Credit Default Swaps

What is a Credit Default Swap (CDS)? Basically, it is bond insurance, usually. Due to the Clinton and Bush administrations not wanting to regulate the CDS market (codified in the Commodity Futures Modernization Act of 2000) it also became a way to gamble on financials.

Here is how a CDS is supposed to work: Person A owns $1 billion par value worth of a 10 year ACME Company (ACME) bonds that pays 8%; so Person A gets payments of $80 million each year from ACME for the next ten years. Person A really only needs $40 million a year to be happy, so Person A is looking to lock in a 4% return. Enter Person B; Person B thinks that there is only a 2% chance a year that ACME will default on the bond; so, Person B, knowing a little about probabilities, and such, knows that Person B needs $18,292,719.31 a year to cover the expected value of default on ACME’s bond. Or, to put it another way: Person B is willing to sell insurance on the bond for at least 1.829271931% of the par value of the bond peryear. So, since Person A is willing to pay more for the insurance than Person B is willing to charge, a deal will eventually happen; to continue this example, lets assume both are happy with 3% of the par value of the bond. So, Person A is getting $80 million a year from ACME, paying Person B $30 million a year to insure the cash flows (including the repayment of $1 billion at the end of year 10), thus netting Person A $50 million a year of ‘riskless’ income.

Well, let’s make this example a bit more complicated: suppose that Person B is happy with $15 million a year in income, and Person C thinks there is only a 1% chance that ACME will default, so, Person C, also knowing a bit about probabilities, is willing to cover ACME’s bond at $9,561,792.50 a year. Or, Person C is willing to insure the bond at 0.956179250% of par value of the bond. So, as with Person A and Person B; Person B and Person C’s bid-ask spread is positive, so a deal will take place. Let’s say they agree on 1.25% of par value of the bond. So, Person B receives $30 million a year from Person A, and pays person C $12.5 million a year to insure the bond. This can happen again and again, as long as someone thinks the payments they receive are greater than the expected value of payout on a default.

There are a couple of issues that CDS’s bring up: 1) counterparty risk, 2) lack of transparency, and 3) speculation. One of the biggest drivers of the bailout is counterparty risk. In the my example Person B and Person C are just people, or they could be hedge funds, private equity firms, banks, businesses, pension funds, etc; what they are not are insurance firms. The lack of regulation allowed these entities to take on these risks without having the necessary assets to cover the losses incase of defaults. Lets consider what happens if ACME defaults after 5 years: Person A ask person B for $1 billion, and Person B asks person C for $1 billion. Person C has received $12.5 million for 5 years which it has used to buy T-Bonds a 4%, so Person C (a retirement fund) only has $67.7 million for this asset. So, Person C goes bankrupt and has Person B (a hedge fund) seize the $67.7 million plus the $100 million Person C had in assets for the retirement fund. Person B (the hedge fund) has the $167.7 million, plus the $15 million for 5 years, which it invested at 4%, or $81.2 million; or, $248.9 million in assets from the CDS’s. But, being a hedge fund they had $150 million in assets under management, so Person A seizes all $398.9 million of Person B’s assets. So, Person A, with their $50 million a year at 4%, expected to have $1.6 billion in total value at the end of year 10, but only will have $814.9 million, or 51% of expected value. This is 18.5% less than the original $1 billion Person A paid for the bond. Also, Person B and Person C are wiped out in this situation.

In the current situation, lots of banks, hedge funds, insurance companies, and other institutions entered in to lots of these transactions. A lot of companies bought and sold these kind of CDS. So, as illustrated above, once a link in the chain is broken, the system soon collapses; this is called counter party risk. More broadly, counter party risk is the risk associated that the other party in the transaction will not be able to cover their position. (Person B and Person C did not have enough assets to pay Person A $1 billion)

The second big issue is a lack of transparency. Both the Clinton and the Bush (the second) administrations declined to regulate this market. Because this market wasn’t regulated a couple of problems occurred. The first was mentioned above, the insuring firms did not have to have enough assets on their books to cover the losses. The second issue is that because each transaction was private, every entity buying insurance did not know who the originator of the insurance was “re-insuring” the obligation to. They might transact with an entity who resided in a jurisdiction where legal recourse couldn’t be taken. (Imagine that Person C couldn’t be sued) This lack of transparency led the potential for something bad to happen grow in both probability and scope.

The third big issue that CDS’s created is gambling on financials. In the end, people didn’t have to own the bonds to buy insurance. Imagine that Person A believed ACME might fail 10% of the time over the next 10 years, so they agreed to the contact in the above example with out actually owning the bond. They would still get the $398.9 million with only having the out lay of $30 million a year. Firms were allowed to make bets on defaults without actually having to own the bonds.

Perhaps that is the ‘casino like atmosphere’ that John McCain is talking about. Anywho, that is what a CDS is, in its most simplest form.


Later,

B