I have been following this issue for some time and found a good summary in the FT for those of you interested in seeing what the hell I have been talking about:
The article is here:
Insight: CDS market may create added risks
By Satayjit Das
Published: February 5 2008 15:31 | Last updated: February 5 2008 15:31
In May 2006, Alan Greenspan, the former Federal Reserve chairman, noted: “The credit default swap is probably the most important instrument in finance. … What CDS 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.”
The reality may prove different.
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. Current debate has focused on the size of the market. But the key problem is that a combination of documentation and counterparty risks means that the market may not function as participants and regulators hope if actual defaults occur.
CDS documentation, which is highly standardised, generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are also 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 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, for example, the volume of CDS outstanding was $28bn against $5.2bn of bonds and loans. 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 have forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement (based on the market price of defaulted bonds) for physical delivery. In Delphi, the protocol resulted in a settlement price of 63.38 per cent (the market estimate of recovery by the lender). The protection buyer received 36.62 per cent (100 per cent - 63.38 per cent) or $3.662m per $10m CDS contract. Fitch Ratings assigned a recovery rating to Delphi’s senior unsecured obligation equating to a 0-10 per cent recovery band - far below the price established through the protocol. The buyer of protection may have potentially received a payment on its hedge below its actual losses – effectively it would not have been fully hedged.
CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. Some 60-70 per cent of ultimate CDS protection sellers are financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented. Recently, Merrill Lynch took a charge of $3.1bn against counterparty risk on hedges with financial guarantors.
In the case of hedge funds, the CDS is marked to market daily. 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. As the case of ACA highlighted, banks may not be willing or able to close out positions where collateral isn’t posted. Collateral models also use historical volatility and correlation that may underestimate the risk.
Then there are operational risks – mark to market of the CDS and control of collateral.
If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. The CDS market entails complex chains of risk – similar to the re-insurance chains that proved so problematic in the case of Lloyd’s of London. A default may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts trading.
As the credit crisis deepens, the risk of actual defaults becomes real. The CDS market will be tested and may be found wanting.
CDS contracts may not actually improve the overall stability and security of the financial system but actually create additional risks.
The writer is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
Copyright The Financial Times Limited 2008
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2 comments:
Hi, tks for the post.
As a protection seller, is it obligatory to maintain credit ratings? What happens if there are no credit events but the credit ratings of the protection sellers is downgraded.
Regards
Hi Anonymous,
For any "professional investor" or "professional investment advisor" to invest their own or a clients money based solely on credit ratings is where the problems start. Most of the people who run corporate America (top end) and most "professional investors" i.e.; want to get rich quick think they know what they are doing, managers, are completely insecure overpaid "idiots" with no street smarts (gut investment talents backed by intense info absorption and street experience) or basic understandings of the companies they run. The pathetic amount of money paid to "consultants" hired to help these weenies make corporate decisions has much to say about your question of ratings. Ratings are guides, not substitutes to knowing what you are doing or having some idea of what the hell is going on in the market. That said, if you are selling a product that has real liabilities you may have to cover if your product "goes bad" then how your company is rated should definitely factor into any person's decision to deal with your company (purchase your products). I will reserve my judgment on the soundness of your industry (and the amount of money you guys make for selling insurance products that only the idiots I mentioned above are stupid enough to purchase). Suffice to say, if any rational is applied to your industry right now, I would be actively seeking other job prospects.
Patrick Henry
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