A Hybrid That Converts Junk Bonds To Triple A?

Ringing Alarms

“The way we make money for our clients is by assessing risk and generating risk-adjusted returns, and if you have a security that hedges that risk premium away, then why is it compelling? I would just buy Treasuries,” says Bonnie Baha, the head of global developed credit at DoubleLine Capital, a Los Angeles firm that manages about $56 billion in fixed-income assets. “This product sounds like a great idea in theory, but in practice it may be a solution in search of a problem.”

And, of course, fusing a security as straightforward as a bond with the notorious credit-default swap does ring a lot of alarms, says Phil Angelides, former chairman of the Financial Crisis Inquiry Commission, a blue-ribbon panel appointed by President Barack Obama in 2009 to conduct a postmortem on the causes of the subprime mortgage disaster.

In September 2008, American International Group Inc. didn’t have the money to back the swaps it had sold guaranteeing billions of dollars’ worth of mortgage-backed securities. To prevent AIG’s failure from cascading through the global financial system, the U.S. Federal Reserve and the U.S. Treasury Department executed a $182 billion bailout of the insurer.

‘Strikingly Similar’

“When you look at this corporate eBond, it’s strikingly similar to what was done with mortgages,” says Angelides, a Democrat who was California state treasurer from 1999 to 2007. “Credit-default swaps were embedded in mortgage-backed securities with the idea that they’d be made safe. But the risk wasn’t insured; it was just shifted somewhere else.”

McQuown and MacWilliams counter that soon CDSs will not pose the systemic threat they did in 2008. Back then, they were traded between two parties in an unregulated and unaccountable system.

To bring the $19 trillion CDS market out of the shadows, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandated that most of these securities be traded through exchanges and processed by clearinghouses that guarantee settlement and record every transaction in a database open to regulators. The SEC is writing rules to implement the measure. (Bloomberg LP operates a swap execution facility for trading these derivatives.)

New Safeguards

The two men are betting these new safeguards will ease worries about swaps. ICE, the No. 1 global clearinghouse for credit derivatives, will process the swaps used to create eBonds.

ICE requires sellers of swaps to backstop their contracts with various margin accounts. If the seller fails to pay off, then ICE can tap a “waterfall” of margin funds to make the investor whole. In the event of a market crash, it can call on clearing members such as Citigroup and Goldman Sachs to pool their resources and fulfill swap contracts.

There’s still a danger that the banks themselves may be unable to muster cash in a crisis. But this shared responsibility marks a sea change from the bad old days when investors gambled their counterparties would make good on their contracts.

‘Trust and Faith’

It’s late afternoon at Stone Edge Farm, and McQuown is meeting with MacWilliams and eBond Advisors CEO Bryan Jennings in his billiards room as shadows stretch across the swimming pool outside. The three men are discussing the restructuring of the derivatives market since the crash.

“We could never have developed eBonds without Dodd-Frank and centralized clearing,” says MacWilliams, 62, an easygoing man who rides in the Krewe of Hermes parade in his hometown of New Orleans every Mardi Gras.

“In 2008, it wasn’t the swap that was broken -- it was trust and faith in the system,” adds Jennings, 48, who headed fixed-income capital markets and derivatives at Morgan Stanley from 2003 to 2012.

“It’s absolutely stupid to have a derivatives market based on bilateral trading,” McQuown chimes in. “And to load up dealers with an inventory of credit-default swaps is the second- dumbest thing imaginable. Centralized clearing is one of the benefits of ’08, and I think it’ll change the debt markets.”