Felix Salmon

John Thain seems to think that the CDS basis trade was at least partly responsible for Merrill Lynch’s $15 billion loss last quarter. This from the transcript of his interview with Maria Bartiromo:

Cash assets completely separated from their

derivatives. There were huge spreads between the

prices of cash assets and credit default swaps as

an example…

The– the correlations that should

exist between derivatives and cash also broke

down.

Well, he’s right about that. But how come no one else seems to have made these kind of losses from hedging their assets with CDSs? Or are those losses still hidden, and the banks are just hoping the basis will bounce back towards zero?

Many thanks to JP Morgan, which sent me the data for the above chart, which shows the CDS-bond basis for BBB-rated debt. In English, that means it’s the number you get when you take the CDS spread on BBB-rated credits (that’s the lowest investment-grade rating), and subtract the yield on those credits’ bonds.

The lower this number goes, the higher the arbitrage opportunity: you can buy a bond, hedge it with a CDS, and pocket the profits.

It’s not a perfect hedge, since there are counterparty risks involved, but they’re normally dealt with through margining requirements. Was the plunge in the CDS basis between September and December the result of a huge increase in counterparty risk? It’s possible: it’ll be very interesting to see what happens to the basis if and when these credits migrate to a CDS exchange with minimal counterparty risk.

It’s also far from clear whether the above chart is what was responsible for a large part of Merrill Lynch’s $15 billion in fourth-quarter losses. But remember that historically the basis has been positive, which means that Merrill’s traders might well have seen a juicy profit opportunity when the basis turned negative in 2008. After all, what were the chances it would get much worse?

In the wake of making my proposal below (which I’m entirely serious about, by the way), I’m forced to agree with Gretchen Morgenson about this:

Credit-default swaps clearly played a role in this debacle, and it is crucial that they are part of the solution.

That’s about all I agree with her on, however. Consider this:

Sellers of C.D.S.’s spent years raking in premiums while underestimating or simply ignoring the possibility of rising defaults…

The fear that already-hobbled financial companies may have to pay off huge amounts on C.D.S. arrangements hangs like a cloud over the markets.

C.D.S.’s have already figured prominently in taxpayer bailouts. The $150 billion rescue of the American International Group, for example, came about because of swaps the insurer had written on mortgage securities. And the $100 billion taxpayer backstop handed to Bank of America on Jan. 16 had a good bit to do with soured credit-default swaps that the bank inherited when it acquired Merrill Lynch.

To read this, you’d think for all the world that the problem in the CDS market is that the big banks have written lots of credit protection, and that they’re liable to make huge payouts if and when companies start defaulting.

But the losses at AIG came overwhelmingly because the insurer was selling default protection to banks on their super-senior CDOs. In other words, AIG was bailed out largely because if it hadn’t been, many of the world’s largest banks would have found themselves to be insolvent overnight. The banks were the prudent ones, insuring themselves against loss with the world’s largest insurer; it was AIG which wrote more insurance than it could realistically handle.

And yes, Merrill Lynch lost money on the CDS basis trade. But that trade, again, involves buying credit protection, not selling it. The problem was that not that the CDSs had soured, so much as that the CDSs hadn’t soured enough.

Morgenson writes, from atop her high horse:

Obviously, something must be done to eliminate the possibility that taxpayers will wind up paying off entities that essentially bet against the American economy.

She’s talking here about people who bought credit protection. And the entities which bought the most credit protection — on their loan books, on their CDOs, and for their basis trades — are America’s biggest banks. The net sellers of credit protection, by contrast, apart from AIG and the monolines, were generally hedge funds.

So Morgenson is essentially asking the beleaguered banking sector to bail out the hedge funds it bought protection from. Which makes no sense to me.

Morgenson then pushes a proposal from Chris Whalen that the CDS market on certain financial institutions be shut down entirely:

“It is absurd for the government to allow private speculators to profit by trading against public-guaranteed liabilities of banks,” Mr. Whalen said.

Again, this doesn’t make a lot of sense. If the liabilities are guaranteed by the government, then speculators aren’t going to profit by trading against them, since the entities in question won’t default. Sure, there might be some short-term mark-to-market profits if the CDS spreads widen out. But over the medium term, if the guarantee is real, then the government knows that all those speculators who are long protection are going to end up losing all their insurance premiums, with nothing to show for them.

Morgenson also seems to support a proposal from Sylvain Raynes which bears more than a family resemblance to the bright idea which Ben Stein came up with in October. Essentially, all CDS contracts would be unwound — leaving the banks which hedged their loan portfolios in the nasty position of having much more credit risk on their books than they ever counted on. Raynes’s proposal is basically a forced transfer of credit risk from the people who did want it to the people who didn’t want it: how that makes any sense at all I have no idea.

It may or may not be true that we would have avoided much of this crisis had credit default swaps never been invented. I suspect it’s not true, and that the CDS market, in allowing people to short the credit market, actually helped at the margin to stop the credit bubble from expanding. But even if it is true, that doesn’t mean that the solution is to ban or unwind the CDS market which now exists. It was foolish to sell protection too cheaply on risky debt; it was sensible to buy that protection when it was cheap. So let’s not punish the sensible people and bail out the foolish ones by abrogating those contracts.

Tyler at Zero Hedge has a wonderful post on the CDS basis trade today, which is a must-read for anybody who’s interested in what happened to the CDS basis in the fourth quarter of last year or how Merrill Lynch could have lost so much money in December.

Tyler explains that while the CDS basis was positive during most of the Great Moderation — it cost slightly more to insure a bond against default than you were receiving in coupon payments — the basis on many names has become very large and negative over the months since Lehman Brothers collapsed.

Now a negative basis violates, in theory, the no-arbitrage rule: it means you can buy a bond, fully insure it, and lock in risk-free profits just by holding both the bond and the CDS to maturity.

But after Lehman and AIG blew up, that arbitrage trade became hard to put on, because prime brokers started asking for collateral from the buyers of credit protection:

Traditionally the margin requirements on CDS would be in the sub 1% range; after Lehman some counterparties raised the margin requirements as high as 20%, and others even asked for the whole margin to be paid up front. On a $10 million CDS position, which traditionally would only have cash outflows every quarter to fund the quarterly insurance payment, all of a sudden accounts would have to pony up to $2 million in margin just to put a trade on (or keep it on, leading to many basis forced unwinds).

This is truly a strange world: it’s rare to ask people to put cash up front for the privilege of being able to pay an insurance premium every quarter. But as a result, the negative basis hasn’t been arbitraged away, and the mark-to-market losses on anybody playing the CDS basis trade can be enormous — yes, bigger even than the losses that Jerome Kerviel managed to rack up at SocGen.

A $15 billion loss could have been created as simply as experiencing a blow up on $25 billion on basis trades. And this assumes no leverage which is naive for the prop desk model: if ML had leveraged its pre-existing basis trades even 10x, the total basis trade notional needed to create this loss would have been only $2.5 billion. Is it inconceivable that ML had $25 billion in basis trades? Not at all – after all they were a preeminent CDS trading powerhouse and had one of the most active basis trade prop desks.

It seems to me that this is one area where government funds could be put to very good use — and be guaranteed to make a profit. The government starts buying up lots of corporate bonds where there’s a negative CDS basis — Tyler cites CIT, Marriott Hotels, Home Depot, Temple-Inland and Omnicom as examples of credits where the basis is 300bp or more — and then buys CDS protection on those bonds; it then promises to hold both the bonds and the CDS to maturity. Naturally, the government would buy the CDS protection on the new CDS exchange which it’s trying to get the market to set up.

The result would be good for credit spreads, as bond prices would rise. It would be good for price discovery, as the confusion generated by the huge difference between bond and CDS prices would largely go away. It would lock in significant profits for the government. And it would get the new CDS exchange off to a flying start. What’s not to love?