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.