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Wednesday, October, 17, 2007

Credit Default Swap (CDS): Contract shifting the risk of third-party indebtedness from the debt holder (buyer) to an independent party (seller) that assumes the risk of default in exchange for periodic payments by the buyer to the seller.

CREDIT DEFAULT SWAP (CDS) IN THE REAL WORLD: Last week, Pocket MBA threw out the number $9 trillion. This week we're going for $45,460,000,000,000 (or as it is more commonly recognized, $45.46 trillion). That is the current size of the credit derivative market. (You can take Pocket MBA's word for it or play around on the website of Fitch Ratings.) And what is more astonishing is that at the end of 2006, the size of the market was a mere $26 trillion. Pocket MBA can't ignore growth like that, even if it is in the arena of swaps and derivatives, a subject PMBA deals with annually, if only to confuse itself and convince itself that it would be better off writing children's books about dogs and how to clean up one's play area. There's a lot of money in children's books-not $45 trillion certainly, but at least $45. But since credit default swaps (CDS) made the Wall Street Journal a couple weeks back, that means dreams of scribing the next Where the Wild Things Are will just have to wait.

The newsletter first visited swaps briefly in Volume 1, No. 26 ("At its most basic, a SWAP is simply an agreement to trade payments" on two financial instruments) and then more thoroughly in Volume 2, No. 38, but even then, PMBA only dealt with the (at the time) most common swaps: interest rate, currency and equity. Back then the CDS market was a mere drop in the bucket ($3.58 trillion) compared to what it is today. And in any event, a CDS is not like other swaps, in that payments aren't traded. Rather the risk of a default event is traded. Party A trades its risk to Party C that Party B will default on an instrument, and Party A pays Party C for the privilege. If that sounds suspiciously familiar, it's because it's very much like the following: Party A buys a car and trades its risk that the car will get damaged to Party C, which receives a periodic payment from Party A. That's right-a CDS is a lot like insurance, except that, unlike that car, the financial instrument at issue in a CDS won't get you out of town for the weekend.

As long as you keep the insurance model in mind, understanding how a basic CDS works is relatively simple. Of course, as with all swaps, institutions come up with new variations that transform the original into the somewhat quaint (which is why they're now called "vanilla CDS"). But that's not important for present purposes.

So a basic CDS involves three parties: Party A (the buyer, usually a bank); Party B (the reference entity, primarily sovereigns in the early CDS years, but increasingly corporate entities) and Party C (the seller, usually an insurance company or other financial guarantor, even hedge funds). Party A has loaned money to Party B, and that loan is memorialized in some way (e.g. a corporate bond). In order to hedge the risk that Party B will default in some specified way on its payments to Party A, Party A contracts with Party C, which agrees to assume the risk of Party B's default. In exchange, Party A agrees to pay Party C a premium (or "spread") amounting to $X quarterly, which is determined in terms of basis points per year on the notional (or face) value of the contract, until the contract expires. So if the contract is for five years, is worth $10,000 and the spread is .02, Party A will pay Party C $200 quarterly over five years, which amounts to $4,000 assuming the reference entity never defaults. And that's pretty much it, except for determining what it means for the reference entity to default such that Party C would have to pay Party A for its loss.

Party C's liability will be specified in the contract as contingent on certain "credit events." The International Swaps and Derivatives Association's ISDA 2003 Credit Derivatives Definitions specifies six such events: bankruptcy; failure to pay; obligation default; obligation acceleration; repudiation/moratorium; and restructuring of the debt in a manner unfavorable to the creditor. For definitions of each of these events, see here. In practice, most CDS contracts use only bankruptcy, failure to pay and restructuring of the debt in a manner unfavorable to the creditor.

Now, assuming one of these credit events occurs, Party C's liability to Party A kicks in, and the question becomes, how does Party C pay up? There are two ways, one of which will be specified in the contract: physical settlement or cash settlement. A physical settlement requires Party C to buy the debt obligation at its par value (which is the face value plus interest). In a cash settlement, Party C will pay Party A cash amounting to the difference between the par value and fair value on the valuation date.

And that's your basic, "vanilla CDS." As Pocket MBA is a chocolate lover, it feels duty-bound to at least mention the newer "loan-only CDS." These began catching steam last year and differ from the standard CDS in that "settlement is linked to the syndicated secured loans of a company, rather than all of its senior debt." See here for a richer explanation. When the market for loan-only CDS reaches $45 trillion, maybe Pocket MBA will give it another look-see. Until then the only swaps that are important are those that Pocket MBA's favorite sports team, the Chicago Cubs, will make to help them improve on their embarrassing (even for the Cubs) playoff performance.

Correction: Last week, the definition of Federal Funds Target Rate read "duns" instead of "funds." 'Nuf said. And now, PMBA 5-37 is finally dun, er, done.

Posted at 11:06AM | Permalink | Comments (1)

Comments

How has the latest financial crisis been affecting how all this works? I know that there have been a lot of changes being made to the way CC's and loans in general are handled, but I'm not sure how that specifically applies to this. Any thoughts?

Posted by: Matthew | Friday, March 19, 2010 at 08:50 PM

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