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Wall Street

The $58 Trillion Elephant in the Room

by Jesse Eisinger | See Archive

The roots of this year’s financial crisis go back to a small team of bankers at J.P. Morgan in New York. Now, their invention—credit derivatives—has helped bring down Wall Street and has left Morgan with its biggest exposure of all.

National News

Death by Derivatives

View Interactive Feature

Though it hasn’t been around long, the derivatives market nevertheless has managed to do some serious damage. A timeline of how it came about. See All Video & Multimedia

Behind the Story: Market Mayhem

by Portfolio Staff

Q&A with senior Condé Nast Portfolio writer Jesse Eisinger. Read More

Recent Columns

• Deny Another Day
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• The $58 Trillion Elephant in the Room
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• Sep 18 2008
• London Banks, Falling Down
• Aug 13 2008
• Bank Job
• Jun 16 2008
• Diary of a Short-Seller
• May 12 2008
• It’s (Really) the Economy, Stupid
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• It’s a Mad, Mad, Mad, Mad World
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• Wall Street’s Next Crisis
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• Wall Street Requiem
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• The $300 Trillion Time Bomb
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Photograph by: Phillip Toledano

JPMorgan Chase & Company (JPM)

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James S. Dimon,

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At a time when the reputation of bankers has been shredded, Bill Demchak is a throwback. The day I meet him, the financial world is once again poised on the brink of destruction. The Dow Jones Industrial Average lost 358 points the day before and is already down another 150 this morning. Yet the green-eyed Demchak, in pleated khakis hiked up unfashionably high onhis waist, seems preternaturally calm—especially for a man who, unwittingly, has had a hand in bringing Wall Street to its knees.

Demchak, now the vice chairman of PNC Financial in Pittsburgh, returned to his hometown in 2002 to help rescue the bank after it became mired in an accounting scandal. Under Demchak and the rest of its new management team, PNC has avoided most of the terrible mistakes of its Wall Street peers by spurning bad mortgages, dubious off-balance-sheet deals, and questionable corporate loans. It’s now one of the best-performing banks in the country.

But before he had this life, Demchak had another, as the leader of a small group at J.P. Morgan in New York that pioneered the kind of financial instruments that eventually led to this autumn’s wreckage on Wall Street. The J.P. Morgan team created and then industrialized credit derivatives, which have enveloped the global markets, growing to a mind-numbing $58 trillion worth of credit contracts. They have spread and morphed in ways that Demchak never intended but always feared.

Long celebrated as a way for banks to diffuse their risks, the credit derivatives invented by Demchak’s team have instead multiplied them. The new credit vehicles encouraged banks and other financial firms to take on riskier loans than they should have; helped increase leverage in the global financial system; and exposed a much wider array of financial firms to the risk of default. (View an interactive timeline of derivatives.)

Credit derivatives aren’t, of course, solely to blame for the pandemic that has helped bring down Wall Street. They didn’t single-handedly force Bear Stearns and Lehman Brothers to bulk up on toxic debt, dooming them to collapse. But they made the financial world more complex and more opaque. Ultimately, they have exacerbated the market panic, as financial firms and regulators have belatedly come to grips with the enormity of the problems. Merrill Lynch ultimately capitulated to a sale because investors had no confidence that the firm had a handle on what its problems were. When the federal government took over A.I.G. in September, it was largely because of the insurance behemoth’s exposure to credit-default swaps, a type of derivative that flourished in the wake of Demchak and his team’s creations. By mid-September, Treasury Secretary Hank Paulson was forced into proposing the largest bailout in U.S. history. Securities and Exchange Commission chairman Christopher Cox (S.E.C. No Evil, October) called for regulating credit derivatives.

Morgan’s derivatives project began in the wake of the Asian financial crisis in 1997 as an attempt to protect the bank from bad loans. Demchak’s innovations worked—for his bank. Morgan came to dominate this corner of the financial world while preserving a culture of prudence. Morgan—deemed to be so safe that it snagged two of the victims of the financial-system collapse, Bear Stearns and Washington Mutual—is still swimming in credit derivatives, far more than any other firm on Wall Street, though the bank says it’s hedged. As of the second quarter of 2008, the bank had written derivatives contracts backing credit valued at $10.2 trillion, roughly three-quarters the size of the U.S. economy.

But Demchak’s innovation has a more troubling legacy. J.P. Morgan, rather than being inoculated, was actually becoming the Patient Zero of Wall Street, eventually carrying the credit virus to the far corners of the global financial system. The structure of the first derivatives deal wasn’t as solid as Demchak’s team had intended. That initial, flawed financial instrument was later replicated thousands of times by J.P. Morgan and other banks, with the same defects repeated and magnified over and over again.

The creation of credit derivatives, only a decade ago, is more responsible than anything else for binding the global financial world together more closely. Now some of the trailblazers are puzzling over what has been wrought. “How can we have a financial system so precariously balanced after such an extraordinarily profitable period?” asks Andrew Donaldson, a former colleague of Demchak’s who runs an asset management firm in London.

CREDIT DEFAULT SWAPS THE NEXT CRISIS
Sub Prime is Just ‘Vorspeise’
by F. William Engdahl
June 6, 2008

While attention has been focused on the relatively tiny US „sub-prime“ home mortgage default crisis as the center of the current financial and credit crisis impacting the Anglo-Saxon banking world, a far larger problem is now coming into focus. Sub-prime or high-risk Collateralized Mortgage Obligations, CMOs as they are called, are only the tip of a colossal iceberg of dodgy credits which are beginning to go sour. The next crisis is already beginning in the $62 TRILLION market for Credit Default Swaps. You never heard of them? It’s time to take a look, then.

The next phase of the unravelling crisis in the US-centered “revolution in finance” is emerging in the market for arcane instruments known as Credit Default Swaps or CDS. Wall Street bankers always have to have a short name for these things.

As I pointed out in detail in my earlier exclusive series, the Financial Tsunami, Parts I-V, the Credit Default Swap was invented a few years ago by a young Cambridge University mathematics graduate, Blythe Masters, hired by J.P. Morgan Chase Bank in New York. The then-fresh university graduate convinced her bosses at Morgan Chase to develop a revolutionary new risk product, the CDS as it soon became known.

A Credit Default Swap is a credit derivative or agreement between two counterparties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the “buyer.” The second party gives credit protection and is called the “seller”. The third party, the one that might go bankrupt or default, is known as the “reference entity.” CDS’s became staggeringly popular as credit risks exploded during the last seven years in the United States. Banks argued that with CDS they could spread risk around the globe.

Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against a default on a debt. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes.

Warren Buffett once described derivatives bought speculatively as “financial weapons of mass destruction.” In his Berkshire Hathaway annual report to shareholders he said “Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).” A typical CDO is for five years term.

Like many exotic financial products which are extremely complex and profitable in times of easy credit, when markets reverse, as has been the case since August 2007, in addition to spreading risk, credit derivatives, in this case, also amplify risk considerably.

Now the other shoe is about to drop in the $62 trillion CDS market due to rising junk bond defaults by US corporations as the recession deepens. That market has long been a disaster in the making. An estimated $1,2 trillion could be at risk of the nominal $62 trillion in CDOs outstanding, making it far larger than the sub-prime market.

No regulation

A chain reaction of failures in the CDS market could trigger the next global financial crisis. The market is entirely unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb. The US Federal Reserve under the ultra-permissive chairman, Alan Greenspan and the US Government’s financial regulators allowed the CDS market to develop entirely without any supervision. Greenspan repeatedly testified to skeptical Congressmen that banks are better risk regulators than government bureaucrats.

The Fed bailout of Bear Stearns on March 17 was motivated, in part, by a desire to keep the unknown risks of that bank’s Credit Default Swaps from setting off a global chain reaction that might have brought the financial system down. The Fed’s fear was that because they didn’t adequately monitor counterparty risk in credit-default swaps, they had no idea what might happen. Thank Alan Greenspan for that.

Those counterparties include JPMorgan Chase, the largest seller and buyer of CDSs.

The Fed only has supervision to regulated bank CDS exposures, but not that of investment banks or hedge funds, both of which are significant CDS issuers. Hedge funds, for instance, are estimated to have written 31% in CDS protection.

The credit-default-swap market has been mainly untested until now. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody’s Investors Service. But Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide was on companies or securities that are rated below investment grade, up from 8 percent in 2002.

A surge in corporate defaults will now leave swap buyers trying to collect hundreds of billions of dollars from their counterparties. This will to complicate the financial crisis, triggering numerous disputes and lawsuits, as buyers battle sellers over the technical definition of default - - this requires proving which bond or loan holders weren’t paid — and the amount of payments due. Some fear that could in turn freeze up the financial system.

Experts inside the CDS market believe now that the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $150 billion in defaults. Banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That will not work as many of the funds won’t have the cash to meet the banks’ demands for more collateral.

Sellers of protection aren’t required by law to set aside reserves in the CDS market. While banks ask protection sellers to put up some money when making the trade, there are no industry standards. It would be the equivalent of a licensed insurance company selling insurance protection against hurricane damage with no reserves against potential claims.

Basle BIS worried

The Basle Bank for International Settlements, the supervisory organization of the world’s major central banks is alarmed at the dangers. The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.

“It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred,” the report said. “It can be difficult even to quantify the amount of risk that has been transferred.”

Counterparty risk can become complicated in a hurry. 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. That has created a huge concentration of risk. As one leading derivatives trader expressed the process, “The risk keeps spinning around and around in this daisy chain like a vortex. There are only six to 10 dealers who sit in the middle of all this. I don’t think the regulators have the information that they need to work that out.”

Traders, and even the banks that serve as dealers, don’t always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDSs, some far more complex than others. More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company’s debt or collateralized debt obligations…

Banks usually send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, as there is no regulated exchange to pricess the market or to insure against loss. To find the price of a swap on Ford Motor Co. debt, for example, even sophisticated investors might have to search through all of their daily e-mails.

Banks want secrecy

Banks have a vested interest in keeping the swaps market opaque, because as dealers, the banks have a high volume of transactions, giving them an edge over other buyers and sellers. Since customers don’t necessarily know where the market is, you can charge them much wider profit margins.

Banks try to balance the protection they’ve sold with credit-default swaps they purchase from others, either on the same companies or indexes. They can also create synthetic CDOs, which are packages of credit-default swaps the banks sell to investors to get themselves protection.

The idea for the banks is to make a profit on each trade and avoid taking on the swap’s risk. As one CDO dealer puts it, “Dealers are just like bookies. Bookies don’t want to bet on games. Bookies just want to balance their books. That’s why they’re called bookies.”

Now as the economy contracts and bankruptcies spread across the United States and beyond, there’s a high probability that many who bought swap protection will wind up in court trying to get their payouts. If things are collapsing left and right, people will use any trick they can.

Last year, the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn’t worked. It’s been boycotted by banks, which prefer to continue their trading privately.

Credit Default Swaps: The Next Crisis?

By Janet Morrissey Monday, Mar. 17, 2008

Traders work on the floor of the New York Stock Exchange.

Richard Drew / AP

Credit Default Swaps and Financial WMDs

Gretchen Morgenson’s NYT article yesterday offered a good primer about Credit Default Swaps (CDS):

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

As the graphics explain, counter-party risk is an ever present factor.
>

click for larger graphics

graphic courtesy of NYT

>
What’s truly astonishing is the size of this market: The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — bigger than the US equity markets, US Treasuries, and Mortgage Securities — COMBINED.
>

click for larger graphics                                                             

graphic courtesy of NYT

>
CDS are thinly traded, have huge counter-party risk, are difficult to analyze, and are unreguylated insurance products. This leadsme to this money quote:

“As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in.”

Sounds kinda familiar . . .

>

Source:
Arcane Market Is Next to Face Big Credit Test
GRETCHEN MORGENSON
NYT, February 17, 2008
http://www.nytimes.com/2008/02/17/business/17swap.html

Credit Default Swaps and Financial WMDs

Gretchen Morgenson’s NYT article yesterday offered a good primer about Credit Default Swaps (CDS):

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

As the graphics explain, counter-party risk is an ever present factor.
>

click for larger graphics

graphic courtesy of NYT

>
What’s truly astonishing is the size of this market: The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — bigger than the US equity markets, US Treasuries, and Mortgage Securities — COMBINED.
>

click for larger graphics

graphic courtesy of NYT

>
CDS are thinly traded, have huge counter-party risk, are difficult to analyze, and are unreguylated insurance products. This leadsme to this money quote:

“As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in.”

Sounds kinda familiar . . .

>

Source:
Arcane Market Is Next to Face Big Credit Test
GRETCHEN MORGENSON
NYT, February 17, 2008
http://www.nytimes.com/2008/02/17/business/17swap.html

From Wikipedia, the free encyclopedia

In essence, a Credit Default Swap can be thought of as a type of “insurance” taken out on an investment. The “premium” is paid, to protect the buyer from any potential drop in the original investment value; though CDS are not generally considered insurance for regulatory purposes.

CDS’s are made between counterparties. The issuer of the CDS calculates the risks of their potential loss, and charges a ongoing fee, to cover the life of the CDS cover. The original issuer of the CDS may pass on part, or all of the the risk to others, making it difficult to trace who owns the obligation. Also see Derivative (finance), rating agencies and hedge. A more complex explanation follows.

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the “buyer” pays periodic payments to the “seller” in exchange for the right to a payoff if there is a default^[1] or “credit event”^{[citation needed]} in respect of a third party or “reference entity”.

If a credit event occurs, the typical contract either settles by delivery by the buyer to the seller of a (usually defaulted) debt obligation of the reference entity against a payment by the seller of the par value (”physical settlement”) or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation, typically determined in an auction (”cash settlement”).

[edit] Market

Credit default swaps are the most widely traded credit derivative product^[2] and the Bank for International Settlements reported the notional amount on outstanding OTC credit default swaps to be $42.6 trillion[4] in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005) and by the end of 2007 there were an estimated USD 45^[3] to 62.2^[4] trillion worth of Credit Default Swap contracts.

In the US, the Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from reporting banks to be $16.4 trillion at the end of March, 2008.

[edit] Structure and features

[edit] Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association.^[5] The confirmation typically specifies a reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond or government bond. The period over which default protection extends is defined by the contract effective date and scheduled termination date.

The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations, and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.

CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not. The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is restructured). This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco’s restructuring in 2000 led to the credit event’s removal from North American high yield trades.^[6]

Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard currency and that it not be subject to some contingency before becoming due.

[edit] Quotes of a CDS contract

Sellers of CDS contracts will give a par quote (see par value) for a given reference entity, seniority, maturity and restructuring e.g. a seller of CDS contracts may quote the premium on a 5 year CDS contract on Ford Motor Company senior debt with modified restructuring as 100 basis points. The par premium is calculated so that the contract has zero present value on the effective date. This is because the expected value of protection payments is exactly equal and opposite to the expected value of the fee payments. The most important factor affecting the cost of protection provided by a CDS is the credit quality (often proxied by the credit rating) of the reference obligation. Lower credit ratings imply a greater risk that the reference entity will default on its payments and therefore the cost of protection will be higher.

The swap adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical minutiae such as specific settlement differences, shortages in a particular underlying instrument, and the existence of buyers constrained from buying exotic derivatives. The difference between CDS spreads and Z-spreads or asset swap spreads is called the basis.

To give an example, ABC Corporation may have its credit default swaps currently trading at 265 basis points. In other words, the cost to insure 10 million euros of its debt would be 265,000 euros per annum. If the same CDS had been trading at 170 basis points a year before, it would indicate that markets now view ABC as facing a greater risk of default on its obligations.

[edit] Pricing and valuation

There are two competing theories usually advanced for the pricing of credit default swaps. The first, which for convenience we will refer to as the ‘probability model’, takes the present value of a series of cashflows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds.

The second model, proposed by Darrell Duffie, but also by Hull and White, uses a no-arbitrage approach.

[edit] Probability model

Under the probability model, a credit default swap is priced using a model that takes four inputs:

• the issue premium,
• the recovery rate,
• the credit curve for the reference entity and
• the LIBOR curve.

If default events never occurred the price of a CDS would simply be the sum of the discounted premium payments. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract. For the purpose of explanation we can imagine the case of a one year CDS with effective date t₀ with four quarterly premium payments occurring at times t₁, t₂, t₃, and t₄. If the nominal for the CDS is N and the issue premium is c then the size of the quarterly premium payments is Nc / 4. If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end: either it does not have any default at all, so the four premium payments are made and the contract survives until the maturity date, or a default occurs on the first, second, third or fourth payment date. To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value of the payoff for each outcome. The present value of the CDS is then simply the present value of the five payoffs multiplied by their probability of occurring.

This is illustrated in the following tree diagram where at each payment date either the contract has a default event, in which case it ends with a payment of N(1 − R) shown in red, where R is the recovery rate, or it survives without a default being triggered, in which case a premium payment of Nc / 4 is made, shown in blue. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the contract is terminated the square is shown with solid shading.

The probability of surviving over the interval t_{i − 1} to t_i without a default payment is p_i and the probability of a default being triggered is 1 − p_i. The calculation of present value, given discount factors of δ₁ to δ₄ is then

Description	Premium Payment PV	Default Payment PV	Probability
Default at time t1
Default at time t2
Default at time t3
Default at time t4
No defaults

The probabilities p₁, p₂, p₃, p₄ can be calculated using the credit spread curve. The probability of no default occurring over a time period from t to t + Δt decays exponentially with a time-constant determined by the credit spread, or mathematically p = exp( − s(t)Δt) where s(t) is the credit spread zero curve at time t. The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time.

To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give

[edit] No-arbitrage model

In the ‘no-arbitrage’ model proposed by both Duffie, and Hull and White, it is assumed that there is no risk free arbitrage. Duffie uses the LIBOR as the risk free rate, whereas Hull and White use US Treasuries as the risk free rate. Both analyses make simplifying assumptions (such as the assumption that there is zero cost of unwinding the fixed leg of the swap on default), which may invalidate the no-arbitrage assumption. However the Duffie approach is frequently used by the market to determine theoretical prices. Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of 100, and the swap spread is 70 basis points, then a CDS contract should trade at 30. However owing to inefficiencies in markets, this is not always the case. The difference between the theoretical model and the actual price of a credit default swap is known as the basis.^{[citation needed]}

[edit] Uses

Like most financial derivatives, credit default swaps can be used to hedge existing exposures to credit risk, or to speculate on changes in credit spreads.

[edit] Hedging

Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.

For example, a pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. In order to manage the risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million that trades at 200 basis points. In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) in quarterly installments of $50,000 to Derivative Bank. If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million loan back after 5 years from the Risky Corporation. Though the protection payments reduce investment returns for the pension fund, its risk of loss due to Risky Corporation defaulting on the bond is eliminated. (However, the fund still faces counterparty risk if Derivative Bank becomes insolvent and cannot honor the CDS contract). If Risky Corporation defaults on its debt 3 years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million (either by taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond). Another scenario would be if Risky Corporation’s credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.

[edit] Speculation

Credit default swaps give a speculator a way to profit from changes in a company’s credit quality. A protection seller in a credit default swap effectively has an unfunded exposure to the underlying cash bond or reference entity, with a value equal to the notional amount of the CDS contract.

For example, if a company has been having problems, it may be possible to buy the company’s outstanding debt (usually bonds) at a discounted price. If the company has $1 million worth of bonds outstanding, it might be possible to buy the debt for $900,000 from another party if that party is concerned that the company will not repay its debt. If the company does in fact repay the debt, you would receive the entire $1 million and make a profit of $100,000. Alternatively, one could enter into a credit default swap with the other investor, by selling credit protection and receiving a premium of $100,000. If the company does not default, one would make a profit of $100,000 without having invested anything.

It is also possible to buy and sell credit default swaps that are outstanding. Like the bonds themselves, the cost to purchase the swap from another party may fluctuate as the perceived credit quality of the underlying company changes. Swap prices typically decline when creditworthiness improves, and rise when it worsens. But these pricing differences are amplified compared to bonds. Therefore someone who believes that a company’s credit quality would change could potentially profit much more from investing in swaps than in the underlying bonds, although encountering a greater loss potential.

[edit] Taxation

The U.S. federal income tax treatment of credit default swaps is uncertain.^[7] Commentators generally believe that, depending on how they are drafted, they are either notional principal contracts or options for tax purposes,^[8] but this is not certain. There is a risk of having credit default swaps recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event).^[9] If a credit default swap is a notional principal contract, periodic and nonperiodic payments on the swap are deductible and included in ordinary income.^[10] If a payment is a termination payment, its tax treatment is even more uncertain.^[11] In 2004, the Internal Revenue Service announced that it was studying the characterization of credit default swaps in response to taxpayer confusion,^[12] but it has not yet issued any guidance on their characterization. A taxpayer must include income from credit default swaps in ordinary income if the swaps are connected with trade or business in the United States.^[13]

[edit] Criticisms

Warren Buffett famously described derivatives bought speculatively as “financial weapons of mass destruction.” In Berkshire Hathaway’s annual report to shareholders in 2002, he said, “Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses–often huge in amount–in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).“ The same report, however, also states that he uses derivatives to hedge, and that some of Berkshire Hathaway’s subsidiaries have sold and currently sell derivatives with notional amounts in the tens of billions of dollars.^[14] Berkshire Hathaway, with a market capitalization of $196 billion^[15], certainly does have enough equity to collateralize or guarantee these contracts.

The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name is vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and there may be $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. When the CDS have been made for purely speculative purposes, in addition to spreading risk, credit derivatives can also amplify those risks. If the CDS were being used to hedge, the notional value of such contracts would be expected to be less than the size of the outstanding debt as the majority of such debt will be owned by investors who are happy to absorb the credit risk in return for the additional spread or risk premium. A bond hedged with CDS will, at least theoretically, generate returns close to LIBOR but with additional volatility. Long term investors would consider such returns to be of limited value. However speculators may profit from these differences and therefore improve market efficiency by driving the price of bonds and CDS closer together.

However CDS premiums can act as a good barometer of company’s health. If investors are not sure about a firm’s credit quality they will demand protection thus pushing up CDS spreads on that name in the market. Equity markets will then draw a cue from the credit markets and push down the stock price based on fear of corporate default. For example the credit spread of Bear Stearns widened significantly in the period immediately prior to being bailed out by the Fed and JP Morgan, providing equity investors with advance warning of impending problems at the company.^{[citation needed]}

[edit] Operational issues in settlement

In the US, the settlement and processing of a CDS contract is currently the subject of concern by the US Federal Reserve. In 2005, the Federal Reserve obtained a commitment by 14 major dealers to upgrade their systems and reduce the backlog of “unprocessed” CDS contracts. As of January 31, 2006, the dealers had met their commitment and achieved a 54% reduction.^[16]

In addition, growing concern over the sheer volume of CDS contracts potentially requiring physical settlement after credit events for names actively traded in the single-name and index-trade market where the notional value of CDS contracts dramatically exceeds the notional value of deliverable bonds has led to the increasing application of cash settlement auction protocols coordinated by ISDA. Successful auction protocols have been applied following credit events in respect of Collins & Aikman (With distinguished employee Pawel), Delphi Corporation, Delta Air Lines and Northwest Airlines, Calpine Corporation, Dana Corporation, Dura Operating Corporation and Quebecor. ISDA is also using a protocol for the settlement of contracts on Fannie Mae and Freddie Mac debt, after these entities were placed in conservatorship.^[17]

[edit] LCDS

A new type of default swap is the “loan only” credit default swap (LCDS). This is conceptually very similar to a standard CDS, but unlike “vanilla” CDS, the underlying protection is sold on syndicated secured loans of the Reference Entity rather than the broader category of “Bond or Loan”. Also, as of May 22, 2007, for the most widely traded LCDS form, which governs North American single name and index trades, the default settlement method for LCDS shifted to auction settlement rather than physical settlement. The auction method is essentially the same that has been used in the various ISDA cash settlement auction protocols, but does not require parties to take any additional steps following a credit event (i.e., adherence to a protocol) to elect cash settlement. On October 23, 2007, the first ever LCDS auction was held for Movie Gallery.[5]

Because LCDS trades are linked to secured obligations with much higher recovery values than the unsecured bond obligations that are typically assumed to be cheapest to deliver in respect of vanilla CDS, LCDS spreads are generally much tighter than CDS trades on the same name.

[edit] See also

• Credit derivative
• Credit default swap index
• Credit default option
• Swap (finance)
• Recovery Swap

[edit] References

[edit] External links

• 2003 ISDA Credit Derivatives Template
• BIS - Regular Publications
• OCC - Quarterly Derivatives Fact Sheet
• A Beginner’s Guide to Credit Derivatives - Noel Vaillant, Nomura International
• A billion-dollar game for bond managers
• Hull, J. C. and A. White, Valuing Credit Default Swaps I: No Counterparty Default Risk
• Hull, J. C. and A. White, Valuing Credit Default Swaps II: Modeling Default Correlations
• Elton et al, Explaining the rate spread on corporate bonds
• Warren Buffet on Derivatives - Excerpts from the Berkshire Hathaway annual report for 2002.
• Roundtable on MiddleOffice - Hedge Fund Manager Week

[edit] In the news

• January 18, 2008, Wall Street Journal: “Default Fears Unnerve Markets” by Susan Pulliam and Serena Ng on CDS counterparty risk.
• February 5, 2008, Financial Times: “CDS market may create added risks” by Satayjit Das.
• February 17, 2008, New York Times: “Arcane Market is Next to Face Big Credit Test” By Gretchen Morgenson
• March 17, 2008 Credit Default Swaps: The Next Crisis?
• March 23, 2008, New York Times: “Who Created This Monster?” By Nelson D. Schwartz and Julie Creswell
• May 20, 2008, Bloomberg: “Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults” by David Evans.
• May 28, 2008, Financial Times: “Moody’s issues warning on CDS risks” by Aline van Duyn.
• June 1, 2008, New York Times: “First Comes the Swap. Then It’s the Knives.” by Gretchen Morgenson about a CDS dispute between UBS and Paramax Capital.
• September 18, 2008, Reuters: “Buffett’s ‘time bomb’ goes off on Wall Street.” by James B. Kelleher about credit default swaps turning a bad situation into a catastrophe.
• September 27, 2008, NYTimes: “Behind Insurer’s Crisis, Blind Eye to a Web of Risk” by Gretchen Morgenson.
• September 30, 2008, Fortune Magazine: “The $55 Trillion Question” by Nicholas Varchaver and Katie Benner on CDS spotlight during financial crisis.

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