Theoretical Arbitrage CDS

Thinking of this last night, hypothetically, one could arb CDS as a bond issuer, ignoring counterpary risk, and/or capital maintenance requirements, etc. Suppose you are insurance company (lets call you ZIG). You issue a 5 year bond, $100MM worth. You take those proceeds and invest in treasury bond. You then create a shell investment company called, XIG, that is in the business of credit arbitrage. You fund the investment company with the $100MM used as collateral for you prime brokers. You then go out and leverage 5 times, selling $500MM worth of CDS on the ZIG bonds that your parent company issued. You collect the premiums, using them to offset coupons and anything left over is profit. Is this theoretically possbile? I know you may have margin calls by PB’s, etc, but wouldn’t this be arbitrage? If so, is/would there be a way to make this a reality without margin risk/counterpary risk?

Its not credit arbitrage because you are ignoring credit risk. Firstly, the credity rating of your insurance company plays a large role in how much it costs to issue debt. People aren’t looking to buy debt, they’re looking for cash. The other problem I see is that if you’re selling 5x the CDS than there is bonds available, who will be the buyer for the 4x of debt that doesn’t exist? Are you assuming that there will be 4 speculators to 1 actual investor in your bonds looking to eliminate default risk. So, two problems. You won’t sell $500M in CDS. Because of that, you MAY be able to sell all the CDS to specs but at the expense of the spread meaning that you won’t be able to make up the difference between the corporate cost of debt and treasury cost of debt.

^ not sure about that. So assume that you can sell all this stuff. You have $100M in your investment company and you have sold these unsecured bonds to get the money. So you set up your shell company, transfer the $100M in return for debt from the shell company, sell a bunch of CDS. Your shell company needs to be pretty remote because nobody would buy CDS protection from someone on their own bonds and by setting up a shell company to do it, you are pretty close to fraud. But now you have terms of the CDS, and presumably you are going to have margin requirements (it’s a new shell company, not AIG). That means that when your own company’s debt gets hurt, you need to come up with more margin from the bond proceeds, which hurts your shell company. So now we are in the Enron SPV situation. If you don’t disclose the connection between your investment in the shell company and the losses you are taking there, you can share a jail cell with Fastow when the whole thing blows up. If you do disclose it, you are in a death spiral where your losses hurt your bonds whose losses are multiplied times 6, which hurts your bonds, … There’s an illegal scam in this that puts you in a variation of the funding up SPV’s with company stock Enron scheme, but not an arbitrage.

JoeyDVivre Wrote: ------------------------------------------------------- > ^ not sure about that. > > So assume that you can sell all this stuff. You > have $100M in your investment company and you have > sold these unsecured bonds to get the money. So > you set up your shell company, transfer the $100M > in return for debt from the shell company, sell a > bunch of CDS. Your shell company needs to be > pretty remote because nobody would buy CDS > protection from someone on their own bonds and by > setting up a shell company to do it, you are > pretty close to fraud. But now you have terms of > the CDS, and presumably you are going to have > margin requirements (it’s a new shell company, not > AIG). That means that when your own company’s > debt gets hurt, you need to come up with more > margin from the bond proceeds, which hurts your > shell company. > > So now we are in the Enron SPV situation. If you > don’t disclose the connection between your > investment in the shell company and the losses you > are taking there, you can share a jail cell with > Fastow when the whole thing blows up. If you do > disclose it, you are in a death spiral where your > losses hurt your bonds whose losses are multiplied > times 6, which hurts your bonds, … > > There’s an illegal scam in this that puts you in a > variation of the funding up SPV’s with company > stock Enron scheme, but not an arbitrage. So you’re saying we should definitely go ahead with this…sounds good!

I just don’t see $500M in notional CDS being sold on $100M on debt, for a yield that is any higher than the company’s actual probability of default. Thanks for the ethical reminder JDV. I would have never though of it that way.

You can’t ignore counterparty risk. Who is going to buy bankruptcy insurance on an insured entity from the insured entity? If the entity goes bankrupt, how does the entity pay out on the claim? Secondly, where is the arbitrage? While there may be a positive or negative basis in the CDS compared to the bonds, this is not the trade that you are recommending. You are recommending taking a leveraged position on the credit risk of ZIG, and that’s it. The fact the entity that is taking the position is ZIG makes the trade ludicrous, as indicated in the first point.

I think you can sell $500M worth of CDS on $100M worth of debt. Imagine if MSFT issued $100M debt for some reason. Suddenly, there would be this whole new world of cap structure arbitrage on MSFT based on a measly $100M worth of debt. Not to mention the end-of-the-world types, the Apple true believers, Bill Gates haters who would buy it out of spite, etc, etc…

joekinde Wrote: ------------------------------------------------------- > You can’t ignore counterparty risk. Who is going > to buy bankruptcy insurance on an insured entity > from the insured entity? If the entity goes > bankrupt, how does the entity pay out on the > claim? > They’re not - that’s why there is the remote vehicle. > Secondly, where is the arbitrage? While there may > be a positive or negative basis in the CDS > compared to the bonds, this is not the trade that > you are recommending. You are recommending taking > a leveraged position on the credit risk of ZIG, > and that’s it. The fact the entity that is taking > the position is ZIG makes the trade ludicrous, as > indicated in the first point. The arbitrage could be bankruptcy arbitrage - you either make boatloads on the CDS or go bankrupt. These sorts of bankruptcy arbitrages need to be more opaque than this or you go to jail.

But this is only the case should the CDS not reflect the true probability of default, which is next to impossible to figure out. One thing that hasn’t been mentioned is that the original equation completely ignores the cost of CDS on treasuries which is necessary for this to truly be arbitrage (which are now going for about 50bps). So in a situation where the CDS does not properly reflect the probability of default, this will also likely be true for the CDS you must buy on treasuries.

Why are you even issueing debt? Why not just sell protection on everything and collect coupons? Isn’t that just free money?

Joekinde Bio Until recently, joekinde was the MD of AIG Capital Markets Division. Joe left AIG to explore new opportunities. While at AIG, joe developed a money machine that produced an enormous flow of free money, benefiting shareholders, policy holders, management, and particularly joekinde. Joe believes that rumours of forthcoming indictments are baseless.

That’s my point. AIG was writing protection using its AAA rating as collateral, and was using doing underwriting. I don’t think XIG, a remote entity of ZIG, would find many buyers for anything that it is selling.

Agreed. Marketability of corporate debt is the issue. Why would anyone buy the debt at a reasonable yield when the CDS spread shows them that the market perceived risk is through the roof. This was my point that it comes down to a balance between market perceived credit rating and market perceived credit risk, not credit risk as per S&P, etc.

aren’t you selling insurance on yourself? not sure buyers will be crazy about that…

joekinde Wrote: ------------------------------------------------------- > That’s my point. AIG was writing protection using > its AAA rating as collateral, and was using doing > underwriting. I don’t think XIG, a remote entity > of ZIG, would find many buyers for anything that > it is selling. I think that the world woke up to the problem with this - that leveraged derivatives bets like this can take a company from AAA to receivership in no time. The collateral requirements will be different going forward.

now that’s interesting the futures notionals for equity markets also exceed cash market caps, don’t they? so why not let people express views on credit risk without limiting the notional values to the issued debt.

There is no limit on the notional value and some CDS out there have notional value that exceeds the value of the debt.