Wednesday, June 18, 2008

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.


Anonymous said...

"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."

How is this different from equity options? Aren't put options only as good as the creditworthiness of whoever is writing the put? Counterparty risk applies to equity options as well, doesn't it?

Anonymous said...

Good post.

I still don't get a few things.

1. You can short stock up to a point -- naked shorting is at least technically illegal. I suppose people could buy and sell derivatives, but if there is no more stock short, the puts would be naked. On the other hand, CDS's allow essentially unlimited shorting of a reference debt instrument of a company or the trigger (restructuring?). The notional dollar amount of CDS's isn't limited by anything but finding solvent firms to bet the other side. This introduces the potential for enormous systemic risks. It also introduces opportunities for people to behave badly.

How much was bet on Bear CDS's? They had about $10 billion in capital. They obviously didn't have that much unsecured debt. I'm thinking there may have been 10x more bet on the default of BSC then their market cap.

2. As far as netting, which is a huge deal, per the banks, BIS, etc. who knows the extent to which the CDS's would actually net to zero across all balance sheets? Just timing differences would account for some mismatch. Also, OTC, no transparent liquid market, so who really knows the proper book value. Given the tendency for accounting to be optimistic under uncertainty, you have to think that there must be a net positive of at least a fraction of a percent of these instruments.

It has to be positive, negative or zero -- I'm betting that the aggregate, if it could be computed, is adding a few billions or 10's of billions to balance sheets.

Traditional insurance accounting is in the stone age, but it has lasted through events like the 1908 SF earthquake, the depression, etc. so it is robust if inefficient. The idea that some financial guys can just come up with an insurance like scheme and that it will work like it *should* in the textbooks is not comforting. Basically, instead of using fancy risk based capital requirements, there are these archaic statutory capital requirements.

So, yea. If these are either more like insurance or more like vanilla swaps. If the former, treating them like the later is asking for trouble.

cap vandal said...


equity options are traded on exchanges. They are standardized. The exchange monitors collateral, etc.

So you aren't depending on john doe to make good on the put. Rather the exchange is your counterparty.

Anonymous said...

Hi. Thanks for the post.

Based off the analogy with OTC equity options, is it possible for counterparties (or "market-makers") to delta-hedge on CDS?

Say if GS shorts a F CDS, can they theoretically delta-hedge and short F bonds or something? Understand above is not apples for apples comparison but just thinking aloud. Thanks.

Anonymous said...

I don't think it is appropriate to dismiss the notional value of the CDS market. A major default can lead to a cascade where counterparties on the edge could start collapsing and the price of replacing CDSs may become too high. It is also a question of what happens first, the default of the insured credit risk or the failure of the counterparty. When one looks at replacement cost, one is looking at the counterparty having failed first. But really, the first event is the default of the insured credit risk not the counterparty.

So for example if GM went bankrupt, I forget what the estimates are on the notional CDS written on it - 500 billion?? or more? Well if GM defaults, resulting in a counterparty failing, one will not be able to find another counterparty to insure the event. The event has already happened. In the already weakened environment of capital ratios of counterparties, this event could be catastrophic as multiple counterparties could fail.

Instead of GM going bankrupt, we right now have CDOs defaulting and this has already had the effect that multiple counterparties will default - i.e. MBIA, AMBAC, etc. and as we see Merrill Lynch, Morgan Stanley and Citigroup are not going to find another counterparty to insure these CDOs because the default of the CDO came first. So the notional value is very important and it is this notional value that is going back unto Merrill Lynch, Morgan Stanley and Citi's books not the replacement cost of the CDS.

Now in the weakening environment of the financial guarantors, if you have a series of bankruptcies in entities that are being insured by CDSs, you could have a cascade of insurers failing along with rising CDS costs and a meltdown. For example, are there lots of CDS written on GMAC, Chrysler, GM, Ford, airlines, banks. If these start failing what happens to AIG, are they insuring this stuff? Who is? Remember CDSs are taken out on the most likely entity to fail.... why else would you buy insurance? you buy it when you perceive a significant risk of default otherwise you'd be wasting your money. And recessions and credit crunches are when these entities start failing.....

David Merkel said...

>>Had Bear Stearns, for example, declared bankruptcy, any CDS with Bear as the counter-party would be worthless.<<

I don't believe that is true, but correct me if I am wrong. Derivatives are pari passu with senior unsecured debt, usually. Anyone with a derivative contract from a bankrupt counterparty would be able to file to collect on at least a portion of the obligation if it is in the money.

edmund said...

I believe swaps netting occurs in any case if a counterpary is going bankrupt (similar to the exchange solution) and also that in the U.S. at least, swaps get settled(paid) before bond holders get paid or then equity holders (last in line) get paid in the event of bankruptcy. So there are more structures in place to soften if not completely prevent CDS from spiraling out of control than even this good article describes. So risk in swaps is as described 'replacement cost.'

edmund said...

Also thinking aloud,
anonymous and ziggurat bring up interesting issues however...since CDS originated due to the lack of sufficient quantities of actual bonds
to use as what extent are there imbalances in quantities of long versus short positions that cannot be 'covered.' And, the AMBAC et al issue, more related to CDO, CLOs etc, remains an unresolved open question in terms of ancilliary damage if they go under...

edmund said...

A CDS contract when the credit defaults means
the credit protection seller will pay par for the delivery of the defaulted bond by the protection buyer...SO
the seller is at risk for the difference between par and the now current value of the delivered bond less the annual payments received so far in the contract, so notional value here is a bit different than usually construed and generally exceeds the actual risk (unless the delivered bond is worth zero which is unlikely though possible in theory)(cash settlement is an option as well)

in that context, a speculative thought is that Morgan Guaranty owned Bear Stearns, before they bought it being on the 'winning side'of many CDS contracts versus they netted unto themselves.

edmund said...

re delta hedging...
if you could find enough bonds in the underlying name of a single name credit default swap or could substitue an index product sufficiently correlated to it (like beta in stocks) you could hedge the swap.
but the finding sufficient available corporate bonds is unlikely which is why CDS came to be in the first place...

[and yes, when a corporate's risk reads 'default likely', the expense to hedge out buying the opposite position will have become prohibitive.]
leaving only the index correlation hope.

til next time.

edmund said...

the real crime here is the 'moral hazard'... if only, say, Morgan Guaranty and Deutsche Bank had a clue of how to handle the CDS risk then they have, by default, cornered the market and will own most of the other banks...and the Fed bailing anyone out is participating in the cornering process at the cost the populace which will pay up under this disturbing fraudulent scenario...a fake financial crisis in effect.

The Fed apparently can't tell the difference between the mortgage crisis and the moral hazard I describe. So not only do they not have the tools they are also fools.

edmund said...

ask yourself,
'Why is anyone giving any of the institutions that failed (lost money) more capital?(through offerings)?' --Because investing in crooks is 'good business.'

Going back to mortgages,Countrywide should be in jail, and people should keep their homes and all the contracts are trash since they were illegal contracts in the first place.

edmund said...

This is what happens when central banks have no better idea
than the monotonic belief they should control inflation without any consideration of what an appropriate level of interest rates might be for economic growth in various countries at different stages of economic development and different weighted roles in the world economy.

--Rates so low, financial firms steal until the bubble blows and the world economy grazes or enters deflation.

Truly ignorant chaos under the guise
of intelligent control.

Certainly not capitalism in any rational recognizable form. The distance from reality politically correct thinking/language/meaning leads contact at all.
Really more like fascism huh?

mOOm said...

Would they be more like the options market or the futures market if they were on an exchange? In the futures market each long is matched by another investor short. But the options market has so many possible options that there are market makers who trade with most investors placing trades. From what I understand the market makers end up with net long or short positions in each option as there is no guarantee that as many investors want to go long as short. For example, shorting calls is the most popular options strategy, so the market makers have to end up with a net long calls position from the research I've read. But maybe this is wrong.

Bottom line is that maybe it wouldn't help that much and market makers would have net long or short positions in each CDS?

Accrued Interest said...

Some responses...

On delta hedging: Wouldn't be easy in any case. Look at Lehman's recent woes! They owned cash CMBS vs. the CMBX CDS index and got crushed. That should have been a situation where the delta exposure was low.

But the point of all this is not whether any given market maker could run into trouble. If CDS were primarily exchange-traded, Lehman could still f up their delta hedging and wind up going under. Currently, the system is relying on Lehman as a CDS counter-party, so they are too big to fail. But if the CDS counter-party was a stable exchange, we could let Lehman go down much easier.

It isn't about eliminating risks to investment banks, but decreasing risks to our system.

Accrued Interest said...


Now I'm not a real expert on equity derivatives... but is there any real limit on equity puts? Or short futures? I mean, as long as someone will sell you the put, you can buy an infinite amount?

DKenny said...


I agree that CDS's should be centrally traded on an exchange, but I fear that the point at which that can be accomplished has passed. Besides the legal barriers (that is, contracts were not standardized), how much capital would need to be raised to appropriately mitigate systemic risk? And who is going to put that capital up? Certainly the banks who hold these contracts are in no position to increase the capital they (or the exchange, which I assume would be funded by them) would hold as collateral on these contracts.

This was a good idea a few years ago, but alas, it is too late to save the CDS market, especially given current market circumstances. The task would be an extremely complicated process in the best of market conditions, and nearly (anything is possible?) impossible with things deteriorating as rapidly as they are now.

Accrued Interest said...

On the idea that a major default could cause problems...

I won't dismiss this idea out of hand, but it would take one of the market makers being heavily net short the CDS. I don't think the MM as a group are that stupid. They might be... but I don't think so.

But if you look at it from a system-wide perspective, its more concerning that a default of a CDS MM could cause an uncontrollable contagion.

Accrued Interest said...


If IBs were able to move existing positions onto the exchange, that would be a capital creating event, not a capital cost. Right?

Anonymous said...

A clearing-house (NOT an exchange) for CDSs is being set up and has been blessed by the Fed.

TH said...

I still don't get something related to the workout of outstanding CDS after the Delphi bankruptcy. My understanding is that the inability for all buyers of protection to deliver bonds, (more CDS contracts than debt outstanding) led to the creation of an auction process whereby all buyers of protection received something like 73 cents on the dollar in cash. It has been mentioned often that a CDS market is typically larger than their reference debt. If the issue of physical settlement has actually been addressed, and contracts now can be settled in cash, why did investor receive far less in payouts than they had paid to have insured, as they did with Delphi. And if that has not be addressed, has CDS pricing been adjusted to reflect that 10 million in credit protection will not pay out $10 million dollars after a credit event?

PNL4LYFE said...

There has been a clearing house of sorts for interest rate swaps for several years. I'm not sure what % of volume it handles (still small I think). CDS would probably be a little more difficult to handle since the potential exposure to individual counterparties is much less stable than for rate products. Still, I think a clearinghouse would be preferrable to an exchange with standardized contracts. Having fixed strikes will change the risk characteristics of the contract as the market spread changes while having multiple strikes could hamper liquidity. Has anyone seen proposals to address these issues?

Anonymous said...

IS there a better post on CDS elsewhere ? I havent seen one

A humble plea : Could you please also link all your previous posts on CDS at the bottom of the post ?

or better tag it under CDS etc

edmund said...

Re Better post on CDS

Pimco has a nice summary on how CDS work...
also Wikipedia is not bad either.

Re 73 cents on dollar

protection seller pays par to buyer and receives the current actual market value today of the bond in the cash settlement...SO auction was to determine what that current value was, given illiquid/unreliable pricing of bond seller lost 27 cents minus whatever was paid to it in annual payments for credit protection.

Option characteristics do inhabit the credit default swap structure>

Credit Events are binary option like in that they happen or don't.

Overall the CDS is comparable to a put loosely.

Pricing is option like since probability of credit event is taken into consideration in pricing PLUS there is an input for the likely value of the bond after a credit event...somewhere between %25 and %50 percent usually.(so %73 percent exceeded the probable bond value at default expectation input at pricing!)

At least one Canadian Academic views CDS as a swaption for pricing >Hull.

Likely called swaps to obscure the option aspects and allow companies prohibited from putting options on books to put them on as swaps. (Similar to 'cancellable swap' which is after all a swap with an embedded swaption)

Correlation is the key to running a book, i.e. one would want a very diversified portfolio(no correlation between individual pieces constituting the book) such that no one event triggers being completely on a losing side for a portfolio.

To that, bigger the institution the easier it is to be diversified in the portfolio and that is an advantage for MGty or DB for example.

If one is not using CDS to hedge an owned bond position or running a diversified book as described then one is speculating and deserves the possible negative

Anonymous said...


You may find this post interesting:

The extraordinary protection derivatives receive under our modern bankruptcy code probably explains why the market no longer works to restrain counterparty risk.

Anonymous said...

Maybe it's just the very late hour, but I don't understand what a centralized exchange has to do with counterparty risk. An exchange is just what the name says, a place where counterparties meet. It is not a counterparty itself. At the end of the day, when all trades are settled, the counterparties to a CDS are the same whether they have dealt through an exchange or directly with each other. So how is the proposal of a centralized exchange supposed to reduce counterparty risk?

Anonymous said...

>Now I'm not a real expert on equity derivatives... but is there any real limit on equity puts?<

AI ....

In theory, sure -- I don't see why there would be any limits. In practice, I don't think that the outstanding options exceed the outstanding shares with any frequency.

I have to admit, I am far from an expert here and I dislike what is going on more on a gut level dislike for the scale and potential risks to the real economy.

If the investment banks want to run a huge casino to bet on credit (rather then hedging), fine. But if there is a real threat of contagion, and the players are considered threats if they fail, then they need responsible risk management, either internal or from regulators.

Anonymous said...

>I still don't get something related to the workout of outstanding CDS after the Delphi bankruptcy. My understanding is that the inability for all buyers of protection to deliver bonds, (more CDS contracts than debt outstanding) led to the creation of an auction process whereby all buyers of protection received something like 73 cents on the dollar in cash. It has been mentioned often that a CDS market is typically larger than their reference debt. <


When you start thinking about the answers to questions about actual settlement, the overall nuttiness of having such huge notional amounts floating around becomes obvious -- at least to people that aren't experts or close to the process.

I think there have only been a small number of defaults, and the earliest ones, as you noted, had issues.

I actually like the idea of only doing settlements using the specific reference security. Anyone that bought a hedge against the reference security is fine, but people speculating have to get the bonds, so that would reduce the payout.

I think things are moving in the other direction, with less onerous settlement mechanisms.

edmund said...

to Anonymous re exchange
no you don't understand...
At an exchange the exchange
IS a counterparty to everyone
collateral has to be posted sufficient
to cover positions you do
not when trading at an exchange have anyone other than the exchange as counterparty...see CBOT

central clearing operation is not an exchange, in this case the advantage is the central clearing nets all the trades througout and at end of trading day, and notifies parties if they have not delivered or paid for what they traded with another counterparty
see DTCC

Anonymous said...

What was that old saying about a chain only being as strong as it's weakest link?

Anonymous said...

You are 100% correct that a centralized clearing should be required for CDS markets. This is a costless solution that will shield the markets from the systemic risk that worries so many, and the only cost is that the monopoly profits that have accrued to the Wall St dealers will decline. Only time will tell if the government has the same backbone it showed in the 1930s in dealing with these types of issues, or are they mere puppets played by the bankers.

Just think of the inverse question, would anyone recommend that stocks no longer trade on an exchange and that the Wall St banks take over the trading of equities, that if you would like to buy or sell a stock you would be required to call each dealer get a quote and negotiate a trade with each? That would be insane, and no one would recommend it, so it is with CDS.

All exchanges exist in the best interest of the market as a whole, but they owe there existance to the insistance of regulators that they are a public good.

I have yet to hear the argument that centralized clearing, netting and settlement could ever be a bad thing for a market.

Lets remember that Refco (futures) and Enron (energy) were far more important to their markets then Bear was to CDS, and yet they were allowed to fail and did not require a taxpayers bailout because what they traded were on cleared exchanges. So it should be with all OTC derivative trading.

DKenny said...


It depends on how they were being valued before they were put on an exchange, how much collateral is being held against them etc.

I am assuming that (rightly or wrongly) that they are overvalued, with less collateral than should otherwise be held against them. So I think, net net, that it would be a capital cost, and just as important, an increase in transparency that will show just how screwed these banks really are.

So I think you're right in some sense that it would 'create capital' in an accounting sense, but the phantom valuations and lack of proper margin requirements would negate that, in my opinion, drastically.

But no one really knows. Just try to read through their financial statements. There is lots of intentional deception going on. When chicanery like that is going on, I tend to assume the worst.

Anonymous said...

anon 7:08 am: "All exchanges exist in the best interest of the market as a whole, but they owe there existance to the insistance of regulators that they are a public good."

Not true. Exchanges are a market phenomenon that grew up before regulation. There was a time when financial institutions tried to address counterparty risk themselves. However, since the bankruptcy reforms of the 80s and later, financial institutions have the right to syphon off many firm's assets just prior to bankruptcy -- while legally protected from the fraudulent conveyance statutes the rest of us are subject to.

No wonder they don't bother protecting themselves from counterparty risk anymore!

Anonymous said...

You hit the nail on the head! Policitcal pressure is causing all sort of financial "mood swings" that someone else said could be worsen if "McSame" takes the Presidency's office.