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"Frankenstien's Monster"

[sorry, that should be "Frankenstein's."]

Swaps Tied to Losses Became `Frankenstein's Monster' (Update1)

By Neil Unmack and Sarah Mulholland

April 15 (Bloomberg) -- The credit-default swap market has become a lesson in being careful what you wish for now that Wall Street has taken $245 billion of losses partly tied to such exotica.

Rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the contracts have exacerbated the debt crisis. What was intended as a way for lenders to protect against defaults spawned a market covering $45 trillion of bonds and loans where no one knows how much is traded and speculators who bet on deteriorating credit quality end up forcing that reality.

Some credit-default indexes have morphed into what Wachovia Corp. analysts led by Glenn Schultz call ``Frankenstein's monster'' because they now often drive prices in the so-called cash bond market, rather than the other way around. Fearing a repeat of losses, banks are refusing to support new indexes that would allow investors to wager on everything from auto loans to European mortgages, reining in a market that's about doubled in size every year for the past decade.

``The indices are just trading on their own account with no relationship whatsoever to an underlying cash market that's ceased to exist,'' Jacques Aigrain, chief executive officer of Zurich-based Swiss Reinsurance Co., said at a March 18 insurance conference in Dubai.
Lack of Support

Markit Group Ltd., the London-based index provider, said banks last month shelved plans for indexes intended to allow investors to speculate on the $200 billion market for bonds backed by U.S. auto loans because of a lack of dealer support. Indexes on European mortgages and U.S. Alt-A loans, or mortgages made to borrowers a step above subprime, were also postponed.

``The last thing the securitization market needs is another no-cash-upfront instrument that people can use to knock the markets about with,'' said Andrew Dennis, the London-based head of the asset-backed debt syndication group for UBS AG of Zurich.

Wachovia, based in Charlotte, North Carolina, wrote down $600 million of commercial mortgages in January because of declines in prices indicated by CMBX indexes, which measure the derivatives tied to bonds backed by loans on everything from offices to shopping malls. New York-based Citigroup Inc., the largest U.S. bank by assets, wrote down its subprime holdings by $18.1 billion after using ABX credit-default swap indexes that track securities derived from the loans to help value the assets.

`Vicious Cycle'

Accounting rules require companies to estimate a value for some assets that are seldom traded and to record any change as an unrealized gain or loss. Where quoted prices aren't available, companies are required to use other measures, such as indexes of credit-default swaps.

``The dealers got caught in a vicious cycle,'' said Schultz, head of asset-backed bond research at Wachovia. ``They did a great job of selling the indexes. At the end of the day, they had to mark their own books to the prices on the indexes. They fell victim to their own sales job.''

Investors, traders and bankers start gathering today in Vienna for the International Swaps and Derivatives Association conference's annual meeting.

The damage on Wall Street has been exacerbated by the ABX indexes, which are based on a sample of 20 bonds from the thousands backed by home loans to Americans with poor credit. The ABX is the main benchmark that prompted banks and securities firms to write down the value of collateral provided by mortgage companies in exchange for financing.

`Totally Uncorrelated'

The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz, almost four times the 13.75 percent rate predicted by Wachovia.

The cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, more than four times the 2.8 percent forecast in the event of a recession by JPMorgan Chase & Co. analyst Alan Todd in New York.

``ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,'' Swiss Re's Aigrain said at the Dubai conference.

`Greater Transparency'

The market for credit-default swaps was created in 1994 by banks led by JPMorgan to protect against the risk of lenders and companies defaulting. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements, or provide compensation if asset-backed debt fails to make scheduled payments.

Markit, which is partly owned by 16 banks from Citigroup to UBS, said its indexes should be used as a tool to gauge the direction of credit markets, not necessarily to value the underlying assets.

``The ABX index has brought greater transparency to the market,'' said Kevin Gould, head of data products and analytics at Markit in New York. ``Without it there would have been a number of market participants that would not have been aware of the levels of distress some of their assets were under.''

Markit doesn't have data on the amount of trading based on its indexes because the transactions happen outside of exchanges, or over-the-counter, the company said in an e-mailed statement.

`Enhanced Resilience'

Greenspan told a banking conference sponsored by the Chicago Fed in Washington on May 8, 2003, that ``the use of a growing array of derivatives and the related application of more sophisticated methods for measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial intermediaries.''

A decade after its creation the market shows little resemblance to its beginnings as investors
and traders use credit derivatives as an alternative to buying bonds. While ISDA estimates that there are contracts tied to $45 trillion of debt, Lehman Brothers Holdings Inc. estimates that there is only about $43 trillion of debt outstanding.

Banks grouped hundreds of corporate bond issuers in indexes, and in 2006 began to create benchmarks on everything from subprime mortgages to leveraged, or high-yield, high-risk, loans. Some contracts were packaged into securities known as collateralized debt obligations.

The Commercial Mortgage Securities Association, an industry body whose more than 470 members include banks, pension funds and real-estate owners, wrote an open letter to Markit this month asking for details on the amount of trading on the CMBX to help gauge how useful its prices are for valuing mortgage securities.

``In a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals,'' wrote Dottie Cunningham, chief executive officer of the New York-based CMSA.
``ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,'' Swiss Re's Aigrain said at the Dubai conference.

I don't think this should be taken to mean the indexes are irrelevant or unreliable. In fact, in the absence of any cohesive value indications on the securities themselves, these indexes are probably providing the most meaninful information there is. As a matter of fact, given the usefulness of anonymous markets in predicting or indicating trends, it would seem that people ought to be paying very close attention to the disparity between default rates as indicated by the indexes and those offered up by an investment bank's research department or industry concensus.

Remember to try to separate fact from opinion.

Conspicuously absent is the obvious logical connection between accounting rules and writeoffs leading to losses. It's hinted at but never explictly made. Not missing, however, is the requisite implicit blame on Alan Greenspan for failing to be omniscient.
Excellent article. Gives accurate snapshot of what is going on out there.
As for the comment about the index and the underlying market are uncorrelated, it bears some truth. People coming to work have been saying the correlation level is out of whack for the past few weeks. People also notice how misplaced everything is now. Good opportunity to take some big bold moves but people seem to just sit tight and wait it out.

For credit derivatives news, creditflux.com is a good source.
thx for the link.

What I was trying to say below is that perhaps the indexes are handicapping default probabilities (like Intrade handicaps elections), even if that isn't what indexes are designed to do. Do you think that is plausible?


This ( Index tranches ) was a very helpful entry along with the discussion of implied correlation.

I would gather the issue expressed in the article is that index tranche prices are implying higher correlation and therefore higher default rates than currently expected by other more fundamental analysis. Sound right?