How Credit Default Swaps Work

One of the many terms you’ve been reading about is Credit Default Swaps (CDS). They represent a market that is currently valued at some $50 trillion (yes, trillion, not billion) and can, given today’s counter party risk, which I alluded to in a recent post, affect the markets very negatively given the right circumstances.

So what on earth are CDSs and how do they work? Minyanville had this explanation:

The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who, for a fee, indemnifies the protection buyer against credit losses. The CDS market has grown exponentially to current outstandings of around $50 trillion. Even eliminating double counting in the volumes, the figures are impressive, especially when you considered that the market was less than $1 trillion as of 2001. However, the size of the market (which has attracted much attention) is not the major issue.

Banks have used CDS contracts extensively to hedge credit risk on bonds and loans. Documentation and counterparty risk means that the market may not function as participants and regulators hope when actual defaults occur.

CDS documentation is highly standardized to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought. In fairness, all financial hedges display some degree of mismatch or “basis” risk.

The CDS contract is triggered by a “credit event”, broadly default by the reference entity. The buyer of protection is not protected against “all” defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan. Some credit events like “restructuring” are complex. There are different versions – R (restructuring), NR (no restructuring), MR (modified restructuring) and MMR (modified modified restructuring). Different contracts use different versions.

“PAI” (publicly available information) must generally be used to trigger the CDS contract. Recent credit events have been straightforward Chapter 11 filings and bankruptcy. For other credit events (failure to pay or restructuring), there may be problems in establishing that the credit event took place.

This has a systemic dimension. A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. This may exacerbate losses in the case of defaults.

In the 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, the volume of CDS outstanding was estimated at $28 billion against $5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called “auction system”. The auction is designed to be robust and free of the risk of manipulation.

In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100%-63.38%) or $3.662 million per $10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi’s senior unsecured obligation equating to a 0-10% recovery band – far below the price established through the protocol [see James Batterman and Eric Rosenthal Special Report: Delphi, Credit Derivatives, and Bond Trading Behavior After a Bankruptcy Filing (28 November 2005); www.fitchratings.com].

The buyer of protection, depending on what was being hedged, may have potentially received a payment on its hedge well below its actual losses – effectively it would not have been fully hedged.

The settlement mechanics may cause problems even where there is no default. One company refinanced its debt using commercial mortgage backed securities (“CMBS”). The company was downgraded by rating agencies. A shortage of deliverable obligations (the company used the funds from the CMBS to repay its bond and loans) meant that the CDS fee for the company fell sharply (indicative of an improvement in credit quality). This resulted in mark-to-market losses for bemused hedgers. This is known in the trade as an “orphaned CDS”.

In the case of actual defaults the CDS market may provide significant employment to a whole galaxy of lawyers trying to figure out whether and how the contract should work. There is the risk that contract may not always provide buyers of protection with the hedge against loss that they assumed they would receive.

To me, it’s a huge pyramid game that totally depends on the opposing parties making good on their promises to cover their end of the bargain. What is unknown is how many parties to these contracts will actually be able to fulfill their obligations given the current credit mess and the fact that many participants are capital impaired.

I have no idea how this will play out, but it would seem that if only 5% of these “bets” go bad, that will be $2.5 trillion worth of “transaction” that have to be covered somehow. It will take only one Black Swan event, such as a major bank failure, to get the ball rolling and push the economy into unchartered territory with unknown consequences.

I am not trying to be negative here, just realistic. We’ve witnessed the quick unraveling of the subprime/housing market and its effect on the credit markets with many banks struggling to raise capital to stay afloat. That result was caused by negative numbers in the billions; what if there are trillions involved?

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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