Crawling in the dark through the muni CDS market

November 4, 2011

I’m beginning to think that Europe’s sovereign debt crisis might kill more than municipal credit default swaps. As the financial system trembles alongside the deliberations of the Greek government, areas of the markets that have quietly lumbered along in the dark are getting more and more attention.

Bloomberg held an excellent state and local finance conference on Wednesday where there was a brilliant session with the state treasurers of North Carolina, Delaware and New Jersey. Bloomberg Editor-in-Chief Matt Winkler grilled the trio on the use of derivatives, mainly interest rate swaps, by public officials. In the most thought-provoking back-and-forth, Winkler asked what the difference was between Alabama’s Jeffereson County and Greece. Both Greece and Jefferson County have extensive ties to financial institutions through the bonds they issued and derivatives they have either entered into or that have been written on them. In the case of Jefferson County this exposure is mainly concentrated with JP Morgan Chase, the lead underwriter for most of the bonds and derivatives written on the county. In the case of Greece it’s fairly well-known who owns its bonds but it’s practically unknown how deep the interconnections are for derivatives. As Bloomberg wrote:

The European nations are linked in a network of debts, as Bill Marsh recently illustrated in the New York Times with a beautiful piece of graphic art. The image is like a complex wiring diagram for a ticking debt bomb. Yet what it shows may be less important than what it leaves out: a largely invisible network of ties among institutions around the world, which could ultimately cause global financial chaos.

This hidden network has been created by institutions that buy and sell unregulated credit-default swaps. These are essentially insurance contracts on bonds; in the event of a default on the bond, the seller of the swap promises to pay the buyer the bond’s value.

This web of interconnections is amplified many times over because of the intense concentration of derivatives on the trading books of a handful of large, global banks. The graph below from the blog Jesse’s Cafe shows the level of concentration for U.S. commercial banks using data from the Office of the Comptroller of the Currency (OCC). Basically five U.S. banks control the whole U.S. market and embody the concentrated risk. A publication from ISDA, the trade association that represents the large, global banks in the derivatives area, said the OCC reported the notional amount of derivatives outstanding at the five largest U.S.-based dealers was $281 trillion as of June 30, 2010. That is a massive spiderweb of risk given that the U.S. annual GDP is about $14 trillion.













Now ISDA is not happy about people questioning the fragility and opacity of the credit markets. In fact they seem a little thin-skinned and specifically singled out Bloomberg’s lament about the level of connectivity and concentration with CDS. In the snarkiest tone imaginable, they wrote while identifying Bloomberg by name:

It’s hard to overstate the amount of nonsensical chatter on credit default swaps (CDS) in the past few days.

Does the author not know about DTCC’s CDS Trade Information Warehouse?  (For that matter, doesn’t anyone at Bloomberg BusinessWeek know about it either?)  It’s only been up and running since 2008, capturing more than 98% of all CDS transactions.  Its launch may not have rivaled the neutrino time trials recently carried out by CERN in Europe.  But surely its existence should be known to someone purporting to be an expert on the CDS market.

The CDS warehouse offers a significant level of regulatory transparency and helps to ensure that AIG can’t happen again.  Some of the information it captures is public and is available here.

I have a real beef with this claim: how do we know the data is accurate? When I wrote about the municipal CDS market on Monday I mentioned that the current amount of muni CDS outstanding is $1.2 billion, according to DTCC Warehouse data. I drew this number from Table 2 which aggregates CDS by “Single Name Reference Entity Type.” The amount I quoted was from the “Muni: Government” category.

Unfortunately the Table 2 DTCC’s CDS Trade Information Warehouse data does not correlate in any way with the breakout level of data on Table 6 that shows CDS outstanding for individual names. In the data for Table 6 someone has managed to index California, Texas, Illinois, New York City and the Middle Eastern cities of Abu Dhabi and Dubai under the category of “States.”  There are no single name listings for “Muni: Government” in Table 6 to underlay the data reported in Table 2.

Here are the  “States” as listed in the DTCC Table 6 :











When I asked the corporate communications department at DTCC about these odd indexing methods they said they would call back after inquiring with data provider Markit. After a short wait I was informed that Markit, who compiles trade confirmations from the dealers, had been sending the data over at least since February in this form and they didn’t know the method for categorizing the swaps. Muni CDS is a tiny category compared to other types of swaps but this muni information seems poorly indexed and cross-referenced. Why believe any of it? And more importantly, how would it be verified?

Lisa Pollock, formerly of Markit and now a blogger at FT Alphaville, wrote a useful post laying out more refined levels of data transparency that DTCC and Markit could provide for the CDS market. I think Lisa may have the cart before the horse, though, because I now have concerns about the reliability of any data at the DTCC warehouse. ISDA’s ultra-snarky tone really set off alarm bells with me. In my time in financial markets it’s rare to see a trade association respond with such dismissiveness to criticism from a major publication. I smelled smoke and wondered if there was fire.

Before the $281 trillion of derivatives shakes the U.S. financial system to the core again, I think we need some more cooperative efforts from ISDA and a little more regulatory oversight of the data flowing into these “data warehouses.” The biggest global banks and their proxy trade associations have kept these dangerous markets pretty dark. We may need to kill more than municipal CDS.


Credit Flux: Greek “voluntary” exchange likely to turn mandatory, says Barcap

Deus Ex Macchiato: CDS and CVA

IFR: Sovereign CDS questions remain

Bloomberg: U.S. Banks Sell More Insurance on Europe Debt

A-Team Group: DTCC Files SDR Applications with CFTC

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