Thursday, November 29, 2007

CDS: Phantom Menace

I started writing about Credit Default Swaps (CDS) just a year ago. But, for this market, that's ancient history: within just 12 months notional amounts outstanding have increased from 26 to 46 trillion dollars.
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Credit Default swaps allow hedgers and speculators to bet on the likelihood of default (or other "credit events") by borrowers like governments, corporations or pooled-asset Special Purpose Vehicles like CDOs. In addition, a very large portion of CDS contracts are now written against indices tracking debt classes such as investment grade or junk corporate bonds, MBSs, etc. That's the purpose of all those ABX, CDX, iTraxx, LCDX, etc. indices calculated by Markit.

The growth in the CDS business has been nothing short of phenomenal: within just six years amounts outstanding have increased 72-fold. The International Swaps and Derivatives Association (ISDA) in its latest semi-annual survey for the second half of 2007, put the total notional amounts outstanding at $45.5 trillion. In a separate survey, the Bank for International Settlements (BIS) reports a similar amount ($42.6 trillion) and also breaks down the instruments by type: single-name (i.e. against a single borrower like a corporation) and multi-name (i.e. against indices). The growth has been significantly faster in multi-name CDSs, suggesting increased use of CDS by speculators, instead of hedgers (see charts below).

Total CDS Outstanding (Data: ISDA)

CDS Outstanding by Type (Data: BIS)

This last finding is quite significant: even though financial index trading can and is used for broad-based portfolio hedging, it is most frequently involved in outright speculation, regardless of the instrument involved. Take the example of stock indices: it does not take much argument to ascertain that the dizzying array of broad and narrow derivatives is targeted almost entirely to speculators seeking to increase their leverage.

So why are CDSs a phantom menace, as the title proclaims? There are two major reasons:

Reason #1

At $45 trillion, the notional amount of CDS in existence is now fast approaching the total amount of credit market debt
outstanding in the entire world.

Given that many debt issues are too small and unmarketable for CDS purposes (e.g. small municipal and corporate issues), it is more than likely that CDSs equal or exceed the amount of all readily marketable debt in the world. This is further aggravated by the risk concentration implied in the popularity of index trading: for example, the active CDX Investment Grade index consists of only 125 individual bonds, the CDX High Yield (junk) index of 100 bonds and the iTraxx (Europe) index of 125 bonds. While these three are not the only indices traded, the BIS survey showed there were $18.5 trillion in multi-party CDS outstanding in June 2007, an enormous amount considering the small number of bond issuers involved.

This means that far more CDSs are written relative to the amounts outstanding in individual bonds and thus credit events will infect and destroy much more speculative capital than previous increasing default cycles, when CDSs did not exist. The model is that of a viral infection or a nuclear reaction - thus their description as "financial weapons of mass destruction".

The likelihood of future corporate defaults is rising very sharply, as observed from credit spreads going up almost vertically in recent weeks: for US investment grade bonds the option adjusted spread over Treasurys has reached nearly 200 basis points and for high yield bonds 600 bp (charts below).


Merrill Lynch US Corporate Index (Charts: SIFMA)


Merrill Lynch US High Yield Index

To summarize point #1: There are too many CDSs being written by speculators against relatively few borrowers, just as the probability of default events is increasing sharply. Therefore, the possibility of a generalized financial infection through the CDS medium is substantial and rising.

Reason #2

CDSs are closely correlated to equities because, just like them, they represent business risk. CDSs have created a new way for speculators to generate highly volatile equity exposure with minimal or even zero margin requirements.

By selling a CDS on a corporation's debt, a speculator is betting that its credit will improve or stay the same. In the first case the CDS will become more valuable and result in a capital gain, while in the second the speculator will at least collect the CDS premia, almost like a series of dividends. This is identical to a speculator buying a stock expecting it to appreciate and/or pay dividends.

However, there is a crucial difference between stocks and CDSs: in purchasing a stock outright the speculator has to put up 50% margin, as required by the Fed's Reg T.

[Note: there are currently ways to lower this down to 15% through Contracts For Difference (CFDs). The Federal Reserve, much to its shame, is completely ignoring this blatant evasion. If you are familiar with bucket shop operations from the late 19th-early 20th century, CFDs are practically the same. If you are not, the classic Reminiscences of A Stock Operator is highly recommended. There are many instructive similarities today with what happened 100 years ago, despite our so-called financial innovation.]

But selling a CDS requires zero margin and even produces immediate and regular income from payments received for underwriting the credit insurance. Theoretically the sellers should maintain adequate reserves on their balance sheets to cover their credit risk exposure, but does anyone believe that hedge funds and traders actually do? Not a chance... The result is a highly volatile equity exposure, carried at zero margin in a completely unregulated over the counter market. Recipe for disaster? You bet...

Not only that: CDSs create these infinitely leveraged equity positions out of thin air. Unlike options, single stock futures or other equity derivatives that require the delivery of actual securities at settlement, CDSs do not. They are pure bubble-air and can be created regardless of the amount that is outstanding in the underlying securities.

To summarize point #2: CDSs are equity substitutes carried at zero margin, masquerading as credit instruments. They create a feedback loop mechanism to equity markets that results in reducing volatility when things look good and increasing it when they don't. In other words, they work as risk amplifiers and not as risk attenuators.

Putting the above two points together, we have the potential for a financial viral disease of pandemic proportions. The CDS market is so new that it has never been tested on the downside of the credit/business cycle. We simply have no inkling of how it will behave under real life duress, when major credit events occur with increased frequency and magnitude.

This is why I chose to describe CDS as a "phantom" menace or, as the dictionary defines it: An imaginary embodiment in threatening form of an abstract thing or quality. But in this case, the imagination is embodied in facts and the sure knowledge that the business cycle has not been abolished.

One final observation, also related to the phantom quality of the CDS market: the vast majority of people are simply unaware of its existence, let alone its importance in shaping credit and equity markets. You won't hear about it in the popular media and very little seeps through even in the financial press. This is incredible, given that it is a $45 trillion market, even if this is only the notional amount and not the value of the contracts. By comparison, the capitalization of the entire US stock market is $20 trillion.

P.S. I want to thank "cds trader" for making significant comments on the above. They appear on the comment section and so do my replies.

Something else: The term "swap" as applied to Credit Default Swaps is greatly misleading, at least in the professional meaning of the term. For example, there exist FX swaps and interest rate swaps; very large amounts of such derivatives trade OTC on a daily basis, certainly more than CDSs. Their notional amounts outstanding are even larger than CDS. But they are real swaps, i.e. the counterparties swap payments immediately and in the future. The risk involved is not at all the same as in a CDS, which is in fact an insurance policy. The only thing that is being "swapped" in CDS are regular premium payments in exchange for undertaking the risk of paying off the entire loss in case of default (equal to the notional amount minus recoveries). This is a very close equivalent to the business model of the monoline bond insurers like MBIA, AMBAC and FGIC.

The proper name for CDSs should have been DIPs = Default Insurance Policies. But that name would have certainly attracted the attention of the insurance regulators - anathema for investment banks, traders and speculators. So they called them swaps, just like the more innocent and common derivatives already residing in banks' books (off balance sheet, of course).

Oh what a tangled web...

45 comments:

Brian Woods said...

Thanks for this update. Quite instructive, and bothersome.

Could you recommend a source that I could consult to detail and explain (if that is possible) what these new-fangled financial 'instruments' are.

Thanks.

Brian P

Hellasious said...

Wikipedia has a surprisingly comprehensive entry, for a non-specialist site. Go there and enter Credit Default Swaps in the search box.

Regards

Anonymous said...

Is it me or are the charts not displaying? Normally I can see the pictures in your posts, but not today - everything looks a little cross :-)

Peter.

A said...

Me again in France... 2 comments, 1 question:

1) I agree that Wikipedia is extremely useful.
It is in the french version that I first found explanations about securitization ("titrisation") of any form of cash flow, the pooling of a number of cash flow sources, the manufacturing of tranches (this word because it is a new financial industry, isn't it?) and the different ratings given to the tranches before reselling.
Indeed in my company there was a project with our bank to securiticize our customer's invoices. Nobody could explain what this was about except Wikipedia. At that time I still could not imagine why it was better to the bank than factoring. Thanks to your blog I understand: fees and dropping the risk into "the markets".
In the end the project was stopped by our swiss holding.

2. What I already pointed to after the Swiss Re losses: here in Europe it is true that the public (me) is not informed about the real nature of this CDS monster.

3. To the question: I have some difficulties to imagine the consequences for an investor who bought "synthetic CDOs" made of CDSs if there is a single failure of an underlying real world debt. In this case my feeling is that this 2 stage system should damp the financial consequences for the synthetic CDS holder. Am I wrong?

Anonymous said...

charts didn't display for me either

OkieLawyer said...

Charts did not display for me, either.

Hellasious said...

will fix charts asap

Anonymous said...

So, if I understand you, it is like a person making a $5 bet on the outcome of a $2 bet.

Hellasious said...

The charts should display now... don't know what happened. It was OK when I first put them up.

Hellasious said...

a in France:

A hybrid CDO (i.e. one that has sold CDS's to generate income) is very vulnerable to "credit events" because it would have to come up with the cash to pay off the buyers of the CDS on their credit insurance.

Such a CDO will also have a tranche structure, just like regular CDOs, and if credit events multiply beyond a certain point the trouble will rapidly move up the ladder to the higher-rated tranches.

Regards

Anonymous said...

Hellasious,

Thank you for the post. It´s easily the most informative - not to mention disturbing - piece I´ve read about CDS thus far.

François said...

Hello French,

Another Froggy here. I have been reading hellasious posts (along with Roubini's) for a couple of months with acute interest.

I understand that there may be a difference of scope between US CDS and European ones.

Possibly their scope is more narrow in continental Europe. In a sense that they may not have been used outside their logical use. Covering sizable business relationships.

Any French banker reading this site?

We are getting quite nervous on this touchy issue here in Paris in view of the signicant derivative activity of SOCGEN...

François

Hellasious said...

Francois said...

"I understand that there may be a difference of scope between US CDS and European ones. Possibly their scope is more narrow in continental Europe. In a sense that they may not have been used outside their logical use."

Unfortunately this is not the case. The iTraxx (Europe) index is extremely popular with traders.

Regards

the cds trader said...

I don't want to be insulting to your otherwise well-written post (and excellent blog), but you just lumped yourself in with the "I don't know anything about this but I'll try and appear like an expert" crowd.

1) Notional amounts outstanding aren't particularly important. It's roughly equivalent to the VOLUME traded on, say, S&P futures. And I don't hear anyone proclaiming the end of the world when volumes pick up on futures trading?

2) The rapid increase in notional outstanding over the last couple of years is indeed due to index trading (or multi-name trading as you called it). This has vastly increased liquidity, efficiency and transparency in the CDS market. Which is a good thing. Yes there are definitely speculators involved, but it's a market, so what?

3) "active CDX Investment Grade index consists of only 125 individual bonds"

You want to re-phrase that to 125 individual credits...pretty much all of these credits will have a number of bonds or loans outstanding which are deliverable into CDS (eg. let's say Countrywide defaulted, you would have the option to deliver any one of HUNREDS of bonds or loans into that CDS once it's triggered).

4) The likelihood of increased corporate defaults is indeed increasing, but I think you should have posted a chart of one of the CDS indices to show this (you can get them at Markit.com), since the graph you used of the Merrill High Yield index is taking spreads over Treasuries, so part of the widening will be due to swap spreads whereas you want just the credit spread component.

5) CDS are indeed leveraged instruments...like any derivatives. However you are wrong about them offering unlimited leverage. Without going into the nitty gritty, a bank can sell CDS protection but must put capital of 8% against that position (or sometimes 1.6% if on its trading book). For a hedge fund, it will be up to the prime broker to decide on the haircut to apply, but I can guarantee you they will apply one and that is effectively limiting the leverage. So CDS are NOT zero margin.

6) Whilst there are issues with outstanding CDS on a particular credit being more than the deliverable amount of securities around if that company was to default, this is not such a big deal. If you are a genuine hedger, you will already own a deliverable instrument. And even if you don't, contracts between counterparties are usually offset prior to the default settlement. And worst case scenario is that someone CANNOT get hold of a deliverable obligation, then they can't trigger the CDS contract, since it requires a defaulted bond or loan to be delivered in order to get paid PAR back.

To summarise...with light regulation, CDS are excellent and liquid instruments to transfer risks to counterparties who want a certain risk and/or are able to bear that risk. Without them, risk would be far more concentrated within the banking system. There have been plenty of defaults so far to test the market, and I can tell you that back in 2002 the credit crunch was far more severe (for corporates anyway, perhaps not banks), so we have been through a substantial spread widening test already.

Still love the blog, but gotta completely disagree with you on this post.

Regards,
the cds trader

Anonymous said...

Don't forget too that some of the brightest minds in the world are utilized for all this speculative finance.

http://tinyurl.com/2q8w2v
Simons at Renaissance Cracks Code, Doubling Assets

We need to put more brain power into finding renewable energy..

A said...

Thus when a CDS seller bundles the cash flow of several CDSs together and resells them as tranches of a synthetic (or hybrid?) CDO, then this CDS seller has resold the risk again? Right?

As there should be many buyers of these synthetic CDO tranches, the impression is that the risk is very much smaller for each one of these buyers.

But maybe I don't understand the complete mechanism, especially possibly the leverage side of things. I feel that this needs one or more further posts.

Arnould

NB I discovered your blog in April or May, I had read all your posts before the summer crisis. You made a great work. Please continue!

Anonymous said...

"Reason #1: At $45 trillion, the notional amount of CDS in existence is now fast approaching the total amount of credit market debt outstanding in the entire world."

Hel,

Did you mean US TCMD instead of world TCMD? The Federal Reserve's Z.1 report for September 17 2007 shows that the US TCMD was 46,573.6 billion dollars (Line 1, Table L.1, page 58).The entire world's TCMD is probably much greater.

Your posting addresses CDS risk. There may be additional derivatives out there not being discussed, what with the notional value of derivatives worldwide being more than $400T, 6 to 7 times world GDP.

CDS Trader says notional value does not matter. This is an assertion, not a proven. Why did the Fed get so worried about LTCM in 1998 and organize a rescue? Notional value does matter because it has (Tsunami-size) ripple effects on lending, especially when margin is very small fraction of notional value.

You've got a good blog, Hel.

Hellasious said...

Heh, I knew that the cds trader would pop up.

Let's take the issues one by one.

1. I am fully aware of the difference between notional and market value, which is why I pointed it out in the first place. But notional DOES matter because

a) CDS's are marked to market. As spreads widen a trader could see losses doubling, tripling, or much worse without putting on any additional positions. Double notional and doubled spreads = quadruple exposure. And these babies can be VERY volatile, as you know.

b) What about defaults? That's when the cookie crumbles and the big bucks go out as payouts (i.e. not MTM losses). Notionals will sure matter then...

2. The simple answer is that when we run out of bona-fide hedgers (as I believe we have with CDS's) we are left with speculators and trading desks for the balance. That's not healthy at all. I mean..hybrid CDO's? CPDO's? We can rationalize everything as two-way bets, but in the end the total amount of money at risk has increased very substantially.

3. I agree with you and I am aware of the CDX structure. But I presumed most people reading this blog would get confused by a term such as "125 individual credits". I try to avoid jargon, when I can.

4. I have posted Markit's stuff so often in previous entries, I figured what the heck... give Mother Merrill a go. They need the advert (smile). Plus they go back significantly longer and give a better picture.

5. Goldman calls you up and hits you on a CDS quote. Does your back office ask Goldman for margin? I presume you work for a major bank, so I expect you know the answer: no. It all goes into the trading limit (the line). You gives them your financials, they gives you theirs and we all hope it works in the end. The same goes for most large hedge funds, believe you me. Margin is expected from the lesser souls.

6. Most CDSs are cash settled these days. You don't need to deliver anything. I'm sure you know this...? And with index trading, it's even more so.

In summary: of course we have been through credit widening periods before. But in 2002, which you accurately mention, total CDSs outstanding were ~1/45th of what they are today. Double whammy potential: increasing default rates with 45 times more credit risk insurance outstanding. OUCH.

Thank you very much for your comments and for your kind words about my blog. The former makes me think and check my assumptions and the latter feeds my ego, though it's fat enough as it is.

All the best.

Hellasious said...

To a:

Naturally each individual buyer of a synthetic CDO chooses how much he risks depending on how much he buys/invests into it. But the SUM of the risk does not change because it has been cut into smaller pieces. All buyers will be affected in proportion to their participation and depending on which tranch they chose to buy.

Regards

Hellasious said...

to anon. abt. credit market debt.

CDSs are commonly written against marketable debt, i.e. they usually reference an issuer's particular debt instrument that trades in the secondary market (or an index that is made up of such instruments).

Not all debt in the world is thus traded, not by a long shot. For example, mortgages and other bank loans are not all securitized, particularly outside the US. Such debt is not covered by CDSs.

Regards

Jesse said...

cdstrader said:

"Notional amounts outstanding aren't particularly important. It's roughly equivalent to the VOLUME traded on, say, S&P futures. And I don't hear anyone proclaiming the end of the world when volumes pick up on futures trading?"

The example that came to mind for me was not equities volume, but commodities open interest, or the number of contracts with regard to quantifiable 'stuff.'

If I saw open interest in a particular commodites for a given month was, let's say, equivalent at delivery to the entire world supply of that commodity, that might pique my interest and set off a few alarms about a potential short squeeze and liquidity situation.

It would be the same thing in stocks IF in the daily float were to meet and exceed the amount of shares outstanding.

Does this square up?

In other words, yeah its volumes UNTIL something happens and the market wants to sell, and suddently the liquidity dries up.

If this is valid comparison, then we would also look at commodities for the example of counterparty risk. What if you really NEED that commodity or credit default insurance, and when the time comes the counterparty either a) can't be found or b) is not solvent?

Thanks guys

gn said...

Thanks for the interesting read!

I find it fascinating that financial engineers continue to profess that overall systemic risk can somehow be reduced by levering up and making lots of bets with each other. Fancy way of avoiding (prudent) capital requirements, IMO. Should be interesting when it starts to come apart.

Also, are the same eggheads who told investors subprime debt, when sliced and mixed and sliced, bore no systemic correlation risk (i.e. the senior tranches were AAA safe), now telling us the banks are running hedged CDS books?? Somehow I doubt they can predict correlation across their various gigantic (notional) positions quite that well.

Anonymous said...

François said...

"Any French banker reading this site?"

From Mr Max Keiser.

Sir, Lawrence Summers needs to wake up and smell the inadequacies of his analysis (“Wake up to the dangers of a deepening crisis”, November 26). Two months ago (“Beware the moral hazard fundamentalists”, September 24) he was trying to convince us that the problem with banks was not insolvency but rather illiquidity. Insightful observers of the credit markets knew then, as they know now, that the primary source of revenues for much of the banking industry for the past decade has been their foolhardy participation in a global Ponzi scheme backed by what we now know to be largely counterfeit mortgage paper. Therefore it is insolvency along with its corollaries – opacity, misleading statements, dishonesty and larceny – that constitute the problem and illiquidity that is its symptom.

Max Keiser,
Founder and Chairman,
Karma Banque,
Paris 75005, France

Anonymous said...

I think the risk here is misunderstood. Suppose the cds market was used entirely for hedging - that is banks were writing the swaps and buysiders were buying them. In that environment you end with way more asymetric risk than if there are speculators taking the other side in the market as well allowing banks to be net-flat even if they are holding n contracts.

I also find it hard to imagine that the discussion of cds risks comes up without mention of what seems a highly likely catalyst for problems, the insolvency of insurers leading to counterparty risk.

just my .02

Anonymous said...

I think these are interesting comments , but as CDS trader eludes to , perhaps a bit sensationalist.

All primary dealers have many checks and balances in place to manage, control and evaluate the counterparty risks which you elude to. The capital supporting this OTC "exchange" is way in excess of a futures exchnage which is percivec to be riskless. Did we ever see the main futures exchanges fail in any of the stock or bond market crashes of the last 70 years?

The issue with regards to notionals is a complete smoke screen, what is important is the volatility of margin accounts and credit worthiness of your trading counterparty. Neither can be distilled into a notional headline number.

What is true however is that systemic risks can't be "hedged" away with CDS. But that was true prior to the advant of CDS markets. A large bank failure is also going to be a very large problem for all of us not because of CDS, but because of money markets and liquidity instruments in those markets that are percieved to be riskless. It is here where the transformtion of credit risk to liquidity risk that the confluence of events is felt most, and indeed being felt most now. The hoarding of cash in these markets is increasing the risk of insolvency in the markets of underlyings on which CDS are written, not the other way round.
The money markets are as old as banking themselves, and have never been set up well for shocks due to the implicit massive leverage and very low pricing and understanding of tail risk.

In the CDS market dealers are moving towards ever tighter and more transparent operations which will ultimately evolve into a centrally capitalised clearer, much as the market has for Repo and Swaps now. BOTH of which are other financial instruments of percieved infinite leverage and have operated through thick and thin for the last 20 years.

Last comment is you all need to brush up on the ISDA cash settlement protocol if you wish to understand how a synthetic market can easily operate in net volumes that are larger than the deliverable pool of underlyings.

Hellasious said...

Dear 11/30 Anon.

Thank you for your comments.

Being somewhat sensationalistic, as you so aptly put it, is the price to pay for stirring the pot - which I strongly believe needs stirring.

A year or two ago, anyone who called real estate a "bubble" was chastised. Six years ago, even Greenspan did not dare speak too loudly against the historic dotcom/Y2K/telecom bubble. I could go on, of course.

If you read today's post ("More On CDS") you will see that I make a clear distinction between true swaps and other such derivatives and CDS. Unlike other, usually less informed commentators, I don't view all derivatives as evil, neither do I lose sleep over huge notionals and volumes for FX or interest rate swaps, FRAs, etc.

But CDSs are very different to the above - aren't they?

Please read the new post, if you are so inclined and comment further.

Best wishes,

H.

Anonymous said...

Interest rate swaps do not swap notional amounts.

Anonymous said...

Counterparty default reverts risk back to the protection buyer.

Credit default swaps don't create credit risk in aggregate. They don't increase the amount of net credit risk in the system - they only redistribute the outcome. They either transfer risk as intended or fail to transfer risk as intended. There is no net systemic risk change as a result.

In this sense, the systemic problem is typically overstated.

Dr Housing Bubble said...

Love this Hellasious. Keep up the fantastic work. It makes it more apparent why the politicos are trying so hard to avoid further defaults even if it means a life of servitude for a note holder to an asset that is depreciating. The Warren Buffet comment is very apt here.

I'm curious to know if you have a link to the breakdown of the CDS market by area (i.e., MBS, CDOs, etc).

Cheers,

Dr. Housing Bubble

Jesse said...

"Credit default swaps don't create credit risk in aggregate. They don't increase the amount of net credit risk in the system - they only redistribute the outcome. They either transfer risk as intended or fail to transfer risk as intended. There is no net systemic risk change as a result.

In this sense, the systemic problem is typically overstated."

They may not increase the 'risk' in that they do not increase the risk of default of a specific company, but they do amplify the losses in the way that highly leveraged margin can create a greater loss potential in a market than otherwise, since the assets are bid up speculatively.

This is clearly the case with CDS. Further, depending on the amounts relative to the holders of the risk, it may increase their own probability of default risk, therefore increase the aggregate.

The notion that they do not increase risk but merely spread it around sounds like one of those nice academic theories that is correct from one angle, but when proven wrong takes down a significant chunk of the real economy. Will we never learn?

Anonymous said...

" The notion that they do not increase risk but merely spread it around sounds like one of those nice academic theories that is correct from one angle, but when proven wrong takes down a significant chunk of the real economy. Will we never learn? "

The real economy loss is due to the excessive amount of the originating credit exposure - e.g. subprime mortgages in the case of housing. The exposure was facilitated by financial engineering, but financial engineering doesn't increase it beyond what was created. This is a classic case of fallacy of composition - thinking that 1 + 1 = 3. It doesn't. This isn't theory. Its a fact. Ultimate net credit losses attributable to the originating exposure can't exceed the originating exposure no matter how hard you try to argue it. CDS that traded at low yields merely ended up increasing the offsetting loss/gain wealth transfers when payments were triggered.

Arguably there is a further real economy loss due to contraction of jobs in the financial sector area that supported the mania, but that isn't categorized as a credit loss.

birdseye said...

The key to CDS's is not the volume outstanding, for that can be no more than the original credit and therefore no ADDITIONAL risks are added beyond the credits which already exist. It is also correct that the risks are more dispersed than residing in the few banks that are left.

The credit swap in itself is not a bad thing, but it is WHO writes those swaps (options!). If a credit or CDS is on the banks' books it's subject to the eye of the regulators and higher capital ratios and probably monitored better.
If the credit swaps end up with a pension or a hedgefund and they are called upon, they most likely will have to sell some other (leveraged?) asset to raise liquidity. In the case of mostly highly leveraged hedge fund operators
that may trigger price depressions of other assets and hence increase the systemic risk as could be well observed during the LTCM crisis as well as in August this year. Also, it has removed the leverage from the
regulotors' eye and allows unregulated leverage on the books of the buyer, except for the hair cut. As the implosions of large hedge fund like structures in the summer and last
year by Amaranth (crude) have proven, the hair cut obviously was not enough. The leveraged industry, will say mainly hedge funds, has, through their commission generation, the power to force prime brokers
to keep the haircut to a minimum, for if the prime broker doesn't, they will move on.

In the end it's not the the fact that risks are transferred to interested buyers, but rather the leverage that those buyers have on their books, for if they are called upon to pay, there migth be nothing left and the risks revert back to the banks that did not want them in the first place.

Hellasious said...

Dear birdseye,

I totally agree with you about leverage. It has always been proven that excessive leverage has lead to tears being shed in the end.

But I have to correct you on your first premise: CDSs CAN be issued in excess of total credit outstanding and these days they commonly ARE. The CDS contracts are netted and settled for cash if there is a credit event - no need to deliver bonds at settlement anymore.

Regards

Hubert said...

Thanks for stirring the pot.
As a non-expert I am wondering for some time about CDS and mainly about a point not mentionned here or anywhere else:
Do CDS really not increase the notional amount of default risk in the system ? I beg to differ:
IN practical terms a default happens for lack of liquidity f.e. a creditor is pressing for payment, or a supplier, or a bank or somebody who won one a big lawsuit not wanting to settle against the defaulting company, a crucial union, a crucial customer who blackmails/squeezes the company; even the media can force or at least quicken an 11 filing....
The lack of solvency is much more delicate; accounting normally gives enough time to avert or delay the default event as long as one can refinance. Legal risk for management is subjective as they mostly want to avoid filing for bankruptcy (note exceptions where management gets enriched by filing, f.e. Delphi, maybe Stelco in Canada).
Now with CDS you add one interested party - the buyer of credit protection. If this buyer is one of the parties above (or has influence on such a party) - voilà you have a new conflict of interest where he might gain more with forcing the credit event than by losing with his claim. One may even imagine a run on a company where the quick&clever get their cash out and profit on top from the CDS-hedge.
IN the past solvent but illiquid companies often made it mostly with some expensive dilution but they and their shareholders could avoid a catastrophic filing - I would not bet on the same happening once only one crucial party owns enough CDS.
Now this may sound convoluted but the valuation difference between going concern and Chapter 11 liquidation is big, not even calcualting lawyers fees and auditing fees and court fees and consulting fees - so one could make out big in being short junior debt by forcing a very uneconomic outcome overall.

Hellasious said...

Dear hubert...

What devious mind you have ;) !

In fact you are 100% correct. What you mention about interested parties forcing Chapter 11, instead of working things out is amongst the unintended consequences of CDS. A reader actually alluded to knowing exactly such an event taking place, not long ago. It makes perfect sense.

It all depends on who has the biggest pull: the CDS owners or the sellers..We are going to see much more of this as the credit cycle tightens.

Regards.

Tom a taxpayer said...

Anonymous (Nov 30) said
"The hoarding of cash in these markets is increasing the risk of insolvency in the markets of underlyings on which CDS are written, not the other way round."

I found Anonymous's comments on the role of money markets in this process very interesting, and I would like to learn more.

Can Anonymous or any one else please explain more about the role of money markets in this process?

Hubert said...

Oh, I could also imagine the protection buyer cheating somewhat.

Let´s say you are a bank with deep pockets and you have sold 5 year protection on a former good credit. Now 4 years and six months have passed and the company is on the edge. Why not provide some super-senior financing with some equity kicker attached for six months plus? Or have it arranged by somebody else and refinancing this entity nonrecourse?
Head you win and convert, tail you avoid paying out protection. Look at Citadel - ETrade for inspiration. As most big companies have a growing finance side, this can be arranged easily.

Guess we will see those cases in time.

NOt to talk of insider trading. If you are a senior creditor of a company you know much more about it than somebody outside. The terms of covenants, let alone the ability to change/defer covenants. YOu know earlier if the CEO/CFO is a crook..... and on and on.....

This is a rathole and lawyers will make out like crazy. Just imagine a case like Enron with credit protection ten times junior credits outstanding. Time to become a corporate lawyer.

Hubert said...

Sorry, too much red wine with dinner. I meant: The protection seller cheating somewhat.....

Anonymous said...

If anyone is looking for further information on Contracts for Difference (CFDs), a website worth checking out is 123cfd.com - for traders, or anyone who is interested, it covers technical analysis, trading techniques and some other aspects of CFDs.

Well worth checking out.

Anonymous said...

In one quarter, JP Morgan added $10 trillion in derivatives to their portfolio. Of that the biggest increase was in swaps... credit default swaps?

As mortgage derivatives started crashing, investment banks shifted to a logical extension - gambles of deteriorating credit (those are CDS).

The increase in CDS reflects banks trying to get away from one derivatives problems (mortgages) by speculating in other derivatives (defaults on mortgages). The CDS is a derivative on a derivative. The problem is still, who is the counterparty to your swap? The swaps have an extreme counterparty risk problem. The contract is only as good as the guy on the other side.

Here's another example, CDS on Citigroup are skyrocketing. The banks expect Citigroup to default. OK great but once Citigroup defaults, is that CDS still any good? Whose your counterparty on that OTC contract, probably JP Morgan. Are they still solvent?

Probably not. CDS, like CDOs, will be discovered to be "phantom wealth" once the counterparties are unable to make good on their promises.

CDS are a vehicle that is buying the banks some extra time and keeping the market afloat. They too are fundamentally worthless.

And on and on like this we go. Derivatives on derivatives. Then derivatives on derivatives on derivatives. Until everyone loses faith and just acknowledges that the money doesn't exist, it never did.

hyperspectral said...

Credit Default Swaps.

This is the best thing since 9/11. Crash and Burn Banking is out of this world. Super Dooper. It's Fun. Let's do it some more. Maybe we could vary it a bit though, perhaps let's Burn "then" Crash for a change.

Probable outcome? Encore. Do it again.

My Bubble Gum Card collection is full of "doubles"

Really these "Guys" (Merchant Bankers) act like 5 year olds playing tricks (silly little word games) on 3 year olds in the playground. And Daddy's gonna bring the boss home to abuse the kids.

It's like all your "Bad Hair Days" rolled into one. You’r gonna need another "Brokers Haircut".

See y'all on the other side

BR said...

A thought - money is in itself a speculable unit of trade, having absolutely no meaningful value in itself (err wallpaper ?). While various well placed but not necessarily well meaning or informed personalities are busy laying down the global workings through which money or valuable assets might flow so as to keep the earths economical machine accelerating , financial oportunities opening, geopolitical relations strengthening , in their favour, nothing , but nothing (no , not even the feel good factor) can change the true reality of what is available, what can be made available and what is necessary for fruitful human progress on this planet. I don't have an imediate solution , so I shall return to mine. Good luck!

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ithaca said...

The notion that theyデータ復旧
do not increase risk but merely spread it around sounds like one of those nice academic theories that is correct from one angle, 会社設立
but when proven wrong takes down a significant chunk of the real economy. Will we never learn? "

The real economy loss is due to the excessive amount of the originating credit exposure - e.g. subprime mortgages in the case of housing. The exposure was facilitated by financial engineering, but financial engineering doesn't increase it beyond what was created. This is a classic case of fallacy of composition - thinking that 1 + 1 = 3. It doesn't. This isn't theory. Its a fact. Ultimate net credit losses attributable to the originating exposure can't exceed the originating exposure no matter how hard you try to argue it. CDS that traded at low yields merely ended up increasing the offsetting loss/gain wealth transfers when payments were triggered.