Friday, November 30, 2007

Further On CDS

Yesterday's post on Credit Default Swaps (CDS) generated considerable discussion. There are a few points that should be expanded.


Despite their name, CDSs are not swaps, but insurance policies.
This is not merely a philosophical argument about names, as the following will make clear.

First, let's look at a real swap - for example, a foreign exchange forward swap.
This is how it works:

On Date X
Bank A sends to Bank B 100 million dollars
Bank B sends to Bank A 67.567 million euro

So far, this looks like a spot USD/EUR foreign exchange transaction taking place at a rate of 1.48 dollars per euro. Notice that actual cash changes hands on both sides: Bank A and Bank B have to send money to each other.

On Date Y, the transaction is reversed:
Bank A returns to Bank B QQ.qqq million euros
Bank B returns to Bank A 100 million dollars.

The exact amount of euros that is returned (QQ.qqq) and the duration of the swap (Date X to Date Y) are agreed and set at the inception of the deal. Again, actual cash payments are exchanged.

These swap transactions are extremely common, with hundreds of billions of dollars, euros, yen and other currencies swapped daily. The crucial point to keep in mind is that they are real swaps, i.e. the parties involved have to send money to one another at the same time.

There are other transactions also termed swaps, e.g. Interest Rate Swaps (IRS). They, too, involve the concurrent exchange of cash flows between the parties involved and are very common. More information on them can be found here.

Unlike the above, a Credit Default Swap transaction swaps nothing. One party buys an insurance policy against default and pays fixed premiums, typically for five years, while the other party sells insurance policies and receives premium income. Like all insurance operations, the seller is exposed to significant event risk and the buyer expects that his insurance company is well enough capitalized to meet its obligations, when it is called to do so.

At this point the difference between a credit insurance scheme and a real swap is obvious. Indeed, when they first started to become popular around 1999-2000, CDSs were not called swaps but, more accurately, Credit Insurance Contracts. Somewhere along the line, for reasons not entirely clear, the terminology was changed to the more familiar and innocuous-sounding "swap".

I leave it to the informed reader to deduce why a name which clearly denoted actuarial risk and the need for substantial reserves, was exchanged for one that falsely implies the concurrent exchange of cash flows.


Who is in the CDS market?

As the above made clear, credit default swaps are insurance contracts, not two-party swaps that exchange cash flows. When an insured event occurs (i.e. a default), CDS sellers have to pay out on the insurance they sold. But CDSs are not underwritten by regulated insurance companies whose operations and reserve requirements are tightly regulated (though some insurance companies are also in the CDS business), but by almost anyone who wishes to participate in the action: investment banks, hedge and private equity funds, family offices, pension funds, special purpose entities like synthetic CDOs and CPDOs, even wealthy individuals. They each buy and sell CDSs for different reasons, including the generation of highly leveraged equity equivalents, but they all have one thing in common: they are not insurance companies.

Credit defaults risk is certainly being spread around this way, but is it adequately reserved against? We won't know until the next credit cycle and, as Warren Buffet says, that's when we will find out who is swimming naked. Knowing how the above participants operate when in party mode, I wouldn't bet on many swimsuits being worn.

But don't take my word for it; look at what is happening right now with mortgage-backed CDOs, SIVs, etc. They, too, were constructed with the extremely optimistic assumptions that defaults would remain at record lows. Now that defaults are rising, even AAA paper is defaulting in one go. This toxic paper was manufactured at the exact same "plants" that also sold credit insurance, by the exact same workforce and under the same assumptions.


Notional CDS amounts matter and should not be immediately dismissed by comparing them to their market value.

The reason, once again, has to do with their insurance policy nature. For as long as defaults are low, anyone can make money writing enormous amounts of credit insurance. Property and casualty insurers are also very profitable, until three Category-5 storms hit in a row. Dismissing notional CDS amounts in favor of market values is similar to a P&C insurer disregarding how much insurance it has underwritten and focusing instead on the present value of its premiums.

The last time defaults rose sharply was in 2001-2002 (see charts below). At that time, the total amount of CDS outstanding was $918 billion, whereas today the amount has reached $45.5 trillion (ISDA). Very little debt was covered by credit insurance in 2001 and thus the effects on the financial system were minimal. We simply cannot compare that experience with today's massive risk exposure. Yes, we had the equivalent experience of three Cat-5's in 2001, but there was very little insurance outstanding back then.

Defaults of Speculative-Grade Bonds (Chart: Altman)

Defaults of Leveraged Loans (Chart: Altman)

Perhaps the CDS market is so spread out that it cancels itself out. Perhaps everything is just perfectly matched between credit assets and liabilities that nobody is holding a risk tail. But with $45 trillion around I wouldn't bet on it.

And you know what? Greenspan was worried about that, too. Last time he spoke on the subject he urged bank operations departments to rapidly clear their CDS paperwork so that open positions can be netted and the real risk profile of each may be assessed. Apparently there is some progress being made on this front.

But the truth be told, netting is not all that it's cracked up to be. All it takes is one nervous risk officer to hold up payment until he receives the other guy's money first and the whole structure goes poof. When push comes to shove everyone holds on to their cash much more tightly, everyone gets much more suspicious. No one wants to be on the no-show side of a "fail".

The full story will be told, like always, after the fat lady sings. For credit default insurance this means during the next high of the default cycle.


  1. Hello from France again!

    I think that the CDS post generated so much interest because those who tried to gather some infos about the credit crisis now feel that the next bomb will detonate in this area. Indeed after reading some of your former messages, I fear that in France alone 3 institutions could be caught into big problems from one day to the other (Socgen, Calyon, Axa).

    Now to my question again, and this time I will try to be very clear.

    Companies C1, C2, ... Cn emit bonds

    Funds F1, F2 ... Fk buy some of these bonds.

    Bank B sells CDSs to the Funds to protect them from Companies defaulting. Bank B then bundles the incoming cash flows from all those CDSs into a pool, manufactures "securities" and resells rated tranches of "hybrid" CDOs made of those securities. OK, understood.

    Investor has too much money (not my case BTW :-). Investor has the choice to

    a) either buy bonds directly from the Companies
    b) or buy hybrid CDO tranches from the Bank

    In case a) if all the companies default (three cat-5 storms in a row), Investor is exposed to complete loss of his investment. OK.

    In case b) Investor is exposed to bank's default, ie again to complete loss of his investment... but not more??? I mean in this case b) Investor has no liabilities against the Companies (as has the Bank) only because he bought those hybrid CDOs?

    Surely this is an extremely silly question, but I can't find a definitive answer. OTH as this is over the counter contracting, maybe there is no rule?


  2. OT-

    Three-Month Libor for Euros Soars to 6 1/2-Year High, BBA Says

    By Gavin Finch

    Nov. 30 (Bloomberg) -- The cost of borrowing euros for three months rose to the highest since May 2001, according to the British Bankers' Association.

    The London interbank offered rate, the amount banks charge each other for such loans, rose 3 basis points to 4.81 percent, its 13th straight day of gains.

    That's 81 basis points more than the European Central Bank's benchmark rate, the biggest gap ever.

    The overnight euro rate rose for a second day, up 9 basis points to 4.08 percent, the BBA said today.

  3. "Perhaps the CDS market is so spread out that it cancels itself out."
    That's exactly the case, at least for banks.
    I posted some pictures data for US banks.
    The mark to market is a very small fraction of notional [around 1%], and the books are in balance.For exemple, in the 2nd quarter JPM was down $165 million on a book worth $ 6.512 trillion...another scare story imho.

  4. to jck,

    The 2q2007 was when CDS spreads reached the lowest ever. How about their (or anyone else's) books on the end of the 3Q, or better yet, right now? CDX IG went gone from 35 to 85 bp and the HY went over 500 bp.

    That's (almost, not quite) like saying that my naked stock index put portfolio produced no losses in the 2q. Well... of course not!

    Also, everyone focuses on being net flat. But how do you net a long CDS position from UBS with a short from XYZ hedge fund with 100 mio in assets? It just isn't the same risk.


  5. Dear Arnould,

    You seem to be misunderstanding a basic concept about CDS's: the companies issuing the bonds c1, c2, c3 are not involved in the CDS process at all. Their bonds only serve as reference items to those buying and selling CDS's.

    To use a life insurance analogy: it would be as if I bought life insurance from AXA on YOUR life, with the death benefit payable to ME. God forbid.


  6. If I'm not mistaken, an insurance claim becomes a level 1 asset until proven otherwise. It has been reported on another blog that the back rooms at Bank of America are taking 8 weeks to correct mistakes, wanna bet that that extends to 16 weeks as time goes on. It's all cover, just as the CDO seminars were cover for top level bribery in brown paper envelopes. It only takes one bribe to the policy setter to cause a 200 billion state fund to start purchasing toxic waste in moderate quantities. The top guy in Florida is reported to earn a high 5 figure salary.

    I believe we have RICO actions available to State Attornies General everywhere. It's time to start searching freezers.

  7. Hellasious:
    "The 2q2007 was when CDS spreads reached the lowest ever. How about their (or anyone else's) books on the end of the 3Q, or better yet, right now?"
    Did you look at the graph ?
    Guess not, it shows that the win and loss on mtm are approximately equal so they are long and short, spread level irrelevant.I will post q3 when i get the data.

  8. Dear Hellasious,

    I still do not have my answer (excuses!)

    I understand that the CDS issuer (the Bank) has nothing to do with the bond issuers (the Companies).

    But the Bank has to reimburse the Funds if companies default.

    Now if I (Investor) bought hybrid CDO tranches made of CDSs and issued by the Bank, would I have liabilities against the Funds (through the Bank) because I would own these hybrid CDOs? In that case I may lose more than my investment.

    That is my question. Of course I hope that the answer is "NO". Or this system would really be a mass destruction weapon.


  9. I just saw that I made a mismatch between Companies and Funds in my first post! I am sorry for this.

  10. So glad you're posting on CDS - I've thought for years they were more of a danger than a hedge.
    1) Collateral-posting requirements on counterparty downgrade (with an A trigger) are widespread. Unlikely that a large player could post the required amount if downgraded (particularly since the likelihood of downgrade probably correlates with a relatively risky business strategy and credit environment). Probable result: failure or rescue.
    2) Similarly, ISDA's standard definition of bankruptcy can be triggered by an involuntary filing (since it's not possible to get a filing dismissed within the permitted 15 days); standard cross-default provisions would carry through to the party's entire swaps portfolio, this time requiring termination payments. Probable result: failure or rescue.
    3) Pay-as-you-go CDS can be done on RMBS (and ABS and CMBS) for notional amounts that exceed the outstanding or even initial principal of the reference tranche. The reference tranche may not be SEC-registered (of course it's not listed), with the result that information isn't publicly available and may not be available at all (so the protection seller is supposed to rely on the buyer's certificate as to the occurrence of a credit event and the amount due). Don't believe this is tracked by anyone.

    While most CDS probably are hedged, as you point out end users are required to take on the actual risk. Hedge funds and CDOs are large end users.

    Also, synthetic CDOs and baskets of synthetic assets (CDS) in CDOs, were never hedges; they were new investments. That creates brand-new risks beyond the reference credits and tranches. Fortunately, I think the curtain came down before volume really took off.

    Finally, you're spot on about CDS and insurance. It will be interesting to see whether protection sellers start refusing to pay on the grounds they weren't authorized to sell insurance (and financial guaranty insurance at that, making this defense available to non-monoline insurers). Except the monolines, of course, who are expressly authorized to guaranty CDS if they could guaranty the underlying.

    Great post.

  11. Dear arnould,

    No worries about the mismatch mate.

    The synthetic CDO will have tranches of varying risk, just like regular CDOs. An investor can choose which level of risk he is comfortable with. The very bottom tranche, the "equity" will absorb much more loss than the top tranches.

    But yes, some financially engineered CDS products work so that you COULD lose more money than you originally put up. CPDO's for example...

  12. Insurance is supposed to lower risk. However, if it is sold by undercapitalized entities, then risk is increased.

  13. just to clarify on notional amounts on CDS, which I'd commented on yesterdays post...

    what i'd meant by it not mattering was when it was between 2 counterparties...for example, I could have $5bn of trades on the CDX index with JP Morgan, with $2.5bn of them being buys and $2.5bn being sells. Both mine and JP's net risk on the trade is zero (and unlike single-name CDS, it's EXACTLY zero as cash payments are paid out upfront representing the Mark-to-Market difference between the standard index contract and the level we traded at).

    BUT...this will get counted as a $5bn notional outstanding by the BIS.

    So ESPECIALLY due to the explosion in index trading over the last 3 years or so, notional amounts outstanding have also exploded, although risk exposures haven't gone up by anything like as much due to all these offsetting trades.

    To give you an idea, 5 years ago a VERY busy day in CDS might have seen me trade $250mm of CDS contracts. Today, a VERY busy day for an index trader could be over $10bn!!!

    Oh and I'd agree with you that the best description for a CDS contract is an insurance policy. Although it can be shown that the economics of selling CDS and buying a "risk-free" asset is (ALMOST) the same as buying a corporate bond.

  14. Thanks for another excellent dose of information and exchange of ideas.

    CDS sounds to me like the sort of vehicle that works fine when it works, but when you get an event out on the tails of probability, as happened in the case of LTCM, then the cascading impact is really something to behold.

    My gut feel was that the CDS market is an accident waiting for the right trigger event.

    As an aside, did you all notice a change in temperament amongs the Fed chairs Benny and Don this week?
    I'm keeping an open mind that they are just pimping rates for the funds and trading desks year end close, especially if the spin machine goes into reverse next week.

    But, from a number of different areas, I am wondering if something has gone beyond smoldering in the closet, and has broken into a fire in the attic. Benny looks like a guy with a chimney fire, and he is trying not to alarm the guests, although he's called Hank, who's on the clock, but did page his relatives at the party to hit the exits now, maybe even take out a little fire insurance as well.

  15. Benny looks like a guy with a chimney fire, and he is trying not to alarm the guests...

    Benny is living through what he researched when he was a professor. He has an economy going sour because of financial market excess (a la 1929) and he is delivering the medicine he said in his books and papers: more and more easy money.

    He is like a general that prepares to fight the PREVIOUS war (you know, like digging trenches in 1939 instead of building airplanes).

    He is fighting the terrible effects of too much easy money by... more easy money. NOT SMART.This does not mean that he should tighten money, either. It means, I believe, that the Fed is not the entity that should be fighting this "war".

    We need real political leadership here, not just monetary policy.


  16. Excellent blog, but we are missing quite possibly the biggest dirty secret of the CDS market: The integration of CDS into the calculation of bank capital ratios.

    When Bank A buys CDS from Bank B against a risky loan it has, the regulators then permit Bank A to hold a very small amount of capital against the now insured loan. This makes sense in isolation.

    Bank B then in turn has to only hold a small amount of capital for holding this CDS position. This small amount is now the only capital held against the original loan in the entire banking system.

    This practice clearly removes a large amount of capital from the banking system without any reduction in risk. This happens all day.

    Remember this example when you read news articles about the banking system's low capital ratios. One can easily imagine what the actual capital ratios are considering the above.

    Bloated capital ratios are the Phantom Menaces.

  17. Question for CDS trader on the net exposure - is this based on an assumption of zero counter party risk?


  18. Thanks for the post on CDS contracts.

    May I suggest an article for anyone interested in more details? Google the following:

    "The Next Dominos: Junk Bond And Counterparty Risk"

    Financial engineers pretend they can measure risk just as scientists and engineers measure chemical, electrical or fluid potential or temperature.

    The idea that CDS contracts reduce systemic risk is dangerous!