I am sticking my neck out a bit on this post, since the credit default swaps market doesn’t garner much coverage, so any readers who are involved in this busines are encouraged to comment.
Yes, there are frequent references to what changes in CDS prices mean about the credit-worthiness of particularly names, but there is parlous little attention paid to the health and activity of the market as a whole.
Despite the use of the term “swap,” CDS are really insurance contracts. A protection seller (effectively, the insurer) agrees to make a payment to the protection buyer if specified bad things happen (a “credit event” usually defined as bankruptcy or failure to pay) to a “reference entity” which can be a company (“single name”) or an index. See here for more detail.
Now while it may look like the risk being traded here is default risk, there is a second risk: counterparty risk. CDS are the largest credit derivative product, and they are traded solely over the counter. That means that the CDS agreement is only as good as the protection seller that wrote it.
When Warren Buffet described derivatives as “financial weapons of mass destruction” he wasn’t worried about speculators blowing themselves up, but about counterparty risk:
Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).
So why should we be concerned about CDS? Even though they have been around since the mid 1990s, they have grown explosively since 2002, in a (until a few months ago) benign credit environment:
Notice that the notional amount outstanding is $45 trillion. While the economic exposures of derivatives are a fraction of the notional amount, this is still large enough to focus the mind.
Who is standing behind these contracts? As Ted Seides tells us:
Banks are the primary sellers of CDS, totaling 40% of all written CDS and representing notional exposure of $18.2 trillion.[xv] Banks claim to run hedged books, effectively serving as a market-maker in the CDS market. As should be evident from the events in subprime, even the most sophisticated systems are often unable to fully hedge risks of this size and degree of complexity. If printed materials are any indication, banks may be asleep at the switch. The “Counterparty Considerations” section in the Credit Derivatives Primer of market share leader JP Morgan is a single paragraph on the last page of the volume, which proclaims “the likelihood of suffering (counterparty default) is remote.”[xvi] (italics added)
Hedge funds appear to be in over their heads as well. According to printed statistics and consistent with anecdotal evidence, hedge funds are sellers of 32% of all CDS, insuring exposure of $14.5 trillion.[xvii] Recent estimates indicate that the entire hedge fund market is approximately $2.5 trillion in net assets under management. Thus, hedge funds are bearing risk in excess of their ability to pay the piper if anything goes wrong.
Although, as noted above, there is comparatively little reporting on the CDS market, we are seeing some signs of stress.
The last two years have seen the growth of CDS based on asset backed securities and ABS indices, such as the ABX and the CMBX, based on the CMB, an index representing commercial real estate securities. CDS were also one means to achieve credit enhancement in collateralized debt obligations. Given the sharp decline in the ABX indices and downgrades of CDOs, it’s a no-brainer that anyone who wrote protection on them has taken large losses. Case in point: Swiss Re recently announced that it had taken over $1 billion in losses on two CDS referencing mortgage-backed investments.
Consider another troubling development: banks are already worried about counterparty risk in the money markets, as witnessed by the uncharacteristically large spread between T-bills and Libor. It seems inconceivable that banks wouldn’t have similar worries about CDS exposures. We have indirect confirmation via this story in the Financial Times, “Trading in derivatives slows to a trickle“:
Liquidity in some of the world’s biggest derivatives markets has dried up this week amid increasing fears over the health of the international financial system.
Over-the-counter trading in derivatives of equities, credit and interest rates have all seen much lower volumes as problems in financial markets have prompted investors to sit on the sidelines…
Analysts said flows had slowed to a trickle this week – even lower than in the summer when the credit squeeze was at its peak – as investor appetite for risk had diminished amid talk of potential bank defaults…
David Brickman, head of European credit strategy at Lehman Brothers, said: “Generically, trading volumes [in credit derivatives] are a lot lower than they were in the summer.
“The theory is that if people can’t trade bonds, they’re going to go to CDS [credit default swaps]. But in an environment like this you can’t get liquidity on single-name CDS either. That just leaves the indices.”
And a more colorful confirmation comes from a reader:
To remind you we have been short the ABX CMBX and CDX since last January. To keep this short I will summarize my points.
1. Our counterparties are Bank of America and Barclays. We only have ~20 million in equity and were allowed to go short the market 150M notional by posting 3% margin. Presumably the numbers are similar for someone who wanted to go long (should be a little higher).
2. After July hit we were no longer allowed to take ‘new’ short positions. We were originally told that we are allowed to close out our shorts at any time but not allowed to open a new one. So we couldn’t roll into the on-the-run series or move our shorts up the capital structure as the environment continued to deteriorate.
3. My original thought was that they wanted to artificially prop up the market because the market makers may have too much of a net long exposure – and they are extrememely concerned – or they have someone on the proprietary desk that got themselves into a pickle. So I thought this would pass in a few weeks and we could move our position around.
4. Today I still cannot open a new position. In the past few months a few friends have been let go from some of the larger banks and have shed light on the topic. The reality is that they are concerned about collecting from hedge funds that were long. Although this is just hearsay from friends – it completely matches my own experience. To further the point – working with the collateral team at BOA in pay as you go contracts – they are a mess. They are overdrafting accounts – forgetting to pull money when its due – they can’t reconcile a mistake in less than 8 weeks. It’s a debacle.
The credit teams for these banks may have been allowing hedge funds to trade at excessive leverage without enough controls. They most likely were basing margin requirements on the volatility of the security (or contract). I am a firm believer that this type of analysis blinds analyst to real risk and gives them unjustified confidence in how ‘secure’ they are – but that’s another story. I am not going to pretend I can estimate these losses or give accurate numbers to even shed light – but this is definitely and ‘unknown unknown’ with a high potential impact. As Nassim Taleb would say – this has the makings of a Black Swan.
What seems odd, given all the foregoing, is that Swiss Re, admittedly a new player but one with a small book, is the only concern to have reported CDS losses. Someone has to be on the other side of the eyepopping trades entered into by Paulson & Co. and for that matter, Goldman, which has been short mortgage-related credits. That raises the question of how much latitude financial firms have in marking their derivative books (and auditors have no hope of getting to the bottom of their economics).
The other open question is what happens to the CDS market as banks continue to shrink their balance sheets? CDS have become integral to the way a lot of players measure and manage credit risk, but if the market becomes illiquid, there will be a lack of reliable price information and a dearth of protection sellers to write new contracts.
If you’d like to worry even more about CDS, this post from “CDS: Phantom Menace” from Sudden Debt is insightful.