Credit Default Swaps: From Protection To Speculation
September 1, 2008
Published in the September 2008 issue of Pratt's Journal of Bankruptcy Law. Copyright ALEXeSOLUTIONS, INC.
Credit default swaps (CDS) are a segment of the credit derivative market, which includes other derivative products such as interest rate swaps and foreign exchange swaps. The credit derivative market, including CDS, is an unregulated market. CDS have become the largest component of the credit derivative market as CDS have moved from a form of protection to speculation.
Credit Default Swaps (CDS) are a private contract between two parties in which the buyer of protection agrees to pay premiums to a seller of protection over a set period of time, the most common period being five years. In return, the seller of protection agrees to pay the buyer an amount of loss created by a "credit event" related to an underlying credit asset (loan or bond) - the most common events are bankruptcy, restructuring or default. Each individual contract lays out the specific terms of their agreement including identifying the underlying asset (loan or bond) and what constitutes a credit event.
The following diagram illustrates how CDS were originally designed to function:
|Protection Buyer||Protection Seller|
|Tends to own underlying credit assets||Does not usually own underlying credit asset|
|Purchasing credit protection||Selling credit protection|
|Short-selling credit exposure||Long credit exposure|
Even though CDS appear to be similar to insurance, it is not a form of insurance. Rather it is an investment (more akin to an option) that "bets" on whether a "credit event" will or will not occur. CDS do not have the same form of underwriting and actuarial analysis as a typical insurance product rather is based on an analysis of the financial strength of the entity issuing the underlying credit asset (loan or bond). There are no regulatory capital requirements for the seller of protection (such as exists with insurance companies and banks).
CDS are not regulated and are "sold" through "brokered" arrangements. Initially, commercial banks were the "broker" that put together the two sides of the CDS contract. However, investment banks became very involved in "brokering" the CDS contracts for corporate bonds, municipal bonds and, later, structured investment vehicles.
Credit Default Swaps (CDS) were originally created in the mid-1990s as a means to transfer credit exposure for commercial loans and to free up regulatory capital in commercial banks. By entering into CDS, a commercial bank shifted the risk of default to a third-party and this shifted risk did not count against their regulatory capital requirements.
In the late 1990s, CDS were starting to be sold for corporate bonds and municipal bonds. By 2000, the CDS market was approximately $900 billion and was viewed as, and working in, a reliable manner, including, for example, CDS payments related to some of the Enron and Worldcom bonds. There were a limited number of parties to the early CDS transactions, so the parties were well-acquainted with each other and understood the terms of the CDS product. In most cases, the buyer of the protection also held the underlying credit asset (loan or bond).
However, in the early 2000s, the CDS market changed in three substantive manners:
- Numerous new parties became involved in the CDS market through the development of a secondary market for both the sellers of protection and the buyers of protection. Therefore, it became difficult to determine the financial strength of the sellers of protection
- CDS were starting to be issued for Structured Investment Vehicles, for example, ABS, MBS, CDO and SIVs. These investments no longer had a known entity to follow to determine the strength of a particular loan or bond (as in the case of commercial loans, corporate bonds or municipal bonds.); and
- Speculation became rampant in the market such that sellers and buyer of CDS were no longer owners of the underlying asset (bond or loan), but were just "betting" on the possibility of a credit event of a specific asset.
The result was that by the end of 2007, the CDS market had a notional value of $45 trillion, but the corporate bond, municipal bond, and structured investment vehicles market totaled less than $25 trillion. Therefore, a minimum of $20 trillion were speculative "bets" on the possibility of a credit event of a specific credit asset not owned by either party to the CDS contract.
Another result was that the original two parties that entered into the CDS contract may very well not be the current holders of the rights of the protection buyer and protection seller. Some CDS contracts are believed to have been passed through 10-12 different parties. The financial strength of all the multiple parties may not be known. Therefore, it has become very difficult to determine, or "unwind," the parties of the CDS in the event of a "credit event."
Finally, a "credit event" that triggers the initial CDS payment may not trigger a downstream payment. For example, AON entered into a CDS as the seller of protection. AON resold its interest to another company. The bond at issue defaulted and AON paid the $10 million due to the default. AON then sought to recover the $10 million from the downstream buyer, but was unsuccessful in litigation - so AON was stuck with the $10 million loss even though they had sold the protection to another party. The legal problem was that the downstream contract to resell the protection did not exactly match the terms of the original CDS contract.
Sub-Prime Mortgages and other Asset-Backed Problems
The problems in the subprime mortgage area which started in the summer of 2007 exposed the problems in the CDS market. As the subprime mortgage and their related CDOs started to have valuation problems, and ultimate defaults, the sellers of protection in the CDS market started to realize that the CDS tied to collateralized subprime mortgages and other CDO-type securities were going to require substantial payments.
For example, Swiss Reinsurance entered into two CDS as the seller of protection for two CDOs totaling $1.5 billion that contained collateralized subprime mortgages and other collateralized assets. The CDO's "credit event" was triggered due to reduced values of the CDO's underlying mortgages. In October 2007, Swiss Re wrote down the value of the CDS a total of $1.1 billion based on the reduced values of the two CDOs (and the subsequent payment required to cover those losses). In April 2008, Swiss Re took another $240 million write-down for continued reduced value in the two CDOs.
Insurance Company Risks
Insurance company may be exposed as both buyers of protection and sellers of protection in the CDS market. Many insurance companies have entered into CDS as buyers of protection as a hedge against the potential decline in their vast bond holdings, including holdings of ABS, MBS and CDO. The risk to the insurance companies on the buyer side is that the counterparty (seller of protection) will not have sufficient assets to pay if a "credit event" occurs. This is commonly referred to as counterparty liquidity risk. If the counterparty does not have the ability to pay, the insurance company realizes a loss on the bond holding and loses its premiums that it paid for the protection.
The bigger problem most likely occurs when the insurance company is the seller of protection as Swiss Re was in the earlier example. Insurance companies often enter into the CDS as a seller of protection since the CDS pays a stream of premiums that is a consistent source of investment income for the company. Premiums are generally 3%-5% of the value of the underlying asset and are paid on a quarterly basis. However, the risk of payment unknowingly increased when the CDS were related to securities such as CDOs, ABS and MBS which are fraught with structural problems, but were offered as secure investments. In this scenario, the insurance company may have to pay large amounts to the buyer of protection, which dwarfs the stream of premiums received.
The value of a CDS is based on computer modeling of cash flows including the stream of premium payments less projected pay-outs due to anticipated events of default in the underlying debt or, at least, the risk of payment for such events of default. As the stream of premiums is often set by the contract terms, the volatility of values in CDS is primarily due to changes in the risk of projected pay-outs due to events of default. For example, AIG wrote-down the value of its CDS portfolio by $20 billion during the past two quarters. AIG sold credit default swaps to holders of CDOs guaranteeing payments in the event of default in the underlying debt, which were pools of subprime mortgages. In simple terms, as the risk of higher subprime mortgage defaults increased in the CDOs, the credit default swap values decreased due to the risk of anticipated higher pay-outs by the CDS seller (in this example, AIG) to cover the increased events of default.
Speculation Enters the Market
Speculation entered the CDS market in three forms: 1) using structured investment vehicles such as MBS, ABS, CDO and SIV securities as the underlying asset, 2) creating CDS between parties without any connection to the underlying asset, and 3) development of a secondary market for CDS.
Much has been written about the structured investment vehicle market and the lack of understanding of what was included in the various products. Sellers of protection in the CDS market more than likely did not have sufficient understating of the underlying asset to determine an appropriate risk profile (plus there was no history of these products to assist in determining a risk profile). As it has become clear, the structured investment vehicle market was a speculative market which was not really understood, which led to speculative CDS related to these products.
A larger problem is the pure speculation in the CDS market. Many hedge funds and investment companies started to write CDS contracts without owning the underlying security, but were just a "bet" on whether a "credit event" would occur. These CDS contracts created a way to "short" sell the bond market, or to make money on the decline in the value of bonds. Many hedge funds and other investment companies often place "bets" on the price movement of commodities, interest rates, and many other items, and now had a vehicle to "short" the credit markets.
A still larger problem was the development of a secondary market for both legs of the CDS product, particularly the seller of protection. The problem may be like the AON example above. The problem may be that a "weak link" would occur in the chain of sales even if the CDS terms are the same. The "weak link" is often a speculative buyer that offers to sell protection, but, in fact, is just looking to quickly turn the product to another investor. This problem becomes particularly acute when the CDS is based on structured investment vehicles and firms looking for a quick profit.
An insurance company may unknowingly be pulled into one of these speculative aspects of the CDS market. The insurance company would be viewed as "the deep pocket" and may be asked (or sued) to recover losses by the buyer of protection.
CDS are sold as individual contracts and appear not to be subject to securities laws (further legal research in this area is warranted). There is no regulatory body that governs the buying and selling of CDS. The International Swaps and Derivatives Association (ISDA) does provide recommended CDS documentation guidelines, but the ISDA is not a regulatory body that issues regulations which are enforceable.
Causes of action in the CDS market are most likely tied to the underlying CDS contract(s) in place, in both the original market and the secondary markets, related to the underlying asset that suffered a "credit event." Further, CDS as an industry is in its infancy, especially, regarding the structured investment vehicles and the speculative products and, as such, the litigation history is limited to date and is still being developed.
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