Credit Default Swaps, Who Really Knows What They Are Worth?

by: Asa Harrington

A Credit Default Swap (CDS) is a derivative contract traded over the counter, designed to "transfer the credit exposure of fixed income products between parties." Essentially the buyer of a CDS pays a premium to the seller of the CDS, and if a credit event as defined by the ISDA (International Swaps and Derivatives Association) occurs, the Seller of the CDS pays the notional amount to the buyer of the CDS. CDS can be likened to insurance on fixed income products (bonds).

In a perfect world, the CDS market is a great $15.7 trillion market, where buyers and sellers of these derivative instruments are compensated for the risk they take on. I would like to believe this, but as we have seen in the past, Wall Street bullies never play fair and there is always an angle. A huge gigantic conflict of interest exists in this perfect market. The sellers of the CDS are also in charge of deciding when CDS should be triggered and the notional amounts on these CDS should be paid out.

Ninety nine percent of all OTC CDS are sold by 5 insured U.S. commercial Banks: JP Morgan Chase Bank (NYSE:JPM), Bank of America (NYSE:BAC), Citibank (NYSE:C), Goldman Sachs Bank (NYSE:GS), HSBC Bank (HBC). These 5 banks are the market for CDS.

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Graphic source: Office of the Comptroller of the Currency 3rd Q 2011 Report

Having established which banks are responsible for the market in CDS, let's look at the organization that decides when CDS are triggered and when a "credit even" occurs. For fun's sake, let's look at the European region; specifically the situation of Greece, which we know is very tense.

The Voting Dealer Members of the IDSA for the European region are: Goldman Sachs, Bank of America, JP Morgan Chase, UBS (NYSE:UBS), Morgan Stanley (NYSE:MS), Barclays (NYSE:BCS), BNP Paribas (OTCQX:BNPQF), Credit Suisse (NYSE:CS), Deutsche Bank (NYSE:DB), Societe Generale (SGLF.PK). The Consulting Dealers are Citibank and the Royal Bank of Scotland (NYSE:RBS). The Voting Non-Dealer Members of the IDSA are 5 investment managers. Some names of big banks may seem very familiar. A decision in favor of a credit event requires at least 12 of the 15 votes.

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Source: IDSA DC website.

When the no longer "voluntary" haircut occurs in Greece, who thinks this board of banks and investment managers is going to decide that the CDS have been triggered?

The total Greek Sovereign Debt outstanding is about $350 billion. The gross notational value of CDS issued on the Hellenic Republic is about $69 Billion. I am reporting the gross notational value of CDS because I don't know if we can just assume away the counter-party risk by reporting net notational value.

Besides Greece, other countries such as Portugal are subject to default rumors and fears. The next chart is a list of the top 15 sovereign CDS positions (gross notional.) Sub-investment grade ("junk") ratings are BB+ and lower.

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Numbers from DTCC website.

The next graph is the ratio of sub-investment grade CDS issued to investment grade CDS issued to help investors see the risk these 5 banks are taking on.

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Graphic Source: Office of the Comptroller of the Currency 3rd Q 2011 Report

I don't know how this situation is going to play out when Greece eventually defaults, but I do believe it will either involve some large US Banks voting to chop their own arm off or a 15.7 trillion Dollar market becoming an overnight crazy show when the CDS are not triggered.

The magnitude of these "bets" astonishes me. While I do understand that bilateral netting makes this picture a whole lot nicer, how can one possibly measure counter-party risk? When one pillar falls, the rest of the house is surely in danger.

Who can say what these sovereign CDS are really worth?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.