1 northwestern university did market structure contribute to the recent financial crisis? p...

1

Northwestern University

Did Market Structure Contribute to the Recent Financial Crisis?

PRESENTATION TO

Ravi Mattu

2

(CDS – Bond) Basis Post the Lehman Bankruptcy:

What happened to the basis?

– Historical behavior of the basis and volatility during the crisis

Plausible explanations

– Issues with LIBOR

– Risky counterparties and impact of default correlations

– Market structure? Was the deleveraging in corporate bonds triggered by the basis?

– Flows in the derivative market

A look at other Forward/Futures Markets

– FX, Equities, Mortgages, Treasury Futures

Role of Market Structure

3

236

1236

0

500

1000

1500

2000

2500

Jun-89 Jun-91 Jun-93 Jun-95 Jun-97 Jun-99 Jun-01 Jun-03 Jun-05 Jun-07 Jun-09

bp

/yea

r

Investment Grade High Yield Breakeven Spreads IG Breakeven Spreads HY

OAS (bp)

Date Corp IGCorp HY

9/12/2008 327 815

12/16/2008 608 1971

10/8/2009 218 771

U.S. Investment Grade and High Yield Corporate Bond Spreads: Option Adjusted Spreads Over Treasuriesa

Source: Barclays Capital, Moody’s for default rates in the 1932-1935 period, we assume recovery rates of 20% and that losses were equally distributed over this time period.

ª Average for the Barclays Capital Indices.

Breakeven Spreads Implied by default rates from 1932-1935

4

Definition of the (CDS – Bond) Basis

Basis = CDS Spread – Par Priced Asset Swap Spread (over the Swap curve) of bond

Adjustments

• Calculate CDS spread for a default swap with maturity matched to the cash bond by interpolating the par CDS curve.

• The Par Priced-Asset Swap Spread represents the Spread over LIBOR that would equal the risk-free present value of the coupon stream of a cash bond plus the current difference between par and the price of the bond:

Where DFi is the risk free discount factor for time i, Li is the LIBOR rate for time i, c is the risky bond coupon and s is the par priced asset swap spread.

n

iii

n

ii DFsLDFcpricepar

11

**

5

Average Daily Asset Swap Spread and (Bond–CDS) Basis: for A-rated Bonds

-100

0

100

200

300

400

500

1/2/2007 7/2/2007 1/2/2008 7/2/2008 1/2/2009 7/2/2009

bp

/ye

ar

A-Rated Par Asset Swap Spread A-Rated (Bond-CDS) Basis

Date

Par asset Swap

Spread(Bond-CDS)

Basis

9/12/2008 244bp 54bp

12/16/2008 427 282

10/8/2009 162 51

Source: J.P.Morgan

6

Average Daily (Bond–CDS) Basis: by Rating

-200

-100

0

100

200

300

400

500

600

700

800

900

1/2/2007 7/2/2007 1/2/2008 7/2/2008 1/2/2009 7/2/2009

bp

/ye

ar

A-Rated BBB-Rated BB-Rated

(Bond-CDS) Basis

Date A BBB BB

9/12/2008 54bp 105bp 126bp

12/16/2008 282 388 760

10/8/2009 51 100 123

Source: J.P.Morgan

7

Libor As Well As Swap Spreads Were Contaminated

Libor is not a true transaction rate. Banks are asked at what rate they “perceive” they can raise rates.

Swap spreads have become extremely low in the 10-year sector and have been negative in the 30-year sector due to demand to receive fixed.

-100

-80

-60

-40

-20

0

20

40

60

80

1/2/2007 7/2/2007 1/2/2008 7/2/2008 1/2/2009 7/2/2009

bp

/yea

r

On-the-run Off-the-run

On-the-run and Off-the-run 10-year Treasuries Par Asset Swap Spreads

Spreads over LIBOR

Date On-the-run Off-the-run

9/12/08 -61bp -38bp

12/16/08 -17 56

10/08/09 -14 7

Source: J.P.Morgan

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Impact of Counterparty Credit Risk on CDS Spreads

Both parties in a CDS are exposed to counterparty risk.

However, the exposure is “asymmetric” with the buyer of protection having more exposure to the counterparty than the seller.

Bond spread = CDS spread + Counterparty credit adjustment + Liquidity

To estimate the adjustment required calculate the implied default probability of both the reference entity (on which the CDS is based) and the financial counterparty (the seller of protection) from the cash bond spreads.

For an assumed default correlation calculate the joint probability of both the reference entity and the counterparty defaulting.

Calculate counterparty credit adjustment from (see Appendix) and back out “liquidity” compensation. Subtract it from bond spread and iterate again using Bond Spread less liquidity premium to calculate default probability in step 1.

1

2

3

9

Calculating Counterparty Credit Cost Adjustment – Numerical Example

• Reference Entity: A-rated Industrial

• CDS protection seller: A-rated financial

• Assumed recovery rates: Counterparty = 25%, Reference entity = 35%

• Assume, default correlation = 0.2 (3 to 5 year maturity)

• Date: November 3, 2008

• Financials spread = 446 bp/treasuries

• A-rated Industrial spread = 602 bp/treasuries

• A-rated CDS – Bond basis = -279 bp

• Probability of default (4yr) for Financials = 15%Probability of default (4yr) for Industrial = 31%Joint probability of default = 8%Counterparty credit costs = 35 bp16

The example shown should not be relied upon as representative of an actual investment. No representation is being made that any account will or is likely to achieve profits or losses similar to those being shown.

10

Sensitivity of Counterparty Credit Costs to Spread Levels

300 400 500 600 700 800 900

200 9 13 17 20 23 26 29

400 19 28 36 44 52 60 68

500 23 33² 43 53 63 73 83

600 26 38 49 61 72 85 97

800 30 45 59 74 89 105 122

900 32 47 63 79 97 115 134

1000 33 50 67 85 104 124 145

Reference Entity Bond Spreads¹

Co

un

terp

arty

Bo

nd

Sp

read

s (b

p)

¹ Par Asset Swap Spread is assumed to be 200bp above CDS spread.

² If reference entity bond spread is 400 bp and the spread on the seller of protection is 500bp, then the Counterparty credit adjustment is 33bp and the liquidity premium is 167bp.

Default Correlation = 0.2

Source: Citadel Investment Group

The analysis shown above is performed using Citadel proprietary models. The estimates and projections used in this presentation rely on numerous assumptions that forecast market conditions. These assumptions can be materially inaccurate. Further, regulatory changes can cause the models used to be materially inaccurate. The example shown should not be relied upon as representative of an actual investment. No representation is being made that any account will or is likely to achieve profits or losses similar to those being shown.

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Sensitivity of Counterparty Credit Costs to Spread Levels

300 400 500 600 700 800 900

200 19 27 33 37 38 38 39

400 41 58 72 86 98 110 122

500 49 69 86 102 117 132 147

600 56 78 97 116 134 151 169

800 66 92 116 139 161 184 206

900 62 98 123 148 173 198 223

1000 57 103 130 157 184 211 238

Reference Entity Bond Spreads

Co

un

terp

arty

Bo

nd

Sp

read

s (b

p)

Default Correlation = 0.4

Source: Citadel Investment Group


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Does Counterparty Risk Explain Movements in the (Bond-CDS) Basis? Counterparty Credit Adjustment Versus Average Basis in A-Rated Industrials

Default Correlation between Reference Entity and Protection seller = 0.2

-100

-50

0

50

100

150

200

250

300

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09

Basis (bp) Counterparty Credit Adjustment

Source: Citadel Investment Group and J.P. Morgan


13

0

50

100

150

200

250

300

350


0% Correlation 20% Correlation

40% Correlation Max Possible Correlation

Sensitivity of Counterparty Credit Cost Adjustment to Default Correlation

Source: Citadel Investment Group and JP Morgan


14

Maximum Possible Counterparty Credit Cost Adjustment Versus Average (Bond-CDS) basis on A-Rated Industrials

-100

-50

0

50

100

150

200

250

300

350


Basis (bp) Counterparty Credit Adjustment

Source: Citadel Investment Group and J.P. Morgan


15

Historical Default Correlations

Five and Ten Year Default Correlationby Initial Moody’s Ratings (1970 to 1993)

Source: “Default Correlation and Credit Analysis”, Douglas J. Lucas, The Journal of Fixed Income, March 1995.

Five Year Ten Year

A Baa Ba B A Baa Ba B

A .01 .02

Baa .01 0 .01 0

Baa .04 .03 .15 .04 .02 .08

B .06 .07 .25 .29 .09 .06 .17 .38

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Scale of Dealer Deleveraging in Corporate Bonds over 2007 and 2008

0

100

200

300

400

500

600

01/05 05/05 09/05 01/06 05/06 09/06 01/07 05/07 09/07 01/08 05/08 09/08 01/09 05/09 09/09

Date

$ B

illio

ns

Repo for Clients Dealer Positions

Just prior to Lehman Bankruptcy (9/10/09)Total Dealer Inventory: $340BN

for Clients: $180BN

Peak (7/18/07)Total Inventory: $524BN

for Clients: $243BN

(9/16/09)Total Inventory: $215BN

for Clients: $91BN

Source: Primary Dealer Survey, Federal Reserve Bank of New York

17

Scale of Deleveraging Relative to Peak Levels

0%

20%

40%

60%

80%

100%

120%

07/01 07/02 07/03 07/04 07/05 07/06 07/07 07/08 07/09

Date

% o

f Pe

ak

Po

sitio

ns

Repo for Clients Dealer Positions

Source: Federal Reserve Bank of New York

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Why did Dealers Have Large Positions in Corporate Bonds?

• Many Clients took credit risk exposure through single name CDS or structured credit tranches.

• Dealers could not offset the hedges by buying protection in the CDS market and, therefore, were buying corporate bonds (cash).

• These cash positions became extremely hard to finance during the crisis.

19

Change in “Haircut” or Initial Margin, April 2007 versus August 2008

April 2007 August 2008

U.S. Treasuries 0.25 3.0

Investment-grade Bonds 0-3 8-12

High-yield Bonds 10-15 25-40

Equities 15 20

Investment grade CDS 1 5

Senior leveraged loans 10-12 15-20

Mezzanine leveraged loans 18-25 35+

Prime MBS 2-4 10-20

ABS 3-5 50-60

Source: “Financial Stress and Deleveraging”, IMF Global Financial Stability Report, October 2008, Page 42

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Market Structure and Dislocation in other Forward/Futures Markets

Product Exchange/OTC Clearing Mechanism

Credit Derivatives OTC Bilateral till recently

U.S. Agency Mortgages OTC Multilateral, MBSCC

Foreign Exchange Largely OTC Multilateral

Equities Futures Exchange (CME) Multilateral

21

Implied Financing of Forwards/Futures during the Crisis: Agency Mortgage Current Production Coupon

(Implied spread over LIBOR for financing between front month delivery and back month delivery)

Spread of TBA Mortgage Financing to LIBOR (Front Month)

-600

-500

-400-300

-200

-100

0100

200

300


bp

Source: JP Morgan

22

Implied Spread in Financing Deposits in Various Currencies (Euros, Sterling, Yen) through 6 month U.S. Dollars

Investing in Sterling

-100

0

100

200

300

Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09

bp/y

ear

Investing in Euro

-100

0

100

200

300


bp/y

ear

Investing in Yen

-100

-50

0

50

100


bp/y

ear

Source: Citadel Investment Group and JP Morgan


23

Implied Financing Rate in S&P 500 Futures (90 days Constant Maturity) Versus 3 months LIBOR

-60

-40

-20

0

20

40

60

1/2/2008 5/2/2008 9/2/2008 1/2/2009 5/2/2009 9/2/2009

bp/y

ear

Source: JP Morgan

24

Appendix

25

NyrDefaultyrNDefault

NyrDefaultyrNSurvival

yrDefaultyrSurvivial

)Prob1(1Prob

)Prob1(Prob

Prob1Prob

)1()(

)1()(

)1()1(

Citadel Methodology for Calculating Counterparty Credit - Derivations

Step1: Calculating the marginal 4 year default probability

:iprelationsh following theusing calculated isy probabilitdefault year -N The

entity. theof raterecovery theis R where

1)exp(

1)exp()Pr(

:computed isy probabilitdefault 1yr theNext,

21)exp(

:Annual)-(Semi one observed thefrom deduced is spreadcash continuous equivalent theFirst,

1

2

RCashSpread

CashSpreaddefault

CashSpreadCashSpread

cont

contyr

Observedcont

1

26

BA

BABA

BA

BA

II

IIII

II

IICovBA

varvarvarvar

),(),(

Let A be the event that the counterparty defaults, and B be the event that the reference entity defaults. Also, define IA and IB as the indicator functions of A and B respectively.

Following these definitions, we have:

BABBAABAAB

AB

BBBAAAA

PPPPPPP

PAnd

PPIBPPPIP

and

11

II

1var,I,1var,I

: variablesrandom Bernoulli areIIBut

,

BA

BA

AA

2

(Joint Probability)


Step2: Calculating the 4 year Joint default probability

27

3

2001. Spring 3, No 8, Vol. s,Derivative of Journal ,Alan White and HullJohn ,II" SwapsDefault Credit Valuing" :Source *

1

2rcP

1

321

s Credit ty Counterpar

11ss-s Credit ty Counterpar

riskdefault ty counterpar no assuming spread CDSs

spread CDS observed s

rtycopunterpa theofy probabilitdefault 4yr cP

entity reference theofy probabilitdefault 4yr rP

years 4in defaulting entitiesboth ofy probabilitJoint rcP

321

2rcP

1

ˆ CF

:spread* CDS observed in the embedded

cost credit ty counterpar for thecorrect tocalculated isfactor correction following The

rP

rcPcP

CF

wherercPcP

rP

s

s


Step3: Backing-out the counterparty credit from the 4yr joint default probability

28

This presentation reflects the analysis and views of certain members of Citadel Investment Group, LLC’s Fixed Income Team. No recipient should interpret this presentation to represent the general views of Citadel Investment Group, LLC or its affiliates (together “Citadel”) or its personnel. Facts, analysis and views presented in this presentation have not been reviewed by, and may not reflect information known to, other Citadel professionals.This presentation is based upon information that Citadel considers to be reliable, but Citadel does not warrant to its completeness, accuracy or adequacy and it should not be relied upon as such.

Assumptions, opinions, views and estimates constitute the Fixed Income Team’s judgment as of the date of this presentation and are subject to change without notice and without any duty to update. Citadel is not responsible for any errors or omissions contained in this presentation and accepts no liability whatsoever for any direct or consequential loss arising from your use of this presentation or its contents.

The analysis in this presentation was based on a number of quantitative and qualitative estimations and assumptions. These assumptions and estimations were subjectively determined and may not be accurate. Different estimations and assumptions would have produced materially different results. As a result, the analysis in this presentation has many inherent limitations and no representation is being made that the analysis will translate into actual outcomes.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument.

Nothing in this presentation constitutes investment, legal, accounting or tax advice or a representation that any investment or strategy is suitable or appropriate to your individual circumstances or otherwise constitutes a personal recommendation to you.

This presentation is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Citadel to any registration or licensing requirement within such jurisdiction.

None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of Citadel.

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Copyright 2009. All rights reserved.

1 northwestern university did market structure contribute to the recent financial crisis? p...

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