Contract designers face the same question. Should a designer rely on precedent, extending existing methodology in a slightly new direction in an evolutionary step? Or should a designer try to begin an entirely new era in derivatives trading? These inquiries may seem abstract to traders who are new to the markets, but there are concrete histories to study behind every question.

The best designs always seem obvious—after the fact. In the beginning, each contract starts with a blank piece of paper.

A design that is successful in the short run may not stand the test of time: years of evolving markets. Conversely, many contracts that are introduced with a whimper assume a dominant position later on. The histories of the first agency futures contract on the Chicago Board of Trade (CBOT), the Eurodollar contract on the Chicago Mercantile Exchange (CME), and the interest rate swap futures contract on the CBOT illustrate this point.

In 2001, the CBOT introduced an Agency futures contract based on the same forward contract methodology that its successful Treasury note and bond contracts employed. With thirty years of success with the Treasury futures design, and nearly a trillion dollars in outstanding Agency notes, the CBOT was fairly confident that there would be a market for an Agency futures contract. The contract met with some initial success, but, ultimately, an unwillingness to break with tradition spelled its doom. Like Treasury note and bond futures, the Agency futures contract was a forward instrument. This means that its valuation depended on a repo rate to determine the opportunity cost of capital. Unfortunately, there were no developed repo markets for Agency debt at the time, so accurate valuation of the contract was impossible, as was an enforceable cash-and-carry arbitrage trade. The CBOT couldn’t bring itself to break with tradition, so it created a contract that relied on a component of the market that didn’t exist. Like a moth intent on immolation, the exchange refused to stop mimicking the contracts that had come before. All of the legwork and research that went into launching the contract were eventually proven to be pointless.

Eurodollar contracts at the CME initially received a lukewarm reception, but they went on to become the most liquid and actively traded contracts in the world. A year after the contracts were introduced, Institutional Investor magazine ran a glib headline proclaiming the death of the Eurodollar market. The contract design proved to be flexible enough to adapt to an evolving market. Eurodollars eventually served the needs of interest rate swap traders looking to offset the risk of the short-dated positions in an anonymous central marketplace. The evolution of the market tells us that not even the contract’s creators could foresee the specific path to success of their product, because they launched only a few contracts with short expirations. The strength of the Eurodollar market is that contracts can be traded in strings of adjacent maturities to create synthetic fixed-rate instruments. There are now ten years’ worth of quarterly expirations trading at the CME. About the first half of contracts are actively traded—out to five years. The “back month” contracts were added only after trading picked up in the front contracts, which implies that the creators never foresaw such interactions.

Interest rate swap futures at the CBOT offer a third instructive case. The contract was bad-mouthed for many years by the dealer community before eventually being embraced by two of the largest dealers on the Street. The CBOT approached the creation of an interest rate swap contract in a traditional way, by creating a forward instrument, as it had done when it created Treasury note and bond futures. The forward starting nature of the instrument meant that the CBOT didn’t have to keep track of accruals payments for a coupon or of intermediate cash flows, because the forward instrument converges to the spot rate at expiration. The forward nature of the instrument wasn’t a serious departure from the over-the-counter market, since a great many interest rate swaps trade on a forward basis. When the swap contract was introduced, the CBOT approached Salomon Smith Barney, the brokerage arm of Citibank, and asked if the bank was interested in becoming a market maker in the contract, which would mean being required to keep a certain size on the bid and ask at a predetermined bid/ask spread. At the time, over-the-counter interest rate swap trading was probably the most profitable desk in fixed income; the CBOT was laughed out of meetings when it brought up the idea that Citibank should become a market maker in the exchange-trades contract. Five years later, both Goldman Sachs and Citibank agreed to be market makers in the CBOT swap contracts, taking on a much more significant obligation than had originally been proposed. In just five years, a market that had been the most profitable and exotic desk on Wall Street was so highly commoditized that it no longer made sense for the dealers to carry the administrative costs of handling those trades on their own balance sheets. Interest rate swap contracts have certainly not become as liquid as Treasury note contracts, but they now have significant Street backing and their future is certainly bright.

Three different contracts, three different design choices, three different results. The maddening truth is that contract design is only part of the formula for success: timing and education are as important as cobbling together the right instrument. The original Agency futures contract attracted some volume, but ultimately failed because it relied on a repo market that didn’t exist in the over-the-counter market. Furthermore, the CBOT introduced interest rate swap futures just a few expirations after the launch of Agency futures, which cannibalized most of the volume from their original product.

As of 2008, the Agencies were the last fixed-income market without an active derivative market; my work to create an Agency futures market was the second attempt at such a goal. It probably isn’t reassuring for mountaineers to look down the slope and see a pile of fallen climbers, but it does give one some perspective on the task at hand. Equally, knowing what didn’t work can be an important step towards improving the design of future contracts. The contract that eventually emerged mimicked the over-the-counter market in the most important respects. The rest of this chapter and all of the next chapter describe the second attempt to launch an Agency credit derivative futures contract. I highlight two aspects of the story. One, how the choices the designers made affected valuation. Two, how the design complements the broader market.

The most important aspect of a contract’s design is how it settles, because settlement determines the value of a derivative. For example, Eurodollar futures are listed ten years into the future, but the fact that there is an inviolable settlement to three-month Libor forces the contracts to trade close to their fair value. This is important because it shows that even a contract that doesn’t have a quick and enforceable arbitrage can be successful. Imagine holding on to a back-month Eurodollar contract and explaining to the CEO of your hedge fund that the trade is guaranteed to work out—in another decade! Credit derivatives on Agency debt, while unlikely to ever see a bankruptcy that would trigger settlement, can still faithfully represent the latest credit conditions of the issuers, just as a 10-year Eurodollar contract remains fairly priced even though its settlement is quite distant.

Credit default swaps are credit options, with one leg that is fixed and another that is contingent on a credit event. This contingent payout structure is very much like one of the commodity options that already trades on the exchanges; just the trigger event is different. The underlying risk, in the case of a credit default swap, is a credit event, namely a default, rather than the price movement of a financial instrument or physical commodity. The rapid growth of the credit default swap market and the flexibility of the contract’s design were enticing. Would it be possible to bring derivatives to the Agency market and, at the same time, bring credit derivatives to an exchange? It wasn’t hard to imagine an Agency credit default swap contract being successful, combining a derivative structure from a market that doubles every year with the relatively virgin territory of the Agency market.

However, bringing credit derivatives to an exchange was not an entirely untried path, and we knew success was not guaranteed. In 2006, Eurex was the first exchange to list a credit derivative futures contract on the popular iTraxx index, an index of credit default swaps from European countries. This contract has yet to attract significant volumes. Eurex was able to exactly copy the over-the-counter contract, save for the fact that it only listed the on-the-run expiration. Eurex even went so far as to reference the International Swaps and Derivatives Association (ISDA) auction value for defaulted notes, a move that riled both the ISDA and dealers, who used this as an excuse to claim that an additional derivatives contract referencing this value would distort the existing process in some way. Does betting on a coin toss influence the chance of turning up heads? Certainly not. The ISDA could do nothing to prevent Eurex from referencing its published values, because they are being published for the very purpose of settling the unregulated over-the-counter credit swap market. Criticizing the efforts of the exchange was the natural reflex of dealers who were making handsome profits trading an over-the-counter product. After all, if default swaps make it to an exchange, won’t that mean lower profits for the dealers? In reality, Eurodollar futures greatly aided the development of the interest rate swap market. Treasury futures certainly haven’t eliminated the Treasury market. Rather, futures added another active trading point, similar to the on-the-run issues. Given these parallels, it is possible to imagine that the true heyday of credit derivatives trading has yet to happen, since the credit derivatives market lacks a futures contract to really fuel its growth. In spite of the short-sighted criticism, a default swap index made it onto a European futures exchange. Without a trading pit to take up valuable real estate, there is virtually no cost to list the contract.

The situation was a bit stickier in the U.S. because of a regulatory hurdle not faced by the European market. In the U.S., there is no regulation of the over-the-counter derivatives market, but the Commodities Futures Trading Commission (CFTC) regulates the listed derivatives market and the Securities and Exchange Commission (SEC) regulates corporate bonds. The grim reality is that no country is better at erecting administrative barriers than the U.S. There is no comprehensive regulatory framework in place to handle the financial markets, merely a patchwork of regulations that credit derivatives and credit derivative futures highlight as antiquated. The SEC prohibits futures on registered securities, including corporate bonds, and the CFTC has yet to develop a unified approach to regulating security futures with the SEC.

The experience of the CME is telling. Originally the CME planned to launch event futures that were like credit default swaps in every respect, except that the payout was fixed at 40 percent, rather than set by either the market price for the reference note or an ISDA auction. The CME did this in order to steer clear of the SEC rules regarding registered securities. Before the exchange could launch the contract, the Chicago Board Options Exchange (CBOE) sued the CME, claiming that only the CBOE had the right to list single-name contracts like the one the CME was proposing. The exchange shifted gears and wrapped up a group of its contracts into an index in order to extricate itself from its problems with the CBOE. However, before the CME could launch the product, the CFTC asked for a pause to review the implications of the contract in 2006. Of course, every dealer making profits in default swap trading is going to tip off the regulators to a “problem” when a competing contract comes along that might drive profits from the industry and make it more transparent. Unfortunately, regulators are sometimes not as sophisticated as the industry they regulate, so it is sometimes difficult for these people to separate genuine concerns from self-serving criticism.

Knowing all of this, how was one to design a new derivative for the Agency market that acknowledged the mistakes of the past without repeating them and took advantage of more recent innovations in derivatives design? The first step was the knowledge that everything about pricing a derivative has to do with settlement.

An important lesson came from understanding that the CBOT’s first attempt at Agency derivatives had failed because the product was a forward contract that relied on a repo market that didn’t exist in order to derive the forward price. Corporate bonds face a similarly incoherent financing market, which is one reason why credit derivatives evolved as spot instruments that have nothing to do with forward prices. This is an interesting parallel, because credit default swaps sidestepped a major gap in the infrastructure of the market, a gap that traditionally had to be filled before derivatives could be developed. Interest rate swaps, on the other hand, are the kings of forward pricing, since the carry is so simple at Libor. Interest rate swap traders sometimes sneer at simple solutions to problems, as if complexity had some intrinsic beauty all its own.

The second lesson from the first Agency futures contract and credit derivatives was physical delivery. Like Treasury notes and bond futures, the Agency contract required the physical delivery of a note from the issuer, which is exactly how the first credit derivatives worked. Physical delivery solves the problem of specifying a terminal value for a derivative, since the market prices the note that will be delivered. One alternative was to settle to a reference value, such as the three-month Libor. This would work if there were some guarantee that the reference value would not be tainted by the influence of the derivative. The rules for setting Libor, which are created by the British Bankers’ Association, are longstanding and impeccably administered. The obvious solution to the hazard of manipulation was that one must be willing to trade at the rate that’s submitted. Libor is literally an offer rate; the less-often-quoted Libid is the bid rate for borrowed money.

Having eliminated forward pricing for the new Agency credit derivative, the next step was to consider the solution offered in the credit derivatives market. Was there a way to sidestep the tradeoff between physical delivery versus cash settling to a rate? Remembering that the entire value of the derivative comes from the settlement mechanism, we could borrow the contingent structure from credit derivatives, but make a substitution for the recovery value at expiration. The implication was that the quarterly premiums would remain fixed for the life of the swap, just as they do in the over-the-counter market. What would happen if there were to be a default? Would these payments cease and the seller of protection incur a loss? What should this loss be? Rather than handing the sellers of protection a predetermined fixed rate, like the 40 percent loss called for in the CME contracts, or handing them a note of the defaulted issuer if there were a default, why not pull the loss rate from current market prices and spreads? One way to do that was to mandate that the loss incurred by the seller of protection would be equal to the percentage of the Agency spread against a Treasury note of the same maturity. For example, if the Agency note had a yield of 5.50 percent and the Treasury a yield of 5 percent, then the relevant loss rate would be 10 percent, which is 0.50 percent divided by 5 percent. As with all interest rate commodities, there is little question about what the price of the notes would be, and presumably every desk on Wall Street would be pricing the Agency and Treasury issues right until the credit event by the Agencies, so we could use these prices to assign a loss rate to the new Agency credit derivatives.

Figure 8.1 illustrates the historical values of just such a spread of Agencies against Treasuries and the implied loss rate for a credit default swap using the simple ratio described above. Interestingly enough, the spread as a percentage of the Treasury rate is fairly stable and relatively low, compared to the common modeling assumption in the default swap world of 40 percent. The average loss rate using this approach over the time period shown in the figure would have been between 10 percent and 15 percent, meaning that the Agency yields are generally this percentage above the Treasury rates. Given the high quality of the assets held by the Agencies, it might make sense that the loss rate in the real world would be in this neighborhood, although admittedly there is no history to draw on for the default of a government agency. Figure 8.1 also highlights the fact that the spread of Agencies to Treasuries is quite different from the spread of interest rate swaps to Treasuries. Agency yields are certainly more stable compared to interest rate swap yields than Treasuries, but it is a common misperception that Agency and swap yield performances are nearly identical.

For one thing, Agency debentures represent the credit risk of two businesses: a relatively highly levered mortgage portfolio, at times as much as 40:1, and a mortgage-guarantee business, where fees are collected to insure against default by homeowners. There is also the political risk of investing in the Agencies, as one 2007 plan by House Democrats to siphon money from Fannie Mae and Freddie Mac into a hurricane-disaster recovery fund vividly illustrates. This is not to say that disaster relief isn’t a worthy cause, but the prospect that the government would force a publicly owned company to make a contribution toward a social goal, no matter how worthy, surely had private stockholders grinding their teeth.

Interest rate swaps, on the other hand, represent the counterparty credit risk of the traders who are involved in the market. JPMorgan overwhelmingly dominates this market, so as goes the house of Morgan, so go swap rates. JPMorgan has always had a dominant hand in derivatives trading—it was an early believer and investor in interest rate swap trading. By some estimates, more than half of the notional value of the $100 trillion dollar-plus market is written with JP as the counterparty, with the other dozen or so global dealers gobbling up the remaining market share. It’s remarkable to see this kind of concentration of individual firms in markets that, at least on the surface, appear largely anonymous. The other users of interest rate swaps are mortgage hedgers (including the Agencies), banks, insurance companies, and Wall Street dealers looking to offset the risk they must take in underwriting bond deals. The Agencies are heavy users of interest rate swaps, but they aren’t the sole users, while the debentures of the Agencies represent the sole risk of those entities. Given the diversity of users, it’s not hard to imagine why there should be nontrivial differences between the yield movements of Agency debentures and interest rate swaps listed in Figure 8.1.

Figure 8.2 shows the calculated values in Figure 8.1 in a different light by comparing them against defaults of lower-rated companies. Rather than backing out a probability based on the market yields of Agency debentures compared to default risk-free Treasury notes, this chart attacks the problem of recovery rates directly, by looking at historical patterns. The data in this chart comes from Moody’s Investors Service’s Default & Recovery Rates of Corporate Bond Issuers: A Statistical Review of Moody’s Ratings Performance 1970—2001, by David Hamilton. The majority of these values fall on the lower end of the spectrum, with recovery rates somewhere between 30 percent and 40 percent. This is an interesting result because it lends credibility to the common modeling assumption of a 40 percent recovery rate (and a 60 percent loss rate). However, this chart also emphasizes that historical loss severities are far from predictable. There appears to be another uptick in the frequency of recovery rates at the very high end of the spectrum. The distribution isn’t exactly bimodal, but there appears to be a division between firms with high- and low-quality assets.

Of course, Agency debt would fit into the higher range of these values, but there was so little precedent to rely on that it was difficult to take further steps from there. However, in 2007 there were more than three dozen bankruptcies by subprime mortgage lenders, many of which also had what appeared to be well-hedged real estate investment trusts to house some of the residual pieces from their securitizations. While standards for subprime underwriting are different from the standards usually held by the Agencies, some parallels may yet emerge from the failures of these funds that might be applied to future consideration of the risk of the Agencies. It is also worth noting that, according to the Moody’s report, the sum total of the ten largest bankruptcies in 2001 was $46.5 billion. The year 2001 was one of severe financial stress on the U.S. economy, which slid into a mild recession at the end of the year. The scale of defaults in the corporate and Agency worlds would be completely different: Fannie Mae and Freddie Mac each hold retained portfolios of around $725 billion, plus debentures worth the same amount. The Federal Home Loan Bank system has consolidated debt worth slightly more than this figure—above $800 billion—but its risk is distinct from the other two housing-related Agencies. The Agencies present an interesting intermediate case full of contradictions: their size is quite small in relation to Treasury notes and bonds, but they are far larger than any other individual corporation. The Agencies are certainly private entities with some chance of default, but, given their Federal charter, it is likely that they have the least credit risk of any corporation in the U.S. While they are the largest single issuers of corporate debt, there are no dedicated Agency credit derivative traders on Wall Street, and their derivatives are poorly represented compared to those from other parts of the corporate world.

Assuming one could use this market-based ratio to determine the recovery rate for an Agency in default, the next question was: Where would we get the data? It isn’t enough to wave one’s hands when it comes to the details of specifying a contract, because the devil is often in the details. In this case it was conceivable that no one would give the data source a second thought until there was a default, at which time emotions would surely be elevated anyway. Should there be some quirk or road-block to using the data, settlement of billions of dollars of contracts might be delayed, and the future of the instrument would surely be in doubt. What gave me hope when I was designing the first Agency credit derivative with a market-based recovery rate was that the Agencies, at least Freddie Mac and Fannie Mae, already published benchmark spreads for the Bloomberg AOAS function. The motivation for publishing spreads wasn’t to value credit default swaps, but at least I was not the first to deal with transparency issues in the Agency market. Prior to the Bloomberg AOAS screen, each issuer would have had its callable notes evaluated by a generic Agency curve with nonstandardized models. This is a bigger deal than it might seem, since the option-adjusted spread valuation is unique to each model, given how many judgment calls are made when cobbling together such an estimate. How could one create a commodity market when everyone was quoting values separately? One dealer might have looked at a 5-year note with a call option in one year and seen an OAS of +5 basis points, while a second dealer might have looked at the same bond and seen an OAS value of +2 basis points. In a market that generally trades on a yield spread basis to a reference Treasury note, this difference was a real hindrance to liquidity.

To solve the problem, the Bond Market Association stepped in at the behest of the Agencies and created a uniform model and standardized curves for each issuer. Once they had a unique yield curve from each issuer, traders across Wall Street could speak the same language regarding callable Agency valuations; one dealer’s quote of an “AOAS of +2” had the same meaning for the whole market. The history of the Bond Market Association is not the main subject of this book, but it did create something that was quite valuable to someone who was designing a default swap model that would settle to a ratio of market-priced spreads: customized Agency curves published by an independent and reputable source. The Agencies themselves publish closing prices for their benchmark curves, but filtering these values through the Bond Market Association, an independent third party, ensures their proper administration, which would presumably include watching for any manipulation.

On the surface it appeared as if all of the problems had been solved, but this contract was about to run into what would be just the first of many setbacks prior to its launch.

In talking to investors and traders, it became clear that we had made the most common mistake in contract design: the approach was trying to be too smart for its own good. While the design seemed simple enough to me, it was quite difficult to explain in practice. No one seemed to be able to pick up on the rationale the first time—or third time—that it was explained. The market-based approach to solving the recovery-rate dilemma was beautiful from an analyst’s perspective, but it introduced quite-complicated two-stage modeling issues that were hard to evaluate. For example, in the corporate world, default swap values heavily influence the pricing of the cash notes, and we would have been relying on these notes to determine the price of the Agency default swap. Sound circular? It was. The only way to accomplish this would have been to assume the Agency yields in the cash market were fixed, and to take them as inputs to the valuation model. The results of the valuation model would then have been used to look again at the cash note prices to determine value. Honestly, the results of the idea to settle the default swap to observed spreads in the market ended up being far too complex for its own good. Good ideas don’t have to be simple, but they have to have that satisfying “oh, why didn’t I think of that?” feel to them, and this first approach certainly did not.

The second approach was much more conventional, and it matched the language from the over-the-counter market because it was intended to be an over-the-counter instrument. Design can be quite flexible in this market and, in recognition of the unintended complexity of the first approach, it was important to make the contract innovative in terms of the risk it addressed, rather than in terms of its the operational mechanics. This second contract would call for physical delivery of the underlying note in the case of default, which matched the language from the single-name default swap market. While the physical delivery aspect of the contract bowed to convention, there was a novel element to this second contract: the inclusion of the Federal Home Loan Banks (FHLB). To date there has never been a consensus about how to handle credit default swaps on the FHLB system because of the way that the Office of Finance consolidates debt across the system. The system pools its borrowing needs: the Office of Finance issues debt that is the joint and several obligation of the entire system, rather than of a single issuer. Default is the trigger event for settlement in a default swap, but what would happen if one of the twelve FHLB banks defaulted while the others did not? The banks are geographically diversified and independently managed, but they are all in the same business. One would imagine the risks each faces are largely the same.

Luckily, there was a range of options available in the standard over-the-counter default swap language. Among the most popular default triggers were (and still are): filing for bankruptcy, failure to pay, or renegotiating the terms of a loan. But would the entire system have to go bankrupt before settlement would be triggered in the contract, or would the demise of one bank be sufficient? Different answers produced very different economics. Bankruptcy of the entire system was far more difficult than one of the twelve’s foundering. If only one bank’s going under triggered payment on all of the default swaps written on the joint and several obligations of the entity, the contract would have had a first-to-default structure. Rather than take into account the strength of the entire system, a first-to-default contract would have traded to the weakest entity. This was not a small question, since individual banks in the FHLB system had run into some trouble in the past. For example, S&P placed FHLB Des Moines on its CreditWatch list on concern over the bank’s financial health in 2006, and FHLB Dallas and FHLB Pittsburgh have both been placed on negative ratings watch at various times. While the AAA ratings of the consolidated obligations of the system had never been in jeopardy, it was possible to create contracts with very different economic results from just a small change in language. Our choice of just two criteria (failure to pay and bankruptcy of the entire system) essentially reflected the fears of the dealer community by making it as difficult as humanly possible for the contracts to go into default and force the delivery of the reference notes.

No one thought the collapse of the system was imminent then, and no one does today. However, there have been instances in the past when government-sponsored enterprises have run into trouble.

One instance that barely qualifies was a more than $200 million loss by SLM Corporation, formerly Sallie Mae, in 2007. SLM has been a private corporation since 2004, but this wasn’t always the case. Prior to turning private, Sallie Mae was a government-sponsored enterprise (GSE) that made student loans. While SLM’s risks were quite different than those of the housing GSEs—Freddie Mac, Fannie Mae, and the FHLB system—operations at SLM were certainly cut from the same cloth as those of the other entities. SLM’s losses from poor derivative hedging were $87 million in 2005 and a whopping $357 million in 2006. Please permit an amusing aside about the dangers of outsourcing: After SLM relocated some loan-collection responsibilities from a Nevada call center to one in Indiana, it faced, “unexpected operational challenges that resulted in lower collections,” according to the 2008 10-Q filing by the company. Essentially, everyone who was supposed to be making calls to delinquent borrowers had starting calling around for a new job instead. In April 2007, the company paid $2 million to settle a lawsuit with New York State because of “revenue sharing” payments made by some student lenders back to the schools of the students borrowing money. Essentially, these payments were kickbacks. Although there was nothing new about the practice, this anecdote highlights the fact that, even in a well-established business, the risks that exist are sometimes not well known. Any entity that deals with a highly politically sensitive arena like student loans or affordable housing is bound to face increased scrutiny.

Closer to home, there is a skeleton lurking in the FHLB closet. In 1989, when the savings and loan crisis was in full swing, the U.S. government came up with the idea of creating an insurance fund to backstop some bad loans made by insolvent thrifts. The Resolution Trust Corporation (RTC) was created by what would become the Financial Institutions Reform, Recovery and Enforcement Act. The bill was one of the most significant to impact the thrift industry since the Great Depression. The beauty of the RTC from a political perspective was that it didn’t have to be funded by taxpayer dollars; rather, the FHLB system would be required to purchase nonvoting stock through a complex formula. What happened to the money from there was somewhat complicated: it involved buying zero-coupon U.S. Treasury bonds to guarantee the principal payments of coupon bonds the RTC was issuing. The relevance for the FHLB system was that the government effectively expropriated a large portion of the retained earnings of all of the twelve member banks to fund the RTC. Talk about political risk! Congress and the president decided to shift hundreds of millions of dollars from one entity to another with the stroke of a pen. How do you think default swaps would have performed if they had existed on the FHLB system in 1989?

There are more recent examples of the Agencies running into political trouble, including the proposed Hurricane Katrina relief fund. While the 2005 hurricane that decimated New Orleans was certainly a tragedy, it’s unclear what the Agencies had to do with it, except for the fact that they have deep pockets. Although the proposed relief fund has not made it out of Congressional subcommittee as of this writing, the plan is for the Agencies to contribute a portfolio of their revenues to the fund, which would be used to help rebuild the Gulf Coast. As the storm recedes into memory it seems less likely that such legislation will pass, but the mere proposal highlights the fact that the Agencies, Fannie Mae and Freddie Mac in particular, face political risks that are quite unique. These firms are private corporations, but what politician in his right mind would announce that Bank of America and Citibank should be required to contribute to a relief fund? The scenario sounds like something out of a third-world dictatorship, and would never happen in any other segment of the U.S. market, but the possibility remains with the Agencies. How would default swaps on the Agencies have performed during the debate over hurricane relief? Obviously, this would have been quite a source of volatility.

There was another reason for including the FHLB system in the Agency credit derivative index. Although there were proposals circulating in Washington, D.C. to bring the FHLB under the Office of Federal Housing Enterprise Oversight (OFHEO), the regulator for Freddie Mac and Fannie Mae, the FHLB system was—and still is—regulated by the Federal Housing Finance Board (FHFB), which is an independent regulatory branch of the U.S. government appointed by the president. The secretary of the U.S. Department of Housing and Urban Development (HUD) also serves as part of the FHFB, but OFHEO explicitly falls under HUD oversight. This difference in regulatory structure has led to a difference in the way the FHLB’s $860 billion in debt and the Agencies’ $1,460 billion in debt ($730 billion each from Freddie Mac and Fannie Mae) trade in the market. The difference in regulators changes the dynamic for political risk. When Congress threatens Freddie Mac and Fannie Mae, there is sometimes a mini-flight to quality into FHLB debt. This trade was far more common before the portfolio limits on Freddie Mac and Fannie Mae were imposed in 2006, But, as Figure 8.3 illustrates, there was still enough of a distinction between the way debt from the FHLB and the rest of the Agencies traded that it was worth including all three in the (very narrow) index. Put another way, including FHLB debt along with the other two made the index more stable.

There is another way to think about including FHLB debt in an Agency credit derivative index. There is no way to know ahead of time which issuer’s debt will be the most volatile in any given month. It would be convenient if we could always look to Fannie Mae as the market leader in pricing, a company where all news first hits and then is filtered into the rest of the curve. Before 2007, when Fannie Mae had quite a bit more debt outstanding than Freddie Mac, this was sometimes true, but now that the two are roughly equal, the difference has largely evaporated. Table 8.1 illustrates just how difficult it is to anticipate which issuer’s debt will be the most or least volatile in any given month. The purpose of including all three issuers in an index is to dampen swings due to uncharacteristic volatility of the market. Perhaps one issuer is experiencing a squeeze in short-term financing or unusual demand for its debt. As just one of three, its unwanted influence would be diluted. Table 8.1 illustrates the volatility for each issuer during the months shown. The lowest volatility for each month is underlined. The Federal Home Loan Banks (FH) had the lowest volatility for five months, Freddie Mac for three months, and Fannie Mae for two months. The results confirm our general assertion that FHLB debt acts as a sort of shock absorber to the other two housing GSEs. The FHLB had the lowest volatility for half of the months, but there is no clear pattern of which other issuer is the most volatile; Freddie Mac and Fannie Mae are almost evenly matched. The series is by no means conclusive because it covers just ten months, but it supports the idea that including the FHLB system makes the whole index less volatile.

There was another important reason to include the FHLB system in the index: it is included in the Lehman Brothers Aggregate Index (Lehman Ag). The vast majority of money managers, a percentage somewhere in the high 90s, are benchmarked to the Lehman Ag. The index is composed of subindexes that are specific to individual markets, which is convenient because it allows managers’ performances to be compared. While not strictly based on market value, the government portions of the index are relatively straightforward; there is almost an equal weight between FHLB, Freddie Mac, and Fannie Mae. By including FHLB in the Agency derivative index, we would be able to accurately replicate the Lehman Ag with a single instrument, rather than having to create three credit default swap trades (assuming the question of how to account for the FHLB portion was resolved). The idea of this overlay was simple enough, and we went to great lengths to illustrate how the FHLB system sometimes acts as a “shock absorber” for the Agency market when traders flee Freddie Mac and Fannie Mae because of headline risk, whether regulatory or accounting. The economics and language matched the over-the-counter market—because this was an over-the-counter product! Why wasn’t this structure the one that was eventually launched?

For one thing, we stuck to the idea that something new was necessary in order to launch the index. The way we handled the FHLB debt, although it was logical, wasn’t the only way to approach the issue, and, as of this writing, there still remains no consensus about how to handle default swaps on such an unusual entity. Perhaps such a consensus would have been built if the product had been launched, but having to explain the handling of the FHLB seemed an unnecessary extra battle to fight when we already had to convince people of the merits of trading Agency default swaps.

When we first approached the problem, it seemed as if everything had to be new in order to solve the problem of bringing derivatives to the Agency market. The market-based approach to determining recovery rates from bond yields was intellectually interesting but needlessly complex given the alternatives that already traded in the market. The handling of the FHLB system was similarly interesting from an academic or structuring perspective, but it simply seemed a bridge too far in terms of bringing a new concept to market and at the same time trying to explain a new structure to people. Having said that, the structure around the FHLB system isn’t complicated, and in practice this problem might have been overcome with a few minutes’ worth of explanation. Unfortunately, there was never an opportunity to try, since the contract was never launched as an over-the-counter default swap.

The concept was to be transformed yet again on its way to becoming a futures contract. One of the legitimate concerns about launching this contract as an over-the-counter swap was that the firm that launched the product would have no other dealers to trade with. This would be a problem if the firm launching the product got “one way” with risk and wasn’t able to offset the position with a customer trade. In well-established markets, a trader in that position would simply call an interbroker dealer or another trader at a competing firm in order to lay off the risk. Being the first to launch a contract means the chance to receive kudos for innovation, but there is also no one else to trade with on the Street, at least not until others enter the market. This was a classic “you go first—no, you go first” situation. There didn’t seem to be an Agency trader in the dealer community who was willing to commit to trading this product for fear of retribution from the Agencies. Remember, the whole reason the Agency credit derivative market was in such a sorry state to begin with, the reason it never traded as actively as the other corporate names in the CDX index, was that the Agencies had long ago strong-armed the dealer community into trading their debt from Treasury-trading desks, rather than corporate desks (see Chapter 2). The whole idea behind the tactic was to give Agency debentures the liquidity and legitimacy of government debt. The end result was to starve the product of a derivatives counterpart. By 2007, every other market, from municipal to asset-backed debt, had an active derivatives market, while Agencies were still traded on their own only infrequently, and outside of the CDX index. It is obvious today that more trading in the derivatives means better liquidity in the cash market, but who could have anticipated the explosion of credit derivatives trading in the last decade? Credit derivatives didn’t even exist when the Agencies first got the idea of dramatically growing their retained portfolios and the amount of debentures they had outstanding. Wresting Agency debt from corporate trading ended up being a short-sighted decision, because as a result it never attracted the attention of corporate-only traders, and the cash notes traded on a different desk from the derivative, retarding the growth of the market.

One of the benefits of a futures contract is that trading is centralized in a single place, and there is no physical or informational advantage to being tied to this or that trading desk on Wall Street. Working in the markets day after day, it’s easy to forget some of the basic assumptions that we all make. Traders in the old pits in Chicago might wonder how anyone could possibly trade sitting in a high-rise in New York, and vice versa. One of the reasons the original futures traders met under the same old tree in Chicago was to bring everyone interested in trading a product to the same spot. The so-called centralized trading that goes on in New York City across two dozen different firms isn’t quite the same thing, as geographic concentration and specialization are signs of economies of scale, rather than characteristics of a single information disseminator, which is essentially what a market is.

The introduction of an Agency default swap index would have been somewhat difficult for one dealer to pull off, but not impossible. The working assumption would have been that other dealers would subsequently begin to trade the product, as clients demanded unwinding of trades with someone besides the initiating broker. The interdealer market would then develop, and the new product would be well on its way to success. At least, that was the over-the-counter template.

Creating a futures contract skips all of the intermediate steps of establishing interbroker dealers and brings everyone to the same place at the beginning. This total transparency sometimes paints a frighteningly stark picture, because unlike in the over-the-counter market, everyone knows exactly how much (or little) liquidity a product enjoys. In the over-the-counter world, dealers often wave their hands and provide assurances that “we’ll be there when you need us,” but except for extremely broad market volume reports from the ISDA, the derivatives trade group, no one really knows what the outstanding values are of a particular product. In contrast, information about futures trading, including volume and open interest, is updated in real time, which lends a much different perspective to the listed-derivatives market.

As I mentioned before, swap futures are an idea that has been around for a long time, but they have only recently garnered the liquidity and institutional interest that are the hallmarks of a successful contract. In the early stages of the contract at the CBOT, there was quite a bit of buzz about the future of the product, so traders were surprised to see how little was actually trading in the market. Discouraged by this utter lack of liquidity, because everyone could see the open-interest and volume facts directly for themselves, many stayed away. New over-the-counter markets are more difficult to get hold of. In a strange way, traders don’t seem to expect a lively over-the-counter market; they seem increasingly willing to leave orders in the market in order to see if the broker can search for the other side. In futures this is seldom the case; many expect instant gratification. This was certainly the experience of the swap futures contract. Many wrote off the product until Citibank and Goldman Sachs agreed to be market makers, stunning the naysayers. There is a depth to many markets that is not easily observable. Having said that, it is still difficult to tell whether a contract is on the verge of breaking into the big leagues or whether it is fated for the scrap heap, at least in the very beginning. There are advantages and disadvantages to both ways of starting a new product, either over-the-counter or on an exchange. The Agency credit derivative index was fated to be an exchange product; it’s just that no one realized it in the beginning.