Accounting treatment of Credit Default Swap

In KGAAP(Korean Generally Accepted Accounting Principles), the seller of CDS(Credit Default Swap) should treat the transaction as either a guarantee or a derivative instrument depending on the terms and conditions of the trade. A protection seller shall pay the final payment to recoup the loss of a protection buyer incurred by default of reference obligations, then the CDS is recorded as a guarantee by the seller on his balance sheet. If the final payment, on the other hand, shall be made depending on such variables as creditworthiness, the transaction is recorded as a derivative product which shall be subject to marking to market and evaluated as its fair value.

In US (SFAS 133) and Japan (Practical Guideline 226), credit derivatives basically should be evaluated as their fair value. Thus, some argue that KGAAP should follow its counterparts in U.S. and Japan as treating credit derivatives as a guarantee may cause the financial statements not to reflect the protection seller's obligation correctly.

Recent credit crunch in the capital markets make this argument sound even more plausible. Let me take an example. Suppose X bank invests in a AAA-rated Ambrose CDO(Collateralized Debt Obligation) and another Y bank sells a protection in a credit default swap where reference asset is the same Ambrose CDO as X bank buys. Setting conterparty risk related to the CDS aside, the two banks are exposed to almost identical credit risk as the risk mainly involves Ambrose CDO

What if the value of Ambrose CDO falls sharply but its credit ratings do not change? The X Bank has to reflect the impairment on its financial statements as much as the CDO deteriorates because it shall adjust the CDO's book value to the then fair value; however, Y Bank may not even reserve for the impairment. In Korea, a guarantee with its reference asset' rating untouched do not require making additional provision for the potential loss.

In my opinion, all credit default swaps should be treated as credit derivatives and be marked to market. This change will help to enhance transparency of accounting.

Bond Trading Idea Using Primary Dealers Prediction

On Jan. 2, 2007, "Wall Street's biggest bond-trading firms, confident the Federal Reserve will lower interest rates as the U.S. economy cools, say Treasuries will post the best gains in five years during 2007." reported Bloomberg News.

Primary dealers predicted the biggest bull market for Treasuries since 2002 at the start of this year. In a Bloomberg survey in January, the firms forecast gains of 5.4 percent in 10-year notes and 5.1 percent for two-year securities.

Following are the results of Bloomberg's survey, conducted from Dec. 18, 2006 to Dec. 28, 2006:
.................................................2-year......... 10-year

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Then (End of 2006)....................... 4.8%........ 4.62%

Median* ........................................4.5%....... 4.55%

Current (Nov.26, 07) .................... 3.135%... 4.042%

* Median forecasts in a Bloomberg News survey of the 22 primary government security dealers for Q4, 2007.

Now is November 26, 2007 and Treasuries are poised to post higher returns than corporate debt and the S&P 500 for the first time since 2002 as the primary dealers predicted. Treasuries of all maturities have gained 8.6 percent this year, compared with 3.9 percent for company debt, according to Merrill Indexes (See the right-hand side charts). The S&P 500 paid 3.3 percent, including dividends, Bloomberg data show. Indeed, the returns on Treasuries may exceed even primary dealers' forcasted returns as indicated in the U.S. Government Indices (as shown in the left-hand side table) as the yields fall by more than their expectation.

Will a primary dealers prediction be a good indicator for trading Treasuries for the coming years?

Structured investment vehicle, or SIV

From Wikipedia :

A structured investment vehicle (SIV) is an "evergreen fixed income maturity transformation fund", similar to a CDO or Conduit. They are usually from around $1bn to $30bn in size and invest in a range of asset-backed securities, as well as some financial corporate bonds. An SIV is formed to make profits from the difference between the short term borrowing rate and long term returns. The risk that arises from the transaction is twofold. First of all, the solvency of the SIV may be at risk if the value of investments falls below the equity part. Secondly, there is a liquidity risk, as the SIV borrows short term and invests long term, that is the debt comes due before the asset falls due. Unless the borrower can refinance short-term at favorable rates, he may be forced to sell the asset into a depressed market.

My thought :

I recently found the definition was slightly altered (presumably owing to some critics). Formerly, it went like "A structured investment vehicle (SIV) is an evergreen credit arbitrage fund." However, such explanation looked a bit misleading.

"Evergreen ... arbitrage " fund meant classic borrow short to invest long. At first, the evergreen may not be proper adjective. The word still remains in the current description, though. Some disagreed saying they are evergreen until the fire comes and burns them down. That is what I am all for.

Meanwhile, "why do people keep thinking this is an arbitrage play when it is not? It is speculation. I suppose evergreen credit speculation fund doesn’t have the same ring to it" another said.