So, when you ask the question - "How about separating the risks from the instrument [the bond], and forfeiting a part of the interest received by the bond, and paying that as an "insurance premium" to the bond insurer. Well, this has been going on for a while - especially in the municipal bond industry. So far, so good.
'http://mycrains.crainsnewyork.com/40under40/profiles/2004/228' Ms. Masters</a> took this to the next logical step. What if you could "bet" on whether a financial entity will default on their debt [or not]? This "bet" is what a CDS is...... a CDS is a contract between a buyer - who makes periodic payments to the seller. If the financial entity defaults on their bonds, or if the entity's financial health changes significantly, the buyer of the CDS gets paid the face value minus the market value of the financial entity's bond.
You (Bond Guru Inc.) were long a Lehman Brothers' CDS, and were probably paying a healthy quarterly premium to the seller (Default Newbie Inc.) of the CDS. When Lehman filed for bankruptcy, this created a <a href="http://en.wikipedia.org/wiki/Credit_event">credit event</a>. When the <a href="http://www.bapcha.com/?p=182">Lehman bonds were finally auctioned off</a>, they settled for 8.625% - or 8.625cents per dollar. In this case, Bond Guru Inc. - who were long Lehman's CDS, was obliged to get ($1.000 - $0.08625) = $0.91375 per dollar (from Default Newbie Inc.). The converse is true too. If Lehman's financial health improved [instead of deteriorating], Bond Guru Inc. could stop paying the premiums, and Default Newbie Inc. keeps all the money that they had collected in premiums. Alternately, Bond Guru could buy a "cheaper" CDS - where the premiums are lower.
Congratulations Bond Guru Inc.! You did great with the Lehman CDS's. But, Default Newbie Inc. allocated [set aside for default] a half a cent per dollar of bond value of the CDS that he sold to you [for which you dutifully paid your premiums]. So, BG Inc. will receive 0.005 + 0.08625 = 0.09125 cents per dollar. Plus, Default Newbie Inc. will be in bankruptcy [liquidation].
The CDS market
Is $55,000,000,000,000.00 strong. So, everyone wants a piece of it. The players are:
While The Knight/Trimark group has already launched their CDS platform NetDelta; the ICE has a formidable record of bringing scalable products on-line in record time. In fact, the ICE's dominance of the West Texas Crude Intermediate [WTI] blind-sided the CME, an CME's stranglehold on the energy market/energy futures. Both the CME and ICE will dominate the market, but the NYSE, Nasdaq and Knight/Trimark aren't exactly spring chicken. They know this business too, and know how to make money with the slimmest of margins.
1. There are two possible models for a CDE exchange. Once is the OTC model - where the exchange provides a medium to transact the business. The second model is the one of a central counter-party [the ICE/CME model] - where in either party's default, the exchange makes the parties "whole".
2. Since the numbers involved here are huge, and as we have found from the collapse of the banking system; mere capital requirements are insufficient to guarantee a functioning CDS market - where all defaults can be cured.
3. The CDS market is not [yet] regulated. Hence, there is little if any in margin requirements. Even 1% in margin equates to 550 Billion dollars. Capital that CDS sellers [insurers] like Default Newbie Inc. above cannot afford to lock up in these times [or other].
4. Neither can a central counter-party unconditionally guarantee the proper execution and clearing and in the case of default/credit event - the "making whole" of the party that purchased and paid the premiums for the CDS.
In other words, as we saw recently [during the Lehman Credit Event] - the default of one huge entity can wipe out a half a trillion dollars of equity. In other words, none of the five companies mentioned above can cure [the default of] their trading clients in the event of a default similar in size to the Lehman debacle.
In Part-II of this article, I will discuss which of these five companies are a worthy investment, and why.
Disclosures: No positions on all stocks mentioned in this article.
All right then, I gave it away in the title of the article. My favorite investment in the CDS market to be is the Intercontinental Exchange. Founded in the year 2000 in Atlanta, the ICE pioneered the market for WTI Crude [West Texas Intermediate Crude]. Most of this commodity is from smaller wells in Texas and Oklahoma. Plus, the ICE recently has benefited from the surge in sugar and coffee prices [and hence traders were buying/selling these contracts to hedge their volatile positions].
Anyway the ICE has benefited from providing liquidity in the commodity market - and their purchase of the NYBOT was accretive to earnings from an early stage [from the get-go in fact]. Some analysts have recently downgraded the ICE and reduced earnings estimates by a little. But, more significantly, on June 3, 2008, the Company entered into a definitive merger agreement to acquire Creditex Group, Inc. (“Creditex”) for a combination of stock and cash. Creditex is a market leader and innovator in the execution and processing of credit default swaps (“CDS”) with markets spanning the U.S., Europe and Asia. Creditex is a leader in the most liquid segments of the CDS market, including indexes, single-names and standardized tranches. The transaction consideration will total approximately $625 million, comprising approximately $565 million in the Company’s common stock and $60 million in cash, as well as a working capital adjustment to be finalized after the closing of the transaction. Upon the closing of the transaction, estimated to occur in the third quarter of 2008, Creditex will be a wholly-owned subsidiary of the Company. The transaction has received FSA approval, as well as early termination of the applicable Hart-Scott-Rodino waiting period, but remains subject to U.S. Financial Industry Regulatory Authority approval1.
Creditex and their subsidiary Markit were the outfits that recently liquidated Fannie-Mae’s, Freddie Mac’s and Lehman Brothers’ Credit Default Swaps - making the ICE the clear leader for now. Prior to the merger with the ICE, Creditex/Markit agreed to be the platform for trading CDS’s on the NYSE - increasing the opportunity for ICE to grab market share from the other players vying for a piece of the CDS market - viz. the CME/Nymex (CME), Knight/Trimark Group NITE, The NYSE/Euronext NYSE, and the Nasdaq/OMX Group NDAQ.
My pick #2 is the CME/Nymex Group - for their sheer size, experience in bringing to life new markets, and for ensuring liquidity. CME has teamed up with the Citadel Group. I am picking the ICE ahead of the CME - for the simple reason that the ICE is hungrier, and made the first move by buying up Creditex/Markit.
Pick #3 is the NYSE/Euronext. The reason I picked them at #3 is because of their existing relationship with Creditex/Markit.
My pick #4 is the Nasdaq/OMX group AND the Knight/Trimark Group. Both companies want to use an OTC platform to trade CDS’s - which I think will be the weakest product in a market - where deals are driven by inside information, or a very deep understanding of the ability of a specific issuer of a debt instrument - to default on a loan. The basics of CDS’s and what is important in the inception of a trading market/platform were discussed in Part I.
Since all five of these stocks have been beaten down in recent months, I think that all of them [except the Knight/Trimark Group] offer adequate double digit per year [annualized] capital gains looking forward three to five years, but my #1 pick is the ICE - with the caveat that the stock will probably be weak in the months ahead - due to the tanking of commodity prices - which will put pressure on the amount of contracts traded on ICE’s platform. Meanwhile the biggest driver of CME’s and ICE’s stock in the next few months - will center around the inception of and the beginning of trading of CDS’s. I expect ICE to be the first to market [they (Markit) already were responsible for the liquidation of FNM, FRE and LEH's CDS's].
There are significant issues that need to be solved - regarding margin and equity requirements for traders, and the central counter-party model suggested by both the ICE and the CME [I think] will rule at least in round #1 of CDS trading, as the market is filled with distrust. Plus, the four issues outlined in Part I are yet to be solved. Re-hashing the issues, they are:
a. What kind of market ? Central counter-party or OTC ?
b. Can all defaults be cured by margin/equity requirements ? Will these kill the CDS market - or add liquidity by adding transparency ?
c. How much will the margin requirements be ? How can they be enforced ?
1. The italicized paragraph was derived from research into an SEC filing by the ICE. The clearances mentioned in the 10Q are now through [as the federal filing is a quarter old].
2. No positions in all stocks mentioned above [yet].
3. I will discuss earnings, valuation and other traditional valuation [of ICE and CME] in a subsequent article.