A Misleading Chart on Credit Default Swaps

This graphic comes from Gretchen Morgenson's front-pager in the NYT yesterday. I'm not going to try to reproduce it here, because my column width isn't big enough to really see what's going on. But suffice to say that it shows the market in credit default swaps, at $45.5 trillion, dwarfing the markets in U.S. stocks ($21.9 trillion), mortgage securities ($7.1 trillion), and U.S. Treasuries ($4.4 trillion).

Morgenson's article makes it clear that it's reasonable to directly compare market sizes like this. Indeed, she refers to CDSs as "securities" in the third paragraph of her piece:

The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion -- roughly twice the size of the entire United States stock market.

But of course a credit default swap is not a security, it's a derivative. The $45.5 trillion is a notional amount; the size of the stock market is a hard valuation. There's an enormous difference.

Morgenson is right that there are problems in the CDS market. But she over-eggs her pudding so much that it's very hard to separate the good points from the bad. And when she leads with the statement that credit default swaps are securities, it's hard to take the rest of the article seriously.

There's another chart in the article, too, which explains that one counterparty to a CDS transaction can "assign" his liability to a third party who may have to be "tracked down" and who "may or may not be in a position to pay".

The irony here is that the problem of assigning CDS liabilities to third parties is actually relatively small for exactly the same reason that the nominal size of the CDS market is so big. Let's say a trader at a hedge fund or an insurance company has sold credit protection to a client. In order to balance out his books, he can do one of two things: either assign that contract to a third party, or simply buy the same amount of credit protection from someone else. The way the CDS market works, he will almost always do the latter rather than the former.

As a result, there are lots of equal-and-opposite contracts being held on the books of all manner of banks and hedge funds and insurance companies. When people tot up big numbers like $45.5 trillion, they're adding all those contracts up together as though they don't cancel each other out, when the whole point of writing them was precisely that they offset existing positions.

Of course, that doesn't mean counterparty risk has gone away - far from it. But it does mean that the problem of tracking down your counterparty is probably smaller, in practice, than Morgenson makes it out to be: in the vast majority of cases, your counterparty will be whoever you entered into the contract with in the first place.

Morgenson also uses up a lot of space talking about what happens in an event of default, when the protection seller has to pay up. But it's not clear if she's worried that protection sellers will have to pay too much, or whether she's worried that protection sellers will have to pay too little. At first, it seems like the former:

A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank's losses would have to be reflected on its books.

In this case, a bondholder buys protection against default, but never gets paid by the protection seller, who can't afford to pay out on all the claims he's written. Later on, though, the problem is different:

When Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company's debt exceeded the value of underlying bonds tenfold. Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt.
Market participants worked out an auction system where settlements of Delphi contracts could be made even if the bonds could not be physically delivered. This arrangement was done at just over 36 cents on the dollar; so buyers of protection on Delphi who did not have the bonds received $366.25 for every $1,000 in coverage they had bought. Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond.

In this case, a bondholder buys protection against default, but only gets $366.25 for every $1,000 of bonds he insured. If he thought that protection was worth $1,000, then yes, there will have to be write-offs. But no one values credit default swaps as though recovery value is zero. And if the bonds are trading at 70 cents on the dollar, then it's worth pointing out that a bondholder with $1,000 face value of bonds, plus an insurance contract on those bonds, now has bonds worth $700 and an insurance contract worth $366.35, for a total of $1,066.25. Which doesn't sound like too much of a loss to me.

Comments

[globalmacro]

It seems like more people on SA could use this kind of education on the CDS market. People on the comment boards keep posting about a company's total CDS exposure as if the money has already been lost. Thank you for this thoughtful article.

[Whisper On The Wind]

Not just SA, either. Every newspaper I read has horrendous predictions and opinions that scare the pants off everyone I know. Seems like everyone is assuming that ALL credit accounts are in default. Sure it's ugly out there, but maybe it's just not as bad as the media is trying to say it is.

[algorithmbetting]

Correct there are equal and opposite positions to each swap. Someone loses but at the same time someone wins. But let's not lose sight of the main thrust in the referenced article.

The issue is there is a lot of financial exposure out there that wasn't around 10 years ago. I even read of a furniture company today which has large investment in headge funds. The size of the CDS market shows there are so many more entities gambling and quite simply, the more people that go into a casino, the more people will be left broke.

[LVMReader]

How about geared synthetic CDOs? The case of Delphi is perhaps not going to be the norm, especially as a default cascade happens.

The issue at play here is counterparty risk - contracts may exist, but are they able to be fulfilled. Since the Bond Market Association closed down the CDOLibrary.com site in April 2007, how are people really going to assess what risks they have. How can they do sensitivity analyses.

You gave only 1 example to prove why CDS losses may be smaller than feared, but how about if all automakers simultaneously defaulted?

Porsche is a Hedge Fund basically, as is BMW. The risks here are significant. Perhaps spontaneous free market auctions may spring up and people will do what they must, but in many cases certain counterparties could be wiped out completely forcing others to do things they did not expect to have to do.

e.g. Amaranth in August 2006. Made a wrong way bet on Natural Gas and was forced to sell oil and equity in Cinram to cover losses. This drove down petrol prices in Europe at the pump for weeks,

[Noel]

Recovery was actually 53%

www.noelwatson.com/blo...

Quebecor defaulted recently

www.noelwatson.com/blo...

recovery around 40%

[KAIMU]

AloHa !!

Any insurance whether car insurance, home insurance or credit default is only as strong as the counterparty backing it. I lived through Hurricane Alicia that hit Galveston in the 1980s. Many had insurance but the insurance companies lobbied the Texas legislature and were allowed to only pay ten cents on the dollar for claims. What good was insurance unless you want to trumpet the 10% protection, but I would rather look at the 90% loss. What was the impetus for the Texas legislature to legalize this theft? The insurance companies threatened to pull out of Texas completely!

Now we look at massive trillions in credit default swaps, which is essentially insurance against a company going into default. What do you think the counterparty will do when faced with huge losses(claims)? DUH-H??

Keep your eye on the insurers. One already filed bankruptcy and another is constantly at the begging bowl ... That is if you don't count the $138bil JP Morgan bailout right before LEH hit BK! What do you think that $138bil was for?

I could care less about the ones that pay out. In the best of Worlds that is supposed to be what they do, but are these times the best of Worlds? Besides what sort of a gain is $66 for assuming such great risk? Its a 6.6% return and when inflation is added it is still a loss!