On 5 April 2012¹, it was first reported that substantial credit derivative positions assembled by a JP Morgan trader (referred to by some as “The London Whale”) might have moved the market pricing of certain credit default swap (“CDS”) index products. In an announcement on May 10, 2012, JP Morgan’s CEO confirmed that the trader in question was part of a team responsible for hedging the foreign exchange, interest rate, and other structural risks for the firm and that losses of US$2 billion on CDS contracts had been incurred to date. The initial response of the media and the public to this news has been to ask why there were not more regulatory and risk management controls in place.

While regulatory oversight may be effective under certain market circumstances, it is most important that front-line practitioners have a clear and full understanding of the potential uses and risk management issues involved with an investment product. To further explore the relationship between risk management and the increased use of credit derivatives in global markets, we talked to David Long, Senior Vice-President and Chief Investment Officer (Asset Liability Management, Derivatives and Fixed Income), for the Healthcare of Ontario Pension Plan (HOOPP), one of Canada’s biggest public pension plans, with assets under management of over $40 billion. Here are some excerpts from our discussion.

Q. Derivatives are important tools for investment and risk managers. Can you share with us your experience on the use of derivatives in HOOPP’s asset liability management? What are some of the important risk management measures used to monitor derivative positions?

A. HOOPP uses derivatives as a tool to invest in different asset classes, to hedge unwanted exposures, and to engage in absolute return strategies.

Frequently, derivatives are the most efficient economic choice for trading the risk we want to trade.

It is critical that derivative exposures be integrated with exposures that come from securities and other investments, so exposure to the underlying asset or security needs to be measured. As well, counter-party risk needs to be measured and managed and–sometimes overlooked–liquidity needs have to be kept in mind. Derivatives are mark-to-market contracts that need to be collateralized daily and cash settled frequently.

Q. JP Morgan’s losses came as a surprise since the firm is at the forefront of market risk management practice. It pioneered the value-at-risk²(VaR) and Credit-VaR tools. Can you share with us your insights into the potential uses and limitations of VaR?

A. VaR can be a very useful tool to quantify risk and allow the comparison of risk across a wide variety of types of financial exposures. Risk measures like VaR, or how they are used in practice, can depend on the assumption that markets in the future will behave as they did in the past, in particular with regard to the volatility (or uncertainty) of exposures and the correlations between exposures. Sometimes markets undergo sudden changes in behaviour, and the possibility of such events does not seem to be captured by VaR.

For example, in 2007, VaR would have badly underestimated the risk of subprime mortgage-backed bonds, as they reacted much more severely than historical data would have indicated.

More recently, a position long in Spanish stocks and short in U.S. stocks would have been more risky than VaR would have estimated, as the correlation between the two markets has broken down in the past year or so.

Q. The phenomenal growth in the CDS market is a good indication of the popularity of its use among investment managers and risk managers. However, after the global financial crisis, there are suggestions that CDS contracts be regulated as insurance contracts. What are your thoughts on this?

A. One can argue about principle indefinitely, but the real question is what practical effect a regulatory change would have.

Such a change would sharply reduce activity and liquidity in the CDS market and reduce liquidity in credit overall. This would increase costs and risks for all market participants and thus increase systemic risk as well.

Q. There have been incidents of significant trading losses on CDS contracts at AIG Financial Products (a seller of protection) and very recently at JP Morgan. What are the lessons for risk managers with regard to monitoring the risk exposure of their portfolios?

A. Without commenting on those situations, I would say that the most important and overlooked aspect of risk management is a qualitative understanding of what risks are being taken and why. Are positions reflective of speculative activity, hedging activity, or investment activity? None are bad, but it’s important to know.

Secondly, risk management is taking action to alter exposure, not just measuring exposure.

In general, risk management failures can be due to measurement errors, not understanding the risk, or not taking action to alter or reduce risk exposure.

Q. Baseline CDS pricing is dependent on some of the criteria used by rating agencies. As we know, ratings are “through the cycle” and not a “single point in time” risk measure. Is the practice of using credit ratings an arbitrage-free strategy?

A. The CDS market has evolved over the years. Prior to 2007, CDS pricing was largely driven by “structured credit” investors, who took risk based on the spread/rating relationship of those instruments. After the financial crisis, this kind of risk-taking has fallen sharply. As a result, the CDS market has evolved into a more ratings-neutral environment.

Unexpected and dramatic changes in credit ratings can still move spreads. But since market participants are discounting potential ratings changes and other events in real time, it is unclear whether positions based on anticipating ratings changes will generate profits in the long run.

Q. Corporate bonds are an important component of the DEX Bond Universe weighting³; what are some of the benefits that bond investors can achieve by using credit derivatives?

A. The current CDS market references several hundred corporate credits in the United States, Europe, and Asia. Through CDS, fixed income managers can access exposures to many issuers.

Credit derivatives allow the management of credit risk in pure form, without currency or interest rate exposure. They also permit the taking of short positions in credit, thus enabling managers to express a negative view they may have.

APPENDIX: A brief description of credit default swaps

CDS are used by bondholders to hedge or trade the credit risk in their fixed income holdings. Under the CDS contract, the protection buyer pays a premium at a periodic fixed payment (expressed in spread in basis points) and will receive a contingent payment from the protection seller should a credit event occur over a specified time period.

The payment level in basis points that the buyer pays is therefore a function of the creditworthiness of the bond issuer. The credit event is defined in the contract, which includes bankruptcy, failure to pay, or debt restructuring.

Below is a schematic presentation of a CDS contract⁴:

A CDS contract is quoted on $10 million notional amount against a $10 million nominal amount of a bond.

Key market assumptions are the likelihood of default and the recovery rate in the event of default.

The CDS Market

Several initiatives undertaken by the International Swaps Dealer Association (ISDA) have contributed to the rapid growth of the CDS market over the past decade, including (i) standardizing the definitions and contract terms, (ii) improving the trading and settlement process, and (iii) establishing the governing determination committee process. In 2002, it was reported that the notional balance of CDS was US$2 trillion. In December 2011, the balance was US$29 trillion⁵ after reaching a peak of US$58 trillion in December 2007 (Chart 1).

As of December 2011, single name credits accounted for US$17 trillion or about 59 percent of all outstanding CDS amounts. Single name sovereign contracts accounted for US$2.6 trillion in June 2011.

Chart 2 outlines the significant weighting of index products among multi-name contracts. As of December 2011, index products accounted for 90 percent of the multi-name contracts or at US$10 trillion.

References:
1. Bloomberg News.
2. Value-at-risk measure is the probable loss on the market value of a portfolio at a defined 95%/99% confidence interval over a given time horizon
3. “Debt market indices,” PC Bond Analytics, April 30, 2012.
4. ISDA CDS market flowchart, www.isdamarketplace.com.
5. “OTC derivative market activity in the first half of 2011,” Bank for International Settlements, www.bis.org, statistics gathered from 10 countries.