Everything You Wanted to Know About Credit Default Swaps

Includes: BAC, C, GS, JPM, MS
by: Christopher Whalen

On Monday, February 23, 2009, American Enterprise Institute in Washington is hosting an event entitled "Everything You Wanted to Know about Credit Default Swaps." IRA co-founder Christopher Whalen and Mark Brickell, the former chairman of the International Swaps and Derivatives Association (ISDA) and founder of Blackbird Holdings, will discuss and debate the market for credit default swaps and proposals in the Congress to reform this over-the-counter market.

It is pretty clear from news reports that the OTC derivatives markets is going to see substantial regulation in the coming year. These reforms to reign in the retrograde characteristics of the OTC derivatives markets hopefully will include:

  • A central counterparty to stand between all parties (dealers and end users alike) and to enforce and hold collateral requirements. To me, the minimum collateral for a writer of protection should be = par value of the basis less recovery value/2, an amount that I am told would preclude most dealers from participating as principal and would leave the insurance part of the CDS business to the insurance industry.
  • Limits on sales of CDS protection to only those parties with an economic interest in the default, such as bond holders. By requiring buyers of protection to deliver the underlying basis of the contracts, much of the systemic risk created by the bilateral OTC credit model will be extinguished. Why should we allow global banks to become platforms for multiplying net systemic risk via cash settlement CDS contracts?
  • And last but not least, centralized clearing for all such contracts. The “new” SEC Chairwoman Mary Shapiro has put this on her to do list. We’ll see if anybody at SEC is smart enough to consider the first two points. As a public policy issue, clearing is basically a distraction, in my view, a minor operational issue that is already resolved by the hard work of the folks at the DTCC and Fed of New York.

Bottom line, it is my hope that we will eventually see a bifurcation of the current CDS vehicle into 1) an exchange-traded option that reflects the underlying corporate bond basis and 2) an OTC default insurance contract that reflects the pricing of P(D), not the short-term yield spreads on an illiquid bond!

Most of the dozens of users of CDS whom I have worked with and interviewed over the past decade would be avid users of the exchange traded contract, but few would have any need for the OTC instrument. Perhaps this observation tells the true tale of the end of CDS as we’ve known it.

In the event, this is very bad news for JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS) and Bank of America (NYSE:BAC) inclusive of the derivative waste dump known as Merrill Lynch. These and other dealers of OTC derivatives were raking in supranormal returns from CDS markets over the past few years, returns that are now disappearing as profits have been replaced by losses. As credit defaults rise and spreads also widen further, look for these dealers to take additional losses from CDS portfolios and counterparties.

As and when credit default instruments are traded on an exchange, there will be no need for the growing number of “new” clearing solutions and risk tracking systems being created for CDS. Sad but true. If we told you how may custom CDS tracking/clearing/trading systems we’ve seen in the past year, you’d cry. It’s like people reinventing the wheel and taking out ads on CNBC to sell them.

Click here for more information about the AEI event on February 23, 2009.

Stock position: None.