Wall Street, The Love (Hate) Affair With Credit Default Swaps, And The Case Of The Misguided Model

By Martin Kidd

Martin Kidd is Managing Director of Embiggen Finance and is completing a Master of Business (Applied Finance) at Queensland University of Technology

Imagine yourself sitting at a dinner party, where everybody has interesting anecdotes and now it’s your turn to tell a story. You’re a derivatives trader, and you know that if you start talking about work, everyone’s eyes will glaze over because there is approximately zero genuine interest in whatever it is you actually do for a living. Unless you’ve allegedly played a part in the 2007 credit crisis, that is. Credit default swaps have had a bit of a hard time in the finance media since the peak of the financial crisis, so perhaps it’s about time we explored the journey they’ve had since conception through to what’s happening in the market today.

The concept of the credit default swap (CDS) has been widely attributed to a young economist at JP Morgan named Blythe Masters in 1994. Then (in only her mid-20s), she was heading a team which extended a US$4.8 billion line of credit to Exxon, but Exxon were potentially facing up to $5 billion in damages due to an oil spill. So, as a hedging measure, Masters and her team “sold” the credit risk to the European Bank of Reconstruction and Development (EBRD). The idea being that JP Morgan would pay a regular premium (not dissimilar to an insurance policy) to the EBRD, in exchange for an agreement where the EBRD would honour Exxon’s debt to JP Morgan if Exxon suffered – as we say in finance-speak – a “credit event.” And lo, the credit default swap was born.

Fast-forward to the year 2008, and all anybody will talk about was the unfolding financial crisis. A major source of interest for commentators and regulatory bodies alike was the over-the-counter credit derivatives sector, where the CDS market alone was reported to be about US$62 trillion in size. This figure was often supplemented with the fact that the US commercial loan market was a comparatively meagre $5 trillion in size at the start of the same year. Rather substantial growth then for a market not even 15 years old by this stage.

If CDSs were being used solely as a hedging tool, there wouldn’t seem to be any logical argument as to why the market for CDS contracts was well over 10-times the US commercial loan market. However, the fact that the market was essentially unregulated meant that large banks and hedge funds didn’t have any obligation to report their activities to the market or authorities. This allowed traders to step in and begin relentlessly profiteering (allegedly) by selling up to five or ten CDS contracts for a single line of credit. These actions gained the CDS market widespread infamy in and after 2008. Why did they become so explosively popular? First, let’s look at pricing.

CDS prices were based either on a probability model (essentially a discounted series of cash flows of premium payments weighted by the probability of default), or an interest rate-based no-arbitrage model proposed by academics such as Darrell Duffie, John Hull and Alan White. The lack of transparency in the market – reflected in the literature available – makes it difficult to ascertain whether these contracts were genuinely mispriced as a result of these models. That said, quantifying credit risk is often inaccurate using any kind of standardised model. A lack of historical data and potential impartiality issues with ratings agencies like Moody’s and Standard & Poor’s conspires to ensure real-world defaults are probably more common (and therefore likely) than models will have you believe. Besides, mispricing probably didn’t matter too much prior to 2007 because credit defaults were at historically low levels, with those “buying” the credit protection getting the reassurance they wanted while people “selling” the protection didn’t have to pay up very often. So this increased risk appetite, along with the attraction of selling CDSs as credit protection, served to drop the prices of CDS contracts, while still providing additional returns for traders selling the CDSs.

The second reason for the explosive growth of CDSs in my opinion is less technical and more human. In fact, I believe that is the reason they became so popular. Traders had these exciting new over-the-counter contracts they could sell to any counter-party who was happy to pay them from time to time in exchange for the promise they’d cough up a few lazy millions in the event of a credit event. In the world of investment banking, making as much money as possible is arguably the only KPI upon which to measure employees, so the thought seemed to occur pretty early that instead of getting one contract’s payments for protection against default on a loan, why not try to offload five or ten contracts! A rich boss is a happy boss, after all.
CDS markets faced their first reality check once the sub-prime mortgage market in the US started to fall over in 2007. Traders suddenly realised that credit defaults were very real and very possible, and they themselves needed to cover the risk they’ve exposed themselves to over the years. So as they all turned to buying CDSs instead of selling, premiums rose sharply. However, this doesn’t really answer the question as to why the market for CDSs dropped from over US$62 trillion in 2008 to a mere $25 trillion at the end of 2010.

The truth is that there hasn’t really been a “crash” in the volume or value of the CDS market in net terms. The decline in value of the market can be largely attributed to the use of trade compression services – commonly referred to as ‘tear-ups’ within the marketplace – where offsetting CDS contracts are cancelled out. This process significantly decreases counter-party risk and gross credit exposure while retaining net credit exposure (which is why investors use CDSs in the first place). Basically, this means that backlogs of old offsetting CDS contracts bought and sold to adjust the investor’s position in the market are officially cancelled out. As a result, we could probably consider the US$25 trillion market estimation to be a lot more accurate than the $62 trillion figure quoted earlier.

The fact that trade compression services are being used to trade CDSs, along with better trade practices such as usage of electronic confirmations, point to the CDS market starting to “grow up” and take itself seriously. Prior to 2007 there seemed to be an attitude of CDSs being the next best thing to printing your own money, however now after a few shocks it’s come of age and entered the realm of more established derivative contracts like interest rate swaps. This shows that traders are treating CDSs more responsibly now that the worst of the financial crisis seems to have passed. No doubt regulatory bodies will also jump on board before too long and impose greater disclosure requirements on CDS activity – perhaps even as part of the BASEL framework.

To sum up, the credit default swap exists for a good reason – as a tool to hedge against the default risk of people to whom you lend money. Traders and salespeople caught onto the money-making potential of CDS contracts pretty early on, with the amount of trading bringing a level of infamy to the market, especially when the same traders started buying CDSs in the midst of the financial crisis. However the marketplace seems to be beginning to treat the CDS with greater respect now. It’s good to see the unfolding realisation that CDSs can wield great power, and with great power comes great responsibility.

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