CDS Transparency, Liquidity and Pricing Paradigm Catherine Downhill Mark Lindup March 28 2011
Agenda Counterparty Risk Workflow CDS Spreads and Implied Ratings Liquidity and the cost of funding Benchmark CDS
Counterparty and liquidity risk Mark Lindup
Management Survey Counterparty Risk 85 counterparty risk manager were interviewed 11 broad questions were asked re: Current practices and changes since the Lehman default Summary of results Sell side actively hedge using derivatives buy side do-not Active collateral management, same day posts, two-way, limit minding Active monitoring For more detail see www.fitchsolutions.com www.fitchsolutions.com March 30, 2011 3
Counterparty Risk Work Flow 66% of CRMs depend upon risk assessments from a centralized Credit Risk function for an official risk assessment; 33% do not use a formal credit risk assessment Counterparty selection: >60% of CRMs deem credit risk the leading reason to NOT trade with an approved counterparty; 40% cited liquidity 5-10 Active Counterparties CRMs adjust limits and collateral requirements according to perceived likelihood of downgrades or credit events www.fitchsolutions.com March 30, 2011 4
Deutsche Bank AG CDS Deutsche Bank AG Banco Bilbao Vizcaya Argentaria SA Banque Federative du Credit Mutuel Credit Agricole SA Credit Suisse Group AG JPMorgan Chase & Co. Lloyds TSB Bank Plc U.S. Bancorp Wells Fargo & Co (bps) 350 300 250 200 150 100 50 0 Jan 10 Mar 10 Apr 10 Jun 10 Aug 10 Oct 10 Dec 10 Feb 11 Source: Fitch Solutions 5
CDS Implied Rating and Spreads 22 Feb 2011 (bps) Banco Bilbao Vizcaya Argentaria SA Banque Federative du Credit Mutuel Credit Agricole SA Credit Suisse Group AG Deutsche Bank AG JPMorgan Chase & Co. Lloyds TSB Bank Plc U.S. Bancorp Wells Fargo & Co 350 300 250 200 150 100 50 0 Jan 10 Mar 10 Apr 10 Jun 10 Aug 10 Oct 10 Dec 10 Feb 11 (bps) 300 250 200 150 100 50 0 A+ 92 Credit Suisse Group AG A 69 U.S. Bancorp A 113 102 Banque Federative du Credit Mutuel A- Deutsche Bank AG BBB+ 71 89 JPMorgan Chase & Co. BBB Wells Fargo & Co BBB 133 Credit Agricole SA BBB- 188 Lloyds TSB Bank Plc BB+ 252 Banco Bilbao Vizcaya Argentaria SA Source: Fitch Solutions 6
BBVA CDS Spread and CDS Implied Rating 22 Feb 2011 bps 350 CDS 5Y (LHS) CDS-IR (RHS) IDR (RHS) BBB- BB+ AA- A+ 300 A A- 250 200 BBB+ 150 BBB 100 50 0 7 23/02/2010 05/03/2010 17/03/2010 29/03/2010 08/04/2010 20/04/2010 30/04/2010 12/05/2010 24/05/2010 03/06/2010 15/06/2010 25/06/2010 07/07/2010 19/07/2010 29/07/2010 10/08/2010 20/08/2010 01/09/2010 13/09/2010 23/09/2010 05/10/2010 15/10/2010 27/10/2010 08/11/2010 18/11/2010 30/11/2010 10/12/2010 22/12/2010 03/01/2011 13/01/2011 25/01/2011 04/02/2011 16/02/2011 Source: Fitch Solutions
BBVA - CDS Implied Rating Bands 22 Feb 2011 8 CDS 5Y AA- BBB BBB- BB+ BB 400 350 300 250 200 150 100 50 0 23/01/2011 23/12/2010 23/11/2010 23/10/2010 23/09/2010 23/08/2010 23/07/2010 23/06/2010 23/05/2010 23/04/2010 23/03/2010 23/02/2010 Source: Fitch Solutions
Using Fitch Liquidity Indicators Usage Monitor CDS pricing quality Low liquidity difficult to get a good average market price (client challenges) Premium for low liquidity Easy of closing out or taking a position Track market interest in an entity Changes in liquidity can signal future events; good or bad Generally market interest and hence liquidity increases in advance of an event and decreases when the risks are better understood Liquidity reserving Adjust bid-offer spreads to account for liquidity www.fitchsolutions.com March 30, 2011 9
Fitch Solutions Approach to Modeling CDS Liquidity Fitch solutions sought the inclusion of market derived indicators as a proxy for all characteristics of asset market liquidity Liquidity can be measured by the following factors Inactivity and staleness of quotes (resilience) Dispersion of mid quotes across contributors (depth) Scaled bid-ask spread (tightness) These factors are then put into a logistic regression to produce an aggregated liquidity score Liquidity score = Function (resilience, DEPTH, tightness) How do we disentangle credit risk from the regression results? The regression has a series of dummy variables including Fitch CDS implied ratings, these controls for credit risk mean the output is net of default risk www.fitchsolutions.com March 30, 2011 10
Liquidity Scores - Counterparty banks Source: Fitch Solutions 11
Liquidity Score data Reference Entity contract information Liquidity Score (4 29 lower the score the more liquid the contract) Global percentile ranking Regional percentile ranking Change in Global rank, daily, weekly, monthly, etc Change in Regional rank, daily, weekly, monthly, etc ICB Sector information Country and region information CDS spreads (if required) 12
BBVA CDS Implied Ratings Bands 22 Feb 2011 Citigroup Inc. Lehman Brothers Holdings Inc. Royal Bank of Scotland Plc (Liquidy score) 12 11 10 9 8 RBS percentile Rk = 72 Citigroup percentile Rk = 63 RBS nationalization RBS percentile Rk = 7 Citigroup percentile Rk = 2 7 Lehman 6 percentile Rk = 8 Lehman bankruptcy Citigroup capital injection 5 Jan 07 Jun 07 Nov 07 May 08 Oct 08 Mar 09 Sep 09 Source: Fitch Solutions 13
Egypt Liquidity and CDS Spreads Egypt CDS (LHS) (bps) 500 400 300 200 100 Egypt liquidity (RHS) (%, rank) 80 Jan 25 th unrest starts 0 0 Jan 10 Mar 10 Apr 10 Jun 10 Aug 10 Oct 10 Dec 10 Feb 11 70 60 50 40 30 20 10 Source: Fitch Solutions 14
Fitch Liquidity Indices Global Index Americas Europe Asia Emerging Market (Sovereigns) Developed Market (Sovereigns) 15 12.5 12 11.5 11 10.5 10 9.5 9 8.5 8 7.5 01/03/2011 01/01/2011 01/11/2010 01/09/2010 01/07/2010 01/05/2010 01/03/2010 01/01/2010 01/11/2009 01/09/2009 01/07/2009 01/05/2009 01/03/2009 01/01/2009 01/11/2008 01/09/2008 01/07/2008 01/05/2008 01/03/2008 01/01/2008 Source: Fitch Solutions
Liquidity Premium Model Extension of the current Liquidity Score model Liquidity Premium Model = Function[Bid-Offer, Mid Spread] Different fits based on credit quality using CDS implied ratings otherwise function fit is non-monotonic especially for lower credit quality Corporate, Sovereign, Financials BBB CDS Implied Rating X-axis Liquidity score Y-Axis absolute premium 16
Liquidity Premium Banque Federative du Credit Mutuel Banco Bilbao Vizcaya Argentaria SA Credit Agricole SA Credit Suisse Group AG Deutsche Bank AG JPMorgan Chase & Co. Lloyds TSB Bank Plc Wells Fargo & Co 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 17 06/12/2010 14/12/2010 23/12/2010 04/01/2011 12/01/2011 20/01/2011 04/01/2010 12/01/2010 20/01/2010 28/01/2010 05/02/2010 15/02/2010 23/02/2010 03/03/2010 11/03/2010 19/03/2010 29/03/2010 06/04/2010 14/04/2010 22/04/2010 30/04/2010 10/05/2010 18/05/2010 26/05/2010 03/06/2010 11/06/2010 21/06/2010 29/06/2010 07/07/2010 15/07/2010 23/07/2010 02/08/2010 10/08/2010 18/08/2010 26/08/2010 03/09/2010 13/09/2010 21/09/2010 29/09/2010 07/10/2010 15/10/2010 25/10/2010 02/11/2010 10/11/2010 18/11/2010 26/11/2010 % Liquidity Premium Source: Fitch Solutions
Liquidity and Cost of Funding Fitch Solutions finds that the liquidity of a sovereigns CDS is highly correlated with the level of underlying bond yield. Where sovereign CDS liquidity is high, bond yields tend to fall, thus reducing the cost of funding for sovereigns Conversely bond yields increase when liquidity in the CDS market falls The research also demonstrates liquidity in the CDS market offers an indicator of the future direction of yield levels that is external to the credit risk factors. The analysis does not demonstrate causality as fundamental credit issues are prevalent in the movement of bond yields. However, realised correlations do highlight the importance of the market attaches to liquidity. http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=563406 18
Dealing with illiquidity Catherine Downhill
CDS in risk management CDS spreads provide a valuable information when looking at risk: Provides granular measure of credit risk on both cardinal and rank ordered scales CDS spreads are a tangible value actively used in CVA and capital charges PDs can be derived from spreads albeit carefully! CDS spreads capture risk migration, not only default and/or failure When handled properly, the CDS market proved to be the most accurate credit signal available 20
The Credit Default Swap Universe
What about CDS spreads for entities where there is no readily available market information? Demand for CDS spreads on a broader universe of names has been increasing as there use in risk management expands as well the need for accurate valuations on CDS positions for these less liquid CDS This demand is leading to the development of benchmarked spreads to assist particularly in CVA and risk management Benchmarked spreads can be validated against and calibrated to a large current and historical data universe many times larger than observed bank defaults
Benchmarking CDS Entities An indicative price for a less liquid CDS, derived from entities/instruments where market prices is readily available. Pricing illiquidity entities today s liquid entity = tomorrow s illiquid entity Additional Basel III requirement Common CDS Benchmarking Methodologies Rating, Region, Sector Bond - Bond basis Equity probability of default type model Derived Data Hybrid models 23
Benchmarking Methodologies Rating, Region, Sector Group together entities with CDS curves by Rating, Region and Sector and aggregate the group as a proxy for entities without CDS spreads within the same grouping Bond Basis Find an appropriate bond for an Entity, find its spread over the risk-free rate and this approximates for the CDS spread, more advance version adjust for CDS-Bond basis and maturity mismatches. Equity probability of default type model Group similar probabilities to create Equity implied ratings; use the Equity implied ratings instead of agency rating in the first approach above 24
Benchmarking Methodologies (continued Derived data Have a good CDS curve but need a curve for the same entity but with different attributes, adjusting good curve for ; Debt subornation level, Currency, restructuring differences. Hybrid models Combining the other methodologies above. to group and aggregate CDS curves which can then be used as proxies to entities without CDS curves but having the same characteristics. Enhancements include using the bond and CDS bonds basis as a cap and floor www.fitchsolutions.com March 30, 2011 25
Which CDS benchmarking methodology do think is best? 1. Rating, Region, Sector 2. Bond - Bond basis 3. Equity probability of default type model 4. Hybrid models of above models 5. Other 6. None work to your satisfaction
Benchmarking Accuracy Breakdown by Rating, Sector, Region, Currency, Restructuring (11 March 2011) %Ind %SupSec %Sec %SubSec % of Universe 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 0% <10% <20% <30% <40% <50% <60% <70% <80% <90% <100% <500% % Deviation Source: Fitch Solutions 27
Indices Global Consumer Goods 28 Consumer Goods Autos Food & Breverage Personal & HH Goods 500 450 400 350 300 250 200 150 100 50 0 01/01/11 01/11/10 01/09/10 01/07/10 01/05/10 01/03/10 01/01/10 01/11/09 01/09/09 01/07/09 Source: Fitch Solutions CDS Spread bps
800 700 600 500 400 300 200 100 0 Indices Global Financials Financials Banks Insurance Financial Services 29 01/07/2009 01/09/2009 01/11/2009 01/01/2010 01/03/2010 01/05/2010 01/07/2010 01/09/2010 01/11/2010 01/01/2011 Source: Fitch Solutions
A Counterparty Risk Manager Requires Timely and Accurate Data to Meet 3 Key Needs 30
Fitch Solutions Client Best Practices: Counterparty Credit Risk Monitoring 31
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