Credit Default Swaps: All craft retreat!

Credit-default swaps (CDS) pose the greatest systemic risk to the worldwide financial system. Housing and oil may be what's pushing the U.S. into a recession currently, but the economy has a way of dealing with these kinds of shocks. Were the CDS market to suddenly collapse, it would truly threaten the very existence of the financial system.

Unfortunately, many commentators are focused on the wrong things when discussing risk in the CDS market. So let's look at what CDS are, what they are not, and why they pose such a risk.

A CDS is very much like a put on a particular credit. If a company defaults on its debt obligations, owners of CDS protection can, in effect, sell one of the defaulting company's bonds to the seller of protection at full face value. This is similar to an equity put, which gives the owner of the put the right to sell the stock to the seller of the put. Both a long CDS position and a long put position express a bearish view on the underlying security. Both can be used to hedge long exposure to the underlying.

Unlike equity options, CDS trade over-the-counter, where the CDS counter-party is an investment bank. This makes buying CDS protection a little like buying insurance: its only as good as the insurer.

So what happens if a major investment bank fails? The direct effect would be painful, to be sure, but probably not enough to threaten the system. Had Bear Stearns, for example, declared bankruptcy, any CDS with Bear as the counter-party would be worthless. Banks and others using CDS to hedge would need to either buy new CDS from another counter-party or risk going unhedged. As market conditions during the near collapse of Bear Stearns in March indicated, the cost of buying CDS protection would be elevated under such circumstances.

For example, imagine a bank has extended a credit line to Boston Properties (an office REIT). CDS on Boston Properties currently costs 115bps/year. Right around the Bear Stearns bailout, the same CDS was around 250bps/year. Say the bank bought CDS to protect against the REIT defaulting at 115. Subsequently a major investment bank runs into serious liquidity trouble. While nothing particular is happening with Boston Properties, the CDS widens to 250 due to contagion effects. That move in spread would result in approximately 6% gain on the CDS hedge for the bank. If the bank had bought $5 million in notional protection, they would be showing a $300,000 gain on the hedge. This means that if bank's counter-party were no longer solvent and the CDS deemed worthless, the bank would have "lost" the $300,000 gain. Put another way, if the bank were to replace the hedge at the former annual spread, it would cost $300,000 up front.

The notional value of all CDS is an oft-quoted figure, currently around $62 trillion. But its the replacement cost of the CDS that matters. In the above example, the bank wouldn't lose the $5 million notional protection unless Boston Properties went bankrupt simultaneous to the CDS counter-party. Moody's has calculated the replacement cost of all CDS outstanding at about $2 trillion. Given that the top 5 investment banks dominate the CDS market, the failure of any one bank would cost CDS holders hundreds of billions.

But it doesn't have to be that way.

For every long CDS position there must also be a short position. For every buyer of credit protection, there must be a seller as well. The overall net exposure to CDS is zero. That fact should be comforting, but alas, no single investment bank is net zero.

For example, a bank might buy protection from Merrill Lynch, leaving Merrill net short. Merrill might then look to cover their short by going long with Goldman Sachs. Goldman is now short, so they cover by buying protection from Bank of America. The system remains net zero, but each of those trades involve separately enforceable contracts. If any of the contracts are rendered unenforceable due to bankruptcy, it creates a problem.

Why should we tolerate this systemic risk when CDS trading could be centrally organized? Why not create a single counter-party which would always and forever have net zero exposure? In other words, why not force CDS trading to an exchange?

It couldn't be accomplished overnight. The exchange would need to be capitalized, customer margin requirements determined, as well as further homogenization of CDS contracts before the exchange would be possible. None of these problems are insurmountable. And the benefits to the system would be enormous.

When J.P. Morgan and the Fed bailed out Bear Stearns, many were concerned about the precedent set, as well as the moral hazard of creating an assumption of future bailouts. But the massive CDS counter-party exposure Bear had forced the Fed's hand. The Fed will not and cannot allow the system to fail. If we want to avoid Fed interference and the subsequent moral hazard, the best thing to do is to improve the system. A central CDS exchange would be a major step in the right direction.