The value of a credit default swap

We’re all familiar with the sub-prime mortgage disaster and the way dodgy debt was sliced, diced and packaged up with various other grades of debt to generate an attractive yield with (so it was claimed) very little risk. We’ve also begun to realise that individual parcels of dodgy debt could be leveraged four or five times so that if it defaulted, the total debt would rocket. That’s why we’re now in the midst of a bail-out worth hundreds of billions of dollars.

What we are now also becoming increasingly acquainted with is the jocular side bets placed with virtually every tranche of sub-prime debt sold. Known as credit default swaps (CDS), these have become the new ghost at the feast, waiting to put an extra chill down the spine of the global economy. But who’s in charge?

Off the scale
As Securities and Exchange Commission chairman Christopher Cox observed in a recent article in the New York Times, CDSs are entirely unregulated and constitute, he says, a $55 trillion market which is “more than the gross national product of all the world’s nations combined”. Actually, no one really knows the exact scale of the CDS market to within even $5 trillion to $10 trillion. It is estimated variously as being somewhere in the range of $50 trillion to $63 trillion ­ maybe more. Either way, that range of estimates prompts the worrying thought that we don’t even know if upwards of $13 trillion of unregulated assets even exist.

There are reasons for the confusion. First, there is no central clearing house for CDS trades so since they are strictly bi-lateral trades, done between two parties in private, there is no definitive final source to go to. Credit ratings agency Moody’s is a frequently cited data source and it puts the notional value of outstanding CDS contracts at $62.6 trillion.

Second, CDSs might have started out as a private insurance contract between two parties (you pay a premium in return for a particular debt being guaranteed against default), but in an unregulated market they have turned into a game any institution can play.

The shakier a debtor’s finances and the nearer they come to defaulting on their debt, the more valuable the guarantee of that debt becomes. So a CDS contract turns into a way of speculating on default and the worse the economy gets, the greater the likelihood of default and the more value accrues to a freely-traded CDS.

Moreover, just as bookies might lay off a large bet on several other bookies, providers of CDS ‘insurance’ will lay off the bet to other institutions in a game of pass-the-parcel. It, too, gets sliced and diced and passed around and so trying to fathom the counterparty risk once this little caper has run its course would send any regulator to an early grave.

What happened with the sub-prime sales game is that the institutions who devised the asset-backed securities sales, sweetened the deal by offering CDSs on these parcels of debt to buyers. So the bankers buying these tasty morsels thought they were getting a solid income stream along with a cast-iron guarantee.

However, the beauty of the CDS game lies in the ‘S’ for ‘swaps’. If they had been called CDIs ­ ‘I’ for ‘insurance’ ­ which they arguably should have been, then they would have fallen under insurance industry rules and the institutions offering them would have had to pass capital adequacy tests on each additional contract they wrote. By substituting the ‘S’ word for the ‘I’ word, the institutions side-stepped the regulatory framework.

No end in sight
When these CDSs came home to roost as a portion of the US sub-prime mortgage paper went sour, the institutions involved did not have the cash reserves to meet them and the rest, as they say, is history ­ except that this ball hasn’t stopped bouncing yet and no one knows where it will end. Not even the Chinese have enough US dollars to buy sufficient Treasury bills to fund a US bailout on the multi-trillion dollar scale.

Moreover, as the class action law suits to come will demonstrate, CDSs raise some challenging disclosure issues even as the law and accounting regulations now stand. David Loweth, technical director at the Accounting Standards Board, points out that IAS 1 (to get back to bedrock) requires the disclosure of the substance of transactions, irrespective of whether they result in assets or liabilities being recognised, so as to enable the user of accounts to understand the commercial risks involved.

So while the spotlight starts to shine on the darkest corners of the CDS market, we can but lament the fact that all that we know now hadn’t been brought out in broad daylight ages ago.