Comments on: Counterparty Risk Problems With Credit Default Swaps?

By: Anonymous

Anonymous — Thu, 10 Apr 2008 12:11:00 +0000

Protection Seller are the one taking the payments and protection buyer are the one paying

By: dd

dd — Sat, 01 Dec 2007 20:11:00 +0000

Then too, I would be remiss in not thanking our host for such a wonderful blog.
Thank you, Mr. Smith

By: dd

dd — Sat, 01 Dec 2007 19:17:00 +0000

“The more relevant analogy is that the existence of stock options in aggregate does nothing to affect the underlying stock market capitalization in aggregate (other than through peripheral interaction such as delta hedging, which is besides the point). Credit default swaps are essentially put options. They don’t affect the credit risk that is generated by underlying reference assets.”
Anon is the stock options market really analogous? My understanding (happy to be corrected) is that indeed CDS do impact subprime underlying assets via their packaging into CDOs (that contain CDS as an insurance mechanism that boosted the rating). So movements in the CDS and ABX indexes can impact overall CDO (and SIV) valuations. Hence the money market and mutual fund withdrawal from the markets (and that too then impacts the CDO valuations) but it all begins with the structured product’s valuation being tied to the quality of “insurance” backing up the CDO valuations. In that context the CDS market impacts the CDOs which in essence are indexed bonds (with the CDO proxy for index as it is composed of slices of many debt instruments but oddly the subprime ends up superweighted at present). So like bonds, CDOs are greatly impacted by CDS as these stand as proxy to the derivatives used to hedge publicly traded bonds and the result was the Delphi & GM freeze up. CDS and ABX indexes may play in their own way play a greater role now that liquidity is gone from the CDO and ABCP markets as now that is all that is trading.
So in a nutshell the CDS market does impact the pricing of the CDO market and and the suprime component. The discovery of the subprime (and perhaps worthless insurance) triggered a self-feeding loop where the prices in one impact the asset valuations in the other.
Then this analysis could be totally incorrect as this those markets are so opaque and this is what I have learned from public filings and news reports.
And thank you both anons for the interesting discussion.

By: Yves Smith

Yves Smith — Fri, 30 Nov 2007 23:53:00 +0000

Anon of 6:45 PM,

Have a look at the Sudden Debt link at the very end of the post. The author provides some detail on the margining practices, such that they are. Also look to the back-and-forth between the author and a CDS trader in the comments section, which provides further information.

By: Anonymous

Anonymous — Fri, 30 Nov 2007 23:46:00 +0000

Nov 30 (Reuters) – Yield spreads on indexes of commercial mortgage bonds narrowed on Friday on speculation that a federally supported plan to curb home foreclosures will improve conditions in all U.S. credit markets.

The yield spread on the CMBX-NA 2 index of “A” rated bonds narrowed by 35 basis points from Thursday to a bid side of 255 basis points and an offered side of 270 basis points, one investor said.

The U.S. Treasury is expected to next week announce a plan with top mortgage lenders and servicers that will freeze payments for many subprime borrowers facing higher rates that would otherwise send them into foreclosure. Soaring defaults on subprime bonds sparked a credit crunch that since mid-year has spread to commercial and corporate borrowing.

By: Anonymous

Anonymous — Fri, 30 Nov 2007 23:45:00 +0000

Can someone explain to me how the notional amount of CDS outstanding can be orders of magnitude larger than the underlying debt? What is the source of a leverage in the system?

By: Anonymous

Anonymous — Fri, 30 Nov 2007 20:42:00 +0000

anon 2:47

Fair point. Still the ultimate proceeds collected by the protection buyer offset the payout of the protection seller. The rest of the seller’s problem and costs are an additional risk of being in the business.

By: Anon

Anon — Fri, 30 Nov 2007 19:47:00 +0000

Anon 2:19 PM

But what if the seller which is bankrupted by the CDS losses has other liabilities the resolution of which will be tied up in bankruptcy court for years (i.e. in the absence of CDS contracts the seller could have made good on its other liabilities). Then the CDS contracts by allowing a new entity to risk insolvency in the basis of a single credit risk has increased the number of assets that are subject to be tied up in bankruptcy proceedings.

By: Anonymous

Anonymous — Fri, 30 Nov 2007 19:19:00 +0000

Anon 1:10 p.m.

A simplified example: The counterparty has bought protection. Suppose the reference asset is a subprime mortgage (or some structured finance variation of it). The underlying credit risk is the failure of the subprime mortgage in some sense –default or otherwise. The rest is a transfer of an ‘insurance’ payoff from the protection seller to the protection buyer. The protection buyer suffers losses equal to the subprime exposure apart from the swap, less any “insurance” realization from the swap. The protection seller’s bankruptcy is the result of all such payouts. The payouts are a cost to the protection seller and a gain to the protection buyer – a wash in aggregate. But the subprime mortgage loss is a net economic loss in terms of aggregate system credit risk.

By: Anonymous

Anonymous — Fri, 30 Nov 2007 19:17:00 +0000

You have a student loan for $100,000, and you're flat broke. I make $200,000 worth of bets with third parties that you will pay off your loan. Then I give you $100,000. Profit.

The bonus is, I'm a white knight rescuer and the counterparties look like greedy speculators seeking to profit from the misfortunes of the downtrodden, etc. etc.

If the notional amounts of CDSs are starting to exceed the total amount of debt, as the linked article states, then what's to stop, say, a sovereign wealth fund from playing this game?

If we're not at that point yet, we surely will be soon. The graph in the linked article shows CDSs amounts growing exponentially, and surely total credit market debt is not increasing as fast.