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Whether reasonably or not, credit default swaps (CDS) have become a key player in recent financial and economic crisis. They were largely used as collateral in various debt obligations. The main problematic collateralized debt obligations (CDO) were mortgage-backed securities (MBS) fow which CDS were used as insurance. Large-scale MBS defaults triggered calls to settlement of vast amount of CDS. Big companies like AIG, Lehman Brothers and Bear Stearns were especially exposed to these CDS. It showed up that they were not ready to withstand their obligations. To avoid system contagion, state authorities decided to bail some of them out.

In media, CDS are reflected in a harsh way. The only adjectives characterizing them are timebomb, crisis, Chernobyl, Gamble, Ponzi and of course collapse. But is that true?

Introduction to Financial Derivatives and particularly CDS

Derivatives are mainly used for risk management (hedging), speculation and arbitrage. Tradable derivatives are traded on derivatives exchanges, for example on Chicago Mercantile Exchange, Eurex and NYSE Euronext Liffe, where the latter two are electronic platforms.

A CDS is an OTC (unregulated) contract based on a financial instrument. Its buyer pays the seller periodic payments whereas the seller pays buyer a specified amount, if and only if the flow of cash from the underlying instrument to the buyer of the CDS changes in a specified way. To give an example, imagine an investor who buyed a bond and is supposed to receive periodical coupons. Eventually, to hedge the cash flow, she can buy a CDS contract from Safety Inc. specified in this way: I will pay Safety Inc. periodic payments (% of my expected total cash flow) and Safety Inc. will pay me the expected total cash flow if the bond defaults.

Holders of bonds are generally exposed to credit risk. A CDS serves as insurance against counterparty’s default. A CDS represents a mean of transferring and reduction of credit risk. From regulatory point of view, the value of an insured asset rises, but to an extent limited by the credibility of the CDS issuer. To realize loss having a CDS, another thing must happen: it is the default of the seller of the CDS.

The difference of CDS to traditional insurance is that the buyer of a CDS does not have to own the underlying instrument. To give an analogy, if this was a feature of standard insurance, one could insure himself against the robbery of his neighbour’s house. It looks like a bet and it actually is a bet. This fact reflects the schizophrenia of derivatives: they are both hedging and speculative tools. Another difference is that contrary to CDS issuers, traditional insurance companies have to meet required reserves and are closely monitored by public authorities. On the CDS market, no reserves are required from the sellers of protection.[2] Then there is the issue of correlation which must be limited in portfolios of both traditional and CDS insurers.

The spread of CDS offers a valuable piece of information: it reflects investors’ opinion on a company financial health. Since CDS can be later traded, they incorporate market’s opinion on the company. It touches the idea behind CDS: market is supposed to price the risk best.

In his article,[3] David Paul mentions that the fact that credit derivatives contracts are difficult to track on corporate financial statements. Therefore, a party can never be sure about the true level of counterparty’s exposure to credit derivatives risk.

In his series of articles on FinancialSense.com, Daniel Amerman presents an example of estimation of profitability of a CDS contract which I replicate here:

Table: Profitability of a CDS contract.

Example on profit from selling a CDS
Guarantee on	$10 000 000
	Assumptions	Cash Flow
% fee	5%
Absolute fee		$500 000
Size of loss	50%
Probability of loss	5%
Expected loss		$250 000
Expected profit		$250 000

A CDS underwriter takes on A guarantee on a $10mil loan for 5%. In its calculations, it assumes a 5% chance that 50% of the loan will default. All in all, the $10mil guarantee assures him $250 000 profit which makes 2.5% return.

CDS prices do not reflect only the credit risk of the underlying debtor.There are situations when even healthy businesses struggle to stand against their liabilities. For a bank to get into serious troubles, a short period of illiquidity on short-term credit market is enough. Recession, a system risk, is a threat for everyone. The relation of financial sector to system risk is specific. It faces more system risk than other sectors. It is thanks to the high degree of interconnection of players in financial markets and thanks to the character of the business and its regulation. For example, if an unexpected number of CDS calls accumulates, issuers’ balance sheets may found it too difficult to absorb the calls.

An insurer can insure himself too, by a CDS. Then, a chain of safety links is created. However, if an element of the chain fails, then a chain reaction comes. The chain may be complicated; according to a Wall Street partner cited in Time’s article,[4] „an original CDS can go through 15 or 20 trades, so that when a default occurs, the so-called insured party or hedged party doesn’t know who’s responsible for making up the default and if that end player has the resources to cure the default." In the same article, however, another partner dismisses this risk by saying that “contractual law requires both parties to inform and get approval”. Nevertheless, “the CDS market is unregulated, does not have a standard contract, no standard capital requirements, and no standard way of valuating securities in these transactions”, says another partner in the article. Summing this up, we see an indicia that the market is simply not correctly specified, put in words of mathematics.

There have been attempts of switching CDS market to an organised market with a global clearing-house. However, stigma of the OTC CDS market would be felt at least for 5 years further on since the bulk of contracts have been made at 5-year maturity.[5] To be concrete, a particular attempt to set up a CDS exchange has already failed in 2007, when the Chicago Mercantile Exchange created a federally regulated exchange-based market for CDS. So far, it hasn’t worked because it has been boycotted by banks, who prefer private trading.[6]

However, recently (November 2008), major US dealers led by Morgan Stanley turned in their opinion and now back several key proposals: clearing of CDS, margin rules, Federal Reserve’s oversight of dealers and large market participants, and SEC jurisdiction over anti-fraud and market manipulation activities. They still oppose trading CDSs on exchanges.

Financial Crisis[7]

The point where CDSs enter the story came when issuers of MBS started to use them as credit enhancement. Eventually, CDS replaced insurance bonds in the role of leading insurance instrument.

Lasting growth of demand for mortgage-backed securities (MBS) pressed interest on them down, closer to risk free rate. Therefore, their issuers demanded as cheap insurance as possible. In face of inherent risk in MBS, traditional investors and debt insuring agencies could not sustain price competition with CDS. The result was that traditional investors exited the MBS insurance market and left CDS as the only insurance instrument for subordinate tranches of MBS.[8] It seems that CDS issuers felt the risk in MBS differently.

Figure: Subprime Mortgage Delinquency Rate. Source: Arthur D. Little.

In 2000, there had been $130 billion in subprime mortgage lending, with $55 billion of that repackaged as mortgage bonds. But in 2005, there was $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds.[9]

The break in optimistic development in mortgages and MBS came in 2006 when prices of real estate in US peaked and ultimately took downward sloping path (see following figure), when ARM’s rates reacted to rising interest rates by an increase and when lending standards tightened.

Figure: S&P/Case-Shiller U.S. National Home Price Index from 1988 to 2008Q3. Bold line represents percentage change of the index compared to its value a year ago. It peakes in 2006 and in 2008Q3 it reaches value -17%. Source: S&P.

Then, financing of mortages became more expensive and defaults on them appeared.

Figure: U.S. Residential real estate loan charge-off rates (%), house prices and lending standards. Source: Global Financial Stability Report October 2008 by IMF, pg. 13.

Let me note that a significant part of mortgages in US are non-recourse mortgages. When defaulting on such a mortgage, one is not personally responsible for the rest of payments. Therefore, the lender takes only the collateral (a house) but not a car, for example. The feature if non-recourse mortgages is that falling housing prices are a rational incentive for people to default on mortgages. It occurs when price of house falls even below the value of the mortgage.

First defaults on MBS appeared and their price begin to fall.

Figure: Prices of U.S. Mortgage-Related Securities, in US dollars. Source: Global Financial Stability Report October 2008 by IMF, pg. 13.

The effect spread all over the economy. MBS served as the mostly used collateral in collareralized debt obligations (CDO). Often, they were insured by CDS.

Credit Default Swaps and Financial Crisis

In October 2008, CDS notional outstanding value was about $55,000bn.[10] After factoring out offsetting positions, the number is about 2% of original value, $1,000bn. Most of this amount is somehow collateralised.[11] (Pickel, 2008)

CDS written on mortgage backed securities (MBS) rolled over AIG’s and others’ balance sheets like thunderball in September 2008. Contrary to corporate and municipal CDS, CDS written on structured finance embody several risky features. In case of a correlated event (a systemic crisis, a recession or a speculation-driven fall of some companies shares’), they tend to attack its issuers’ balance sheet in herd. The subprime part of CDS has increased probability of a systemic event.[12] Recently, it was shown that the MBS part of CDS has plagued balance sheets of many important financial institutions and significantly added to reasons why several of them filled for bankcruptcy. Clearly, in case of MBS, CDS were a wrong bet.

From todays point of view, American sub-prime MBS have been in fact an uninsurable asset. We may guess that some years back, the CDS issuers were biased by collective optimistic upheavel in MBS market. Because of the rapidly growing demand, they might not have had the time to properly evaluate risk which they were taking on their balance sheets, by issuing these CDS. We might think that if they did, spreads on MBS would soar, placing a limit on MBS’ underwriters. However, this was difficult to be done because market was not only optimistic but even ecstatic about MBS. I have to mention rating agencies who are supposed to give a conservative risk-assessment. All of them, Moody’s, S&P and Fitch failed.

Finally, in my opinion, we ended up in the situation when issuers of CDS written on subprime and increasingly also on prime MBS could only pray for a miracle. The miracle was that the whole segment does not experience a serious problem. Otherwise, the issuers would not have money to cover accumulated losses.

Let’s think about the fact that many people have been talking about the real estate bubble burst for years. One of these, Paul Johnson, a successful hedge-fund manager, has been shorting MBS for years and today he is a hero. Let’s see the fact that there is a reasonable possibility that a large portion of CDS written on MBS securities will be exercised.

Table: Profitability of CDS contracts, revised.

Example on profit from selling a CDS
Guarantee on	$10 000 000
	Assumptions nbsp;nbsp;	Cash Flow
% fee	5%
Absolute fee		$500 000
Size of loss	50%
Probability of loss	20%
Expected loss		$1 000 000
Expected profit		-$500 000
Amount of contracts	750
Payables	$750 000 000
Profit	-$375 000 000

Several years ago, when current CDS were originating, issuers were thinking in a different way.

Let’s take an some real world examples.

David Paul (2008) describes the case of AIG. With the decline of real estate market, it was obliged to write off its books a part of its MBS portfolio. Worsening of its financial strength (amount of assets) led Standard & Poor’s and Moody’s to downgrading it from AAA to the single-A level. Now let’s note that some of AIG’s CDS contracts stated that if AIG suffers a downgrade, it is obliged to post collateral equal to a percentage of the notional amount of the CDS. Paul (2008) notes that the amount of the collateral that AIG had to send, given the estimated $450bn of CDS contracts, was close to $100bn. It AIG failed to send the collateral, CDS against AIG would become due and other parties would receive settlement calls. In reality, AIG was taken over by the US Government which warded the calls off.

Daniel Amerman argues that bankruptcy of Freddie Mae and Fannie Mac would trigger settlement of $1,0bn of CDS. Their issuers would not be able to meet their obligations which would trigger another round of CDS settlements which would also fail.[13]

Opinions on what to do with the CDS on MBS differ. Some people support bail-outs and borrowing cheap money from FED. Others prefer bankruptcy model and a form of settling CDS at discount, forced by the US Congress.[14] Third group claims that CDS are generally not a problem, claiming that the cataclysmic chain of counterparty failures in CDS settlements is an unrealistic fear.[15]

Conclusion. Are CDS bad? Can we make them better?

One must ask, is there a difference between traditional bond insurance and newly used CDS? The answer is no. In both cases, market players do what they think is best. They (are) insure(d) for a premium.

CDS are a tool which is not bad per se. What led to their misuse was people’s leniency towards risk embedded in CDS written on MBS. The problem originated roughly five years ago when the popularity of MBS touched the sky. They were regarded as safe as T-bills but with much higher yield. The market of MBS was very profitable and everybody wanted to join it. Unfortunately, this optimistic frame systemically infected risk managers‘ minds. The managers started to default on their attention to risks that not even triple A MBS never stopped to bear: they were standing on sub-prime mortgages and non-recourse prime mortgages, which were sold in unnaturally quickly rising housing market fertilized by cheap credit.

Is there a way how to emphasize risk in future? Is there a way how to make agents avoid in fact investing in assets that, as we see now, were doomed in advance?

First note that companies which are too-big-to-fail will always have a reasonable incentive to make bets which others cannot afford. Second, note that the principle-agent problem poses a difficult problem in joint-stock companies: those whose money are in can never be sure what the company is actually doing.

Some say that in the competitive race towards profit, driven by positive expectations, risk considerations are inevitably left behind, as well as those who do not participate in the race. Probably, it is shareholders‘ interest to enforce long-run view on companies’s strategy, at the expense of short-run motivation of senior management. Clearly, primarily, it should be the risk management department, separated from senior management by kind of a Chinese wall, that should properly manage a company’s risks. However, the risk management department could be changed. It or its part could serve as a special watchdog of shareholders, working on their behalf and ordered by them. Thus, shareholders would get new information that could change their decisions from those made under current state of institutions.

Another step is in making markets more complete. Then we could reduce the chance of occurence of surprises like AIG’s insolvency. Providing more information should enable agents reach higher level of rationality. There are already some proposals, already mentioned. The clearing house is supposed to eliminate possible deadly chain of defaults on CDS payments. Margin rules eliminate credit risk in counterparties. Fed’s and SEC’s oversight should assure smooth functioning of CDS markets. Dealers of CDS agree and oppose only to the proposal of exchange trading.[16]

In my opinion, the mistake is in people. As the best solution how to avoid future financial crisis amplified by CDS, I see improved mediation of shareholders long-run interest on companies’ strategy and in pouring more information into markets.

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[1] Initially, CDS payments on Lehman’s debt were estimated to reach between $100bn and $400bn. Finally, they reached only $5.2bn due to offsetting, for example.

[2] It is possible that counterparties negotiate some forms of marking-to-rating, required reserves or conditional sending of collateral. A Reuters report says that „the standard practice in the CDS market is that hedge funds and other counterparties must adjust collateral on a daily basis as the value of a contract changes“. Source: Reuters, http://tinyurl.com/659b5j .

[3] Paul, D. (11. 10. 2008). Credit Default Swaps, the Collapse of AIG and Addressing the Crisis of Confidence. Read in The Huffington Post: http://www.huffingtonpost.com/david-paul/credit-default-swaps-the_b_133891.html.

[4] Morrissey, J. (17. 04 2008). Credit Default Swaps: The Next Crisis? Read in Time: http://tinyurl.com/48ufdq.

[5] Coudert, V. (13. 10. 2008). Stormy Weather in the Credit Default Swap Market. Read in http://www.voxeu.org/index.php?q=node/2420.

[6] Engdahl, W. (28. 06 2008). Credit default swaps: the next crisis. Read in the Financial sense: http://www.financialsense.com/editorials/engdahl/2008/0606.html.

[7] The limit on word count made me include an appendix concerning the development of the financial crisis.

[8] Little, A. D. (2008). Demystifying the Credit Crunch.

[9] Lewis, M. (01. 12 2008). The End. Read in The Portfolio: http://tinyurl.com/5s5w2b.

[10] $55,000bn = $55,000,000,000,000 = $55 trillion.

[11] Pickel, R. (30. 10. 2008). Is it really fair to cast CDS sector as the central villain? Read in Financial Times: http://www.ft.com/cms/s/0/31c1e67e-a622-11dd-9d26-000077b07658.html.

[12] Let me cite an example by Michael Lewis in his article on Portfolio.com which clearly describes probability that a mortage upon which a CDS MBS is (also) written, will default : „In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $720,000.“ Source: http://tinyurl.com/5s5w2b .

[13] Amerman, D. (08. 10 2008). The Hidden Bailout Of $1.4 Trillion In Fannie / Freddie Credit-Default Swaps. Read in Financial Sense: http://www.financialsense.com/fsu/editorials/amerman/2008/0910.html

[14] I mean writers at the website Institutional Risk Analytics, www.institutionalriskanalytics.com.

[15] They mention that AIG proves this point because it was the only company with AAA rating and as such, it did not need to put aside collateral on CDS contracts. When downgraded, they suddendly needed to send a bold bunch of money. Otherwise, it is being said, companies use marking-to-market wildly.

[16] Reuters: CDS exchange trading not the only solution. Source: http://tinyurl.com/6ypyly.

This essay was written for Banking in December 2008 at IES FSV UK.

 

Článek napsal/a Radovan Fišer dne 19. 5. 2009. Je uložen v rubrice Články a má tyto tématické štítky: CDO, CDS, derivatives, financial crisis. Komentáře k článku můžete sledovat pomocí kanálu RSS 2.0. Za váš komentář budou čtenáři i autor/ka článku vděčni.