The reason why the headline is in the form of a question is not meant to be a teaser, but because I don't know. Although the credit default swap market is not part of my core daily interests, I am intrigued by the subject because of conflicting opinions based on the same data. I start with an article by Vikram Pandit, Citigroup's (NYSE:C) CEO, and bring attention to the following excerpt.
Also, capital requirements are not as transparent as many presume. It is not enough to require financial institutions to disclose capital ratios. Without knowing what that institution's underlying assets are (only insiders and select regulators know that), outsiders, including most investors, cannot properly assess how that institution calibrates risk.
Underlying assets. Insiders and "select" regulators. Thus that beautiful stock certificate that I hold may actually be the cover of a horror story. In a previous article I provided credit default swap (CDS) data from the Depository Trust & Clearing Corporation (*DTCC), and a reader offered an explanation regarding recovery rates, "Gross Notional" and "Net Notional" values, which I include below.
Say I (working at my firm A) buy protection on Greece, $100 notional CDS, from you (working at your firm B). Also, your colleague (firm B with you) buys protection from my colleague, $150 notional (working at firm A with me). Two trades = $250 gross notional.
But, if Greece defaults, my firm (i.e., "counterparty family") has a net notional exposure of $50. Or, I guess per DTCC method, my "family" would have -$50 net notional exposure. But this is still a maximum assuming zero recovery.
It makes sense, as far as the math is concerned, and firm B could even buy protection from firm C. But from a logical insurance standpoint, why would a firm buy protection on Greek bonds and sell protection to someone else for the same exact asset type? Is it a complex hedging strategy that is far too mind boggling for me to comprehend? It's possible, but then I can't help but recall LTCM, AIG (NYSE:AIG), Lehman, Bear Stearns and even Goldman Sachs (NYSE:GS).
The synonym for "notional" is "imaginary," although at times I like the other definition in the dictionary: Given to foolish or fanciful moods or ideas. Using the S&P futures as an example, the notional value of a contract is calculated by multiplying the value of the S&P 500 by $250. Using 1,300 as an example, the notional value is $325,000, although an initial margin of only $25,000 is required.
Since the S&P futures is cash settled (no physical delivery), the $325,000 never comes into play, and if the value of the S&P rises to 1,400 at expiration, the cash settlement is a gain of $25,000, or $250x100 points. Using the same rationale, if the S&P 500 drops 50% (haircut) to 650, the cash settlement would be a loss of $162,500 (650x$250). Without considering margin calls, what is the maximum net notional, or exposure? On the downside and all the way to S&P at zero, $325,000. On the upside, the sky is the limit, like writing a naked call.
Taking the DTCC data presented previously, and the numbers for Greece, the total gross notional of $70 billion and the meager net notional value of only $3.2 billion is at odds with simple math. If the $3.2 billion truly reflects the maximum net funds transfer, does it imply that the buying and selling of roughly the same contracts is taking place between the same parties, or so called "counterparty families," in essence neutralizing the risk transfer? What is the point if "insuring against default" is the primary objective? And where are those analysts quoted by the Financial Times getting their $25 billion figure from?
If I buy an auto insurance policy for a car worth $30,000, and then sell a similar policy back to the insurance company, the gross notional is $60,000. If the car is destroyed, we cancel each other out, and the net notional is zero. Why bother?
Borrowing the graph above and an explanation from a Financial Times article, my initial assumption appears validated. It certainly looks like simple math (green penguin is shown in another graph).
Upon a credit event, the investor hands over the bonds to the green penguin, which are now trading at a recovery value of say $4m. The protection seller thus gets the $4m worth of bonds, but also parts with $10m of cash. It looks like this: The black penguin may be $6m down on the bonds that were held, but this loss is exactly offset by the cash payment received ($10m) less the $4m that the handed over bonds are still worth.
But the world of finance is always evolving, and the cash settlement option eventually found its way into the CDS market, because there were more contracts than bonds in the Delphi case.
Back to 2005 though, the pressure from buyers of CDS protection (who didn't already have the bonds, or not the cheapest-to-deliver ones anyway) led to a short squeeze that saw Delphi bonds jump by approximately 10 points. The ever-nimble credit derivatives market responded by putting in place a protocol that outlined an auction process to determine the remaining value of the bonds. Signing up to the protocol meant agreeing to cash settle CDS at the recovery amount determined by the auction. According to Isda/Markit, 577 firms did sign up.
What does that mean? It means that like the S&P futures one does not have to hold the underlying assets, and the alleged insurance instrument is a simple derivative that can be used and abused. To substantiate the point, the European Central Bank's sheds additional light with a 2009 paper (pdf) titled "Credit Default Swaps and Counterparty Risk," and the following can be found on page 20.
CDS contracts are commonly regarded as a zero-sum game within the financial system, as there is always a buyer for each seller of CDS contracts, as with all other OTC derivative contracts. The financial turmoil has shown, however, that both buyers and sellers of CDSs may suffer losses if counterparty risks materialise. Indeed, with CDSs, both parties are exposed to credit risk derived from the counterparty (or "counterparty risk"), which reflects the potential for the counterparty to fail to meet its payment obligations. In other words, counterparty risk reflects the risk of being forced to replace positions in the market, were a counterparty to default.
Now I feel better. There's a tendency by some to make the world of finance an extremely complex endeavor, but ultimately it always comes down to elementary school math, and the data as presented by the various sources doesn't quite explain the exposure.
Only insiders and "select" regulators know the truth, according to Mr. Pandit, and the rest of us always find out when the bill comes due, although it's usually too late. Considering that public companies spare no effort in broadcasting their good fortunes, and tend to be a bit shy when it comes to financial problems, I can only assume that the exposure derived from the CDS market is worse than it looks.