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Understanding Credit-Default-Swaps

Understanding Credit-Default-Swaps

2010-03-16 07:06:00
Joel Kruger;Jonathan Granby,
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UNDERSTANDING CREDIT-DEFAULT-SWAPS

 

The EU is threatening to ban credit default swaps, lashing out at speculators who officials say made huge bets using these instruments  against the euro and the chances of Greece not being able to repay its debt.


But what exactly are credit default swaps  and why are European officials so concerned about them right now?


CDS are simply a form of insurance. They allow someone who is nervous about a default on a bond, issued by any country or company, to buy insurance. It is the same as people who are aware they may have a house fire or car accident some day and buy insurance so that the insurance covers the money you would have lost. If the borrower defaults, the credit default swap holder is paid by the seller of the protection. Credit default swaps are set up so the buyer makes regular premium payments and if the associated credit instrument (the country or company), suffers no credit event (a default) then the buyer continues paying premiums until the end of the contract and loses money. However, if the company defaults then the credit default swap seller pays the buyer for the loss and the buyer ceases to pay the premiums.


In other words, if a hedge fund thinks Risky Assets Inc. will soon default on its debt and therefore buys $10 million worth of CDS protection for two years from a bank, with Risky Assets Inc. as the reference entity (or associated credit instrument), at a spread of 500 (5%)  basis points per annum. In the first scenario; Risky Assets Inc does not default, then the credit default swap contract will run for two years, and then hedge fund will end up paying $1 million ($500,000 p.a. = 5% of $10 million) without any return. In the second scenario; whereby Risky Assets Inc. does default after a year, then the hedge fund will have paid $500,000 to the bank, but will receive $10 million (assuming the bank has the liquidity to cover the loss – something AIG did not have) and make a profit. The bank and its investors will make a $9.5 million loss, unless it has offset the position before default.


Credit default swaps have been around for about 15 years. Seven years ago less than $3 trillion of these contracts were outstanding; today that has topped $25 trillion, according to the International Swaps and Derivatives Association. There is little publicly available information about who is buying and selling the contracts, which generally are negotiated in private, off exchange deals. Thus it is hard for regulators and others to monitor who is on the hook for selling credit default swap contracts, and whether certain investors might be pressuring the contracts on a nations debt. The first modern credit default swaps were structured in 1997 by a team at JP Morgan Chase. They were designed to shift risk of default to a third party, which involved JPM selling the credit risk of Exxon to the European Bank of Reconstruction and Development.


The one key difference between credit default swaps and regular insurance is that you can buy swaps against bonds that you don’t own, unlike your neighbors house which you cant buy insurance against, this is called a naked credit default swap, or ‘naked swap’. These naked swaps have Eurozone officials concerned, with a lot more people buying insurance than there are actually bonds. In the case of Greece, all the bets against Greek bonds makes the country’s situation appear worse than it really is, creating fear. This in turn makes the credit default swap market more nervous about Greece, with more people buying insurance against the possibility for a  Greek default. This makes it even harder for Greece to raise money in the bond market, exacerbating the problem further. As financial problems have escalated for Greece and other euro-zone countries in recent months, the price of swaps insuring default by these nations have soared, and attracted more and more attention.


Despite the German financial regulator, BanFin, reporting that there is no evidence that speculation on Greek bonds has gotten out of hand, politicians around the world, in particular European officials, have jumped into action to curb naked swaps. Officials have lashed out at speculators and the ability of speculators to bet on  a Greek default.


In recent weeks, politicians and officials have ramped up their rhetoric, with some European leaders calling for a ban of purely speculative naked trading. Jose Manuel Barroso president of the European Commission, the EU’s executive arm, has said that the commission would examine closely the possibility of banning outright purely speculative trading of credit default swaps. German Chancellor Merkel was also out in support  of curbing the credit default swap market. The German government along with France, Greece and Luxembourg are backing the initiative to curtail these swaps. However, while it is widely agreed that European politicians and regulators could initiate a continent-wide ban on speculative trading of sovereign credit default swaps tomorrow, making it stick without United States support would be impossible.


European officials are hopeful of getting the US on board following a speech given by the US Commodity Futures Trading Commission Chairman Gary Gensler who criticised credit default swaps and offered recommendations to limit their use. But Mr. Gensler’s agency doesn’t have the authority to put his recommendations in place and would need to rely on Congress to pass such measures. Therefore, as things stand, despite European politicians making a lot of noise about credit default swaps, and naked swaps in particular, an outright ban looks unlikely. Chancellor Merkel has intimated that Europe would forge ahead even if the US didn’t go along, but any such ban would prove fleeting without unified support. 


There is, of course, another side to this story. This side argues that speculators are not the problem, and the problem is Greece itself. The country’s mismanaged public finances have resulted in a huge deficit and the risk of a default comes from Greece’s poor fiscal situation alone. The AIG blowup is referenced as a perfect example.


Though credit default swaps did have a role to play in the AIG debacle, these swaps were merely a financial instrument used to trade in reaction to a situation that was already unfolding. AIG sold a lot of credit default swaps and sold insurance on bonds, and when markets began to sour, AIG and regulators realized the company wouldn’t have the capital to pay all the claims that could come down the pipe. Therefore, arguably, it wasn’t the credit default swaps to blame, but rather the horrific risk management and negligence on behalf of AIG to set aside sufficient funds.


There are some who argue that credit default swaps have actually prevented the Greek tragedy from worsening. Without them investors would be less willing to buy Greek debt. Greece would likely need a bailout to run its government and service its huge debt, thereby threatening Europe’s economic rebound. Darrell Duffie, a finance professor at Stanford University, quoted by the AP, said “if we get to a point where we’ve had enough with credit default swaps, then I think Greece will have serious problems. With swaps, investors who lend to countries by buying their bonds can reduce their risk, without them Greece’s borrowing costs would escalate because lenders would want higher premiums”.


Analysts acknowledge that heavy buying of swaps can temporarily drive up a country’s borrowing costs, as reflected by a  soaring of credit default swaps last month to a record $420,000 to insure $10 million of Greek debt, up sharply from the $250,000 last year. Yet without credit default swaps, the country’s borrowing costs “would be even higher” said Brian Yelvington, head of fixed-income strategy at Knight Libertas. Mikhail Foux, a credit strategist at Citigroup in New York, said that without credit default swaps investors would be unable to hedge their bets on Greece’s debt, lenders would demand punishing premiums from Greece. Foux continues to say “as soon as you restrict the credit default swap market in even a small way it will be more expensive to borrow and more expensive to hedge”.


At the end of the day, credit default swaps have played a large role in shaping financial markets over the past few years, and it will be interesting to see how officials regulate these financial instruments in the years ahead. Overregulation could indeed have the undesired impact of making the situation even worse, while underegulation  could accelerate the pace of deterioration and fear, resulting in an equally undesirable result. Perhaps there is a resolution somewhere in between that will ultimately be best suited for the financial markets.

 

Written by Joel Kruger, Technical Currency Strategist for DailyFX.com
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