Theme parks for the upper crust

April 10, 2015 | Art, Bankruptcy, Detroit, Diego Rivera, Fundraising, Municipal bankruptcy, Museums, Philanthropy, Public amenities, Theory, US News | No comments 181 views

By: David A. Smith

Because people value only what they pay for, things that are free the same people devalue … until those things are threatened, whereupon the same observant herd that was indifferent and whose pockets were claimed empty suddenly discover newfound reserves, a point mentioned only in passing by an article in The Economist (March 23, 2015) that was actually going somewhere else:

graham_beal_dia

The story’s about to head that way

When Graham Beal, the director of the Detroit Institute of Arts (DIA), realised about a decade ago what a turning point an 11-month visit by Diego Rivera and Frida Kahlo had represented for the city’s art scene in the early 1930s, he decided to make an exhibition out of it.

munkacsi_frida_rivera_1933

Frida Kahlo and Diego Rivera, 1933

The culmination would be the DIA’s immovable crown jewel: Rivera’s “Detroit Industry” murals, a series of frescoes depicting machinery and workers at Ford’s River Rouge plant, which the Mexican artist described as the finest work of his career.

Certainly they’re mesmerizing. 

rivera_mural_06

Organized concentrated activity reminiscent of Brueghel: a detail from a larger panel

Diego Rivera was a modern Marxist Brueghel, and while as a technician his work leaves much to be desired, something about the scale of his conceptions makes them absorbing.

brueghel_august

Ennobling the peasant three centuries before it became fashionable

During the period, which Mr Beal refers to delicately as a time of “interesting financial circumstances”, the planned exhibition was put on hold for several years.

DIA was hostage to Detroit’s bankruptcy, and Mr. Beal stayed at his post, but with Detroit’s emergence from bankruptcy, he is retiring, and this exhibition is his swan song.

rivera_mural_07

Another detail from the Rivera workers’ murals

At that time the city’s funding of the DIA dwindled to nothing and Detroit sank ever deeper into a financial morass.

Which raises the question, what is a city doing owning a museum, anyway?

After the city declared bankruptcy in 2013, the emergency manager considered closing the DIA and selling off its art.

‘Considered’ understates both Mr. Orr’s intentions and his impact – he planned to close DIA and liquidate it, because that was the city’s best unilateral option – and it largely worked:

It was saved by a “grand bargain”. Together, private donors, charitable foundations and the state of Michigan raised $816m to help pay public workers’ pensions in return for transferring ownership of the museum out of the hands of the municipality.

A previous article (Los Angeles Times, January 9, 2015; navy blue font) adds some important color:

The DIA announced this week that it had finished raising its $100 million share of the “Grand Bargain.”

Why did the foundations and the oligarchs pony up?  Even at seventeen bucks a ticket for exhibitions, it could not have been an economic decision; nor could it have been to placate the angry masses, as I never saw any protesters demanding that pensions be cut to save the art collection.

No, they did it because they wanted to, and they wanted to because the museum and its collection represented something psychological to those donors; a theme park for the upper crust, spirited away from unreliable public control:

Under the agreement, the museum and its collection no longer will be owned by the city, but by the private, nonprofit entity that’s headed by the museum director and board of trustees.

rivera_dia_02

Part of what the hundred million bought

And now controlled by those who paid for its protection:

It now belongs to a charitable trust.

Quite clearly, those who wrote the checks had no confidence in the City of Detroit (nor should they),

Observe, didn’t trust the City of Detroit, but did trust the independent institution. 

rivera_mural_14_overseer

We want one of our own minding the store

In fact, although the other parties chipped in most of the money, they’re done paying, whereas the plutocrats have more checks to write:

The DIA has announced a $275-million campaign to increase its endowment and stabilize its long-term finances.

This is a better result all around; better new governance, probably (though not certainly) lower administrative overhead and operating costs,

And what the heck is a city doing owning a museum anyhow?

Diego Rivera and Frida Kahlo in Detroit”, which opened on March 15th [Tickets are $17.50 apiece – Ed.], is the DIA’s first exhibition as an independent institution and the last major show under Mr Beal, who is retiring after 16 years in the job.  As Detroit so nearly lost its 130-year-old museum, Mr Beal feels it apposite to be leaving with a show so focused on the city.

The upper crust enjoyed having the city pay for a benefit that they predominantly used.

Rivera’s murals were commissioned by William Valentiner, a German art historian and director of the DIA, who had convinced Edsel Ford, the son of Henry Ford, to pay up $10,000 ($170,590 today) for the project.

rivera_mural_12_edsel_director_valentiner

Edsel Ford and director William (born Wilhelm) Valentiner, painted into Rivera’s murals

Rivera was a communist, but he never hesitated to pocket his fee—just as he had once accepted a commission by the San Francisco stock exchange, another engine of capitalism.

rivera_banner

Political theorists of the Thirties were fascinated by assembly lines

With the rise of industrialism and the parallel rise of Fascism/ Communism, Thirties political theorists were returned again and again to the assembly line and automation as metaphors for the changing society. 

On arriving in Detroit, Rivera immediately started to tour factories around the city, in particular Ford’s River Rouge plant, then the world’s biggest, making hundreds of sketches. Kahlo, who was pregnant, sometimes came along, but most of the time she was bored and unhappy.

Were men being liberated by the machines, enslaved by them, or mass-produced into mass movements?

“Asking Diego to be consistent is a non-starter,” says Mark Rosenthal, the curator of the exhibition, who points out that Kahlo was more ideological than her husband and accused him of “dressing like a capitalist” in his elegant three-piece suit.

frida_diego_rivera_1930

BY the way, Diego, how much did that cigar cost?

In July 1932 she suffered a miscarriage (which she subsequently described as an abortion), a traumatic event she depicted in “Henry Ford Hospital” with her lying on a hospital bed surrounded by surrealist images of a pelvis, a snail, the torso of a woman, a machine, an orchid and her lost child.

frida_henry_ford_hospital

Surreal and powerful

For Rivera, the visit marked one of the great successes of his career, even though the first showing of the murals turned out to be highly controversial. Depicting despondent workers –

Any critic is entitled to his own interpretation, but the workers have never seemed despondent to me; rather, they are focused, diligent, coordinated, as suggested by Wikipedia’s anonymous editors:

rivera_mural_11

Harmonizing with the machines, not subjugated by them

Rivera depicts the workers as in harmony with their machines and highly productive. This view reflects both Karl Marx’s begrudging admiration for the high productivity of capitalism and the wish of Edsel Ford, who funded the project, that the Ford motor plant be depicted favorably. Rivera depicted byproducts from the ovens being made into fertilizer and Henry Ford leading a trade-school engineering class.

Closer to the mark is this throwaway comment:

– marching in line –

rivera_mural_19_clocking_in

Painting passivity?

The period between the world wars was for many intellectuals a crisis of faith – faith in progress, faith in democracy.  With the Depression sweeping the industrialized world and the democracies, winners of the War to End War, seemingly helpless before it, the only confident answers were proclaimed by the tyrannies – the Bolsheviks in Russia, the Fascists/ Nazis in Italy/ Germany – and it seemed at the time that only these mass movements were economically successful.  For many people, the choice was between Fascism and Communism, and rejecting one meant embracing the other.

rockefeller_murals_lenin

Rivera’s hagiographic portrait of Lenin, painted into Rockefeller Center

(then destroyed on orders of Nelson Rockefeller, and later recreated in Mexico)

– or a machine as an animal was decried as subversive; some even called for the walls of the DIA to be whitewashed.

OLYMPUS DIGITAL CAMERA

Opening the space into a gallery

It was in Detroit that Rivera and Kahlo established themselves as a power couple. They encouraged each other in their art and conspired in their acceptance of the honours and riches bestowed on them by the capitalists that Rivera pretended to infiltrate with his prolonged sojourns in America. In a reversal of artistic fortunes, today it is Kahlo—with her unmistakable eyebrows and feminist aesthetic—who is regarded as the rock-star artist, whereas Rivera is respected but far less popular internationally. This show may help him re-emerge from the shadows.

Recapitalizing the museum will also help Detroit emerge from its self-inflicted half-century decline.

Detroit Institute Of Arts Holds Press Conf. On Donations For Grand Bargain

Director Beal and Mayor Duggan applaud DIA’s recapitalization

Diego Rivera: Undone by the proletariat, rescued by the plutocracy.  I’m sure the old rascal would have smiled at that.

diego_rivera_self_portrait_1954

A little paradox is good for the character

Rien ne va plus: Part 4, Use the product again

April 9, 2015 | CDSs, Consensus, Contract rights, Conventions, Credit default swap, Global news, Innovations, Markets, Regulation, Rulemaking, Speculation, Theory, Unanimity | No comments 115 views

[Continued from yesterday’s Part 3 and the preceding Part 1 and Part 2.]

By: David A. Smith

paul_singer_smile_ish

see?  It all worked out

Sources used in this post

Wall Street Journal (August 6, 2014; brick red font)

Wall Street Journal (August 15, 2014; forest green font)

The Wall Street Journal (January 25, 2015; black font, principal source)

As we saw in Part 3, with the wrapup of the Caesar’s bond issue CDSs, the market-making members of the International Swaps and Derivatives Association were once again united in the rules they had agreed upon, and under which they would play the game going forward.

harrison_tweet

Rightly or wrongly, those are going to be the rules

8. Any updated convention needs an ‘effective date’ for the changeover

Investors say the changes may lead to an uptick in demand for CDS on junior debt.

Inevitability effect.

The inevitability effect also took hold in a different way: with the old contracts now seen as having a huge loophole, the industry was heading toward complete implosion – no new business of any kind – so the observant herd desperately needed a new standard that would enable new CDS’s to be issued and sold.

“Once the sub CDS documentation changes come into effect we will be looking to use the product again to provide hedging for our portfolios and as an alternative product to express trading views through,” said Chris Telfer, a fund manager at ECM Asset Management, a unit of Wells Fargo & Co. Mr. Telfer said his firm has mostly avoided buying protection on junior debt given the limitations of the current contract.

chris_telfer

Telfer avoids risks he can’t hedge

Pressure on the industry to resolve the impasse was immense:

The ultimatum worked.  

Technically, it wasn’t an ultimatum, which is a commitment to unilateral action, but rather a commitment to boycott.

Elliott got its exemption.  

paul_singer_davos

The circumstances were exceptional

Caesars was one of only two U.S. companies exempted from the rule, which took effect Oct. 6.

Of course, there needed to be a reason, or at least a rationalization, and in the case of Caesar’s, both were readily supplied:

Caesars CDS should have been excluded from the new definitions earlier in the process, because it would have been unfair to change the terms of the swaps when the company was unusual in being so close to default, said a person familiar with ISDA’s thinking.

When the croupier is setting up his wheel, he invites the punters, Faites vos jeux, Make your games, place your bets.  And the bets can be placed even as the wheel starts spinning, but as it begins to slow, the croupier advises, rien ne va plus, None more may go.

croupier_clive_hat

Rien ne va plus, ladies and gentlemen

Even when a convention changes – switching the side of the street on which one drives, for instance – this may be debated for years, but when it happens it must happen at a particular instant, it’s imperative that resolution and the changeover happen rapidly, so that the game may swiftly resume.

roulette_ready_to_sign

Let’s get this game in motion

In the early 1960s Sweden, which for centuries had been a drive-on-the-left country, decided it would change to driving-on-the-right.  It did so in spite of popular opposition:

In a 1955 referendum, 83% voted to keep driving on the left. In 1963, the Riksdag approved the change and established the State Right-Hand Traffic Commission to oversee it. It also began implementing a four-year education program. Preparations for the switch started. A national campaign of persuasion was begun, and the Dagen H logo was soon emblazoned on milk cartons, shorts and even women’s underwear.

dagen_h_underwear

Will this help you remember which side to pass on?

Extensive preparations were made, including a painstaking transition rule:

On Dagen H, Sunday, 3 September, 1967, all non-essential traffic was banned from the roads from 01:00 to 06:00. Any vehicles on the roads during that time had to follow special rules. All vehicles had to come to a complete stop at 04:50, then carefully change to the right-hand side of the road and stop again before being allowed to proceed at 05:00. In Stockholm and Malmö, however, the ban was longer—from 10:00 on Saturday until 15:00 on Sunday—to allow work crews to reconfigure intersections.

sweden_dagen_h_crossover

As in Sweden, the market resumed promptly, and smoothly.

The price of one-year credit default swaps on Caesars’s largest unit has risen 59% in recent months amid restructuring negotiations.

inevitability_effect

Fortunately, belief in a convention’s inevitability encourages motivation to adopt it

The new rules “will vastly improve the economics of these contracts, and in simple terms will make them behave far more like senior and subordinated bonds, which after all is what they are meant to do,” said Ben Lord, a fund manager at M&G Investments.

ben_lord_mandg

With the windup of our story from this esoteric but vital segment of global capital finance, we’ve now earned the right to apply the case to other contexts – say, housing policy and program development and evolution, and the emergence or breakdown of international agreements.

1. The initial conventions can be arbitrary, but once selected become path dependencies.  The most famous example is of course the QWERTY keyboard, which once settled upon (for whatever reason lost in the mists of time) has persisted more than a century.

vintage_qwerty_keyboard

Still workable today …

qwerty_iphone

… still replicated today

2. The need for conventions arises and increases with frequency and repetitiveness of interactions.  Like QWERTY, which was worked out only as telegraph traffic increased dramatically, automotive traffic lights only became necessary after the invention of horseless carriages, and the green-yellow-red traffic light convention appeared only in the 1920s, having been adopted from the railroads, where track signaling was obviously critical many decades sooner.

3. Conventions first arise out of unwritten market behavior, then develop into universal networks, and are legislated only late in their evolution.  Because conventions facilitate multiple-interaction encounters among participants who play a particular game hundreds and thousands of times, they emerge from Prisoner’s-Dilemma equilibria.

4. When the system of conventions is effective, the industry self-polices because the brand-reputation makes this worthwhile.  Accountants and lawyers get along fine without government regulation because their brand value as professionals is so valuable they have to expel their miscreants.  Appraisers, less well paid, needed mandatory state certification (via FIRREA) to professionalize themselves.

5. Majoritarian overrule of the minority is dangerous, for it risks the entire convention collapsing.  That fate has confronted the Eurozone for half a decade, as the global financial crisis that started in 2007 has created one convention-tester after another: Ireland’s capitulation to Brussels; The troika’s bond-discount-extortion from private bondholders (which the ISDA, implausibly and probably to its later regret, ruled was not a default or credit event); Brussels’ diktats to Greece and its forcible confiscation of depositors’ money in Cyprus; and now the endless confrontational fudge with Greece’s new government, and its inevitable re-fudging in a month or so.  Next up in Europe will be Spain, or Slovenia, or Austria.  As one by one the peripheral economies are threatened with freezeout if they do not knuckle under, eventually the Eurozone’s masters will be surrounded by those who dislike them.

6. Convention collapse takes only one veto so big it cannot be ignored.  Mr. Singer’s Elliott Management was big enough that its boycott represented ecosystem disruption.  No one big enough has yet challenged the Eurozone – Spain had an opportunity but the situation wasn’t desperate enough then – but this still seems inevitable.

7. Any change in convention rules must have grandfathering up through some date.  At some point you play out the pending games according to their rules … if not, you have no conventions, you simply have power politics.

tspiras_merkel

Yes, she’s agreed to change the rules for us – haven’t you, Angela?

Rien ne va plus: Part 3, Not the protection you need

April 8, 2015 | CDSs, Consensus, Contract rights, Conventions, Credit default swap, Global news, Innovations, Markets, Regulation, Rulemaking, Speculation, Theory, Unanimity | No comments 155 views

[Continued from yesterday’s Part 2 and the preceding Part 1.]

By: David A. Smith

Sources used in this post

Wall Street Journal (August 6, 2014; brick red font)

Wall Street Journal (August 15, 2014; forest green font)

The Wall Street Journal (January 25, 2015; black font, principal source)

Yesterday’s Part 2 established that when a convention is maintained solely by industry agreement, there can be specific issues so important they are worth putting at risk the entire entente.

condor_beak

DO you really want to make me angry?

4. Conventions must be enforced, by sovereign, by geas, or by boycott/ freezeout

Such disputes [when Caesar’s actually defaulted] are typically settled by an ISDA committee of banks and funds even though they often trade in the same CDS on which they rule.

Self-regulation has its limitations, chief among them that self-interest is often short-term.

magoo_myopic

What warning signs?

Some firms that own CDS, such as Elliott, voted that a default had occurred, while those that had sold protection voted against it, people familiar with the process said.

A second weakness in self-regulation is its susceptibility to committee-action tardiness: deferring judgment in hopes that somehow the need to judge will go away – or that it can be punted to someone else.

The matter moved to a committee of external lawyers and market professionals earlier this month, only the second such referral in ISDA’s history. They have yet to rule.

A more practical means of enforcing justice is freezeout: if you wan’t play fair, you can’t play at all.

Elliott, a $25 billion hedge fund that specializes in investing in distressed firms, warned in September that it would boycott a new standard contract….

captain_boycott

Nobody’s going to talk to you any more

When conventions become enforceable by the force of government, they are called laws.  For decades, wearing a car seat belt was a convention that eventually became a law.  The European Union is full of conventions that migrate up to becoming treaties, then in some cases become Europe-wide laws.

The showdown highlights the tensions that can emerge when CDS traders also are market overseers, at times being called on to make decisions that can affect their holdings.

That’s incorrect; the tensions about adjudication are present in any situation (just as the International Criminal Court or the WTO).  However, when the market makers are also the referees, it’s even more complicated.

The [Elliott] fund pushed local authorities to detain an Argentine naval training ship in Ghana in 2012 to pressure Argentina’s government to repay claims worth about $2.5 billion from defaulted sovereign bonds Elliott owns.

And quite rightly so – as I suggested when I wrote about this before, if private parties do not hold governments accountable, other governments are far less likely to do so.  Mr. Singer’s fund did the global capital markets a service.

paul_singer_times

Just don’t you dare call me an altruist

5. Conventions must be well defined, with clear boundaries

Fuzzy boundaries are bad boundaries because their adjudication is always contentious; crisp boundaries are superior because they reduce adjudication entropy – lost time, lost money, and lost emotional investment. 

roulette_wheel_ball

You’ve probably lost, you just don’t know it yet

More importantly, clear boundaries create clear rules, and rules are tools to motivate the players.

Funds that trade Caesars CDS have tried to influence the company’s decisions to their advantage.

In general, one wants one’s investors to advise it, but CDS investors are a different breed, because they are rooting for proxy actions – say, default – that may harm rather than help the company. 

In behind-the-scenes negotiations with Caesars, sellers of CDS, including Blackstone Group LP’s GSO Capital Partners, tried to postpone a default, while buyers of the debt sought to hasten it by pushing the company’s largest unit into bankruptcy, according to people involved.

None of this is surprising – those who would pay if a default wanted to defer the default; those who would collect wanted to accelerate it.  Although totally logical, it’s very funny behavior.  So is this:

Swaps investors wouldn’t typically have a place at the negotiating table, but the funds were in discussions with Caesars because they also own its bonds and loans—their tactics were also aimed at getting better deals when those debts are restructured.

Buying a company’s defaulted or non-performing debt so as to gain leverage over the company’s restructuring is a well-recognized tactic, one that requires plenty of additional liquidity, so this is a game only for those with the bankroll and sophistication to play it. 

stu_ungar_calls

Trust your read, bet your stack

More recently, another hedge fund that owns Caesars bonds and hedged the investment with CDS, Pine River Capital Management LP, lobbied ISDA to rule that the Caesars unit in fact defaulted on Dec. 15, when it missed an interest payment, according to people familiar with the matter.

One would have thought that default was so core a concept in CDS’s that it would have a well-articulated and universally acknowledged definition.  Perhaps there was a definition good enough for the purpose fifteen years ago, but the evolution of financial products might have yielded new creatures not falling into the previously established definition.

The fund’s argument hinges on an interpretation of what triggers a default, which remains a source of some debate.

Clearly the default definition must be updated – but would the new definition apply to existing contracts, or just those written after the new definition’s publication and acceptance?

6. Over time, conventions show cracks in the system

Problems in the CDS market have seen it shrink significantly. The notional amount of contracts outstanding fell to $21 trillion at the end of last year from $58 trillion in 2007, according to the Bank for International Settlements.

If the insurance is defective – if the bookie doesn’t pay off – then the market dries up, and that hurts the whole ecosystem.

foundation_wall_cracks

A visible problem, and a visible symptom

By last fall – with the Caesar’s bankruptcy a looming possibility – the CDS market was fracturing.

“The bond market needs to have a CDS product that allows investors to hedge what’s going on effectively,” said Saul Doctor, a credit strategist at J.P. Morgan Chase & Co. “The current contract just doesn’t give you quite the extensive protection that you need,” he said.

A filing convention can reach a tipping point, where more people think the convention is doomed than believe it can be upheld.  Two examples in the American political arena are marijuana legalization and gay marriage; in both cases, the passage of years gradually redefined the observant herd’s baseline expectations, and when that happens, the inevitability effect takes over.

inevitability_effect

Some investors are counting on changes to the CDS market due Sept. 22 to fix the problem.

Obviously the market needed a refresh.

smack_in_face

You need a reset!

7. Conventions must be periodically updated

Last week [August, 2014 – Ed.], BES was restructured, with the majority of the debt shuffled off to a new bank set up as part of a government-backed rescue deal. The junior bonds were left in the old BES bank, but the CDS were all shifted to the new bank, meaning the buyers of the CDS couldn’t collect.

bes_cds_prices

Something’s going haywire in the market

Even that is an important oversimplification, for the disruption was the ISDA ruling:

A panel of the International Swaps and Derivatives Association Wednesday ruled that the Portuguese central bank’s decision to break up Banco Espírito Santo won’t trigger a payout on insurance-like contracts linked to the stricken lender’s debt.

ISDA was asked late Monday to rule whether the Portuguese Central Bank’s decision to split BES into two would qualify as a so-called bankruptcy credit event, meaning that any contracts on BES debt—known as credit default swaps—would be activated.

Ironically, the ISDA’s ruling of no default, which permanently disrupted the market and led inevitably to the Caesar’s showdown, was swiftly overtaken by events, for the restructured bank filed for bankruptcy only two months later.  But by then the issue was joined, and a new contract had to exist:

Some lawyers are confident the overhaul will mend the shortcomings of the current contract.

“They address certain gaps in the old definitions, take account of market developments such as the introduction of bail-in arrangements, and the drafting is better,” said Simon Firth, a capital-markets partner specializing in credit derivatives at Linklaters LLP in London.

Having come up with an industry-wide solution, the ISDA – which, after all, has no more intelligence than the collective intelligence of its members – sought to secure unanimous consent:

In mid-September, ISDA hosted a conference call to discuss CDS contract changes that had been several years in the making and were supported by hundreds of ISDA’s more than 800 members, according to people familiar with the call.

That’s curiously judgmental phrasing; if there with more than 800 members, roughly half of them could be expected to support anything.  Moreover, the CDS business could well have the same concentration effects as does insurance: those who buy insurance number in the millions; those that sell it number in the thousands. 

snake_mongeese

We outnumber you

A trader from Elliott on the call brought the global initiative to a halt when he said the fund wouldn’t adopt the new definitions unless Caesars contracts were excluded, the people said.

Elliott feared the changes—slated to take effect last Sept. 22—could allow sellers of Caesars CDS to cut the payments they would owe if the company defaulted, the people familiar with the call said.

It’s a difference between majoritarian democracy and contract law.

Some other investors balked at Elliott’s demand, but the exception was ultimately allowed because of the amount of CDS contracts Elliott holds and because other funds also supported the exclusion, the people said.

Doubtless the others objecting had positions similar to Elliott’s.

i_object

[Continued tomorrow in Part 4.]

 

Rien ne va plus: Part 2, Boycott the new standard

April 7, 2015 | CDSs, Consensus, Contract rights, Conventions, Credit default swap, Global news, Innovations, Markets, Regulation, Rulemaking, Speculation, Theory, Unanimity | No comments 232 views

[Continued from yesterday’s Part 1.]

By: David A. Smith

Sources used in this post

Wall Street Journal (August 6, 2014; brick red font)

Wall Street Journal (August 15, 2014; forest green font)

The Wall Street Journal (January 25, 2015; black font, principal source)

Yesterday’s Part 1, whose subject was Credit Default Swaps and whose theme is multi-party conventions, established that risk can be sold, and if sold, it must be bought.

take_risks

If only it were that safe

Risk is a complicated thing to perceive; no two human beings evaluate risk alike.  So there may be a situation where the market rates risk as high, but I rate the risk lower because I have insight, skill, or foolish courage.  In that case, I should buy the risk from you.

I can buy your risk, and you can sell it to me, if we enter into a Credit Default Swap (CDS).

what_is_cds

Real risk, perceived risk, risk transfer, and risk transmutation

In a CDS on an existing security, you already own this dodgy bond, and you’re afraid it’ll default.  I think it won’t default (especially if I take certain actions), so I sell you a CDS.  You pay me an agreed CDS price (C) up front (or over time, for our purposes it makes no difference), and I write you an insurance policy – if the bond goes into default, then I pay the insurance amount.

[Technical note: by buying CDS one hasn’t eliminated risk; rather, it’s been transmuted into counterparty risk – the possibility that the insurance company won’t pay off on its insurance policy.  For the present, we’ll assume counterparty risk is zero because the counterparty is rated AAA. – Ed.]

economist_counterparty_risk

The risk is nominal … except when it increases 30x in a year and a half

Unlike normal credit enhancement, which is provided at the time of issuance, CDS are a form of later supplement, akin to retrofitting a building that has been discovered to have seismic risk.  That’s handy in the same way that retrofitting properties is hand; you shore up an existing structure, you don’t tear it down.

The Journal shorthands the explanation, understandably if unhelpfully:

CDS can be used to speculate on bonds or as insurance, with buyers getting a payout if default occurs within the term of the swap. Sellers of the swaps essentially bet borrowers won’t default before the contracts expire.

To call it a bet is accurate, but that terminology applies equally to every form of insurance; when you buy car insurance, you bet you will have an accident, and the insurer bets that you won’t.

mille_bornes_cards

I bet this would happen

Now, if you’ve bought the CDS, your bond is worth V – C, not V – R.  And if C, the price of buying the CDS, is less than R, you’ve made money for your company. 

That is precisely what Elliott did:

It couldn’t be learned how much Elliott holds in Caesars CDS or how much money it stands to make on the contracts.  It also is hard to tell how much money Elliott has at stake because the fund has invested more in the company’s bonds than in its CDS, said a person familiar with the fund’s thinking.

In other words, Elliott spotted a market inefficiency: the two pieces combined were more valuable than the cost of buying them individually.

Buying into the default is like sailing into trouble; you think you and your craft can come through the storms, and what you gain is worth it.  Elliott’s purchase of Caesar’s bonds was no passive investment; the firm expected to become involved in the company’s eventual recapitalization.

paul_singer_galt

I’m just trying to help a company get back on its feet

The firm has been far more active negotiating with Caesars to restructure the bonds than acting on behalf of the CDS, according to this person.

Even as it was buying the dodgy bonds, Elliott chose to hedge its risk by buying CDS for those same bonds, in effect laying off some of the issuer risk at a price.

Depending on the prices it paid and any eventual recovery for creditors in the Caesars bankruptcy case, Elliott could profit on both its CDS and bonds. As is often the case in bankruptcies, the parties involved are still discussing which creditors will get paid and how much, and swaps payments will be determined by an ISDA auction.

When the game is played by big institutional money managers and hedge funds, the sums add up, into hundreds of millions if not billions, and that’s necessary because the companies in question have multi-billion-dollar market capitalization.

Elliott fought to protect the investment, including threatening to derail a global overhaul of CDS contracts by the International Swaps and Derivatives Association, the market’s rule-making group, according to people familiar with the matter.

In a marketplace run by convention, not by an external sovereign regulation, settlement is done by the trade group itself – and the group is made up of members, including the one that has separated itself from the unobservant herd.

Elliott is a prominent member of ISDA, a trade group that represents hundreds of banks and investment funds active in the $19.5 trillion CDS market.

[Seeking to stun us with the market size, CDS figures are always quoted in the ‘notional amount’ – the face amount of all insurance.  A better measure would be the premiums, which are normally about 3% of the notional amount, yet even with that as a figure it’s a $600 billion market – Ed.]

Elliott, a $25 billion hedge fund that specializes in investing in distressed firms, warned in September that it would boycott a new standard contract that had been accepted by most of the swaps market unless the Caesars CDS were exempted.

At that moment, it was clear the market had gone haywire.

computer_haywire

We can’t shut it down!

3. Conventions must be unanimously adopted

adult_supervision

Is required

“The CDS market is an entirely self-regulated market, which is rife with opacity and conflicts of interest, with little adult supervision,” said Joshua Rosner, a managing director at independent research firm Graham Fisher & Co.

joshua_rosner

Implicitly offering himself as an adult

Adult supervision is an ironic term, for in fact everyone playing this game is an adult, and the game players understand the game better than anyone on the outside, and thus better able to settle their disputes than regulators.

Maneuvers by Elliott and other CDS investors in Caesars come amid a wave of activist investing sweeping the CDS market.  Traders have $27 billion worth of CDS contracts riding on the Caesars unit in bankruptcy, the largest amount outstanding on any U.S. corporation besides banks, according to the Depository Trust & Clearing Corp.

With so many lining up to play the game,

randolph_mortimer_duke

We dukes built this exchange

Many firms that did business with Elliott could have been left with unhedged positions if Elliott didn’t participate.

The dynamics here aren’t fundamentally different from the Eurozone’s governance – semi-sovereign nations that came together to agree on things, all with their fingers crossed behind their voters’ backs.  These systems work when there is unanimity, and when unanimity is lost, the system breaks.

The committee voting on Caesars couldn’t reach the 80% majority required for a decision, according to ISDA.

Quite possibly Mr. Singer’s company and a few others like it held more than 20% of the ISDA’s votes.

“CDS is having a greater influence here than in any restructuring I’ve ever seen,” said a hedge-fund manager who owns Caesars bonds and CDS and has been negotiating with the company on behalf of bondholders.

That’s just a function of Mr. Singer’s company’s size, and his company wouldn’t be large if it hadn’t been successful in performing for its investors.

don_corleone_bonasera

You want me to do this service for you?

[Continued tomorrow in Part 3.]

 

Rien ne va plus: Part 1, One key glitch

April 6, 2015 | CDSs, Consensus, Contract rights, Conventions, Credit default swap, Global news, Innovations, Markets, Regulation, Rulemaking, Speculation, Theory, Unanimity | No comments 249 views

By: David A. Smith

map_drive_left_countries

Why do we drive on the right, whereas the British drive on the left?  Though theories abound, of more importance is the value of a convention, any convention, that is so widely adopted it becomes second nature. 

Until, that is, an extreme situation arises, when the convention cracks apart, as happened recently in the multi-billion-dollar market for derivative financial instruments, especially credit default swaps (CDSs), as reported in The Wall Street Journal (January 25, 2015):

When Caesars Entertainment Corp. put its largest unit into bankruptcy protection earlier this month, it was a victory for Elliott Management Corp., a hedge-fund firm that had bet on the blowup using credit-default swaps.

paul_singer_listening

Victory is won by the bet; keeping score is just the consequence

As so often happens with newspaper journalism, because the Journal’s January story arrived after the fact, the headline simplifies the story to the detriment of comprehension, missing the logic sequence.

numbers_out_of_sequence

Let’s tell the story in proper sequence

Bankruptcy wasn’t the victory, it was the payoff; the victory occurred several months earlier, when Elliot defended an even more fundamental principle: Rien ne va plus. 

croupier_at_wheel

No more bets, ladies and gentlemen

Sources used in this post

Wall Street Journal (August 6, 2014; brick red font)

Wall Street Journal (August 15, 2014; forest green font)

The Wall Street Journal (January 25, 2015; black font, principal source)

Straightening out the logic is worthwhile, for the principles arise in many contexts – contractual adjudication in multi-game leagues, legislative changes, and international agreements, with implications for everything from NFL rulebook changes to the potential Greek exit from the Euro.

patriots_eligible_receivers

You can’t change the rules partway through the game

1. The CDS market operates on industry-defined conventions

Before there was government, people found ways to live together.  Before there was zoning, people laid out houses and farms and roads and paths.  Before there were utilities, there were shared wells.  Whenever there are common resources or common investments, people settle on principles; conventions are older than laws because they are value-additive for everyone involved.

So it is with Credit Default Swaps: for all that they may seem arcane, and financially are the province only of the well-capitalized and well-computered, they add value to the fixed-income securities and debt markets – and they are governed by voluntarily adopted conventions:

The roughly two-decades-old market in credit default swaps is supposed to provide investors with a backstop that pays out when bond issuers default.

Forget ‘supposed’ – the market does provide that protection, at a price, just like any other form of insurance.

But a string of European banking busts, most recently that of Portuguese lender Banco Espírito Santo, has shown the backstop’s not fail-safe.

defenders_hopper

You may not like us, but we’re defending your interests

As we explore the CDS world, bear in mind further that CDS’s are private-market antibodies against the public-market disease known as sovereign counterparty risk – namely, that any time a private participant contracts with the government as the counterparty, the private party takes the risk that government will abruptly and capriciously change the rules, always to the government’s benefit, and by implication usually to the private party’s detriment. 

The CDS governance crisis arose because with the rise default rates around the world, including previously-unthinkable defaults like municipal bankruptcy (as in Detroit, and possibly Chicago), forcible bail-in’s (as in Cyprus), and other forms of capital-markets betrayal to which necessity drove them.

The payday didn’t come easily.

At times principle and self-interest align; at other times, self-interest informs and illuminates principle, and at especially critical times, the stakes are high enough to make the battle worth a showdown.

Founded by billionaire Paul Singer , Elliott has a track record of playing hardball.

If by ‘hardball’ the Journal’s author means ‘Pressing legal claims to enforce contract language,’ any business that involves dealing in post-default situations necessarily requires playing hardball.  If your strength is in consensus-building self affirmations, choose another profession.

michael_and_don_corleone

I want you to short the position, okay, Michael?

One key glitch; at the moment [August, 2014 – Ed.], the contract used for all CDS ties the insurance to the bulk of a company’s borrowings rather than the specific debt it was meant to protect.

Glitch?  Glitch?!? That’s fall-off-your-horse astonishing.

caravaggio_damascus

I get it now

As I pick myself, consider this metaphor.  You, your parents, and your three siblings all live in one house, and your father buys a life insurance policy on himself.  One day dad dies of a sudden heart attack, and when you call the insurance company, they explain, “Actually, the policy doesn’t pay as long as any of your family are still living.”

If a troubled bond issuer is restructured, in most cases the CDS shift to wherever most of the debt ends up, and don’t necessarily stick with the specific debt to they’re supposed to cover.

“But my father died!”

python_insurance_sketch

His death wasn’t death as defined in our policy

“Yes, and you’ve inherited his assets, so that’s not a valid claim.”

Last year, SNS Reaal’s CDS holders were left short-changed after the Dutch government seized the bank’s junior bonds.  As CDS payouts are usually determined by the market value of the bonds, compensation had to be based on where SNS’s senior bonds were trading.

As mentioned, sovereign-counterparty risk can totally upset the apple cart.

fruit_cart

Everything’s in order now

That meant CDS holders in some cases received only a few cents on the euro, even though the junior bonds were completely wiped out. In future if a government expropriates a bank’s bonds and gives investors nothing in return, CDS will compensate holders in full.

Understandably, once the CDS contract language was ruled to be interpreted that way, the insurance policy lost its value, and its market dried up.

Meanwhile, trading in contracts tied to an index of riskier financial-company CDS has slumped by 64% compared with last year, according to Citigroup.

Whether one sees this as a change of rules, or the adjudication of a heretofore open question, there’s no doubt it broke the conventional understanding, and that disrupted the whole industry.

2. Conventions add value because they enable markets to work more efficiently and thus better

Conventions are valuable, as we know from every highway we ever use – and in the capital markets, conventions are essential, because they increase transaction reliability and enable risk to be sliced and diced, and then sold by those who don’t want to bear it and bought by those who do.

bridge_convention_card

It’s a lot of detail that adds value by enabling very efficient conversations

I first learned the concept of ‘buying risk’ nine years ago, when my for-profit company Recap became involved as an outside special service asset manager for some high-yield non-performing tax-exempt bonds on affordable housing properties held by a major investment bank.  They’d bought the bonds at a discount, because the market was (quite rightly) pricing in the expectation of future unreliability of cash flows or even debt cessation and bankruptcy. In working with those fellows, who were very sharp, I realized that any fixed-income security, like a bond, can be seen as a combination of two things, one positive and one negative:

  • A stipulated return assuming zero risk, which has a value V.
  • A discount reflecting risk, which has a cost R.

For any financial instrument, its current price P = V – R. 

The perception of R can be abated at the time the instrument is being issued, if the issuer gets credit enhancement – FHA mortgage insurance, for example, or a third-party enhancement guarantee.  Not everybody does that, for any of a dozen reasons, for instance that the issuer is financially strong – but if the issuer subsequently weakens, or some other blessed thing happens, the bonds can start plummeting in value.  Enter the CDS.

cds_chain

It’s all in who pays what to lay off risk

Once a bond or other fixed-income security is issued, its resale price will fluctuate based on changes in V (inherent value), which derive from market expectations of inflation and sovereign ‘safe’ rates (like Treasuries); and then changes in R, which derive from the market’s perception of the instrument’s risk.

CDS led to big losses during the financial crisis for banks and hedge funds that had used them to amplify bets on risky mortgage loans.

Taking losses is the price of making bets.

[Continued tomorrow in Part 2.]