CDS Debunking - Facts
I’ve been reading a lot about the fears of the CDS markets and its really annoying me. I figured it would be prudent to state some facts that have been mistated in the press for those that are interested. Plus it just annoys me that people insist upon making shit up about CDS because they just don’t understand the product.
1. The size of the market: $54.6 Trillion.
I used to compile the monthly reporting to ISDA that collects data on banks’ positions in OTC derivatives for the bank I used to work for. Typically, they ask you for net and gross notional amounts. When looking at the ISDA Market Survey, which is the report that the media uses when quoting this figure, its not clear whether they are using gross or net notional amounts. Another report published by the Bank of International Settlements actually specifies gross notional and quotes a number around $45 trillion in June 2007. What is the difference between gross and net? Well, if I bought protection for $10m on General Motors and then sold protection for $10m, then my net notional would be $0 and my gross notional would be $20m. The report states that “gross market values are adjusted by adding the total gross positive market value of contracts to the total gross negative market value of contracts with non-reporting counterparties only” while to avoid double-counting, it halves positions of dealers that have positions against each other. It still doesn’t give solid information about whether those numbers that dealers are reporting are net or gross. Assuming that it is net, the proportion of dealer-to-dealer trades is far outweighed by dealer-to-client trades, by probably 6 or 7 to 1. So if they are taking gross notionals of trades facing clients (also called sales trades) and halving the small minority of trades facing other broker-dealers, then the statistics are widely overstated.
2. Credit-Default Swaps are ticking time-bombs, also referred to as “Weapons of Mass Destruction” by Warren Buffett.
I still don’t understand this statement. To me, this says that CDS are the most riskiest of all investments available. Let’s take a quick look at the risks.
CDS subject investors to 3 main types of risks: credit, recovery and default. Credit risk is the risk that credit spreads will change. Recovery risk is the risk that underlying recoveries upon default will change. Default risk is the exposure risk that the underlying issuer will default. The underlying instrument of CDS are bonds. Credit risks are generally the most significant for names that are less likely to default while recovery and default risks tend to be more significant for names that are more likely to default. For names that fall in between those spectrums, changes in credit and recovery tend to offset each other. The closer to perceived default CDS trades, the more they start to trade like a bond, where the credit spread has less of an impact than the recovery assumptions. What risks are investors taking when buying bonds? Credit, default/recovery, interest rate, liquidity. As with CDS, they have similar risks in terms of credit, default and recovery risks, but they also have additional, significant risks: interest rate and liquidity. Since bonds are funded, they are sensitive to the discount curve based on Treasury bond yields. CDS have similar risk but because they are not funded, the interest rate risk is miniscule relative to bonds. And the big one, liquidity risk, has seen to cripple bonds in the current credit liquidity crisis while the CDS market is still a highly liquid market. It is arguable that the CDS market has helped investors hedge against falling bond prices but as I discussed in the prior post, basis risk has exploded reducing the efficiency of that hedge.
The VIX Index, the index of equity market volatility has spiked to as high as 60, which represents more than double your normal volatilities expected and priced into equities. (I should give you a comparison of the levels of volatility of credit spreads because its just the logarithmic changes in daily returns and such but I don’t feel like it. I just know that equities are always on the top of the list of volatile instruments. These levels peg the risk of equities at all-time highs which has been apparent in the current market with unprecedented swings of +/-500 points any given day in the Dow Jones Industrial Average. If you look at the CDX Investment Grade Index, which is an index of Investment Grade issuers in the bond market, the index hovered around 50-80bps during the summer and is now trading around about 200bps. The equity markets have lost about 30% since June. If you assume a $10M 5Y trade in the CDX IG 10 index, you could assume about a $600k loss since June - let’s assume a cool $1M loss because of convexity and tighter recovery assumptions that are plauging the market as a result of more probable default probabilities. If you take $10M in the equity markets since June and you have a $3M loss. If you are invested in bonds, you loss would be much greater than $600k but not as much as $3M most likely. But there are bonds that have lost even more than 30% because of drying up liquidity so its possible depending on what names you are invested in. If you were invested in secured debt (loans), you could see even greater losses. It probably goes without saying that if you were invested in MBS or other types of ABS, you wish you invested in equities. Of course, its always the case that you want to be on the right side of the trade - regardless of where the market is going, but I think its apparent that the risks the bonds and equities expose you to are exponentially greater than CDS. If you wanted to call it a day on your $1M loss on your $10M position in the IG 10, then you unwind. If you want to get out of your $10M in bonds or equity, plan on getting out at even greater losses because of the general lack of liquidity in the market, especially in the bond market. As $10M isn’t that huge of a position, you will still probably have to unwind your position in smaller lots when you can easily do an offsetting trade or simply contact the counterparty to unwind your $10M CDS position.
3. The CDS market does not require financial firms to take capital in reserve in case they have to pay off their bets.
This is partially true but not so much when it really matters most. Let me explain.
It is true that there are no requirements on posting collateral or capital in reserves when trading. However, all broker-dealers and other market-makers in the CDS market require clients (hedge funds, mutual funds, etc.) to post margin and regularly require increases on that collateral when spreads widen. As I stated before, sales trades (trades between broker-dealers and clients such as hedge funds) make up the vast majority of outstanding trades in the market. And the vast majority of trades require margin - just like when retail investors trade equity or commodity derivatives on platforms such as E-trade. The other side of the trade facing the broker-dealer obviously does not require margin and this has been the unprecedented situation that has occurred in the market where the market-maker is defaulting, creating counterparty risk where none was thought to exist. Of course, the collateral posted by clients with trades facing Lehman is now part of the overall bankruptcy proceedings and will most likely not be returned 100%. I don’t disagree that this is a problem and that a centralized exchange or clearinghouse would solve this problem, but I did want to clarify the issue.
Another factor in this is the distressed market. This is the market that trades CDS with underlying bonds trading at the perceived recovery that would result from a default. I wrote about this previously that distressed CDS trade with points upfront. I’m not sure at which point this occurs but at some point, spreads get so high, so wide that the market decides to trade with a flat 500bps plus a percentage of the notional in the trade upfront - in cash. Even though this isn’t seen as capital in reserve, it really is. If I bought protection on a distressed CDS contract I could pay 10-20pts upfront depending on the name traded. On a $10M contract, I would pay $2M upfront to the counterparty and pay a running 500bps quarterly. So if there was a default, the protection seller would actually only be paying another $4M assuming a 40% recovery. Yes, the distressed market does only represent a small portion of the CDS market, but alternatively it represents the vast (if not the entire) majority of the population of likely defaults. Points upfront get into the 30’s and 40’s for those that are really about to jump off the cliff.
4. CDS instruments are the reason why we are in this crisis.
I don’t even know where to begin. First of all, the CDS market is a highly liquid and developed market since it’s inception in 1994. Since the initial defaults occurred back in 2005 with Collins and Aikman and the airlines, ISDA has done a lot to hammer out issues that propped up along the way and protocols developed by them have created a streamlined series of directions or instructions for participants to follow when settling triggered contracts. The claim from what I understand is that the counterparty risk the banks now suddenly exhibit would cause defaults which would cause defaults would cause defaults. I can’t say whether or not this would occur, but the reason we are in this crisis is because the economy’s foundation is built upon credit and is dependent upon banks lending to each other in addition to the use of bad assets as collateral for issued credit securities. There are a lot of reasons why we are where we are but one of the big reasons has to do with how leveraged the world economy is, which makes it heavily dependent upon credit from banks all over the world. CDS makes this more complex because your counterpart could be a bank that may default while the underlying issuer that the contract is based upon has nothing to do with the bank. This is classic counterparty risk that exists in all OTC derivatives where you are not trading with an exchange but with a private institution. This risk has always existed and has been monitored by any banks with a Risk Management department worth its salt. No doubt is CDS a large market, but interest rate swaps are large too and not controlled by an exchange. Variance Swaps, commodity swaps, total return swaps? Granted, there is no default leg on these types of swaps and that is where I believe most of the counterparty risk would be an issue, but total return and variance swaps can both have extremely large settlement amounts just like CDS.
Now, the media won’t get off the fact that synthetic CDOs are being sold at price as low as 10 cents on the dollar because they contained exposure to Lehman. Why is this news? A synthetic CDO is basically a package of CDS trades that you can’t unwind and are thinly traded because they are bespoke bonds based on any combination of underlying issuers. The fucking dumbest idea on the planet. Pricing is based on its composition so its pretty straightforward to price. It basically enables people who can’t trade CDS to trade funded packages of CDS trades that are tailored to the a certain type of exposure that the investor is looking for. I get it but think that its better to just buy the bonds or loans and tailor your own exposure through a mixture of other products that can be unwound more easily. The fact that they are trading low because they have exposure to Lehman is not really news to me (duh!). Its like reporting that its wet because its raining.
Also, everyone thinks that the banks will fall like dominoes because they think the market is really $54.6 trillion in size when its not. Plus, banks have netting agreements that net payments to reduce operational risks and streamline the settlement process. There is a company (TriOptima) the also works to regularly reduce trades outstanding by trilateral and bilateral netting which would reduce greatly the gross exposure while not changing overal net exposure, thereby reducing operational risk further. TriOptima performs these exercises for every credit event for both single-name and index instruments.
5. The CDS market is completely opaque.
Depository Trust and Clearing Corporation (DTCC) has been working to rampup hedge funds and other clients through broker-dealers so that clearing trades between counterparties is more streamlined, reducing operational risk and the amount of time it takes to settle and confirm trades. They have developed a trade information warehouse that tracks trades that use their service. The biggest dealers in the market use this platform so its safe to say that the majority of the market is accounted for. This platform greatly increases transparency and allows participants to track their exposures, handling credit events, reduces errors, etc. Markit Partners offers substantial information on pricing submitted by market participants and market news specific to the CDS market. Surely, you don’t see trading volumes like you do in equities and bonds, but I wouldn’t say that the market is completely opaque. I’m sure there are other sources that offer information on trading volumes but won’t drill-down to intraday times like equities do. Also another issue is that you can’t go to Yahoo or Google to get prices but retail investors can’t trade them anyways. The market participants that trade these contracts have the info they need. Again, I do know that as this product is traded by a wider audience, you will have greater transparency. The problem with that is that you are now more likely to have participants trading these instruments who don’t know how to. The answer to this problem is a centralized exchange or clearing house that becomes the counterparty to all trades in the market. I think that would create a better marketplace and help monitor the market in general.
I hope this has helped to debunk some of the mistatements that seem to surface in the media. Hit me up with any comments.