A very good, accessible article, “CDS market may create added risks,” by Satayjit Das appears in today’s Financial Times.
We’ve sometimes discussed the fact that credit default swaps, which effectively are insurance policies against defaults, suffer from considerable counterparty risk. A policy is only as good as the entity that wrote it, and many of the players in the CDS game hedge or partially hedge the insurance they have written with contracts from others. Thus, a failure to pay could easily lead to cascading problems.
Das gives further insight into the potential trouble spots in the CDS market, noting that even when everyone pays up properly, CDS hedges have failed to provide the insurance against risk that they were supposed to. He also discusses how practice has deviated from theory when parties failed to post adequate collateral as well as operational risks.
From the Financial Times:
In May 2006, Alan Greenspan, the former Federal Reserve chairman, noted: “The credit default swap is probably the most important instrument in finance. … What CDS did is lay-off all the risk of highly leveraged institutions – and that’s what banks are, highly leveraged – on stable American and international institutions.”
The reality may prove different.
The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who for a fee indemnifies the protection buyer against credit losses. Current debate has focused on the size of the market. But the key problem is that a combination of documentation and counterparty risks means that the market may not function as participants and regulators hope if actual defaults occur.
CDS documentation, which is highly standardised, generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are also technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.
In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, for example, the volume of CDS outstanding was $28bn against $5.2bn of bonds and loans. On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.
Shortage of deliverable items and practical restrictions on settling CDS contracts have forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement (based on the market price of defaulted bonds) for physical delivery. In Delphi, the protocol resulted in a settlement price of 63.38 per cent (the market estimate of recovery by the lender). The protection buyer received 36.62 per cent (100 per cent – 63.38 per cent) or $3.662m per $10m CDS contract. Fitch Ratings assigned a recovery rating to Delphi’s senior unsecured obligation equating to a 0-10 per cent recovery band – far below the price established through the protocol. The buyer of protection may have potentially received a payment on its hedge below its actual losses – effectively it would not have been fully hedged.
CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. Some 60-70 per cent of ultimate CDS protection sellers are financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented. Recently, Merrill Lynch took a charge of $3.1bn against counterparty risk on hedges with financial guarantors.
In the case of hedge funds, the CDS is marked to market daily. Any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. As the case of ACA highlighted, banks may not be willing or able to close out positions where collateral isn’t posted. Collateral models also use historical volatility and correlation that may underestimate the risk.
Then there are operational risks – mark to market of the CDS and control of collateral.
If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. The CDS market entails complex chains of risk – similar to the re-insurance chains that proved so problematic in the case of Lloyd’s of London. A default may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts trading.
As the credit crisis deepens, the risk of actual defaults becomes real. The CDS market will be tested and may be found wanting.
CDS contracts may not actually improve the overall stability and security of the financial system but actually create additional risks.
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You need to deliver the defaulted security to collect full payment; if you didn’t, and you don’t, you should have read the fine print.
The really scary part is that the counterparty risk is worse than you may have imagined: “Some 60-70 per cent of ultimate CDS protection sellers are financial guarantors (monoline insurers) and hedge funds.” Thank goodness such over-capitalized entities are underpinning this critical corner of the financial system, as the percentage rate of credit defaults reverts to the mean in a recession and everyone is fashionably loaded up with debt.
I’ve mentioned the Delphi problem before, that because the CDS written were so far in excess of the amount of the cash bonds that there was consider scrambling and, ahem, fudging, but I didn’t have the details that Das provided. Pros basically implied I was a crank for depicting Delphi as anything other than a complete vindication of CDS.
Similarly, I’ve had people who should know better maintain that CDS are written primarily by well capitalized entities like banks and investment banks. Of course, we all know that they are anything but pillars of financial strength these days.
I don’t mean to go into a mini-rant, but it has been astounding how people with more than a modicum of sophistication have insisted that This Is Not a Problem, when looking at some very basic facts says that the likelihood of trouble is high.
When Warren Buffett called these things “weapons of mass financial destruction”, he was ridiculed. You’re in good company. Don’t worry about your critics.
While I agree that the market practice of most CDSes being physically settled as opposed to cash settled, I think the article misses an important point:
If you don’t own a deliverable obligation, you’re not hedging but speculating.
At the best I’d allow for “correlation” hedginig, where you buy/sell something similar, but that is a road to hell as while you might have partially hedged your MTM movememnts, your jump-to-default is still entirely unhedged and you’r stuffed.
A bigger problem I can see is that due to the confusion in most of the back offices I would not be suprised if some of the CDSes that are in the system as being written on some entity were in fact on a slightly different entity. Often parent/child, but bankrupcy-removed. So while you might think that your bond position with XY ltd. is hedged, in fact your CDS is on XY plc.
In general, the doco risk on CDSes is enormous. There are known cases of CDS contracts (Pramalat) not being upheld (and tested in the courts) becasue of the capitalization of the name of the reference entity on the contract. Similar issue might be a missing/wrongly placed comma or a full stop.
You’re absolutely right, this CDS story could get much more interesting very fast (sorry to repeat a link):
Insight: CDS market may create added risks
In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, for example, the volume of CDS outstanding was $28bn against $5.2bn of bonds and loans. On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.
CDO Market Is Almost Frozen, JPMorgan, Merrill Say
Those investors previously bet the classes would default by using derivatives called credit-default swaps. By buying the classes, they want to collect their windfalls sooner, as well as end the regular default-protection payments they owe, which may stretch on for more than a decade, he said…Under about half of the swap contracts, Rizzo said, they can collect their windfalls sooner by delivering the class after a steep-enough downgrade to the bank that’s taken their wager. The bank, which doesn’t want to own the class, could then sell it to a similar investor…”I’ve traded one bond that’s worthless eight times this year,” Rizzo said. “So it’s like, ‘How many times can I trade the same bond that’s worthless for five cents?’ It is kind of funny.”
Speaking of ‘Naked Capitalism’, that’s some whiz-bang money-making strategy, wouldn’t you say?
The reality may prove different.
And so much more entertaining.
“CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged.” That summarizes the core problem.
I strongly recommend reading Satyajit Das’ book Traders Guns & Money (Prentice Hall 2006). I found it by lucky accident in an ordinary Singapore airport news stand but it should be readily available.
While mostly an engaging memoir of his years in different roles within financial markets — he was on both the buy side and the sell side at various Australian houses — there is a very perceptive chapter near the very end where he goes into detail on the limitations and flaws of the CDS model.
He is very droll — “Risk is a four-letter word: it is more polite to use the phrase ‘risk management’. ‘Derivatives’ is an eleven letter, four-letter word. The sanitized ‘derivatives risk management’ is better. All losses are ‘unexpected’, arising from ‘the unknown’ and some sort of ‘failure’.”
But he also knows the markets well and isn’t afraid to show how they actually work, a rare characteristic in a famously self-boosting industry.
His blog is at: http://www.wilmott.com/blogs/satyajitdas/
Re: multiples of swaps contracts on the risk of default for a given bond. If I was a homeowner and took out a fire insurance policy, as required by my mortgage lender, I would think little about it.
If I learned that 100 other people also owned a fire policy on my house, I might wonder. My house might have more value burnt than standing.
rk,
That is a good point and one that hasn’t gotten enough attention. I’ve seen a mention here or there that when companies get into financial trouble, the creditors may have more incentive to push them over the cliff rather than save them, since (if they hedged) they’ll get paid out on their CDS, while working through a bankruptcy incurs hard costs and takes time.