Friday, Jan 18, 2008
Feb 21 2007 Reminder
HPC Blog: Flashback: The CDS that broke the Camel's Back
http://www.atimes.com/atimes/Global_Economy/JA15Dj01.html
The financial system fell under intense stress on Wednesday. The epicenter of the crisis was in the credit default swap, or CDS, market, and contagion fears were building quite a head of steam. The pricing for Countrywide Financial default protection (five-year CDS) surged a huge 469 basis points (bps)to a record 1,610 bps (it would cost US$16,100 annually for five years to insure $100,000 of Countrywide debt against default).
Countrywide:Today 1610, (01/2007) 30
Rescap: Today 3,746, 01/2007 - 95
MBIA : Today 849, (01/2007) - 87
Ambac: Today 841, (01/2007) - 70
Washington 611, (01/2007) - 54
Posted by lvmreader @ 08:34 PM (723 views) Add Comment
7 Comments
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1. lvmreader said...
What Are Credit Default Swaps and How Do They Work?
A credit default swap (CDS) is the most highly utilized type of credit derivative. In its most basic terms, a credit default swap is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, corporate bond investors buy credit default swaps for protection against a default by the issuer of the corporate bond, but these flexible instruments can be used in many ways to customize exposure to corporate credit.
CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, such as a downgrade, from one investor to another.
In a CDS, one party "sells" risk and the counterparty "buys" that risk. The "seller" of credit risk-who also tends to own the underlying credit asset-pays a periodic fee to the risk "buyer." In return, the risk "buyer" agrees to pay the "seller" a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, bankruptcies and credit rating downgrades (For a more detailed list of CDS credit events see the Commonly Established CDS Credit Events table below).
The following graphic illustrates the credit default swap transaction between the risk "seller," who is also the protection "buyer," and the risk "buyer," who is also the protection "seller."
Source: Credit Derivatives and Synthetic Structures, John Wiley & Sons. 2001.
Characteristics of Credit Default Swaps
The credit default swap market is generally divided into three sectors: corporates, bank credits and emerging market sovereigns. CDS can reference a single credit or multiple credits. Multi-credit CDS can reference a custom portfolio of credits agreed upon by the buyer and seller, or a CDS index. The credits referenced in a CDS are known as "reference entities." CDS range in maturity from one to 10 years although the five-year CDS is the most frequently traded.
Unlike total return swaps that provide protection against the loss of credit value irrespective of the cause, credit default swaps provide protection only against previously agreed upon credit events. Below are the most common credit events that trigger a payment from the risk "buyer" to the risk "seller" in a CDS.
The settlement terms of a CDS are determined when the CDS contract is written. The most common type of CDS involves exchanging bonds for their par value, although the settlement can also be in the form of a cash payment equal to the difference between the bonds’ market value and par value.
How Has the Credit Default Swaps Market Evolved?
The CDS market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital. As the credit default swaps market became more standardized and gained credibility, particularly following smooth credit event settlements in high profile cases such as WorldCom and Enron, more investors entered the market. While banks-through broker-dealers and reinsurance companies-are still both the largest buyers and sellers of credit default swaps, investment management firms are following closely.
Today, CDS have become the engine that drives the credit derivatives market. According to the British Bankers’ Association, the credit default swaps market currently represents over one-half of the global credit derivative market. The growth of the CDS market is due largely to CDS’ flexibility as an active portfolio management tool with the ability to customize exposure to corporate credit. In addition to hedging event risk, the potential benefits of CDS include:
The performance of credit default swaps, like that of corporate bonds, is closely related to changes in credit spreads. This sensitivity makes them an effective hedging tool that can assume exposure to changes in credit spreads as well as default risk. Credit default swaps also have given rise to new arbitrage opportunities, particularly in global markets that do not have the transparency or efficiency of the U.S. credit markets.
Conclusion
The event risk embedded in bonds and other credit assets was very difficult to reduce prior to the evolution of credit default swaps. In the brief decade since their inception, credit default swaps have become not only a tool that effectively hedges event risk but also a flexible portfolio management tool that far exceeds that single benefit.
2. little professor said...
Well done lvmreader :)
3. lvmreader said...
You can take credit positions where you are paid e.g. $1 for every bps a CDS moves in a certain direction.
Last year, it may have only cost a tiny amount. This year it costs 100s of times more.
CDS is a better trade than any housing ever could be.
4. Icarus said...
Read the 'Criticisms' section in the Wikipedia article on Credit Default Swaps. Three things stand out. The first is that the major banks which originate syndicated loans or underwrite stocks and bonds of companies (and therefore have insider knowledge of those companies) are the same banks which issue derivatives, particularly credit swaps against the credit of those companies. This is insider trading on a mega scale. The second is that CDSs artificially inflate stock markets because investors don't have to sell failing companies since they can hold on to their shares and buy insurance instead (i.e. derivatives, swaps) and because failing companies can be identified early and removed from the index, thus supporting the indices (Dow Jones, S&P 500). The third is that this artificial inflation and window dressing makes risky things look fairly risk-free and encourages dodgy loans and uncontrollable bubbles. But don't worry, Fionnuala et al. say the fundamentals are sound.
5. lvmreader said...
@little professor
You are welcome. If only this was taught in schools.
6. lvmreader said...
The Good News and the Bad News about Synthetic CDOs
Evil Pension Fund Manager (EPFM but written EPMF): [Brooklyn Accent] Mr Schmo, about your pension I have some bad news and some good news.
Joe Schmo (JS): [Looking worried] Well what's the good news?
EPMF: Well it's like this. We had a little bit of a problem. We lost all your pension money. It's gone. That's it. And there's nothing anyone can do.
JS: Eh! WTF! And you say that's they good news. How the f**k is that good news?
EPMF: Well we still got our 10% cut.
JS: [Ashen faced] Well what's the bad news?
EPMF: We need your house. Well actually it now belongs to (rustling papers) The Government of Kyrgyzstan
JS: [Now angry] But I paid off that house with 40 years of lowly paid productive labour. I have never even HEARD of Kyrgyzstan, let alone invested there.
EPMF: Well it's like this: There is a group of products called CDOs which involve slicing and dicing loans. We invested in Synthetic CDOs and it turns out that MBIA and AMBAC got downgraded and now we have no insurance. So the buyers of the slices of the CDO are now on the hook for 7 times the amount they invested. So that means you and your house..... Hey! Mr Schmo!, what you doing?!....AAAAAAAARGH
JS: [Sound of chainsaw starting] I'll show you some slicing..........................
7. Chud said...
I have just read an article about CDS for UK Banks and their use in gauging the risk of their bank accounts. I need to open several Bank Current Accounts and need to find a list of UK Bank CDS to assist me in comparing the various banks. Where do I find this information?