[OPE-L] credit default swaps: the other derivative problem

From: glevy@PRATT.EDU
Date: Thu Dec 13 2007 - 14:45:07 EST

---------------------------- Original Message ----------------------------

December 11, 2007

Nathan Lewis
By now everyone can recite how crummy mortgages got
packaged into asset-backed securities, and how, after the tastier tranches
were sliced off, the meat by-products got sent along to the CDO sausage
factory to be made palatable again. Now CDO investors are puking up all
over town.
But there has been another derivatives party going on,
where the bubbly is still flowing to a large extent. That, as many will
relate, is the explosion in credit default swaps (CDS) that has appeared
over just the past few years.
Structured finance has been around
since the 1980s, but the CDS market is essentially brand new. The CDS was
invented in the mid-1990s but it was minor until the last four years.
Since 2003, this market has exploded in size by 10x, to a total notional
amount of about $45 trillion. Yes, that's trillion with a "t".
This market has never been tested in any kind of economic downturn, not
even the most recent one of 2001-2002.
The credit-default swap is
insurance against a credit accident. The seller of CDS receives a small
monthly payment. If the insured bond fails to perform, the buyer of CDS
receives a large one-time payment from the seller. At first, in the
1998-2002 period, this was mostly a way for holders of bonds to insure
themselves. However, in recent years, the CDS market has become a way for
CDS buyers to wager on credit deterioration, and a way for CDS sellers to
act like banks.
Banks are a wonderful business, when everything is
working right. They have returns on equity that can range from 15% to as
much as 25%. These are the kinds of returns that get hedge funds, and
their investors, interested. However, it is difficult to enter the banking
business. You need offices, branches, depositors, employees, advertising,
and so forth.
Banks traditionally profit on the interest rate
difference, or "spread", between the money they borrow, from
depositors for example, and the money they lend, to corporations for
example. They may lever up ten to one, supporting $100 billion of assets
on $10 billion of equity. Thus, if their spread is 2%, and they are
levered 10:1, their return on equity is a juicy 20% (actually more like
24% because of the return on the underlying capital).
contract allowed hedge funds to act like banks. The monthly premium on the
CDS is a spread between the equivalent Treasury yield and the implied
yield on the underlying bond. This can be considered payment for the risk
of default, which the Treasury bond presumably does not have. Imagine
you're a fund with $1 billion in capital. You could try to borrow $9
billion - from whom? - and then buy $10 billion in bonds, and enjoy the
spread, like a bank. However, that $9 billion would probably have a higher
interest rate than a Treasury bond, because the fund also has risk. And,
the maturity of the borrowed money would likely be very short, while the
bond has a long maturity, introducing duration risk (this didn't seem to
scare the SIVs however).
The CDS solves these problems. You just
sell CDS on $10 billion of bonds. This doesn't cost any money. You don't
have to put up any collateral. You don't have to hire a single bank teller
or loan officer. You just call your broker, put in the order, and start
getting your monthly payments, just as if you had borrowed $9 billion (at
the same rate as the Federal government) and lent $10 billion.
the fund manager who made this one single phone call? If we assume a 20%
return, and $1 billion of capital, he collects about $60 million per year.
Which explains the explosive growth of the CDS market in the last four
Ah, there's something. You "call your broker."
Actually, you call your dealer. It's not so easy to just find a buyer for
your $10 billion notional of CDS. This is an over-the-counter market. This
is where the big broker-dealers, like JP Morgan, Bank of America, and
Citibank step in. Over-the-counter markets are lovely for dealers because
of the fat spreads - there's that magic word again that pricks up bankers'
ears - between bid and asked in this market. So, what happens is you sell
the CDS to your dealer, such as JP Morgan? JP Morgan then sells CDS - of
its own issuance - to its customers that want to buy CDS.
So, you
see that JP Morgan now sits in the middle, like a banker should. JP Morgan
is "long" the CDS you sold to them, and also "short"
the CDS it sold to someone else, and is thus theoretically hedged from
risk while collecting the spread between the prices it bought and sold at.
This is a lot like bankers' traditional business of pocketing the spread
between the rate it borrows and the rate it lends.
So, it should be
no surprise that the big broker/dealer banks (JP, BofA, Citi) account for
40% of the CDS outstanding. Hedge funds account for 32%. This reflects
banks' monkey-in-the-middle dealer strategy for CDS. The remainder is
likely insurance companies, synthetic CDOs, CPDOs, and other weird fauna
that will soon become extinct. (Thanks go to Ted Seides of
ProtÈgÈ Partners for aggregating this information.)
Now, that 32% of CDS sold by hedge funds has a notional value of $14.5
trillion. This means that, if all those bonds underlying the CDS were a
total loss, the funds would have to pay $14.5 trillion. Not very likely.
However, if there were only a 5% loss - not so impossible these days - the
CDS-selling hedge funds would still be on the hook for $725 billion. Hedge
funds, all together, have estimated assets of around $2.5 trillion.
However, only a small fraction of those are CDS-sellers. Let's take a
guess at 10%, or $250 billion of capital. (It's probably less than that.)
How do you pay a $725 billion bill with $250 billion of capital?
There's an easy answer to that: you don't. So, who pays? The banks,
remember, are in the middle. If the CDS-selling hedge fund doesn't pay up
on its $725 billion, then the bank is unhedged regarding the CDS that it
sold. In this case, the banks would be liable for $475 billion. This is
known as counterparty risk.
That's four-seventy-five billion. More
than four times the entire capital of Citigroup - capital which has
already come under pressure from losses elsewhere.
So, what happens
if there is a CDS counterparty-risk event? Do the big banks go bankrupt?
Probably not, although there would be much wailing and gnashing of teeth.
Instead, they would probably get a nod and a wink from the government to
simply ignore their own CDS obligations. The counterparty risk shifts to
The CDS buyers can take the hit, because they aren't
really out any money. They paid their monthly insurance bills, but never
got a payout after the credit market car crash. So, in a sense, this drama
would likely end in more of a whimper than a bang. In fact, everyone got
off OK: the CDS-selling hedge fund manager made a killing in management
fees, before the fund went bust; the bank made a killing in dealer income,
before kissing their obligations goodbye, and the CDS-buying hedge fund
manager raked in the fees on the enormous mark-to-market profits of his
CDS portfolio (20% of the aforementioned $725 billion), before these
profits were eventually shown to be uncollectible. A perfect Wall Street
happy ending.
However, the kind of situation in which large banks
ignore multi-hundred billions of legal obligations is very extreme. The
last time something like that happened was in the early 1930s. At that
time, they called it a "bank holiday," which has a nice festive
ring. The celebration included a devaluation of the dollar, the first
permanent devaluation in U.S. history. At least president Roosevelt had
the good sense to repeg the dollar to gold at $35/ounce, parity it
maintained until 1971. Feel free to make your own guesses as to what
Paulson and Bernanke might try.
Nathan Lewis
for The Daily Reckoning
Editor's Note: Nathan Lewis was formerly
the Chief International Economist of a firm that provides investment
advice to institutional investors. Today, he is part of the investing team
at an asset-management company. He has written for the Financial Times ,
Asian Wall Street Journal , Daily Yomiuri , Japan Times , Pravda , Dow
Jones Newswires , and other publications. He has appeared on financial
programs in the United States, Asia, and the Middle East.
Lewis is the author of Gold: the Once and Future Money , published by
Agora Publishing and J. Wiley.

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