The Debts of the Spenders: Basic CDS Legal Definitions and Case Law

Credit default swap (CDS) rulemaking remains wrapped in a byzantine array of arbitration and legal settlements. As such, case law is scant and federal regulatory reform even less so. This legal mine field is behind much of the push for a single national or several, competing regional CDS exchange(s). Regulators believe that the introduction of exchanges will bring much needed oversight and transparency to the process.

For non-CDS traders, the closest conceptual comparison are that CDS instruments are like futures and/or options contracts - except when they're not.

Instead of having standardized delivery and settlement procedures, CDS instruments function as bilateral contracts w/nominal industry supervision. A "self-regulating" industry group, ISDA (International Swaps and Derivatives Association) is nominally in charge of overseeing all disputes. However, as events last year demonstrated, they have little power to compel uniformity or performance among market participants.

Generally, a single master agreement governs the relations between the parties to a CDS. From here, individual swaps, confirmations, and other changes branch off from the main body or "tree."

The master agreement will also specify the terms of the CDS contract such as the identities of the "reference entity", "reference obligation", payment triggers, coverage period, settlement procedures, margin requirements, and notice requirements.

Unlike futures contracts, NONE of these terms is standardized by an exchange (although there is some general language that remains the same). The terms can - and are - in flux.

Reference entity refers to the specified debtor and is typically a company or nation. Reference obligations specify the particular debt that is covered - which infamously includes tranches of debt such as CDOs or MBS.

While parties can generally agree on whether a SINGLE entity defaults, confusion reigns when ONE entity among a multitude of entities defaults (such as in a tranche type situation). Has the entire tranche lost its worth when only one issue has defaulted? What about the % of that issue in relation to the entire tranche? What about the relation of that tranche to the same sector? What about the relation of that sector to other neighboring sectors? And so it goes. There were instances when the underlying assets in the tranche were marked to zero. And there were others, when the underlying assets were marked at par value. The truth is somewhere in between.

The MOST critical - and litigated - issue is the margin requirement. This is the cost that a seller must provide to insure that the buyer is able to take full delivery of his purchase should the contract move "in the money" by the settlement date. Like futures and options sellers, the CDS seller does NOT necessarily have to pay out the cost of the entire contract (b/c the contract can move back "out of the money" again) by the settlement date.

But if the OVERALL margin requirement increases - or the NUMBER of scheduled margin payments increase (which both depend on the specific clauses in the contract), then they can represent a crippling blow to the cash flow of a CDS seller. If the CDS seller is an insurance company, consumer bank, or other financial body that is required by state or federal law to have OTHER margin requirements, then the cash flow problem becomes even more crippling. All of a sudden, there is a need for the CDS sellers to liquidate assets at will in order to meet their other obligatory margin requirements.

In 2008, the CDS sellers wrote naked options w/no regulatory oversight from the CFTC or SEC to check their actions. In fact, mounting evidence shows that federal regulators who knew of these problems decided to abandon their duties and instead capitalize by making calculated bets that exacerbated the problem (Ahem...Henry Paulson).

So, what has changed between then and now? Quantitative easing and FASB rule relaxations for fair value. Financial institutions can once again mark the value of their collateral to mythical standards. Regardless of the deteriorating fundamentals.

I don't have time to provide full coverage of the following cases. It is also doubtful whether this information would be of much use to market skeptics and retail traders (the intended audience of this web site).

VCG v. Citibank N.A.
2008 WL 4809078

Aon Financial Products v. Societe Generale
476 F.3d 90 (2nd Cir. 2007)

Deutsche Bank v. Ambac Credit Products, LLC
WL 1867497 (S.D.N.Y. 2006)

www.abanet.org
www.isdadocs.org
www.nycbar.org/index.htm

The Debts of the Spenders: Overnight Fed Loan Hits 7% While FDIC Closes 6 IL Banks

Karl Denniger of Market Ticker first pointed out the alarming 7% overnight loan made at the Fed discount window early Thursday morning.

When the Discount Rate is 0.5% and you pay 7% there is only one reason: Whatever you have won't qual for the discount window. And since they will take goddamn near anything, it means YOU ARE ****ED.

http://market-ticker.org/archives/1177-BOOM!-More-Obfuscation.html

For the actual Fed loan:

http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

MEANWHILE.... the FDIC closed 7 banks on Thursday - 6 of them in Illinois. The Chicago Tribune recently reported that ALL 6 of the IL banks belong to the SAME company: the Campbell Group.

Moreover, the FDIC explicitly stated that the root cause of the IL banking failures was primarily on losses stemming from CDOs.

Hmmm, coincidence?

Founders Bank had gone on a search to try to raise about $50 million in capital after suffering securities losses in the first quarter and falling to an "undercapitalized" status.

The failure of the Campbell family's bank resulted primarily from losses on investments in risky instruments known as collateralized debt obligations and other loan losses, the FDIC said.

http://www.chicagotribune.com/business/chi-fri-failed-banks-0703-jul03%2C0%2C3186096.story

The Debts of the Spenders: Falling Food Prices Are Further Proof of Deflation

Inflation bugs love to tote rising energy and food prices as 2 items that stick out from the US government's reports on inflation. That was true at this time last year. However, falling food prices indicate that their argument has not kept up w/the times. Food prices at the retail level have fallen for 3 straight quarters - or roughly ever since Lehman Brothers imploded last September. Energy prices have also fallen since the 2008 high of crude $145/barrel.

US Food Prices Trend Lower For Third Consecutive Quarter-AFBF

Retail prices for food products at U.S. supermarkets declined slightly for a third consecutive quarter, according to the latest American Farm Bureau Federation Market basket Survey conducted in May.

The AFBF’s informal survey showed the total cost of 16 food items that can be used to prepare a meal was $46.29, down about $1.12, or 2%, from the first quarter of 2009. Of the 16 items surveyed, 10 decreased, five increased and one remained the same in average price compared
with the prior quarter.

Items whose prices declined the most included Russet potatoes, boneless chicken breasts, eggs, sliced deli ham and whole milk, and these accounted for most of the decrease in the average price of the overall marketbasket. Also lower in price were ground chuck, down 12 cents; sirloin
tip roast, down 11 cents; flour, down 9 cents for a five-pound bag; bacon, down 7 cents per pound; and toasted oat cereal, down 5 cents for a nine-ounce box.

“The quarter-to-quarter price decline reported by our volunteer shoppers indicates that consumers are seeing some relief at the grocery store. Even more significant is that average retail prices for eggs, milk, chicken breasts and bacon for the second quarter of 2009 are significantly lower than one year ago,” said AFBF economist Jim Sartwelle.

Overall, the average price for the market basket of foods declined $3.10 or about 6% over a year’s time. Retail egg prices dropped 26%, milk decreased 22% chicken declined 19% and bacon was 11% lower compared with a year ago, the survey showed.

Industry analysts said lower costs for energy and feed grains, compared with a year ago, are among the key factors contributing to the reduction in retail food prices. The foods that declined the most in price are among the least-processed items in the marketbasket, the release said.

“AFBF’s second quarter market basket survey tracks closely with the federal government’s May 2009 Consumer Price Index report for all food, which showed a slight decline of -0.2% for the fourth consecutive month.”

As retail grocery prices have increased gradually over time, the share of the average food dollar that America’s farm and ranch families receive has dropped, AFBF said. “Starting in the mid-1970s, farmers received about one-third of consumer retail food expenditures for food eaten at home and away from home, on average. That figure has decreased steadily over
time and is now just 19%, according to Agriculture Department statistics,” Sartwelle said.

Using the “food at home and away from home” percentage across-the-board, the farmer’s share of this quarter’s $46.29 market basket would be $8.80. AFBF, the nation’s largest general
farm organization, has been conducting the informal quarterly market basket survey of retail food price trends since 1989.

Source: CME News For Tomorrow

The Debts of the Spenders: Can you Balance California's Budget?

Try this interactive exercise courtesy of the LA Times:

http://www.latimes.com/news/local/
la-statebudget-fl-2,0,6957202.htmlstory

The Debts of the Spenders: Spanish Consumer Credit Falls 33%

Trichet must print more! Only 1% interest rate? How about making it .00001% interest rate?

Consumer credit fell by 33.7% in the first quarter, to €5.796 billion, and late payments rose to 17.54%, according to the National Association of Financial Institutions Credit (Asnef).

Of this total, 4.254 billion euros corresponded to consumer goods, which fell by 23.9% and 1542.3 million euros to the automotive sector, which fell by 51%.

Asnef stressed that the fall in the consumer sector has been mainly due to losses on personal loans, due to the sharp decline in the credit available for consumer goods and by the contraction of revolving credit associated with credit card usage.

http://www.creditwritedowns.com/2009/07/
consumer-credit-down-a-massive-33-in-spain.html

The Debts of the Lenders: Vietnam, the Canary in the Coal Mine

For the past 25 years (China) and past 15 years (Vietnam), GDP growth has been 9-12% consecutively - year over year. In some provinces and cities, it was more like 16-18% growth rate (for ex: Shanghai or Ho Chi Minh City). They are 2 of the most dynamic emerging markets and more politically stable beta countries out there in the index.

But all that growth was based on EXPORTS.

For the first time in almost a generation, GDP growth in these 2 Asian countries is being led by STIMULUS - aka govt money printing. How long can it last? I don't know. But the signs are telling.

A slowdown in the export market has forced the govt to adopt inflationary tactics to provide a bump in the economy.

I like to compare Vietnam as an analogous to the Chinese situation - it is China in the early 1990s. But w/one important difference - Vietnam has a smaller forex reserve than China. And therefore is more vulnerable to shocks in the export market. There is an economic dislocation going on - deflating property and equity bubbles while rising food and energy prices.

Combine the 2 and you have the potential for severe political unrest. Perhaps even the potential for an Vietnamese or Chinese Mousavi to emerge (a reference to an Iranian politician whose rise to prominence was fueled by economic dislocations in a deflating property bubble and rising energy/food prices).

The Debts of the Lenders: Chinese Power Struggle Over the Dollar

The official comments from the Chinese media continue to repeat in a schizophrenic loop - one day, they issue calls for a stronger dollar and no plans to change reserve currency status. But the next day, there are bombastic attacks against the dollar/treasuries and calls for a new world order led by a China backed SDR currency.

Well, which is it?

The fallacy in most Western media reporting is that reporters tend to assume that whenever China speaks, it is w/one voice. This is not true. Even in a tightly controlled police state, there is room for dissent - especially in a country as large as China.

The West is hearing an INTERNAL debate that is being made public for two audiences:

a) Domestic audience
b) Western audience


A) Those of us outside China are unable to grasp the full story but details are slowly beginning to emerge:

It seems as if a power struggle is currently playing out between the Foreign Ministry and the Central Bank - both of which are at loggerheads. This is what happens when diplomacy mixes w/economics and finance.

The foreign ministry's goal for the past 25 years has been to promote a cheap yuan in order to lead export based economic growth and provide jobs for the legions of poorly educated peasant class. In contrast, the Central Bank has a more realistic grasp of the global macro situation and is trying to slowly diversify state assets away from the dollar.

Here is some food for thought. What would happen if China were to mark all their dollar denominated assets right now to fair value? They lent money that will never be paid back - at least not in real terms (nominal yield is a different story).

China's economy is held together w/Keynesian scotch tape. Contrary to popular opinion, they have a lot more overcapacity than commodity bulls believe.

B) This debate is being broadcast to the West in order to gauge Western policymakers' reactions to the arguments of each faction. After digesting these reactions, each side has a better assessment on the facts and can prepare for the next verbal riposte.

On a longer time scale, the factions are preparing for China's emerging role as a political and economic counterweight to the OECD. Additionally, these moves are also being orchestrated for the benefit of other observers that are currently sitting on the sidelines, such as the other BRIC states. Such strategy hearkens back to the Cold War era when Maoist China hastened to extend its sphere of influence among the UN Non-Aligned Movement.

Some analysts have described these moves as a global game of chess. A better analogy would be "weiqi", or "go" (as the game is popularly known in the West) where the players wage a "3d" battle w/black and white stones that is spread across multiple dimensions. Instead of exchanging stones though, the stakes are a lot higher.