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CDS And Its Limitations

|Includes: PIMCO Total Return ETF (BOND), SPY

Credit Default Swap (CDS) and it use as an alternative to ratings in various financial agreements between Corporations and Banks.

Pricing of credit spreads in bank loans documentation has been debated in recent years. Rating agencies rate the Bonds issued by the companies and banks reference these ratings in various bank loan documents for pricing of various credit spreads and or for collateral calculations. Typically banks will have a reference in their loan documents that if a company's rating are downgraded then that company has to pay higher interest rate with each downgrade.

Since the financial crises there have been various discussions on what metric to be used in the loan documents and various agreements involving credit between the corporations and other financial institutions.

The liquidity crises at AIG was triggered in September 2008, partly because S&P decided to downgrade the parent company of AIG as in their view US Government was not likely to support any financial institution. Various agreements between AIG and other financial institutions contained explicit clause that in the event of downgrade by rating agencies either party had to post collateral based on the market value of the CDS exposure between the parties.

Companies felt that reliance on rating agencies can expose them to sudden change in perception of risk by few individuals at the Rating Agencies.

Companies have been trying to find an alternate to rating agencies and have been thinking of using CDS in their various agreements. Credit Default Swaps, in my opinion have much bigger problem. Amongst the various problems is that Credit Default swaps, is used by hedge funds as a proxy for hedge against their stock exposures. Their trading is not sufficiently deep enough to reflect the opinions of many market participants. Their bid-ask spread is often wide, due to lack of liquidity in the CDS market.

Prior to financial crises, the spread between company's CDS quote and the credit spreads on the bonds were very narrow. Since the crises the spreads have increased. The CDS quotes also have other components like liquidity risk and counterparty credit risk. Additionally the CDS quotes, like the corporation's stock are highly volatile.

In view of the some of the issues mentioned above CDS is not a good substitute for Ratings rated by Rating Agencies in loan documentation. Other indicators that may be considered are reference to the company's financial disclosures, however from the Bank's point of view these are lagging indicator and they may take a long time to reflect in their financials due to various accounting guidelines.