Credit Default Swaps- the case for regulation

Understanding Credit default Swaps: the case for regulation

Imagine a market where you can trade your perception of someone else’s credit worthiness. Imagine a market where you can encash an insurance policy on an asset gone bad without owning the underlying asset itself. Imagine a market which is larger than the capitalization of New York Stock Exchange and is yet not regulated. Welcome to the world of Credit Default Swaps (CDS).

The Instrument: The Credit Default Swap market is massive, estimated to be in excess of $50 trillion. CDS are derivatives, ie financial contracts without the underpinnings of any actual assets. They are used to bet on the credit worthiness of a loan or debt instrument. The price of the swap moves in line with perception of the borrower’s credit worthiness. A swap seller believes that the borrower’s ability to repay the underlying loan will improve while a swap buyer seeks protection against the possibility of a loan or bond failing. Almost all players in the financial markets are involved in trading CDS be they banks, hedge funds, Insurance companies, mutual funds or pension funds. It is estimated that over 30% of the volumes of CDS markets would be on account of hedge funds. CDS were initially devised as a means of hedging loan default risk by banks in USA. Since then they have grown to cover bonds, corporate loans, CDOs (collateralized debt obligations), auto loans, junk bonds, credit card delinquencies and all sorts of debt securities. CDS can be structured on individual company debt or can be based on baskets of mix of securities or baskets of similar securities with varying risk profiles.

It is this very flexibility that makes CDS fascinating. The fact that it can be structured as per the requirements of the buyer and the seller and can be customized to cover the risk and offer protection being sought by the buyer makes CDS a prudent risk management tool.

Driven by global liquidity: However, with the massive amounts of liquidity injected into the system by the then Fed Chairman, Alan Greenspan, the advent of 2003 saw a significant decline in defaults on instruments of all sorts. The premium earned by hedge funds, who were a significant seller of CDS instruments, became a near riskless and lucrative source of profits in view of negligible defaults.

Sub-Prime assets: Very soon the path of CDS intersected with a reckless mortgage industry in the USA which was busy fuelling the upward spiraling home prices in the USA by bringing in home buyers with dubious credit history through innovative home loan instruments which created the optical illusion of highly priced homes being affordable to many. Borrowers with dubious credit histories and poor balance sheets got home loans creating the much maligned sub-prime category of loans. Then the ingenuity of human hubris took over and led to the creation of an out of control and spiraling circle of greed which now threatens the very banking system which created it.

Transfer of Risk: In the good old banking days, the home loans a bank made remained on its books and the bank earned a profit on the spread between its cost of funds and the return it got from the borrower. The bank had a vested interest in lending to a credit worthy borrower and vigorously following up with a borrower if he or she showed signs of falling behind in his monthly payments. The CDS market enabled the bank or the lender to transfer the risk of loan default on to a third party which often traded it out further. The CDS seller got a premium while the lender having effectively insured the loan against default risk traded the asset out. They buyer of the loan asset was smug in the belief that while he generated a higher than market return, he was covered for the downside of the borrower defaulting on the loan. If the risk of a borrower defaulting was being transferred out to somebody else, the lender had limited interest in evaluating credit worthiness and following up for timely payment. No one bothered to check whether the counterpart insuring the loan (the CDS seller) had adequate capital to back up his potential liabilities or the amount of gross CDS issued by them. This set the stage for massive defaults when the US housing market started collapsing. CDS were getting called in to be honored and the stage was set for collapse of the insurers who could not meet their liabilities.

Role of rating agencies: While all this was happening it was the rating agencies which in my opinion played one of the most critical roles in exacerbating the crisis. The rating agencies did not somehow see the risk in the real estate markets or did not downgrade the pool of toxic securities in time (or were the risks ignored in the chase of profits: that is a separate topic in itself) or did not see the huge quantum of contingent liabilities being underwritten by their investment grade clients. The net result was that banks all over the globe rushed in to capture the high yields being offered by CDO’s riding on the investment grade ratings. From an investor’s perspective, they were buying into graded securities offering high yields and capturing the spread between their cost of funds and the yield.

Enhancing Risk: The returns could be enhanced by using easily available leverage and the adventurous could further boost their return through effective use of carry trade (borrow in a lost cost currency to buy assets in another high yield currency). To put it in perspective, the underlying risk in assets was being multiplied by exchange risk and leverage risk though theoretically, the risks could be contained through forward contracts and swaps. However, friends in the industry aver that this was a fairly inefficient market where CDS trades were done in a non standardized format and settlements took a long time to close, exposing the participants to significant risks. This was a time bomb in the making.

Absence of Regulation: One of the biggest lacunas of the CDS was the absence of regulation. This enabled literally anyone to participate in the CDS market. There were no capital adequacy requirements which would have acted as brakes on profligate writers of CDS protection. There was an absence of a mechanism which shed light on the total exposure or contingent liability of the firms offering protection against default risks. The pricing in the CDS market was not regulated and quotes were not that easily available to players other than the market participants. Settlements in CDS trades were not following any established pattern approved by the regulators and unsettled trades abounded. When the markets started unraveling, there was a wild rush to the exits and price plummeted. Mark to market regulations ensured that banks had to provision for the fall in the value of the securities. With the Capital cover for the banks getting blown up, the stage was set for the de facto nationalization of banks all over the globe. AIG bailout, Lehman collapse, Bear Stearns blowout, Iceland collapse and governments stepping in guarantee deposits to prevent a global crisis of confidence in banking are symptoms of a severe crisis.

Need for strong regulatory bodies: Bailout packages have ensured that governments all over the globe will end up owning significant chunks in their banks. Hopefully, this will lead to better regulation and a clear set of rules governing the markets. It has been amply proven that in today’s electronic age where massive capital flows happen at the press of the button, all markets are interrelated. The need for strong regulatory bodies with participation from the government, the industry and independent experts has never been more acute. Such regulatory bodies will ensure a systematic growth, better risk management and will hopefully prevent sudden collapses with disastrous consequences.

Atim Kabra (October 22, 2008)

The author runs two private equity funds and can be reached at hiatta5@yahoo.com