Credit Default Swaps, Part One: Origins and Implementations

The unravelling of the housing market, followed by the credit markets, was, (in my opinion) due to the proliferation of Credit Default Swaps a.k.a CDS’s. CDS’s were invented by a brilliant British woman - Blythe Masters. In the old days, if you bought a bond, your risks were:

a. Default on the payment of interest.

b. Insolvency of the issuer.

c. Pre-payment of the loan [with interest].

So when you ask about separating the risks from the instrument [the bond], and forfeiting a part of the interest received by the bond, and paying that as an “insurance premium” to the bond insurer, well, this has been going on for a while - especially in the municipal bond industry.  So far, so good.

Ms. Masters took this to the next logical step. What if you could “bet” on whether a financial entity will default on their debt [or not]? This “bet” is what a CDS is - a contract between a buyer who makes periodic payments to the seller. If the financial entity defaults on its bonds, or if the entity’s financial health changes significantly, the buyer of the CDS gets paid the face value minus the market value of the financial entity’s bond.

An example

You (Bond Guru Inc.) were long a Lehman Brothers’ CDS, and were probably paying a healthy quarterly premium to the seller (Default Newbie Inc.) of the CDS.  When Lehman filed for bankruptcy, this created a credit event. When the Lehman bonds were finally auctioned off, they settled for 8.625% - or 8.625 cents per dollar. In this case, Bond Guru Inc. - which was long Lehman’s CDS, was obliged to get [$1.000 - $0.08625] = $0.91375 per dollar (from Default Newbie Inc.). The converse is true too. If Lehman’s financial health improved [instead of deteriorating], Bond Guru Inc. could stop paying the premiums, and Default Newbie Inc. would keep all the money that they had collected in premiums.  Alternately, Bond Guru could buy a “cheaper” CDS where the premiums are lower.

The settlement

Congratulations Bond Guru Inc.!  You did great with the Lehman CDS’s.  But, Default Newbie Inc. allocated [set aside for default] a half a cent per dollar of bond value of the CDS that he sold to you [for which you dutifully paid your premiums]. So, BG Inc. will receive 0.005 + 0.08625 = 0.09125 cents per dollar.  Plus, Default Newbie Inc. will be in bankruptcy [liquidation].

The CDS market

The CDS Market is $55,000,000,000,000.00 strong. So, everyone wants a piece of it. The players are:

1. The Intercontinental Exchange. (ICE) [With Markit].
2. The Chicago Mercantile Exchange. (CME) [With The Citadel Group].
3. The NYSE/Euronext - (NYX) which will also use Markit.
4. The NASDAQ/OMX - (NDAQ) through Liffe [which is actually a part of the Euronext].
5. Knight/Trimark Group (NITE).

While The Knight/Trimark group has already launched their CDS platform NetDelta, the ICE has a formidable record of bringing scalable products on-line in record time.  In fact, the ICE’s dominance of the West Texas Crude Intermediate [WTI] blind-sided the CME, an CME’s stranglehold on the energy market/energy futures. Both the CME and ICE will dominate the market, but the NYSE, Nasdaq and Knight/Trimark aren’t exactly spring chicken.  They know this business too, and know how to make money with the slimmest of margins.

Unresolved Issues

1. There are two possible models for a CDE exchange.  One is the OTC model, where the exchange provides a medium to transact the business. The second model is one of a central counter-party [the ICE/CME model] where in either party’s default, the exchange makes the parties “whole.”
2. Since the numbers involved here are huge, and as we have found from the collapse of the banking system, mere capital requirements are insufficient to guarantee a functioning CDS market - where all defaults can be cured.
3. The CDS market is not [yet] regulated. Hence, there is little if any, in margin requirements. Even 1% in margin equates to 550 Billion dollars - capital that CDS sellers [insurers] like Default Newbie Inc. above cannot afford to lock up in these times.
4. Neither can a central counter-party unconditionally guarantee the proper execution and clearing and in the case of default/credit event - the “making whole” of the party that purchased and paid the premiums for the CDS.

In other words, as we saw recently [during the Lehman Credit Event] - the default of one huge entity can wipe out a half a trillion dollars of equity. In other words, none of the five companies mentioned above can cure [the default of] their trading clients in the event of a default similar in size to the Lehman debacle.

In Part-II of this article, I will discuss which of these five companies are a worthy investment, and why.

Disclosures: No positions on any stocks mentioned in this article.

Comments

[Research123:]

If principal risk can be fully insured via a vibrant CDS market, why should there be a yield difference amongst corporate bonds with differnt credit grades, and for that matter why should coporate yields be significantly higher than Treasury yields?

2008 Oct 20 10:57 AM

[Smarty_Pants:]

Research:

The extra yield for corporates would be required to pay for the "insurance" needed to make them equivalent risks to treasuries.

As the article notes, the insurers can't afford to tie up sufficient capital to cover the worst case at the current premiums.

The premium paid would need to be increase to the point where the cost of setting aside sufficient capital is profitable. It's likely that doing so would make the cost of insuring the bond exceed the interest paid therefore rendering the 'insurance' beside the point. Why buy an asset that pays $100/month when it costs $200/month to 'insure' it?

Sounds like this is a product that isn't finiancially feasible strictly by the numbers unless the credit rating of the issuing entity is top notch and the true chance of default is very small.

As LEH was percieved to be a very small failure risk and later proved that perception wrong. It sorta sounds like these instruments aren't economically sound for all parties.

Hey, at least there's only $55 Trillion of the things out there.

Yikes!

2008 Oct 20 04:31 PM

[moonbat1775:]

What good is insurance if a "cluster of business errors" occurs as Von Mises predicts? Or is there an exclusion for "acts of fractional reserve bankers"?

2008 Oct 20 04:57 PM

[Lawrence York:]

Look the fact is that at its peak the CDS market was in excess of $62 trillion and today it is at $55 trillion. The magnatude of these credit default contracts is currently a double-digit multiple of the net worth of the world. When you consider the enormity of this leverage and that by definition one side has a loss, you get too big to fail, you get amortized losses, you get governments doing creative Enronesque accounting, and you have the world holding its breath. It will take a couple years to deleverage to a safe level. Meantime, its more of the same. Printing money and rewarding too big to fail because solvency trumps fairness. But yes we need transparency and the soon a CDS's can trade the better.

2008 Oct 20 09:35 PM

[Tradesense:]

Any insurance is as good as the insurer!! The result of living beyond means.

2008 Oct 21 06:28 AM

[john s. gordon:]

thanks for explaining the above.

funny money is trumped by imaginary money.
> jack

2008 Oct 21 10:44 AM

[JR1200:]

I don't really know much about this type of stuff but isn't ICE responsible for the shady, deregulated energy futures trading that caused the oil and gas prices to go sky high?

2008 Oct 21 12:29 PM

[Shiv Kapoor:]

I would argue that the old risks (a. Default on the payment of interest, b. Insolvency of the issuer, c. Pre-payment of the loan [with interest]) are the only real economic risks. The CDS looks like it is essentially an instrument to shift risk from the owner of paper to an insurer. The question to which I cannot find an answer is whether CDS's are issued to a party with no insurable interest; for example could a person get cover for a Lehman Default event without owning the underlying Lehman paper. If the answer is yes, the question of whether the so called insurance contract is legally binding arises because of the absense of an insurable interest.

I have no doubt that the availability of a CDS will have encouraged lenders because they thought the risk was covered. It is true that this would have led to an over-leveraged economy (which is no secret). But the real economic risks associated with credit default are the same.

The way I see it is that a CDS did not really separate risk from the instrument; it failed to achieve its purpose. If an insurer goes bankrupt for failing to pay its obligation; it will result in a distress sale of the insurers assets to pay out the obligation to the fullest extent possbile. The buyer of the distressed paper will earn future profits being the difference between the actual recovery from the debtor and the price paid for the paper. In the mean time because the insurer defaulted, another insurer who insured the paper of the first insurer will find itself in the same position as the first insurer; again the second insurers assets will be sold in distress and the buyer will profit in the future. Ultimately, what will occur is that the weak hands will go insolvent while strong hands will gain assets bought at below fair value during a distress sale; the total impact will never be more than that part of the debt which actually went bad. So, instead of separating risk from the security, the CDS actually ended up creating risk for the economy. The real questions to answer are (1) where did the money go - that is where the bubbles will have formed and (2) how much of it will likely go bad.

2008 Oct 21 12:55 PM

[Moon Kil Woong:]

Most people who wrote CDS contracts squandered the payments and would be broke if they actually had to pay out. All those who bought the contracts are flat out of luck and all those that bought bad loans with CDS to cover their asses are out of luck too. Goldman is the only one not out of luck because they have Paulson who is giving $100 billion to AIG so AIG can pay off his old employer (Goldman). So when the FBI comes knocking they don't visit the Treasury to issue fraud arrest warrants.

2008 Oct 21 01:06 PM

[xsuddensam:]

All I can say is that all this really has me spooked. Am I missing something here? It's pretty obvious that with little or no reserves, there was no sense in pay premiums. Are people just stupid or were they duped? The real question is to what extent were the politicians involved.

2008 Oct 21 03:32 PM

[Moon Kil Woong:]

Politician's weren't involved as much as federal regulators didn't do their job because 1) they were dumb, 2)they were lazy 3)they are bankers and brokers usually regulating bankers leading to cronyism 4)Bush Jr.'s cabinet and all his appointees thought they could benefit by not doing their jobs. 5)Lobbyists run the government. So I guess you could say, there was nothing new or significant on the political front besides the usual clown show. I don't think the grand conspiracy played any role asides from the usual moronic responses we tend to get (denial, throw $ we don't have at it, then blame others and ask the lobbyists for advice).

2008 Oct 21 10:15 PM

[xsuddensam:]

Constructe:

There is too much money for politicians not to be involved.

2008 Oct 22 05:35 AM

[john s. gordon:]

i'm surprised the current white-house occupant doesn't blame clinton for everything that has happened 2001-2008.
> jack

2008 Oct 22 02:17 PM