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Unwrapping Financial Derivatives: A Minyanville Primer on CDS and Wrapped Securities

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The $500 trillion market for financial derivatives may in fact be "too big to fail."

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With financial insurers Ambac Financial (ABK) and MBIA (MBI) following ACA Financial into the abyss of insolvency, obscure financial instruments are again becoming part of mainstream lexicon. In 2008 we may be adding "CDS" to our vernacular and "wrapping" may cease to be something we only do in December.

Credit Default Swaps, or CDS, offer financial firms a quick way to offload part or all their exposure to debt backed by state and municipal governments, corporations, or structured debt tied to consumer loans. 'Wrapping' is a technique securities underwriters use to increase the credit ratings of lower rated debt to make it easier to sell to investors.

A CDS is an agreement in which two parties agree to trade, or 'swap' risk for a default event that may happen in the future. Lets say for example, The Bank of Boo owns corporate debt issued by Daisy's Department Store.



If Daisy has a strong balance sheet, good cash flows and a long track record of making her debt payments, credit ratings agencies such as Moody's (MCO) and Standard and Poor's are likely to rate her debt well, making her bonds available for purchase by a wide range of financial institutions, including the Bank of Boo.

Boo's primary risk is that Daisy falls on hard times and stops making her interest payments. Credit ratings help Boo determine the chances of this. A higher rating indicates lower risk, and therefore a lower potential return. Conversely, Boo can make a higher return for buying lower rated pieces of Daisy's debt that are the first to go sour if she has financial troubles.

Enter the CDS.

If Boo lends Daisy $1,000,000 at 5%, he earns $50,000 per year in interest plus a repayment of principal over the life of the loan. To protect this investment, Boo may buy a Credit Default Swap from Sammy's Structured Products, a financial insurer setting up shop in Minyanland. The CDS contract stipulates that Boo pays Sammy a fee, while Sammy is obligated to step in and make Boo whole if Daisy is unable to make her payments.

CDS contracts are priced in basis points, or hundredths of percentage points. So, Boo may pay 100 basis points, or 1% of the notional value of the loan for his credit protection. Although this insurance reduces Boo's potential income by $10,000 per, in the event Daisy defaults, Sammy is obligated to pay up and make sure Boo doesn't lose his investment.

CDS contracts can be written for any type of debt product and have recently been used as speculative tools rather than simply as credit protection.

Suppose a news story comes out that Daisy is being investigated for unsavory business practices and her future profitability becomes questionable.

If Hoofy's Hedge Fund owns the same bonds Boo does and goes to Sammy to buy a CDS contract for protection, the now higher risk of default means Sammy will charge a higher fee, say, 200 basis points for the same CDS he sold Boo for 100 basis points. If Boo believed Daisy were still a good credit, he could turn around and sell his CDS for twice what he paid for it.

In the market for securities backed by subprime mortgages, CDS protection for owners of the riskiest tranches of debt has skyrocketed in value. Since the height of the subprime lending boom in the middle of the 2006, the cost of CDS protection on BBB rated subprime mortgage backed securities has risen by over 2000%.

It is easy to see how investors such as John Paulson won big with short-side bets in this market. And since CDS prices move in the opposite direction as the value of the bonds they protect, it is also easy to see how financial firms like Merrill Lynch (MER) have seen the value of mortgage backed securities portfolios plummet.

The real fear now is 'counter-party risk.' If Ambac or MBI fails and cannot live up to its obligations under various CDS contracts, the lack of oversight and fragmented mechanics of the CDS market make an orderly unwind extremely difficult. If it becomes clear that CDS contracts cannot be unwound, it may undermine the entire market.

CDS contracts issued against corporate debt are rising in value (becoming riskier) as the looming recession pushes up fears that companies will have trouble making their debt payments. And while many point to the strength of corporate balance sheets and large cash reserves as a cushion against economic weakness, money markets and other traditionally secure forms of low risk investments are coming under pressure as the financial market continues to wobble.

"Wrapping," although not as sizable a risk to the markets as CDS is key to understanding the proliferation of structured financial products in the last five years. Similar to Credit Default Swaps, wrapping allows financial insurers to protect debt investors from default.

An asset-backed security is divided into slices, or "tranches" depending on the order in which losses are allocated if a large number of the underlying loans stop making payments. The lower rates (and thus higher yielding) bonds absorb the first losses, protecting the higher rated (and thus lower yielding) pieces. This structure allows big securities underwriters like Bear Stearns (BSC) and Lehman Brothers (LEH) to offer up various tranches to investors with different risk tolerances.

One way in which underwriters entice investors to buy lower rated bonds is by having them 'wrapped' by financial insurers like Ambac and MBIA. Insurers take on the first chunk of potential losses a bond may take, effectively increasing its credit rating. Underwriters pay the insurer a fee to protect the risky bonds, but this credit enhancement allows them to more easily market and sell the riskiest pieces of a security to investors.

Underwriters can no longer wrap low-rated securities because investors no longer trust the insurers whose protection boost the credit ratings, nor do they trust the ratings themselves. While much of the dislocation in the mortgage securities market is due to concerns over increased delinquencies and falling home prices, some of the fundamental dynamics in the market for securitizing assets of all kinds no longer function.

In the coming months, it is likely that we will find out more about how the arcane market for structured debt works, as a $500 trillion market for financial derivatives may in fact be "too big to fail."
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