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More Naked Credit Default Swaps--the Role of Dealers

posted by Adam Levitin

These post titles should definitely increase the hits on our blog...

I want to add another point to the debate:  CDS are often done through dealers, and a naked position for a dealer is different from a naked position for an end-user.  A CDS dealer's swaps desk is unlikely to have any long-term stake in the underlying asset.  Generally, a swap desk tries to execute perfectly matched swaps so that it will never have any exposure itself to the underlying assets, only counterparty risk.  (And dicey counterparties have to post collateral).  It isn't always possible to match swaps instantaneously, however, so the dealer will often enter into one swap hoping to find a match soon.  Until the dealer finds a match, the dealer has exposure.  Moreover, a dealer might be able to get a better price (and hence a bigger cut for itself) if it doles pieces of the swap into the market, rather than trying to move the whole swap position at once.  There might not be a lot of market appetite for a $25B swap position except at a steep discount(this goes for CDS as well as other types of swaps), but smaller pieces might be digestible.  Dealers tend to try and have everything cleaned up by the end of the quarter, but in between, the short-term exposure could be sizable.   If naked CDS were banned without a dealer exception, covered (i.e., not naked) CDS would become quite difficult to arrange and execute. 

Complicating this picture is that sometimes a swap dealer decides that the swap is an inherently good position given the price and holds the action itself.  This is all by way of saying that CDS go through a dealer market, not a broker market.  There might be a case for moving CDS to a broker market, but unless there's sufficient liquidity for the product, that'd be difficult. 

To illustrate the role of dealers, consider the Abacus deal.  It is usually presented as Goldman Sachs simply arranging a swap between Paulson and the CDO.  That's the economic essence of the deal, but not how it worked technically. 

The Abacus deal was actually structured as two completely separate swaps. (I think this is what Goldman means when it says it was just a market maker--it means it was a dealer.)  Swap 1 was between the CDO and Goldman.  Goldman took the short position on the CDS on the underlying CDO assets.  Swap 2 was between Goldman and Paulson.  These two swaps were separate deals, in that they did not formally reference each other or depend on each other. 

In reality, Goldman would never have done Swap 1 with the CDO unless it could hedge its risk in that deal through Swap 2 with Paulson.  (Some of this is surmise, as, to my knowledge, only the documentation from Swap 1 is publicly available.)  Of course, in the Abacus case, Goldman did not have perfectly matched CDS, and it got screwed (luckily for its sake, as that helps its defense).   

The point here, is that dealers play a critical role in the swaps market, and if they happen to have a position in the underlying asset, that is completely by the chance of what an affiliated proprietary investing desk is doing.  A naked position by a dealer is different from a naked position for an end-user. 

Also, I'm not sure that I'd agree with Stephen that "credit is not a commodity."  A bespoke corporate loan is not, but what about when that corporate loan is bundled into a CLO and churned out as securities?  Or how about the consumer context, where there are standard form contracts, frequent resales of the debt, and sometimes no collateral involved (e.g., credit card debt)? 

[Updated 5/23 at 11:30pm EDT-thx to Wilchy and Marks for corrections]


Professor Levitin:
While inner workings of ABACUS 2007-AC1 Swap 1 and 2 and whether dealers and subprime shorts had skin in the game are no doubt fascinating on some level, please allow me to add yet another point to CDS debate that further defines the role of dealers and market makers. This would be their part in deal selection, choosing reference collateral for CDOs in which there are elements that go to the core of CDS scheme plan as it relates to MBS.

Consider the Abacus deal in which there are 90 Reference Entities referring to MBS trusts with 16 different servicers involved, all of which have long and egregious histories of mortgage servicing fraud.

Servicers w/ number of Abacus entities serviced:

Wells Fargo - 26
OptionOne - 11
Select Portfolio Servicing - 9 FKA Fairbanks Capital
Aurora - 9
WAMU - 6
Countrywide - 6
Saxon - 5
JPMC - 3
HomEq - 3
HomeLoanServ. - 3
WilshireCredit - 2
Fremont - 2
Ameriquest - 2
Novastar - 1
CitiMortgage - 1
LongBeach - 1

Of these 90 Reference Entities, 11 comprising 12% are also ABX Reference Entities. ABX Index reference entities were riddled with mortgage servicing fraud that enriched proprietary trading desks as well as many hedge funds.

Just to pour more gasoline on this bonfire, of the 90 Reference Entities, 9 of them (10%) were serviced by Select Portfolio Servicing, http://www.ftc.gov/fairbanks , yes that one. At first blush we already have 22% of ABACUS 2007-AC1 in the hands of known predatory servicers, all of whom have been widely litigated for such.

Professor, you yourself wrote " Foreclosure is frequently more profitable . . ." Just as servicers are incentivized to foreclose, dealers and market makers are incentivized to select reference entities that have servicers engaging in fraud, fabricating defaults for CDS profit.

Even more insidious is replication over and over again of these very same reference entities in many different CDOs. A recent WSJ piece examined how this practice spread the subprime virus which in my view utilized mortgage servicing fraud to game CDS bets and spun this rigged casino out of control. "One mortgage bond, Soundview Home Loan Trust 2006-OPT5 M8, was a component of the ABX and showed up in more than 30 CDOs."
If this link fails, Google "Senate's Goldman Probe Shows Toxic Magnification"

Professor, while it may be academically fascinating to examine CDO deal minutia, there is a far more pressing issue here in need of continued scholarly attention. It's high time the cone of silence was lifted from mortgage servicing fraud because it is truly the incendiary that set this inferno ablaze. It is becoming more and more evident that reference entities were not so much selected but targeted on the basis on complicit servicers. As more CDOs come under the microscope, it's only a matter of time before federal prosecutors realize the complicity of dealers and servicers in this massive insider trading scheme that caused millions of Americans to lose their homes in fraudulent foreclosures.

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