assurance Ltd.'s XL Capital Assurance Inc. last week was sued by Merrill Lynch & Co. after XL voided obligations on $3.1 billion of CDOs because of what it called a breach in agreements over rights to influence matters such as whether the CDOs should be liquidated.

"These guys should have a new motto: Heads we win, tails we rescind," said Julian Mann, the vice president for fixed income at First Pacific Advisors LLC, which manages $3.4 billion of bonds. Mann doesn't oversee positions in bond insurers, he said.

The contracts involved in FGIC's dispute include those that accounted for 75 percent of its loss reserves at the end of 2007, the company said. Fitch Ratings, which today lowered the company's insurance units to BBB from AA, said potential losses account for a "material percentage" of what it's projecting for FGIC, and that the tussle may take "several years" to settle.

Bank Losses

FGIC, the bond insurer owned by Blackstone Group LP and PMI Group Inc., named Credit Agricole's Calyon Credit Agricole CIB in a related lawsuit filed March 12 in New York Supreme Court. Caylon started court proceedings in the U.K. on March 17 seeking to enforce the contracts, FGIC said.

Joerg Chittka, a spokesman for Dusseldorf-based IKB, Anne Robert, a spokeswoman for Paris-based Credit Agricole, and Seth Faison, a spokesman for FGIC, declined to comment.

CDOs, which repackage mortgage bonds, buyout loans and other assets into new securities with varying risks, have been the biggest source of the more than $208 billion of writedowns and credit losses reported by the world's largest banks and securities firms since the beginning of last year. Credit Agricole's total $6.5 billion, while IKB's are $9 billion.

"Legal technicalities" may be a big factor as losses are divvied up, JPMorgan Chase & Co. CDO analysts including Chris Flanagan and Kedran Garrison Panageas wrote in a March 24 report.

Risk Management

The disputed FGIC transaction was part of a series of deals in which Caylon agreed to buy CDOs from IKB's off-balance-sheet Rhineland fund if requested, with both FGIC and IKB providing credit guarantees if that happened, according to FGIC's complaint. The deal followed a similar arrangement involving IKB, Ambac Financial Group Inc. and a "European bank," it said.

Bond insurers including FGIC and SCA were stripped of their AAA grades by ratings companies because of expectations for increasing losses on the more than $100 billion of mortgage-tied CDOs on which they provide default protection. Others including New York-based Ambac have been forced to raise capital to maintain top rankings. FGIC earlier this month reported a $1.89 billion fourth-quarter net loss.

IKB, forced into seeking emergency aid after Rhineland couldn't raise money because of its holdings of CDOs tied to U.S. homeowners with poor credit, has received assistance totaling 9 billion euros ($14.1 billion). KfW Group, the state- owned development bank that controls IKB, has provided some.

`Developing Problems'

IKB officials at a January 2007 conference in Las Vegas assured FGIC officials that their bank was the "top of the class" in the market for asset-backed commercial-paper conduits such as Rhineland, the insurer's complaint says. Such conduits rely on sales of short-term debt, with a sponsor such as IKB promising to buy out holders of the commercial paper who want to turn in the debt if cash isn't otherwise available.

A closing dinner in Dusseldorf for the transaction involving the Havenrock II vehicle set up by IKB to be the middleman for potential risk-sharing occurred on July 25, "just three days before IKB announced its financial collapse," the complaint said. IKB officials downplayed "developing problems," it said.

Lower Ratings

New York-based Blackstone, manager of the world's largest buyout fund, has written down its FGIC investment to "a few cents on the dollar," President Tony James said March 10. Walnut Creek, California-based PMI, the second-largest U.S. mortgage insurer, reported a $776.1 million expense related to FGIC last quarter. General Electric Co. sold most of FGIC in 2003 for $2.2 billion. Cypress Group and CIVC Partners LP also took stakes.

New York-based Fitch today also downgraded Hamilton, Bermuda-based SCA's insurance units to BB, or six levels below investment grade, from A. The dispute with Merrill also may prove important, it said.

"While Fitch is not in a position to opine on the validity or merits of the termination, Fitch notes that a ruling in SCA's favor could have meaningful positive impact on the company's capital position and credit ratings in the future," the firm said in a statement, echoing language in its FGIC release.

Fitch cut the units of SCA and FGIC in January from AAA ratings in January. Moody's Investors Service and Standard & Poor's later did the same for both companies.

Comments

[steven]

I am somewhat lost on some of the points you seem to be making, and perhaps you can help me clarify them.

1)How is the Master Agreement that is used by the ISDA not a standardized contract? While it leaves open certain aspects of the contract that are fact specific to the future deals, the basic tenants are established and is binding and controls all future dealings that transgresses with the two parties As for the idea that one contract could be made that would and could deal with all the complexities of a contractual nature such is confusing to me… With the master agreement, all transactions between the two parties are allowed the exposures to be netted against one another, since the master agreement treats all subsequent contracts that are made with the parties as one binding agreement. This will help reduce your exposure to that specific counter-party, and especially in situations where the parties are engaged in numerous transactions that are different in nature but fall under the same agreement, “currency swaps, interest rate swaps, etc.” This along with the close out provisions that allows the cancellation on all future obligations of these positions help mitigate loses.

I cannot imagine a contract that is fluid enough to capture this, that and each subsequent agreement that the parties would reach would require subsequent contractual formation, and lack interdependence. Therefore failure in one is not grounds for cancellation of other subsequent ones.

2) As for the concern over the counter party, I am not sure why you failed to consider the collateral position most are obligated to post, or the right to the actual underlying asset that you are defaulting swapping against? I am not denying that failure of counter parties could lead to losses, but this would mitigate the aggregate amount of losses in most situations. The obvious downside would be the underlying company fails and their bond recovery is limited, and the counter party is connected and therefore fails along side them. Yet if you decide to take a hedging position against an Italian banks bond with that of another Italian bank, than obviously your reckless actions would cause any one to lose money. There is also the fear the credit even will happen prior to the daily margin posting, or a situation in which fear among the participants over the credit worthiness of the counterparty acts as a “Stag hunt” and sub-sequent closing out of your positions whether or not they are in the money would place a burden upon their available liquidity and push a rumor into the realm of reality.
In the end, while I am in no way denying that there is some risk it is difficult to ascertain to what extent any losses or exposure would be in these situations. From this I do not understand why use the total aggregate of swap contracts as a baseline for losses that might arise?

3) As for the article, I am not seeing it’s connection to the CDS market, so I was hoping you could elaborate. I was under the impression that the contractual relationships that the mono-line insurance companies enter are significantly different than those of simple swaps. Taken from MBIA testimony

“MBIA has a rigorous process for determining the amount of credit losses in our portfolio of financial guaranty policies and our CDS contracts (it must be remembered that our CDS have the character of financial guaranty insurance policies, not tradable CDS as transacted by most market participants)…It is important to note that MBIA’s obligation to pay claims on an insured issue is almost exclusively on an “as due” basis. Essentially this means that upon a default of an insured issue MBIA will pay principal and interest to the holder according the original schedule. Thus in the case of a 30-year bond, MBIA would be obligated to pay the principal and interest over the full 30-year life of the bond, and would not be required to pay off the full outstanding balance at the time it defaults. This is an important feature in all of MBIA’s insured exposures. It is designed to minimize liquidity exposure and prevent a “run on the bank. An insurer's exposure under an insurance policy or a credit default swap is virtually identical. Under either form there are no requirements to post collateral, nor any requirements or rights to accelerate payment against MBIA.”
www.mbia.com/investor/publications/MBIATestimony_02142008.pdf

You have to admit, this is significantly different than a CDS where liquidation or close out of the position is available upon credit default

That and monoline are attached to a conduit which provides mechanisms to further protect or at least mitigate the exposure to losses that arise from the defaulting underlying assets. Cashflow triggers and diversion mechanisms that provide some degree of protection for their positions is enough to question if a comparison between the two are called for.

I will thank you in advance for your consideration in this matter

[Richard]

ISDA's master agreements are primarily for plain vanilla currency or interest rate swaps. While these are OTC products, they are the most standardized. These master agreements are not applicable to credit default swaps or the various CDO's.

[Sackerson]

I guess the smart lawyers will want cash up front - or accept chickens and other goods in kind?