CDS Links
Painful lessons to be learnt for CDSs
The sad, sad story of “Structured Credit Company” a venture that decided to get into selling protection (Credit default swaps) right at the top of the credit bubble.
‘Shipwrecks and casualties’ warning for credit markets
Good. The lucky fool from Newport Beach will benefit greatly from this piece, perhaps learning a few things on how the CDS market works. We need more of this kind of reporting.
Will the CDS Market See $250 Billion in Losses?
Felix writes:”I think (but I’m not positive) that he’s wrong on this one.”
January 12th, 2008 at 1:24 pm
Gross is absolutely right. Bank A has sold protection on Company X to Bank B. Bank A has bough protection on Company X from Hedge Fund Z.
Bank A is allegedly earning an ‘arbitrage’ profit on CDS of Company X. In fact, the reality is that Bank A is just earning a spread for taking on Hedge Fund A’s credit risk. Bank A reports to the OCC that is running a matched book.
Company X goes belly up. Hedge Fund A can’t pay up. Bank A’s arbitrage profit goes ‘poof’.
Assume that Company X doesn’t go bankrupt but starts hitting the rope. Bank A asks Hedge Fuind Z to post collateral. Bank A’s aribtrage again most likely will go poof.
January 12th, 2008 at 4:48 pm
BTW, the chart in the OCC document (which shows almost negligible use by end users of derivatives) has this most curious disclaimer:
This chart does not include credit derivatives
January 13th, 2008 at 12:58 pm
Barry:
bank A has collateral from both sides of the trade from the start and they will make a mark to market call if the collateral is insufficient long before Company X goes bust, if the spread moves you have to pay up just like for a futures contract on an exchange.This is exactly what has happened for most of the second half of last year : no defaults but sharp price moves that triggered additional collateral demand. So the switch of wealth from one pocket to another has already happened and more importantly it has happened in the absence of defaults, just in anticipation of defaults to come. No doubt there is counterparty risk but the OCC document shows clearly that the actual losses from credit risk in derivatives are very small and a lot smaller than for normal commercial lending.
Consider this (from the OCC), the charge-off for Q3 for all derivatives not just CDS was $119 million or 0.05% of net credit exposure which is itself of small fraction of total notional exposure of $172 trillion.
The banks are acting as a clearing house would except they pick up a spread for their trouble.
The issue I have with the Gross scenario is that he ignores the fact that positions are counted multiple times. For example if there are 10 times the amount of CDS written on company X debt, this doesn’t increase risk, it reduces it, because the protection buyer can only get paid if he delivers the bonds in case of default, therefore the buyers will have to scramble to bid for bonds, increasing the price or strike a deal with the seller of protection to exit their position, in both cases that reduces the losses for the CDS sellers, if he fails on both count the seller of protection owes nothing and keep the premiums.
As for the CDS outstanding within private parties that’s very low, 6% according ISDA, around 8% at BIS it varies depending on who is a “private” party but in any case if banks are perfectly matched then whatever is outside the banking system must also be perfectly matched, they aren’t of course but pretty close.The issue is collateral and the OCC, the only one to have comprehensive data on this, appears to be fine on this and “the OCC has examiners on-site at the largest banks to continuously evaluate the credit, market,operation, reputation and compliance risks of derivatives activities.”