Credit Default Swaps - the next wave in the credit crisis?
What is a credit default swap?
A credit default swap (CDS) is a form of credit derivative and is comparable to an insurance contract in that it is an agreement to transfer risk. In a very simple CDS one party (the Buyer) will purchase protection against the credit risk of a third party (e.g. a corporate, X plc) from the other party (the Seller). The Buyer will periodically make a fixed premium payment to the Seller. In return the Seller agrees to make a payment to the Buyer in the event of a ‘credit event’ (these will be agreed in advance and might include events such as bankruptcy or restructuring of X plc). Most of the CDS which are under the current media glare are part of complex investment strategies of debt portfolios.
How has the CDS market developed?
When the market first developed, the parties to the CDS contracts usually owned loans or bonds issued by the third party. Gradually, however, hedge funds, investment banks and other parties became involved in the CDS market on a speculative basis – that is sellers and buyers of CDS no longer held the bonds or loans of the third party and were therefore not hedging a credit risk but instead were betting on the possibility of a credit event.
At the same time CDS were issued for a wider range of third party entities, especially complex structured debt products such as Collateralised Debt Obligations (CDOs).
By the end of 2007 the CDS market had a value of approximately $45 trillion and the theoretical market value is estimated already to have risen as high as $62 trillion to date. The growth of speculative CDS transactions means that the value of this market greatly exceeds the value of the underlying bonds and structured debt products on which it based.
How is the insurance industry affected?
In recent years a number of major insurers, insurance companies, including the monoline insurers, have become heavily involved in the CDS market. In common with other market participants insurers did not just write CDS contracts on corporate entities but also on CDOs and other structured debt products.
As has been widely reported, many of these CDOs contained pools of ‘sub-prime’ mortgages and in many cases the value of these has been reduced dramatically leaving investors in the CDOs facing huge losses. This in turn means that those parties who sold credit protection on these CDOs are facing huge exposures.
What will happen next?
Steps are already being taken to contain and manage CDS exposure.
In the case of monoline bond insurers, the US regulatory authorities have been intervening to urge them to unwind some CDS contracts. In July, Merrill Lynch agreed to unwind $3.7 billion of credit insurance it had bought to cover defaults on CDOs. A number of insurers have paid significant sums to close out their credit insurance exposures; for instance Ambac Financial paid $850 million to Citigroup in order to cancel its cover for a $1.4 billion CDO. It is likely that similar deals will continue to be agreed between insurers and the parties with whom they have entered into CDS contracts, both in the US and elsewhere.
We have already seen litigation challenging the interpretation and effect of the contracts underpinning Credit Default Swaps and greater regulation of the Credit Default Swap market seems inevitable. Already the Governor of New York has announced that from January New York State will regulate part of the CDS market. This means that CDSs are to be characterised as insurance (and therefore subject to greater regulation) if the credit protection buyer owns the underlying bond (even these types of CDS have not previously been treated by regulators as falling within their definitions of insurance contracts). It is not yet clear how this would work in practice, if at all. The Governor also called on the federal government to regulate the rest of the estimated $62 trillion CDS market. Given the events of recent months, further regulatory initiatives seem likely to follow.
There is a palpable fear that all of this may be too little, too late. As each new financial institution collapses or is taken into government ownership, an unknown number of CDSs, of unknown amounts, issued by unknown parties, are triggered and send new waves through the financial markets. Consider, for example, the Lehman Brothers bankruptcy, involving debts in excess of $600 billion. Allowing it to fail was described as a huge risk – precisely because of the uncertain consequences for the CDS market. In reaction, in his recent statement before the US Senate, the CEO of the International Swaps and Derivatives Association was at pains to point out that CDSs have continued to perform well in the wake of the Lehman’s collapse and other major recent credit defaults, with orderly settlements according to the established rules and procedures. He expressed his concern that the role and effects of CDSs are widely misunderstood. In particular, there is a great difference between the notional values of CDSs reported in the media, and their actual net settlement value. For example, despite the huge debts involved, the Depository Trust and Clearing Corporation has recently estimated that the net value of funds transferred in connection with the Lehmans CDS settlement will be in the region of $6 billion.
Watch this space.
