Shiv Kapoor

Credit Default Swaps, Part One: Origins and Implementations

I would argue that the old risks (a. Default on the payment of interest, b. Insolvency of the issuer, c. Pre-payment of the loan [with interest]) are the only real economic risks. The CDS looks like it is essentially an instrument to shift risk from the owner of paper to an insurer. The question to which I cannot find an answer is whether CDS's are issued to a party with no insurable interest; for example could a person get cover for a Lehman Default event without owning the underlying Lehman paper. If the answer is yes, the question of whether the so called insurance contract is legally binding arises because of the absense of an insurable interest.

I have no doubt that the availability of a CDS will have encouraged lenders because they thought the risk was covered. It is true that this would have led to an over-leveraged economy (which is no secret). But the real economic risks associated with credit default are the same.

The way I see it is that a CDS did not really separate risk from the instrument; it failed to achieve its purpose. If an insurer goes bankrupt for failing to pay its obligation; it will result in a distress sale of the insurers assets to pay out the obligation to the fullest extent possbile. The buyer of the distressed paper will earn future profits being the difference between the actual recovery from the debtor and the price paid for the paper. In the mean time because the insurer defaulted, another insurer who insured the paper of the first insurer will find itself in the same position as the first insurer; again the second insurers assets will be sold in distress and the buyer will profit in the future. Ultimately, what will occur is that the weak hands will go insolvent while strong hands will gain assets bought at below fair value during a distress sale; the total impact will never be more than that part of the debt which actually went bad. So, instead of separating risk from the security, the CDS actually ended up creating risk for the economy. The real questions to answer are (1) where did the money go - that is where the bubbles will have formed and (2) how much of it will likely go bad.