Who’s Hedging Whom?
CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. If the seller of protection is unable to perform then the buyer obtains no protection. Currently, a significant proportion of protection sellers is financial guarantors (monoline insurers), hedge funds and regional banks. Concerns about the credit standing of monolines are well documented. In 2008, a number of banks took charges against counterparty risk on hedges with financial guarantors.
For hedge funds, the CDS is marked-to-market daily and 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. In practice, banks may not be willing or able to close out positions where collateral isn’t posted. ACA Financial Guaranty sold protection totaling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement. The banks have agreed to a “forbearance agreement” whereby the buyer of protection waived the right to collateral temporarily. ACA subsequently has been downgraded to “CCC” reducing the value of the CDS contract and the protection offered. AIG incurred similar problems requiring government support. The problems at ACA and AIG are not unique.
A critical element is the level of over-collateralisation. The buyer of protection will want an initial margin to cover the risk of a change in the value of the contract and the failure by the seller of protection to meet a margin call. The seller of protection wants to increase leverage by reducing the amount of cash it must post as initial margin. It is possible that the level of initial collateral may prove be too low. Collateral models use historical volatility and correlation that may underestimate the risk. The entire process also assumes liquidity in the underlying CDS market that may be absent in a crisis. Truth or Dare
The derivative industry’s indefatigable support of the CDS market (motivated undoubtedly by the specter of regulation and greater scrutiny) centers on the fact that all the CDS contracts related to the high profile defaults have settled and the overall net settlement amounts were small. Strictly speaking, this is correct.
In practice, there are actually two settlements. The ‘real’ settlement where genuine hedgers and investors deliver bonds under the physical settlement rules (i.e. those who actually own bonds and were hedging). Then there is the parallel universe where the dealers and large hedge funds settled via the auction. Dealers tend to have small net positions (large sold and bought protection but overall reasonably matched).
For example in the case of Lehman Brothers, the net settlement figure of $6 billion that was quoted refers to the second process. Real CDS losses from Lehman CDS were higher, probably around $300-400 billion. Some banks and investors that had sold protection on Lehmans did not participate in the auction. They chose to take delivery of defaulted Lehman debt resulting in losses of almost the entire face value. For example, one German Landesbank reportedly took delivery of $1 billion of Lehman bonds that are now worth $30 million.
One reason that there were no failures in settlement of the CDS contracts is sellers of protection such as banks and some insurers were propped up by governments concerned about systemic failure of the financial system. Other sellers of protection had to bear losses reducing the capital available to meet future claims. Whether the sellers are in a position to meet potential losses if default rates rise as expected remains unknown.
Efforts are under way to reduce the counterparty credit risk by moving CDS contracts onto an exchange settled platform supported by margining and normal clearing mechanisms. Such moves are, in theory, positive but the devil lies in the detail.
CDS Contracts – Operational Risks
In 2006, Alan Greenspan expressed shock and horror at the state of settlements in the credit derivatives market. He expressed surprise that banks trading CDS seemed to document trades on scraps of paper. The ex-Chairman, perhaps unfamiliar with the reality of financial markets, had difficulty reconciling a technologically advanced business with this “appalling” operational environment.
CDS contracts entail significant operational risks. In recent years, delays in documenting CDS contracts forced regulators to step in requiring banks to confirm trades more promptly. The accuracy of the mark-to-market values of CDS contracts, particularly of less liquid and infrequently traded reference entities, is not unimpeachable. Where collateral is used, as noted above, monitoring and management of collateral poses significant risks.
Expertise in technical aspects of CDS contracts is limited. Banks, insurance companies and other participants may lack the necessary skills to properly assess, price, trade and manage CDS contracts. The depth of skill and expertise in many institutions is also an issue.
A feature of these instruments is that the complexity and risk of structures are frequently inversely related to the understanding of the person trading it. In the words on an anonymous trader: “Credit derivative dealers talk about their market in much the same way spotty teenagers talk about sex. A lot of people profess to be accomplished experts, but when it really boils down to it, most of them are still fumbling in the dark.”
Financial innovation can offer economic benefits. A number of major benefits of CDS contracts are often cited by acolytes and fans, generally those promoting the product. The first is that CDS contracts help complete markets, enhancing investment and borrowing opportunities, reducing transaction costs and allowing risk transfer. CDS contracts, where used for hedging, offers these advantages. Where not used for hedging it is not clear how this assists in capital formation and enhancing efficiency of markets.
CDS contracts also, it is claimed, improve market liquidity. It is generally assumed that speculative interest assists in enhancing liquidity and lowers trading costs. Where the liquidity comes from leveraged investors, the additional systemic risk from the activity of these entities has to be balanced against potential benefits. The current financial crisis highlights these tradeoffs.
CDS contracts also, it is claimed, improve the efficiency of credit pricing. It is not clear whether this is actually the case in practice.
Pricing of CDS contracts frequently does not accord with reasonable expected risk of default. The CDS prices, in practice, incorporate substantial liquidity premia, compensation for volatility of credit spreads and other factors. CDS pricing also frequently does not align with pricing of other traded credit instruments such as bonds or loans. For example, the existence of the “negative basis trade” is predicated on pricing inefficiency.
In a negative basis transaction commonly undertaken by investors including insurance companies, the investor purchases a bond issued by the reference entity and hedges the credit risk by buying protection on the issuer using a CDS contract. The transaction is designed to lock in a positive margin between the earnings on the bond and CDS fees. Negative basis trades exploit market inefficiencies in the pricing of credit risk between bond and CDS markets. CDS contracts also are supposed to enhance information efficiency, improving availability of market prices for credit risk allowing more informed decisions by market participants. As CDS contracts are traded in the private OTC derivative markets, there is limited dissemination of market prices. This limits price discovery and therefore any informational benefits. In reality, pricing and trading information is only available readily to large active dealers in CDS contracts. This informational asymmetrymay advantage these dealers. Knowledge about trading flows in CDS contracts may allow these dealers to earn economic profits. As Mark Twain observed: “I am opposed to millionaires, but it would be dangerous to offer me the position.”
Benefits of CDS contracts must be balanced against any additional risks to the financial system from trading in these instruments. CDS contracts may create additional risks within the financial system. While CDS contracts did not cause the current financial crisis, they may have exacerbated the problems and complicated the process of dealing with the issues. CDS contracts can amplify losses in credit market. For example, when Lehman Brothers defaulted the firm had around $600 billion in debt. This would have resulted in a maximum loss to creditors of that amount. In addition, according to market estimates, there were CDS contracts of around $400-500 billion where Lehmans was the reference entity (the outstanding volume of CDS contracts is not known with certainty reflecting the lack of information about trading in the OTC market).
If the CDS contracts were used for hedging, then the CDS contracts would merely have resulted in the losses to creditors being transferred to the sellers of protection leaving the total loss unchanged. However, market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250-350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200-300 billion) are additional to the $600 billion. The CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by (up to) approximately 50%.
In addition, Lehman Brothers was included as a reference entity in other structured credit products, such as Collateralised Debt Obligations (“CDOs”) and credit indices, and additional losses would have resulted therein. Documentary asymmetries in the contracts may also increase the losses.
The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of the Lloyds market. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance premiums are received up front. In both cases the risks are both potentially significant and “long tail” – they do not emerge immediately and may take some time to be fully quantified.
The transfer of risk assumes that all parties along the potential chain perform their contracts. Any failure in the chain of risk transfer exposes other parties to the risk of insolvency and default. Defaults and failures in CDS contracts may quickly cause the financial system to become “gridlocked” as uncertainty about counterparty risks restricts normal trading. The bankruptcy of Lehmans set off a chain of just these events causing financial markets to become “frozen” in September and October 2008.
As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Derivatives markets generally may have higher concentration risk than considered desirable or acceptable. The CDS market is similar in structure to the overall derivative market with less than 10 dealers having the major share of the market. The potential impact of a bankruptcy filing by Bear Stearns and AIG on the OTC Derivatives market, including CDS contracts, was probably one of the factors that influenced the Federal Reserve and US Treasury’s decision to support the rescue of the two firms.
If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between $33 billion and $158 billion [See Andrea Cicione “Counterparty Risk: A Growing Cause of Concern” (25 January 2008) Credit Portfolio Strategy – BNP Paribas Corporate & Investment Banking]. Barclays Capital estimated that the failure of a dealer with $2 trillion in CDS contracts outstanding could potentially lead to losses of between $36 billion and $47 billion for counterparties. This underlines the potential concentration risks that are present.
CDS contracts may under certain circumstances create volatility and uncertainty instead of reducing risk. For example, the coupling of participants and long chains of risk transfer may mean that uncertainty about the financial position or solvency of any firm is quickly transmitted throughout the financial system rather than being confined to firms directly exposed to the distressed entity. Attempts to hedge this risk or close out positions may increase volatility. There are also negative feedback loops. If reference entities start to default then insurers, hedge funds and banks are affected. If the economic climate worsens and defaults rise then the overall ability to rely on these hedges may decline. The extent of the diversification of risk may diminish exactly when it is most needed.
In providing the ability to transfer risk, CDS contracts may in turn encourage moral hazard in institutions encouraging them to take on more risk on the assumption that the additional risk will be transferred or hedged. It exposes firms to significant risk of losses from a breakdown in markets and also where the hedges do not work as intended due to either problems in the design of the hedge or counterparty risk. This behaviour was illustrated vividly in the securitisation markets.
From Surreal to Hyper Real
The CDS market originally was predominantly a market for transferring and hedging credit risk. The contract itself has many attractive economic features and can serve useful purposes in hedging and transferring risk. In recent years, the ability to trade credit, create different types of credit risk to trade, the ability to short credit and also take highly leveraged credit bets has become increasingly important. To some extent the CDS market has detached from the underlying “real” credit market. If defaults rise then the high leverage, inherent complexity and potential loss of liquidity of CDS contracts and structures based on them may cause problems. The excesses of the CDS market are evident in the recent interest in contracts protecting against the default of a sovereign (known as sovereign CDS). For example, the CDS market for sovereign debt is increasingly pricing in increased funding costs for the US. The fee for hedging against losses on $10 million of Treasuries currently is about 0.48% pa for 10 years (equivalent to $48,000 annually). This is an increase from 0.01% pa ($1,000) in 2007. The specter of banks, some of whom have needed capital injections and liquidity support from governments to ensure their own survival, offering to insure other market participants against the risk of default of sovereign government (sometimes their own) is surreal.
CDS contracts are new and relatively untested in an environment of high levels of defaults. If defaults increase then there is a significant risk of a dislocation in the CDS market. Banks may well incur losses on transactions where they assumed that the risk had been sold off. Settlement problems may result in markets becoming grid locked. This could result in additional problems in inter-bank/ inter-dealer counterparty risk. Significant increases and volatility in credit spreads is possible. This may lead to further problems in availability and the cost of funding for corporations. It might also cause problems for leveraged investors. The extent of problems depends on the number of defaults and the severity of the credit losses.
In May 2006, Alan Greenspan, the former Chairman of the Fed, noted: “The CDS is probably the most important instrument in finance. … What CDS (credit default swaps) 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.” It will be interesting to see whether reality proves to be different. Dr. Greenspan now acknowledges he was “partially” wrong to oppose regulation of such instruments. “Credit default swaps, I think, have serious problems associated with them,” he admitted to a Congressional hearing in October 2008.
Ludwig von Mises, the Austrian economist from the early part of the twentieth century, once noted: “It may be expedient for a man to heat the stove with his furniture; but he should not delude himself by believing that he has discovered a wonderful new method of heating his premises”. CDS contracts may not ultimately improve the overall stability and security of the financial system but may create additional risks.
© 2009 Satyajit Das All Rights reserved. Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).