Pricing Event Risk and the CDS Market

Much has been written lately about those getting smashed in the credit derivatives market, particularly in the wake of several recent corporate reorganizations that have introduced new and unexpected volatility into the marketplace - spin-offs, split-offs, new financing entities, subsidiary IPOs, etc. The ball kind of got rolling with VNU's subsidiary financing, and has picked up steam in light of Verizon's announced spin-off of its directories unit. Bloomberg issued a story today that highlighted some of the heated emotions over this issue:

Hedge Fund Nightmare

The predicament is akin to battling a rare disease because of the more than 1,000 companies with credit-default swaps bought or sold this year, fewer than 3 percent triggered price swings related to a change of corporate control, or so-called succession event, according to data from Frankfurt-based Deutsche Bank AG.

For hedge funds, unregistered pools of capital where managers participate substantially in the profits of the money invested, the volatility of credit-default swaps is a ``nightmare,'' said Simon Ballard, head of research in London at ARC Securities Ltd., a fixed-income broker. ``Credit derivatives have underpinned the evolution of the hedge fund community for the last few years.''

New York Fed

Even the International Swaps and Derivatives Association, the trade group that has championed credit-default swaps as tools to reduce risks in the debt market, is concerned that increased volatility shows the hazard that the contracts no longer reflect the value of assets they're mimicking.

These ``new problems'' are causing widespread confusion, said Kimberly Summe, ISDA's legal counsel in New York. Summe, who helps set the standards for credit-default swap contracts, coordinates a twice-monthly conference call with 150 bankers, investors and lawyers to tie the contracts more closely to a company's credit risk.

So far, regulators aren't voicing concerns. Last August, the Federal Reserve Bank of New York chastised some of the biggest financial firms, including New York-based JPMorgan Chase & Co., the third-biggest U.S. bank, and Goldman Sachs Group Inc., the most profitable securities firm, for allowing 150,000 credit-default swap contracts to remain uncompleted, leaving traders unsure of their obligations.

First of all, a 3% probability is neither akin to the risks of contracting a rare disease nor is it a "tail event." While there is surely improvement to made to the ISDA credit derivatives template, the bottom line is that this (the risks to CDS prices in the wake of corporate reorganizations) is part of the game. Credit risk is not a static measure, and the derivatives marketplace needs to incorporate the probabilities of restructurings and reorganizations into their prices for these instruments. Whining has no place in the markets, folks. People made boatloads of cash on the ride up, and as markets mature and time passes the ride occasionally gets bumpy. Sorry, that's life.

This reminds me of my days in equity derivatives in the go-go late 1990's, when M&A events and spin-offs of dot-com subsidiaries were all the rage. Say we were long some vega (optionality) on a stock (either by owning puts through a synthetic share buyback program or through a short put/long call sold as hedge of an investment position), and the company underlying our position announces a spin-off of its internet subsidiary. What happens? All of a sudden we have positions on two stocks instead of one. So what? The volatility of the basket of two stocks is less than that of the single stock that spawned the two, rendering our long vega position less valuable. Totally sucks, right? Right. But we survived and that was part of the game. The fact is that this potential outcome needed to be factored into our pricing when we initially provided the hedge.

I am glad to hear that regulators aren't freaked about the current situation. They shouldn't be. They were right to be concerned about the massive number of unconfirmed trades, a matter on which the Street has made tremendous progress over the past year. But regulators shouldn't be stepping in where market forces are designed to take care of the problem. Traders can price event risk. They do it every day. If swap spreads need to widen to take these risks into account, ok. But if they don't, all I can say is caveat emptor - and no whining, please.