Surreal Realities of the CDS Markets – Part 2

Who’s Hedging Whom?

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. If the seller of protection is unable to perform then the buyer obtains no protection. Currently, a significant proportion of protection sellers is financial guarantors (monoline insurers), hedge funds and regional banks. Concerns about the credit standing of monolines are well documented. In 2008, a number of banks took charges against counterparty risk on hedges with financial guarantors.

For hedge funds, the CDS is marked-to-market daily and 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. In practice, banks may not be willing or able to close out positions where collateral isn’t posted. ACA Financial Guaranty sold protection totaling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement. The banks have agreed to a “forbearance agreement” whereby the buyer of protection waived the right to collateral temporarily. ACA subsequently has been downgraded to “CCC” reducing the value of the CDS contract and the protection offered. AIG incurred similar problems requiring government support. The problems at ACA and AIG are not unique.

A critical element is the level of over-collateralisation. The buyer of protection will want an initial margin to cover the risk of a change in the value of the contract and the failure by the seller of protection to meet a margin call. The seller of protection wants to increase leverage by reducing the amount of cash it must post as initial margin. It is possible that the level of initial collateral may prove be too low. Collateral models use historical volatility and correlation that may underestimate the risk. The entire process also assumes liquidity in the underlying CDS market that may be absent in a crisis. Truth or Dare

The derivative industry’s indefatigable support of the CDS market (motivated undoubtedly by the specter of regulation and greater scrutiny) centers on the fact that all the CDS contracts related to the high profile defaults have settled and the overall net settlement amounts were small. Strictly speaking, this is correct.

In practice, there are actually two settlements. The ‘real’ settlement where genuine hedgers and investors deliver bonds under the physical settlement rules (i.e. those who actually own bonds and were hedging). Then there is the parallel universe where the dealers and large hedge funds settled via the auction. Dealers tend to have small net positions (large sold and bought protection but overall reasonably matched).

For example in the case of Lehman Brothers, the net settlement figure of $6 billion that was quoted refers to the second process. Real CDS losses from Lehman CDS were higher, probably around $300-400 billion. Some banks and investors that had sold protection on Lehmans did not participate in the auction. They chose to take delivery of defaulted Lehman debt resulting in losses of almost the entire face value. For example, one German Landesbank reportedly took delivery of $1 billion of Lehman bonds that are now worth $30 million.

One reason that there were no failures in settlement of the CDS contracts is sellers of protection such as banks and some insurers were propped up by governments concerned about systemic failure of the financial system. Other sellers of protection had to bear losses reducing the capital available to meet future claims. Whether the sellers are in a position to meet potential losses if default rates rise as expected remains unknown.

Efforts are under way to reduce the counterparty credit risk by moving CDS contracts onto an exchange settled platform supported by margining and normal clearing mechanisms. Such moves are, in theory, positive but the devil lies in the detail.

CDS Contracts – Operational Risks

In 2006, Alan Greenspan expressed shock and horror at the state of settlements in the credit derivatives market. He expressed surprise that banks trading CDS seemed to document trades on scraps of paper. The ex-Chairman, perhaps unfamiliar with the reality of financial markets, had difficulty reconciling a technologically advanced business with this “appalling” operational environment.

CDS contracts entail significant operational risks. In recent years, delays in documenting CDS contracts forced regulators to step in requiring banks to confirm trades more promptly. The accuracy of the mark-to-market values of CDS contracts, particularly of less liquid and infrequently traded reference entities, is not unimpeachable. Where collateral is used, as noted above, monitoring and management of collateral poses significant risks.

Expertise in technical aspects of CDS contracts is limited. Banks, insurance companies and other participants may lack the necessary skills to properly assess, price, trade and manage CDS contracts. The depth of skill and expertise in many institutions is also an issue.

A feature of these instruments is that the complexity and risk of structures are frequently inversely related to the understanding of the person trading it. In the words on an anonymous trader:  “Credit derivative dealers talk about their market in much the same way spotty teenagers talk about sex. A lot of people profess to be accomplished experts, but when it really boils down to it, most of them are still fumbling in the dark.”

Innovative Dysfunction

Financial innovation can offer economic benefits. A number of major benefits of CDS contracts are often cited by acolytes and fans, generally those promoting the product. The first is that CDS contracts help complete markets, enhancing investment and borrowing opportunities, reducing transaction costs and allowing risk transfer. CDS contracts, where used for hedging, offers these advantages. Where not used for hedging it is not clear how this assists in capital formation and enhancing efficiency of markets.

CDS contracts also, it is claimed, improve market liquidity. It is generally assumed that speculative interest assists in enhancing liquidity and lowers trading costs. Where the liquidity comes from leveraged investors, the additional systemic risk from the activity of these entities has to be balanced against potential benefits. The current financial crisis highlights these tradeoffs.

CDS contracts also, it is claimed, improve the efficiency of credit pricing. It is not clear whether this is actually the case in practice.

Pricing of CDS contracts frequently does not accord with reasonable expected risk of default. The CDS prices, in practice, incorporate substantial liquidity premia, compensation for volatility of credit spreads and other factors. CDS pricing also frequently does not align with pricing of other traded credit instruments such as bonds or loans. For example, the existence of the “negative basis trade” is predicated on pricing inefficiency.

In a negative basis transaction commonly undertaken by investors including insurance companies, the investor purchases a bond issued by the reference entity and hedges the credit risk by buying protection on the issuer using a CDS contract. The transaction is designed to lock in a positive margin between the earnings on the bond and CDS fees. Negative basis trades exploit market inefficiencies in the pricing of credit risk between bond and CDS markets. CDS contracts also are supposed to enhance information efficiency, improving availability of market prices for credit risk allowing more informed decisions by market participants. As CDS contracts are traded in the private OTC derivative markets, there is limited dissemination of market prices. This limits price discovery and therefore any informational benefits. In reality, pricing and trading information is only available readily to large active dealers in CDS contracts. This informational asymmetrymay advantage these dealers. Knowledge about trading flows in CDS contracts may allow these dealers to earn economic profits. As Mark Twain observed: “I am opposed to millionaires, but it would be dangerous to offer me the position.

Negative Reactions

Benefits of CDS contracts must be balanced against any additional risks to the financial system from trading in these instruments. CDS contracts may create additional risks within the financial system. While CDS contracts did not cause the current financial crisis, they may have exacerbated the problems and complicated the process of dealing with the issues. CDS contracts can amplify losses in credit market. For example, when Lehman Brothers defaulted the firm had around $600 billion in debt. This would have resulted in a maximum loss to creditors of that amount. In addition, according to market estimates, there were CDS contracts of around $400-500 billion where Lehmans was the reference entity (the outstanding volume of CDS contracts is not known with certainty reflecting the lack of information about trading in the OTC market).

If the CDS contracts were used for hedging, then the CDS contracts would merely have resulted in the losses to creditors being transferred to the sellers of protection leaving the total loss unchanged. However, market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250-350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200-300 billion) are additional to the $600 billion. The CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by (up to) approximately 50%.

In addition, Lehman Brothers was included as a reference entity in other structured credit products, such as Collateralised Debt Obligations (“CDOs”) and credit indices, and additional losses would have resulted therein. Documentary asymmetries in the contracts may also increase the losses.

Chain Letters

The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of the Lloyds market. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance premiums are received up front. In both cases the risks are both potentially significant and “long tail” – they do not emerge immediately and may take some time to be fully quantified.

The transfer of risk assumes that all parties along the potential chain perform their contracts. Any failure in the chain of risk transfer exposes other parties to the risk of insolvency and default. Defaults and failures in CDS contracts may quickly cause the financial system to become “gridlocked” as uncertainty about counterparty risks restricts normal trading. The bankruptcy of Lehmans set off a chain of just these events causing financial markets to become “frozen” in September and October 2008.

As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Derivatives markets generally may have higher concentration risk than considered desirable or acceptable. The CDS market is similar in structure to the overall derivative market with less than 10 dealers having the major share of the market. The potential impact of a bankruptcy filing by Bear Stearns and AIG on the OTC Derivatives market, including CDS contracts, was probably one of the factors that influenced the Federal Reserve and US Treasury’s decision to support the rescue of the two firms.

If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between $33 billion and $158 billion [See Andrea Cicione “Counterparty Risk: A Growing Cause of Concern” (25 January 2008) Credit Portfolio Strategy – BNP Paribas Corporate & Investment Banking]. Barclays Capital estimated that the failure of a dealer with $2 trillion in CDS contracts outstanding could potentially lead to losses of between $36 billion and $47 billion for counterparties. This underlines the potential concentration risks that are present.

CDS contracts may under certain circumstances create volatility and uncertainty instead of reducing risk. For example, the coupling of participants and long chains of risk transfer may mean that uncertainty about the financial position or solvency of any firm is quickly transmitted throughout the financial system rather than being confined to firms directly exposed to the distressed entity. Attempts to hedge this risk or close out positions may increase volatility. There are also negative feedback loops. If reference entities start to default then insurers, hedge funds and banks are affected. If the economic climate worsens and defaults rise then the overall ability to rely on these hedges may decline. The extent of the diversification of risk may diminish exactly when it is most needed.

In providing the ability to transfer risk, CDS contracts may in turn encourage moral hazard in institutions encouraging them to take on more risk on the assumption that the additional risk will be transferred or hedged. It exposes firms to significant risk of losses from a breakdown in markets and also where the hedges do not work as intended due to either problems in the design of the hedge or counterparty risk. This behaviour was illustrated vividly in the securitisation markets.

From Surreal to Hyper Real

The CDS market originally was predominantly a market for transferring and hedging credit risk. The contract itself has many attractive economic features and can serve useful purposes in hedging and transferring risk. In recent years, the ability to trade credit, create different types of credit risk to trade, the ability to short credit and also take highly leveraged credit bets has become increasingly important. To some extent the CDS market has detached from the underlying “real” credit market. If defaults rise then the high leverage, inherent complexity and potential loss of liquidity of CDS contracts and structures based on them may cause problems. The excesses of the CDS market are evident in the recent interest in contracts protecting against the default of a sovereign (known as sovereign CDS). For example, the CDS market for sovereign debt is increasingly pricing in increased funding costs for the US.  The fee for hedging against losses on $10 million of Treasuries currently is about 0.48% pa for 10 years (equivalent to $48,000 annually). This is an increase from 0.01% pa  ($1,000) in 2007. The specter of banks, some of whom have needed capital injections and liquidity support from governments to ensure their own survival, offering to insure other market participants against the risk of default of sovereign government (sometimes their own) is surreal.

CDS contracts are new and relatively untested in an environment of high levels of defaults. If defaults increase then there is a significant risk of a dislocation in the CDS market. Banks may well incur losses on transactions where they assumed that the risk had been sold off. Settlement problems may result in markets becoming grid locked. This could result in additional problems in inter-bank/ inter-dealer counterparty risk. Significant increases and volatility in credit spreads is possible. This may lead to further problems in availability and the cost of funding for corporations. It might also cause problems for leveraged investors. The extent of problems depends on the number of defaults and the severity of the credit losses.

In May 2006, Alan Greenspan, the former Chairman of the Fed, noted: “The CDS is probably the most important instrument in finance. … What CDS (credit default swaps) 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.” It will be interesting to see whether reality proves to be different. Dr. Greenspan now acknowledges he was “partially” wrong to oppose regulation of such instruments. “Credit default swaps, I think, have serious problems associated with them,” he admitted to a Congressional hearing in October 2008.

Ludwig von Mises, the Austrian economist from the early part of the twentieth century, once noted: “It may be expedient for a man to heat the stove with his furniture; but he should not delude himself by believing that he has discovered a wonderful new method of heating his premises”.  CDS contracts may not ultimately improve the overall stability and security of the financial system but may create additional risks.

© 2009 Satyajit Das All Rights reserved. Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

11 Responses to "Surreal Realities of the CDS Markets – Part 2"

  1. Guest   January 19, 2009 at 1:43 pm

    The point is that CDSs have been permitted to be viewed as equities when the facts show they are contracts, and contracts when the facts show they are equities. That “permission” is the corruption.That is not an economic policy, it is an economic crime.But who really cares when it is just one aspect of a thoroughly corrupt world culture. Are we to care about corruption here when there is corruption everywhere? To treat the CDS “problem” is to treat a symptom, not the underlying illness.And even corruption is not the underlying illness. Corruption occurs when there are no individually enforceable rights to prevent it.Do you really except a technotwit like S. Das to understand that? Put him in charge–things would fall apart even more quickly! Ha ha!!John Ryskamp

  2. David Harper   January 19, 2009 at 7:03 pm

    This is a *great* post about the risks of CDS.True the counterparty risk: collateral often hasn’t covered the counterparty risk. If protection sellers had to post collateral based on true counterparty exposure, rather than volatility-inspired M2M, the market would not have exploded.And nails the tricky question: although the instrument itself is “net zero,” what are the concentration and systemic transmission impacts?

  3. Nathan Frazier   January 19, 2009 at 10:03 pm

    CDS’s only reduce risk if the underlying loans that they are comprised of remain uncorrelated. Ramp-up the macro-headwinds in which they are embedded to a sufficiently high level though and spontaneous correlation occurs. Not to mention the fact that such a leptokurtic event increases the macro-drag even further – thereby creating a feed-back loop. Oops.

    • CHRIS DAVIS   January 23, 2009 at 2:26 am

      “leptokurtic”?? Wow, I’m a classics major from Harvard and you have me stumped.What on earth is this word supposed to mean?

      • Dubai Banker   January 25, 2009 at 11:46 am

        Should have asked your buddies from applied math. It means long-tailed…A high kurtosis distribution has a sharper peak and longer, fatter tails, while a low kurtosis distribution has a more rounded peak and shorter thinner tails.Distributions with zero excess kurtosis are called mesokurtic, or mesokurtotic. The most prominent example of a mesokurtic distribution is the normal distribution family, regardless of the values of its parameters. A few other well-known distributions can be mesokurtic, depending on parameter values: for example the binomial distribution is mesokurtic for .A distribution with positive excess kurtosis is called leptokurtic, or leptokurtotic. In terms of shape, a leptokurtic distribution has a more acute peak around the mean (that is, a higher probability than a normally distributed variable of values near the mean) and fatter tails (that is, a higher probability than a normally distributed variable of extreme values). Examples of leptokurtic distributions include the Laplace distribution and the logistic distribution. Such distributions are sometimes termed super Gaussian.A distribution with negative excess kurtosis is called platykurtic, or platykurtotic. In terms of shape, a platykurtic distribution has a lower, wider peak around the mean (that is, a lower probability than a normally distributed variable of values near the mean) and thinner tails (if viewed as the height of the probability density – that is, a lower probability than a normally distributed variable of extreme values). Examples of platykurtic distributions include the continuous or discrete uniform distributions, and the raised cosine distribution. The most platykurtic distribution of all is the Bernoulli distribution with p = ½ (for example the number of times one obtains “heads” when flipping a coin once), for which the kurtosis is -2. Such distributions are sometimes termed sub Gaussian.

  4. David Harper   January 21, 2009 at 7:40 pm

    Agree with nathan, it turns out CDS are high beta instruments.

  5. interested reader   January 23, 2009 at 4:59 pm

    Many thanks to Satyajit Das for shedding light on and bring some sense into this debate.

  6. regionswork   January 26, 2009 at 6:44 pm

    Compared to the thinking of the average investor, the world of CDS is out of sight. Having read part 1 & 2, it appears that CDSs have been doing their job in the short term. My understanding of the concern is that the existing CDSs won’t do such a job in the future. If this is the case, when will the little folks know to make moves, if there are any that can be made at all? Would this drive the Dow to 6,000 or 5,000?The reason I ask is because of a investment advice offer through “The Daily Reckoning” of January 23, 2008 – Here’s some text from the link:Wall Street’s Next Demon Derivative Delivers Final BlowYou’ve heard of the subprime CDO (the derivative at the core of the current crisis). Now another kind of demon derivative is about to take the spotlight. It’s called the CDS (Credit Default Swap). And you’ll soon understand why, no matter what central banks do, it will deal the final blow to the global financial system.At its very simplest a CDS is an insurance contract. And it’s made between two parties, one of whom is giving insurance to the other in hopes that he will be paid in the event that a financial institution or corporation, fails. However, Wall Street big-wigs have been very careful not to call this investment an insurance contract because if it were insurance, it would be regulated. So instead they use a magic substitute word called a ‘swap,’ which by virtue of federal law is deregulated.And this is where we run into trouble. Because what was originally intended as insurance has now often become once again a highly leveraged speculative bet. Now in a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle. And this practice has the potential to put investors into webs of relationships which are not transparent.Since the U.S. Treasury has not classified these derivatives as “insurance,” they trade free of any government regulations. Because of that, the firm selling the CDS is not required to set aside any reserves from the premiums received to insure against possible future loss claims.This obviously makes the sale of the Credit Default Swaps potentially very profitable. But if the bet goes sour, and the company defaults or goes bankrupt, then that small bet can get very expensive.So what was essentially supposed to be a safe insurance contract is now a series of highly leveraged dangerous bets. And in the past seven years trading in this market has leapt a mind-boggling hundred-fold.This new CDS market now stands at a size larger than the entire capitalization of all the world’s stock markets combined.And since these bets are all based on the future credit worthiness of a country, company or consumer (basically a bet on the ability of a party to repay his debts), they’re all about to go horribly wrong.In a global economy made up of thousands of corporations and institutions, many of which borrowed 10-100 times their capital in the past few years, most will be un able to repay their future debts – meaning these new demon derivates are going to unwind at a rapid rate…with fall-out so large it will dwarf the current damage caused by the crisis so far.–The whole offer is at http://www.sovereignsociety.com/portals/0/svs/fullpromo_MSVSK105.html?o=1631651&u=29432500&l=1602307So, what is the risk, what is the strategy, and when would it go into play – what are the signs?Thanks.

  7. Don the libertarian Democrat   January 28, 2009 at 9:02 pm

    “CDS contracts are new and relatively untested in an environment of high levels of defaults. If defaults increase then there is a significant risk of a dislocation in the CDS market. Banks may well(? ) incur losses on transactions where they assumed that the risk had been sold off. Settlement problems may( ?) result in markets becoming grid locked. This could( ? ) result in additional problems in inter-bank/ inter-dealer counterparty risk. Significant increases and volatility in credit spreads is possible( ?). This may( ? ) lead to further problems in availability and the cost of funding for corporations. It might( ?) also cause problems for leveraged investors. The extent of problems depends( ?) on the number of defaults and the severity of the credit losses.”People are reading your “mights” as “will”. The event we are currently experiencing is a Calling Run. This is possible in any system of investments not guaranteed by the government up front. To the extent that there wasn’t full collateral posted or a system to allow time for an orderly exchange of assets, a Calling Run was possible. Not all of it has to do with CDSs or CDOs. It is simply the fact that once the run began, due to a tsunami of foreclosures,many CDSs and CDOs were called, and, being not widely known, became the presumed problem.You need to show that a tsunami of foreclosures would not have caused a run without the existence of insurance on them. I haven’t seen that proven yet, though it might be possible.

  8. Petar Simic   March 25, 2009 at 4:35 am

    Satyajit,Thanks for the article. As always, great and informative reading.The details may be complicated but the essence is very simple. The size of the CDS market being N x times larger then the size of the underlying debt makes it rather obvious that there may be no solution to the problem unless the system is deleveraged. Once the chain reaction starts – like an atomic reaction, all you need is a critical mass of correlated defaults which your average recession could provide – the gigantic Ponzi scheme is activated the result of which is a massive wealth transfer which quickly hits the Main St.This is unavoidable as long as we keep pretending that the existence and legality of the naked CDS is a law of Nature. Yet, unlike the atomic chain reaction which follows from the laws of Nature and is unstoppable, the chain reaction caused by the naked CDS is fully stoppable. It’s existence hinges on the ideological corruption of the intellect and ignorance of our legislators, who even now shy away from annulling these contracts ($160B A.I.G bailout of the CDS counter parties is a good case study).In my opinion, anything but swift cancellation of all the *naked* CDS contracts will just perpetuate the inherently unstable, badly designed system which is a few correlated defaults away from a disaster. Using the taxpayers money to pay off the counter parties of the *naked* CDS contracts is a losing, unsustainable proposition bordering with a criminal malpractice (think of billions payed to the Goldman Sachs and other A.I.G CDS counter parties, no transparency, no question asked).Going forward, the CDS contract should probably be reclassified and regulated as an insurance product, which, as you point out, was its original justification (if not the purpose).Regards.Petar Simic.