Dramatic news: CDS still not 100% evil

There is a somewhat alarmist article by Satayjit Das in the FT currently concerning CDS. Das apparently used to be a practitioner so he does not have the excuse of being a journalist. Let's see what he has to say:

May 2006, Alan Greenspan, the former Federal Reserve chairman, noted: “The credit default swap is probably the most important instrument in finance. … What CDS did is lay-off all the risk of highly leveraged institutions – and that’s what banks are, highly leveraged – on stable American and international institutions.”

The reality may prove different.

Fair enough so far: 'all of the risk' was bound to be an incendiary phrase.

The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who for a fee indemnifies the protection buyer against credit losses. Current debate has focused on the size of the market. But the key problem is that a combination of documentation and counterparty risks means that the market may not function as participants and regulators hope if actual defaults occur.

Hoping is not a robust way of managing risk. Documenting the trade that you intended (rather than an entirely different one) is usually a better defence. Just as you should always read the prospectus before buying a security, so you should also understand the documentation of a derivative in detail before assessing the extent to which it hedges your risk. This is hardly new, or difficult.

CDS documentation, which is highly standardised, generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are also technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, for example, the volume of CDS outstanding was $28bn against $5.2bn of bonds and loans. On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

A CDS is a derivative. Its price is derived from the underlying. The clue is in the name. And yes, like many derivatives, there can be a squeeze on the underlying. This happens in commodity derivatives in particular, yet Das does not suggest that these are imperfect hedges as a result (remember the Hunt Brothers and silver). Why pick on CDS?

Shortage of deliverable items and practical restrictions on settling CDS contracts have forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement (based on the market price of defaulted bonds) for physical delivery. In Delphi, the protocol resulted in a settlement price of 63.38 per cent (the market estimate of recovery by the lender). The protection buyer received 36.62 per cent (100 per cent - 63.38 per cent) or $3.662m per $10m CDS contract. Fitch Ratings assigned a recovery rating to Delphi’s senior unsecured obligation equating to a 0-10 per cent recovery band - far below the price established through the protocol. The buyer of protection may have potentially received a payment on its hedge below its actual losses – effectively it would not have been fully hedged.

Yes, that is recovery rate risk. You get exactly the same phenomenon if you sell a bond post default before the actual workout is known. But presumably if you had a bond and a CDS, the CDS cash settlement would match where dealers were trading the bond, so the fact that the subsequent recovery was different would not matter as you would have settled the CDS and sold the bond, leaving you with no exposure. Of course if you were using the CDS to protect a non tradeable loan, then you could get caught out, but that is basis risk not recovery risk.

Is it just me, or is there a massive dose of caveat emptor missing from all this? The buyers of CDS are not retail investors: they are banks and hedge funds, and it is their job to understand the details of the trades they undertake. Just because something doesn't do what you think it ought to doesn't make it bad -- it just means you have not done your homework.

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. Some 60-70 per cent of ultimate CDS protection sellers are financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented. Recently, Merrill Lynch took a charge of $3.1bn against counterparty risk on hedges with financial guarantors.

The term 'substitute' may be a little misleading here. There is only a direct credit risk if there is a credit event. Therefore the CDS buyer is exposed only to both a credit event then a default of the CDS counterparty. If the counterparty defaults first, they have a claim to the value of the current mark to market of the CDS against the counterparty.

In the case of hedge funds, the CDS is marked to market daily. Any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. As the case of ACA highlighted, banks may not be willing or able to close out positions where collateral isn’t posted. Collateral models also use historical volatility and correlation that may underestimate the risk.

Ice cream makers which use vanilla when you wanted chocolate may produce the wrong flavour too. Most banks - and most cooks - are aware of the need to use the right tool for the job. Moreover (as Das does not make clear) VAR based collateral models which cross margin a whole portfolio of exposures may underestimate risk due to giving too much benefit for diversification within any derivatives portfolio. (I have discussed credit support default earlier so I won't go into more details here, suffice to say that the issues are not unique to CDS.)

Clearly a number of people have it in for credit derivatives right now. I'm reminded of the ill conceived (and subsequently abandoned) rules on credit risk mitigation proposed in the first consultative papers on Basel 2. It is sad, though, to see the FT jumping on the bandwagon. Like any tool CDS can be used well or poorly. If you want a complete hedge to a credit exposure, sell it. If you don't want to do that then you have to understand how the derivative behaves as the underlying exposure moves, just as in any other risk mitigation situation. CDS are neither uniquely dangerous nor a miraculous answer to any credit risk problem. Demonising a structure helps no one, however easy a target it offers. Or as my old boss used to say: if you want a complete hedge, buy a garden.