Credit Default Swaps: Where the Real Action's At

What happens when you sell 1000 puts for $110K/year that give the buyer, Citibank, the right to claim $10M upon when you only have $100 million of cash and assets in hand, and a default actually occurs? You owe almost $10B, and only have $100M to cover what you owe. Thats the risk improperly collateralized credit default swaps pose. Fortunately for you, Citibank isn't permitted to legally hire shady guys to break your legs.

Credit default swaps can be simplified as puts for bonds, but generally without the conventional volatility and time decay exposure that typical options possess. The buyer pays the risk premium over treasuries per year as an insurance policy on his bond holdings, or an outright speculation that the value of the bond will go down. These are done with over the counter markets, and counterparties (buyer and seller without intermediary exchange organization) assume the risk of dealing directly with each other with varying, often none or assumed, collateral requirements. In the popular business media, its becoming known that the amount of total bond insurance they represent has come to 45 trillion dollars, versus only billions literally ten years ago.

The credit default swap seller is obligated to pay the buyer if the bond goes default. Additionally, credit default swaps change value (just as puts do) to match the movement of its risk premium over treasuries. Thus credit default swap value is often equal to risk premium + treasury of comparable maturity of the underlying corporate or asset backed bond it represents.

Total market liabilities, and to the extent their exposure is collateralized (thus ability to pay sour bets), are really unknown. I can just imagine that the superhero of trading and financial markets, Goldman Sachs, must be harnessing the power of these swaps to create extra income on seemingly risk free debt with minimal capital requirements. Regardless if its Goldman, Citi, or even Bank of America who is selling these exposures, capital requirements are a question, and the event of a high quality debt default would probably send some likely overlevered players into collapse and immediate bankruptcy.

This is the underlying reason why I consider corporate bonds, even at current risk spreads, to be relatively unattractive unless you are willing to speculate fear is not properly assessing default risk. A high profile default event, which is likely in a recession, will probably send risk spreads screaming higher across the board.

As evidenced here, its already happening, from the likes of players like MBIA and Ambac. Here is a chart from Markit.com showing this recent move in high quality risk spreads. Remember, as this moves up, short credit default swap players (most likely financials) are losing money. Their risk exposures are likely higher in the aggregate compared to outright underlying bond holders of the same security.

click to enlarge

What happens when players start to fail that many were not betting against already, however? I'm sure the biggest uncollateralized leverers (sellers of CDS), unable to pay upon bet failure, have a majority of their income harvesting short CDS positions in 'risk free' areas, companies ideally unexposed to recession and financial market turmoil risk - players like GE. A place you'd never expect a failure.

Perhaps an epic default would wipe the slate clean of anyone overleveraged in any holdings, especially the risk-seeking credit default swap sellers, resulting in a cleaner system for future generations. According to PIMCO's Bill Gross, the ramifications of even a typical default rate amid recessions is $250B of losses on the seller side, equal to worst-case estimates of subprime asset backed loans and their related derivatives. What if the default rate is double Gross' number of 1.25%, instead at 2.5%? $500B of losses. Obviously the answer is clear: many will be insolvent and even CDS insurance buyers will likely not get paid in full, or paid at all.

The High Yield risk spread tells the story of recession fear more obviously, containing a larger portion of risk.

This CDX chart from Markit.com is useful. Keep the link of http://www.markit.com/information/products/cdx.html on hand. If there is another shoe to drop to send us reeling into depression, you'll likely see it in the HY (high yield) and especially IG (investment grade) charts. Any market watcher should have his eyes glued to this along with the S&P and treasuries as a potential indicator of future/existing turmoil.

Disclosure: None

Comments

[helplessobs...:]

Sometime in the future we on the sidelines will learn what is being discussed right now in the U.S. Treasury and the Federal Reserve. In my opinion the potential collapse of the CDS market is topic 1,2, and on and on. FDR had his bank holiday and some type of CDS holiday will be required to sort out this mess as the stock market dives, becoming a source of funds. Warren Buffett needed 4 years to unwind 23,000 of General Re swap contracts worth only $400M, in what he said, was a quite and orderly market.

2008 Jan 23 10:35 PM

[Tom Armistead:]

This is really about an unregulated insurance business. Capital requirments are very low compared to potential losses, and some participants simply aren't big enough to spread their risk and take advantage of the law of large numbers.

There is also a moral hazard involved. A speculator can buy credit default swaps on a likely target, float a good rumor, and then get out of his position at a profit. If the target is vulnerable enough, an actual loss can be created.

Not to mention credit default swaps as a vehicle for insider trading. Academic research proves this occurs, although it can be referred to blandly as "asymmetrical information" and excused on the grounds it doesn't impair liquidity.

Regulators are strangely silent here. This mess is contributing to the credit crisis and it needs to be stopped, unwound, and then restarted under adequate regualtion as an insurance business.

2008 Mar 15 04:51 PM