Credit Default Swaps – A Primer
A credit default swap is a type of credit derivative. Credit derivatives “derive” their value from an underlying credit instrument; generally the bonds of sovereign nations or the bonds of a corporate entity. In recent years, credit derivatives have been created that are based obligations rather than entities; one common reference obligation are asset backed securities based on home equity loans.
A credit default swap is a contract that allows one to take or reduce credit exposure. The contract is between the two parties and does not directly involve the underlying reference entity. A credit default swap is essentially an insurance policy where one entity pays a premium to a second entity to take on the risk of a loss.
Let’s look at a fictitious example.
Mack’s Widget Company is a very good customer of the Bank of Bob. The companies have been doing business for many years and Mack’s Widget Company has many accounts with Bank of Bob.
Mack’s Widget Company comes to Bob the Banker looking for a loan to expand its production capacity. Bob wants to maintain the good business relationship he has with Mack, but Bank of Bob is concerned about increasing his bank’s exposure to Mack’s company.
Gary’s Bank has a lot of exposure to home loans, but no exposure to widget companies. To diversify their loan portfolio, Gary’s Bank is looking to take on the credit risk of widget companies.
Fortunately for both parties, there is an instrument that allows Bank of Bob to extend Mack’s Widget Company a new loan while transferring the credit risk to another party, thereby limiting Bob’s exposure to the widget business. This instrument is a credit default swap (CDS). This is the most basic type of credit default swap, called a single-name CDS.
In this transaction, Bank of Bob enters into a contract with Gary’s Bank. Bank of Bob holds the Mack’s Widget Company bond, but agrees to pay Gary’s Bank a specified, periodic premium in exchange for Gary’s Bank agreeing to make Bob whole should a specified credit event, such as a default, occur. Gary’s Bank puts up a token amount in collateral to secure his promise to make Bob whole should Mack default on his loan. This collateral is generally a small fraction of the potential loss the swap seller could be asked to cover; in fact, many credit default swaps have no collateral requirement at all.
[Side Note: this is where the inherent leverage of CDS comes into play. Gary’s Bank, Hank’s Hedgefund, or AIG, can put up a small percentage of the notional value of the reference bond as collateral, but receive a premium based on the full notional value of the bond. In this case, Gary’s Bank might pledge 5% or $500,000 as collateral for the swap. In some cases, no collateral is put up at all. In return, Gary’s Bank is taking on the full risk of default on the $10M bond. This is completely unregulated and Bank of Bob is relying solely on Gary’s Bank’s good name (and $500,000) when buying this “insurance.”]
In this way, Bob maintains a good relationship with his best customer, while not taking on additional exposure to Mack’s credit risk. At the same time, Gary’s Bank diversifies its credit exposure without having to go out and directly fund loans to widget companies.
National Public Radio’s Marketplace has an excellent video explanation of credit default swaps here: Credit Default Swaps Overview Included in this video is a brief discussion of how AIG’s troubles began when it suddenly found itself in the position of having to increase the amount of collateral it had posted on thousands of CDS transactions. When S&P downgraded AIG’s credit rating, it triggered massive collateral calls on the nearly half-a-trillion dollars worth of credit default swaps the insurer’s financial products division had sold. This led to the U.S. government’s $85 billion loan package designed to keep AIG afloat.
Evolution of the CDS Market
In the early years of credit default swaps during the late 1980s and early 1990s, the transaction between Bank of Bob and Gary’s Bank typified the CDS market. Swap deals were largely ad-hoc affairs between banks looking to manage their credit risk.
As figure 2 shows, the CDS market has evolved quite rapidly. Estimates from the ISDA place the growth in the notional value of credit default swaps (the amount of the reference bond or obligation underlying the CDS) at greater than 100% per year between 2003 and 2006.
In a paper (pdf) for the Federal Reserve Bank of Atlanta, David Mengle, the head of research at the International Swaps and Derivatives Association described the evolution of the CDS market. He identified four phases within the market:
Phase I – late 1980s and early 1990s – predominated by single name CDS contracts entered into on an ad hoc basis by banks wishing to shed credit risk
Phase II – beginning in the early 1990s and lasting through the mid-to-late 1990s witnessed the growth of a dealer intermediated market for credit default swaps. This brought investors into the market who lacked the ability to fund or process loans, but who wished to gain credit risk exposure. One benefit of this development was greater liquidity and more efficient pricing of credit default swaps. This also brought players into the credit market who may not have had the same expertise as banks in evaluating credit risk.
Phase III – The late 1990s saw credit default swaps enter the mainstream of derivatives trading. Liquidity was greatly improved, dealers began holding diversified and hedged portfolios of credit default swaps.
Phase IV – By 2003, CDS began trading with standardized terms and volume began to greatly increase. By 2004 the first of the CDS indexes began trading. The CDX and iTraxx indexes offered one-stop shopping for those looking to obtain or hedge credit risk. According to Fitch Ratings, index products experience 900% growth in 2005. This truly became a new era in credit derivatives trading. This period also marks the entrance of hedge funds en-mass to the CDS market.
Figures 3 and 4 shows the rapid increase of hedge funds in the CDS market. Between 2002 and 2004 hedge funds greatly increased their share of the market as sellers of credit default swaps. By 2006, hedge funds had supplanted insurers as providers of credit default swap protection.
Figure 3. Buyers of CDS protection
Figure 4. Sellers of CDS protection
Changes in Settlement of CDS
Growth in CDS has been so large, that the notional value credit default swaps on an underlying reference entity routinely exceed the underlying value of the debt. This has prompted a shift in the CDS contracts to a system where “cash-settlement” is the default option. Early CDS contracts often specified “physical settlement” where in the event of a default, the protection buyer would physically deliver the underlying reference bond to the protection seller, and the protection seller would in turn make the buyer whole by paying the difference between the market or recovery value of the bond and par (face value). Today, most CDS contracts specify cash settlement, where in the event of a default, there is an auction or dealer poll to determine the value of the underlying debt and then the CDS seller pays the buyer par minus the recovery value as determined by the auction or dealer poll. There is no physical delivery of the underlying bond, because in most cases, the swap seller doesn’t actually hold the bond.
Growth of index CDS and Synthetic CDOs
As seen in Figure 5, the growth in the credit derivatives market has been driven not by the insurance-like “single name credit default swaps” described above, but by the introduction of index-based credit default swaps and synthetic CDO’s.
There are a number of CDS-based indexes that aggregate the credit risk of a basket of entities, generally corporations. Two of the largest are the Markit CDX index which 125 North American companies and the iTraxx Europe index which tracks 125 of the most actively traded European companies. The introduction of the indexes gave investors a fairly simple and more liquid, if less exact, method of hedging credit risk in their portfolios. Importantly, it also gave investors another way to express a particular view (aka speculate) on the prospects for the credit market.
Cash CDOs, are securities backed by pools of bonds and loans. Synthetic CDOs, unlike cash CDOs, derive their income form pools of credit default swaps. Synthetic CDO’s come in many shapes and sizes, but one fundamental feature of all CDOs is that they are effectively leveraged instruments. Calculated Risk has a wonderful post outlining the creation of CDOs and the pitfalls inherent in the use of leverage. If you want to get really into the machinations of synthetic CDOs, this video will allow you to geek-out with the best of them. The big take-away from the explosive growth in CDOs and Synthetic CDOs is that it allowed banks to move loans in the case of CDOs or loan risk off in the case of synthetic CDOs off of their balance sheets. Through the magic of structured finance, these products allowed banks “free up” capital to make additional loans and start the cycle over again. CDOs and Synthetic CDOs were the essential cogs in the wheels of the stunning growth of mortgage issuance from 2000 to 2007 and could really be a topic unto itself. To simplify synthetic CDOs, remember that sythetic CDOs receive cash flows by selling credit default swaps; by buying a synhtetic CDO, the purchaser is effectively selling credit default swaps. By doing so, the Synthetic CDO purchaser is agreeing to assume the default risk of a basket of loans in exchange for a stream of income. Again, through the alchemy of structured finance, synthetic CDOs were able to take pools of BBB rated loans and turn them into AAA rates CDOs. Again, the Calculated Risk post does a good job of showing how subprime home equity loans from California could be structured into CDOs with AAA rated tranches.
The CDS market began growing exponentially in the in the early 2000s. Banks saw an easy and cost effective way to transfer risk off of their balance sheet while simulatneously raking in handsome fees for their efforts; this in turn freed up more capital to make additional loans and to start the cycle all over again. In a time of zero to negative real interest rates Hedgefunds, investment banks, and other yield-starved investors saw opportunities to get out-sized returns by making leveraged bets on “AAA-rated” CDOs. For much of the 2000s investment banks and hedgefunds were earning stellar returns by borrowing at low rates (see Yen Carry Trade) and using the proceeds to purchase Cash-CDOs and synthetic CDOs.
A second force behind the skyrocketing growth of CDS trading was the ease with which CDS and index CDS’s allowed traders to place bets on all sorts of debt; corporate debt, sovereign debt, mortgage-backed debt, and more. Credit default swaps allow traders to take a “long” or bullish position on the underlying debt without needing to purchase the actual bond or to place a bearish bet by “shorting” the bond (which is very difficult to actually do). A recent article in Fortune Magazine described the speculative factors behind the growth of the CDS market as follows:
ONE REASON THE MARKET TOOK OFF is that you don’t have to own a bond to buy a CDS on it – anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people’s debt. That’s why it’s possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt….
So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world’s largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, “To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract.”
One troubling aspect of this booming, new market at the center the global economy, is that not only is the market unregulated, but many of its largest players are lightly regulated hedgefunds employing large amounts of leverage. Figure 4 shows the growing prominence of hedge funds as sellers of CDS protection. These guys aren’t your trusty State Farm agent. They aren’t required to maintain adequate capital reserves to pay the “claims” on the credit default swap contracts they have written. Worse, most of these hedge funds use leverage to enhance their returns. Leverage, on the downside can quickly amplify losses making a small loss into a large loss that could wipe out their equity and their ability to make good on their CDS obligation in its entirety.
It seems like a market this large, this interconnected, and this important to the health of the global economy should have some oversight. Fortune Magazine had this to say:
There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late ’90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm – most recently in the news when he stepped down as John McCain’s campaign co-chair this summer after calling people who talk about a recession “whiners” – crowed that the new law “protects financial institutions from over-regulation … and it guarantees that the United States will maintain its global dominance of financial markets.” (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would “supersede and preempt the application of any state or local law that prohibits gaming …”) Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives “financial weapons of mass destruction.”
If you want to follow this trail, look to the Commodity Futures Modernization Act of 2000, a 262 page amendment, written by Phil Gram and financial services industry lobbyists that Gramm added just before midnight into a budget fiercely contested budget bill on December 15, 2000. This bill specified that:
The Commission is prohibited from registering, or requiring, recommending, or suggesting, the registration under this title of any security-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act). If the Commission becomes aware that a registrant has filed a registration application with respect to such a swap agreement, the Commission shall promptly so notify the registrant. Any such registration with respect to such a swap agreement shall be void and of no force or effect.
`(3) Except as provided in section 16(a) with respect to reporting requirements, the Commission is prohibited from–
`(A) promulgating, interpreting, or enforcing rules; or
`(B) issuing orders of general applicability;
under this title in a manner that imposes or specifies reporting or recordkeeping requirements, procedures, or standards as prophylactic measures against fraud, manipulation, or insider trading with respect to any security-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act).
In layman’s terms, this bill prohibited credit default swaps from being regulated by the SEC or the Commodities Exchange Commission. This bill also prohibited the regulation of over-the-counter energy trades; a little feature known as the “Enron Loophole.” The Enron loophole is an entirely different story, well told here, with a similar sad ending. As Mark Twain said, “history does not repeat, but it does rhyme.”
Where are we now?
That is the question everyone would like to have answered. With an interconnected credit default swap market equal in size to the total output of the global economy, the possibility of further disruption exists. I see several risk factors that bear watching. The first is a major default or bankruptcy by one of the largest reference entities on which credit default swaps have been issued. Figure 6 shows the largest reference entities for on which credit default swap protection has been bought and sold.
Figure 6. Top Reference Entities
You’ll notice that the “Big 3” US automakers, GM, Ford, and Chrysler are among the largest reference entities. As the economic slowdown and tightening credit market hit these already struggling companies, the prospect of bankruptcy is rising. Should one or more of these companies fail, it could have major reverberations in the markets. It’s probable that many of these swap agreements will simply cancel out, so that the total losses in the marketplace aren’t equal to the notional value of the swaps. However, the bigger question is, who are the entities who have sold GM or Ford credit default swaps and are they in a position to make good on their obligation should one of the companies default? Since the market is completely unregulated, nobody can know for certain where the risk lies. While the politicians say they are concerned about job losses should GM go under, I think the real reason for the $25 Billion in loan guarantees, has to do with the unknown and unknowable impact to the credit markets should GM go under (though this Forbes article makes a good point about the impact to the Pension Benefit Guarantee Corp, oof).
Figure 7. Top CDS Counterparties
The list of potential flash-points is long and frightening. General Electric, once thought of as the bluest of blue-chips, has seen its own troubles, and Russia, has seen massive outflows of capital since its invasion of Georgia. Credit default swaps have a legitimate purpose as insurance contracts. Unlike insurance, the CDS market is wholly unregulated. There are no guideline or watchdogs ensuring that counterparties are maintaining adequate reserves to pay in the event of a default. Considering the network effects to which credit default swaps are subject, they should be even more tightly regulated than say, auto insurance, yet they aren’t. If I get into a car accident, my accident doesn’t increase the chances that my neighbor and my neighbor’s neighbor will also get into a car accident. The same can’t be said for the credit markets. There is a high degree of correlation in the credit markets. If General Motors goes bankrupt, there is an increased risk that all of General Motor’s suppliers and General Motor’s Supplier’s suppliers will go bankrupt. If the economy goes into a recession, there is a correllary increase in credit defaults. (Correlation risk is discussed here pdf).
This economic correlation in the credit markets, the leverage that credit default swaps allow an investor to gain, and the unknown and unregulated status of the counterparties to credit default swap trades have created dangerous systematic risks in the finance markets. It’s hard to imagine how the players in this game couldn’t see that it was bound to end badly; perhaps they did know it was bound to come undone, but the promise of a big pay-day today, blinded them to the calamitous result. Alan Greenspan wasn’t pulling down fat bonuses for his part in this tragedy and while admitting he goofed, Greenspan claims that nobody could have seen this coming. Hindsight is 20/20; I just wish we had all chipped in to get Mr. Greenspan better eyeglasses.
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