Credit Default Swaps and Counterparty Risk: Beware What Lies Beneath

The following is an excerpt from my comprehensive report on the CDS market and the risks it poses:

The Next Shoe to Drop: Credit Default Swaps [CDS] and Counterparty Risk - Beware what lies beneath!

This is a preliminary version of part 3 of my piece on the Asset Securitization Crisis – Why using other people's money has wrecked the banking system: a comparison to the S&L crisis of 80s and 90s. As was stated in the earlier parts, I periodically have third parties fact check my investment thesis to make sure I am on the right track. This prevents the "hubris" scenario that is prone to cause me to lose my hard earned money. I have decided to release these "fact checks" as periodic reports. This installment should be very illuminating to those who are not familiar with the CDS markets. I urge discourse, conversation and debate. To me, it is necessary to make sure the world is as I percieve it. The recent bear market rally took back a decent amount of the directional, unhedged profit (that's right, I'm a cowboy), but it appears that is over and we will soon resume our descent back into reality.

Just in case, let's review some history. I will also release some of my personal bank short research to illustrate how I am implementing these expected stresses to the banking system to my advantage.

The Current US Credit Crisis: What went wrong?

1. Intro: The great housing bull run – creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
2. Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
3. You are here =>The counterparty risk analyses – the counterparty failure will open up another Pandora's box
4. To be Published: The consumer finance sector risk is woefully unrecognized
5. To be Published: An oveview of my personal Regional Bank short prospects
6. To be Published: Credit rating agencies – an overhaul of the rating mechanism
7. To be Published: US Federal reserve to the rescue

And now, on to the report...

Emergence and the extraordinary growth of the CDS market

Innovation in the financial services industry created the Credit Default Swap [CDS] market to allow banks to hedge their risk as well as speculate on the health of any company. The evolution of CDS from the time it was first introduced by JP Morgan's Blythe Masters (Head of Derivatives Department) in 1995 has been exceptional. The CDS over the counter derivative market has grown from US$900 billion in 2000 to US$45 trillion in 2007, almost twice the size of the US equities markets. The US$45 trillion market value of CDS contracts has grown more than 10 times of US$5.7 trillion corporate bonds which it insures. The major players in the CDS market are the commercial banks as its business evolves around the credit risks on the loans its disburses to corporations. The CDS market allows banks (theoretically) to transfer risk without removing assets from its books and without involving the borrowers. Credit default swaps also help banks to diversify their portfolio and gain exposure to various industries and geographies.

Insurance companies and financial guarantors emerged as dominant players in the CDS markets as net sellers of credit insurance protection. Insurance companies and the financial guarantor industry are the big sellers of protection in the CDS market, with a net sold position of US$395 billion and US$355 billion, respectively at the end of 2006. In addition, global hedge funds have emerged as active players in the CDS market. According to Greenwich Associates, the hedge funds are responsible for driving nearly 60% of all the CDS trading volume and 33% of the Collateralized Debt Obligations (CDOs) trading volume.

CDS has emerged over the last few years as an important tool to manage credit risk and has allowed banks to offset risk from their lending and bond portfolios. CDS has similar risk profile to a corporate bond. However, unlike a corporate bond the CDS does not necessarily require an initial funding which helps to build leveraged positions. Credit default swaps also assist in entering into a transaction wherein the cash bond of the reference entity of particular maturity is not available. In addition, by buying credit insurance (protection) of any reference entity, it provides the investors an opportunity to create a short position in the reference entity. Consequently, CDS having all these unique feature evolved as an important tool to diversify or hedge one credit portfolio and even take a long or short call on any company.

The two important factors driving the growth in the CDS market has been the strong US economy growth post 2001 and the low interest rate environment which has allowed for refinancing opportunities for marginal borrowers and deals that may have gotten into serious trouble without such a low cost capital environment – both resulting in very few corporate defaults thus encouraging banks to underwrite more credit insurance. The banks found it to be an attractive and low risk method to make profits since the number of failures were relatively few as the economy was in strong shape. In addition, the advent of speculators in the credit insurance market was a key growth driver for the CDS market as these contracts provided an alternative to bet on the company's health. These instruments provided speculators a means to take short or long positions depending on their analysis of the company's future performance.

Functioning of the credit insurance market

In a CDS transaction, the buyer and the seller of credit insurance protection enter into a contract wherein the buyer pays a fixed premium for protection against a certain credit event such as a bankruptcy of the reference entity, or default on the debt issued by the reference entity. Generally, there is no exchange of money between the two parties when they enter into the contract, but they make payments during the term of the contract. The key terms in the contracts entered between the parties are:

Event of Default: An event of default can occur if the counterparty to a CDS trade files for bankruptcy, or in the case of an insurance company, something functionally equivalent, such as being formally placed under supervision, or liquidation, etc.

Credit Event: A credit event generally refers to the occurrence of bankruptcy or failure to pay (and in some cases, a restructuring) of the reference entity of a CDS trade.

The trigger events can be broadly categorized as (1) bankruptcy, (2) failure to pay, (3) restructuring (4) Repudiation/moratorium, (5) obligation acceleration, (6) obligation default. Bankruptcy is the reference entity's legal declaration of insolvency or inability to repay its debt. Failure-to-Pay occurs when the reference entity, after a certain grace period, fails to make payment of principal or interest. Restructuring refers to a change in the terms of debt obligations that are adverse to the creditors.

In the case of an event of default, the International Swaps and Derivatives Association's [ISDA] calls for the mark-to-market value of the contract to be paid from the out of the money party to the other party, while in the case of a credit event, the protection seller would be obliged to pay the notional value to the protection buyer in return for securities delivered (where par amount delivered equals total notional, assuming physical delivery).

CDS are primarily of two types: Single name CDS and Multi name CDS

Single-name CDS: In a credit derivative contract where the reference entity is a single name.

Multi-name CDS: In a credit derivative contract where the reference entity is more than one name as in portfolio or basket CDS or CDS indices. A basket CDS is a CDS where the credit event is the default of some combination of the credits in a specified basket of credits.

The CDS insurance contract created primarily to transfer credit risk from bond investors to other parties may be insurance companies or hedge funds to protect against the default risk. However, as depicted in the chart below, the financial institutions may sell and resell the insurance contracts among themselves creating the 'entanglement of credit risk'. This also makes it difficult to identify who bears the ultimate risk. This reselling of insurance contacts to another party has created a near untraceable credit risk web among the market participants.

click to enlarge

Source: The New York Times

The growth in CDS market in the last few years has outstripped that of the US equity and bond markets

The credit derivatives market has grown at a remarkable pace as reflected from the tremendous increase in total notional amount outstanding over the last few years. The total notional amount of credit derivatives as of June 2007 increased to US$42.6 trillion, an increase of 109% over the US$20.4 trillion reported in June 2006. This has been driven by both the rise in single name CDS and the multi name CDS instruments. The significant rise in the multi name CDS (traded indices) has notably surpassed the growth in single name CDS. Single name CDS' total notional amount outstanding has increased from US$7.31 trillion in June 2005 to US$24.2 trillion in June 2007 while the multi name CDS has grown from US$2.9 trillion in June 2005 to US$18.3 trillion in June 2007.

Source: Thomson Research

The CDS market has outstripped the growth in every other US market reaching US$45 trillion in notional amount outstanding volume. According to ISDA, the notional amount outstanding of credit derivatives grew 32% in the first six months of 2007 to $45.46 trillion from $34.42 trillion. The annual growth rate for credit derivatives is 75% from $26.0 trillion at mid-year 2006 surpassing the US stock markets at US$21.9 trillion, the mortgage security market at US$7.1 trillion and the US treasuries market at US$4.4 trillion. The ability to bet on the financial health of the company directly in the CDS market (go long or short by buying or selling insurance protection) and the rise in speculative interest saw the rise in the CDS volumes.

Comments

[cp1]

One interesting aspect of this is that, in a normal insurance arrangement, the insurer does not have a right to assign its obligations to unrelated parties. In fact, the insured may pay a premium for the right to have insurance from an entity you trust or whose ratings meet your criteria. The policy is an asset and the insured may sell it. The CDS market seems to have turned the legal concept upside down in allowing the transfers of the obligations to unknown parties with unverifiable financial capacity.

[sivere]

CDS are a big part of the derivatives bubble created by the Fed. If the bubble goes all at once, we are doomed. The Fed is now trying to deflate its own bubble (oddly by reinflating it). They caused it, they are trying to save it, WE will pay for it.

TakeBackTheFed.com