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.

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/

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.

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.

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.

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.