Uncover the CDS Myth
CDS stands for Credit Default Swap, which became the center of the discussion recently because of the Bear Stearns debacle. Wikipedia has a very good explanation:
A credit default swap (CDS) is an instrument to transfer the credit risk of fixed income products. Using technical terms, it is a bilateral contract, in which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. The buyer of a credit swap receives credit protection. The seller ‘guarantees’ the credit worthiness of the product. In more technical language, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement). Simply, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. For example, a mortgage bank, ABC may have its credit default swaps currently trading at 265 basis points (bp). In other words, the annual cost to insure 10 million euros of its debt would be 265,000 euros. If the same CDS had been trading at 7 bp a year before, it would indicate that markets now view ABC as facing a greater risk of default on its mortgage obligations.
Well said, that explains why the global CDS market shot up to $62 trillion when facing credit crunch, according to the article, “Clear the fog.” Wait, the number from Barron’s is not correct (see my last week’s post). It is NO LONGER a $41 trillion market! And, that was about $34.5 trillion a year ago, based on the article from Financial Times.
What does this mean? Again, wikipedia to the rescue, with the help of Buffett:
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.
The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $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. In addition to spreading risk, credit derivatives, in this case, also amplify it considerably.
That might explain why the Fed has to bail out Bear Stearns since it could easily trigger a financial tsunami across the whole world with a $13 trillion loss. Well, even a $1~2 trillion loss could do the trick.
