An explanation of Credit Default Swaps (CDS) – Part 2

CreditLime Reference
First Published September 11, 2009
Last Updated November 24, 2009

An explanation of Credit Default Swaps (CDS) – Part 2

Insurance or CDS?

Most major participants in the CDS market do not call CDS “insurance” because of the technical differences and legal implications associated with buying or selling “insurance” versus other “investment instruments” (or “securities”) or simply “business contracts of value between the parties involved.” We, at CreditLime, understand the fact that there are some very important differences between an insurance contract and a CDS. The main differences stem from the issue of moral hazard which we will now discuss below.

Moral Hazard

One of the most important differences is the separation between the person or entity being insured and the ability to buy insurance on the insured. In most other forms of insurance, only someone with an actual underlying interest in the person or entity being insured can purchase insurance. Only the auto owner can purchase auto insurance on his own car. He cannot buy insurance on his estranged son-in-law’s car, which has already been in 10 car accidents. Only the person who is insuring his own life can buy life insurance on himself. He cannot buy life insurance on his enemy from high school. Only the home owner can purchase fire and home insurance on his own house. He cannot buy fire and home insurance on the neighbour’s house across the street which has its own swimming pool and home theatre system.

The reason for this is to eliminate the risk of moral hazard. Only the individual that owns his own car, lives his own life, or owns his own home, respectively, will care as much about what is of interest or at risk to him. Likewise, he would not care as much about someone else’s car as much as he does his own, he will not care about someone else’s life as much as his own, and he will not care for and clean someone else’s house as much as he would his own. Since buying insurance essentially entails selling the risk of something bad happening, the risk of the worst happening is usually least when the person with the most to lose also benefits from taking as much precaution as possible. The auto owner will (or should) make sure he drives as carefully as possible, locks his doors when he leaves his car and tunes-up his car at regular intervals to ensure he does not get into an accident, have his car stolen and have his car break down, respectively.

Moral hazard can also have an opposite or destructive effect. If someone could buy auto insurance on a bad driver’s car with no link or involvement to themselves, then everyone would buy this insurance knowing that the other person is a bad driver who always gets into accidents and may even try to cause accidents for this bad driver in order to receive an insurance payout from the accident occurring. Another more extreme example of moral hazard can be evident if someone could buy life insurance on their enemy’s life, then everyone (assuming they didn’t have a conscience) would go out and buy such insurance and then go kill their enemy in order to collect the financial payout that the life insurance contract pays out after death.

One of the major differences between a CDS and an insurance contract is that there is the risk of moral hazard in a CDS transaction. There is no specific requirement that says any buyer of CDS protection has to also have an interest or stake in the underlying company’s bonds. Therefore the risk exists that some external party can simply buy a CDS and then hope or try to force a company to go bankrupt and make a profit. This risk has been a growing concern in public circles far and wide as fears about the growth of the CDS industry in an unregulated or speculative form could disrupt the normal course of business economic activity.

In the past, when companies ran into financial troubles or entered bankruptcy protection, bondholders and other banks would try to figure out ways to minimize their losses. The most common financial workouts involved either seizing a company’s assets and liquidating them to the highest bidder or providing more money in the form of loans or equity to help a company get through a tough time in order to get back to profitability. This is similar to a bank foreclosing on a homeowner’s house because he missed his monthly mortgage payment after losing his job. In this situation the bank can either repossess the house (sell it to someone else in order to get its money back) or it can try to re-negotiate with the homeowner for a penalty payment or perhaps a lower monthly payment over a longer period of time in order to help the homeowner through the temporary financial hardship and make it easier for him to re-pay his mortgage.

The risk that is growing in the CDS market involves the fact that CDS buyers, who may also involve a company’s bank lenders or bondholders, can find it more profitable to get paid out on the CDS by having the company go bankrupt than helping a company recover from bankruptcy.  This has been a real issue in the recent bankruptcies of Tribune, General Motors, Thomson, CIT and Six Flags. Whether these companies really deserved to file bankruptcy or not is a debatable topic but there are many non-financial and social issues like job losses, necessarily services, community involvement and sponsorships related to bankruptcies that often impact corporate and government decisions to find ways to work through and recover from dire financial situations rather than simply shutting down or calling it quits. The world has many examples of companies and even industries that nearly went bankrupt at different times in history that went on to recover and become very successful or at least maintain a very important and necessary function in everyday life including Chrysler, Geico, American Express and United Airlines.

Other differences

Aside from the issue of moral hazard there are some other technical differences between credit default swaps and insurance (some of which were already mentioned above in the discussion about moral hazard):

• The buyer of a CDS does not need to have an ‘insurable interest’ in the debt being insured in the same way that an insurance buyer needs to have an insurance interest in the asset he seeks to insure.
• The buyer of a CDS does not need to necessarily incur a loss in order to claim payment on a CDS. Because of the existence of so-called “credit events” that can trigger payments on a credit default swap, even if an underlying reference entity simply re-negotiates the interest payments on its bonds without ever going bankrupt and causing immediate losses for the bond investor. Even more extreme, sometimes an event such as a corporate restructuring or effective takeover that does not cause any realized loss to the bondholders can trigger payments such as the government conservatorship of Fannie Mae (the USA government took effective control without actually declaring bankruptcy or without Fannie Mae ever missing an interest payment).  In insurance, the insuring party must always first suffer a loss like a car accident or fire before he is allowed to file an insurance claim.
• Insurance sellers are regulated by governmental authorities. CDS sellers are not currently regulated by anyone. There is, however, new legislation being proposed to change this environment and regulate CDS market participants directly or indirectly.
• Insurance companies are subject to maintaining insurance reserves to cover possible future insurance-related losses. Most companies engaging in CDS, however, were not, required to maintain reserves to pay off potential CDS-related losses until more recently in certain cases. This was the kind of misstep that caused AIG to need a government bailout since one of its non-insurance subsidiaries engaged in a number of CDS transactions which it was not properly capitalized enough to honour.
• Risk management techniques are different for the major participants in insurance versus CDS. Insurance companies manage (financial) risk by estimating future losses and setting them aside from insurance premiums (called loss reserves) which are then used to pay off expected claims. The major banks, as the main participants in the CDS markets, primarily try to act as agents by taking one side of a CDS trade and then finding someone else to take the other side at a slightly different spread that makes the trade profitable for the banks in between. This is no different than a retail store buying a product from a wholesaler at a low price and then re-selling the product to the consumer at a slightly higher price. Not many banks, until more recently, ever set aside specified and segregated reserves to provide for the fact that there may be future losses over the terms of the CDS contracts that were entered into.
• Final payments on CDS after a credit event are independent of the counterparties involved in a transaction. The final price is set by an auction for the defaulted debt managed by a select group of industry companies and big banks. Whereas in insurance, each claim is individually assessed by a claims assessor and payments can vary depending on how much damage is done and what the deductible amount is. For example, popular amusement park operator Six Flags filed for bankruptcy in 2009 and an auction to determine the value of the defaulted Six Flags debt came up with a value of 14 cents on the dollar (14%) meaning everyone who sold CDS on Six Flags (a total of almost $3 billion across hundreds of counterparties) had to fork over 86 cents on the dollar (100 cents minus 14 cents) to the respective CDS buyers.

As CreditLime does not seek to get into the intricate details and technicalities of this topic, we merely present the basic arguments made by industry officials and would direct readers to other sources for a more detailed explanation of specific technical differences between CDS and insurance.

A recent research paper by Todd Henderson from the University of Chicago entitled ‘Credit Derivatives Are Not ‘Insurance’ is a free source for more information on the topic – although it is somewhat biased in its presentation in arguing that CDS is not insurance.

Mr. Henderson’s research can be found at the following website:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1440945

On the other side of the coin, there are some very prominent members of the financial community who commonly refer to CDS as insurance for basic understanding purposes. Both the New York State Insurance Commissioner Eric Dinallo and Governor David Paterson have referred to credit default swaps as insurance in public. Warren Buffet, one of the richest businessmen in the world and operator of one of the largest insurance companies – Berkshire Hathaway, wrote to investors in his annual report saying “In 2008 we began to write ‘credit default swaps’ on individual companies. This is simply credit insurance, similar to what we write in BHAC [municipal bond insurer Berkshire Hathaway Assurance Company], except that here we bear the credit risk of corporations rather than of tax-exempt issuers [going bankrupt or missing payments].”

Whatever the ‘official ‘ classification of credit default swaps is (whether insurance or not) makes no difference to CreditLime in its explanation to readers. CreditLime does not seek to get involved or take sides in the debate of whether or not CDS should be considered insurance or not but merely seeks to provide the facts for readers to make their own educated judgements.

Common misconceptions about CDS

A credit default swap is a financial product that is often confused with other related or unrelated financial products. It is quite impressive how many times credit default swaps have been misreported, confused or blamed by media, politicians and the general public for a variety of reasons. A lack of understanding can at least be solved by educating oneself but a lack of data cannot be solved (unless perhaps public bodies like regulators step up oversight and access to information for investors as they have been doing in recent months). For those seeking a better understanding of credit default swaps, CreditLime has put together a brief overview of products that they are often confused with.  Some of these often confused products include Collateralized Debt Obligations (CDO’s), subprime bonds, other swaps like interest-rate swaps (IRS) or other possibly more complex financial or derivative instruments. While this report is not intended to provide detailed descriptions of these other confused products, a short summary of the aforementioned products is provided below as well as their differences from CDS.

CDS is not the same as a CDO

A CDS is a derivative instrument. It derives its value from an underlying security (usually a specific type of bond or other debt like a loan). It has no real value in itself other than the value dictated by the terms of the CDS contract and thus costs nothing to enter into or purchase (assuming both sides of the CDS contract have full faith in the ability and willingness of each other to keep their side of the agreement). In reality, both counterparties often do not have full faith and trust in each other and may ask for a pre-set amount of collateral or margin to be set aside to reduce the financial risk of someone not abiding by the original terms of their CDS agreement. A Collateralized Debt Obligation (CDO), on the other hand is something of real value and costs money to buy. A CDO is another type of bond that pays or is supposed to pay an expected amount of regular interest payments and then eventually pay back the CDO bond investor’s principal over time. Like a regular corporate bond, the CDO bond can also miss (or be perceived to have a greater chance of missing) expected payments of interest or principal which will cause the CDO bond’s price to fluctuate. Since CDS contracts can be created to protect or insure any kind of bond, credit default swaps can also be (and have already been) created to protect or insure CDO bonds. One of the reasons why AIG needed a bailout was because the company had agreed to protect or insure (using CDS as well as other insurance and financial instruments) a number of CDO bonds which had lost money and started defaulting.

CDS is not the same as a subprime bond

Again, CDS is a derivative instrument while a subprime bond (or simply “subprime”) is a type of bond called a mortgage bond that pays or is supposed to pay an expected amount of regular interest payments and then eventually pay back the subprime bond investor’s principal over time. A subprime mortgage bond is named as such because of the type of collateral backing the bond which consists of mainly residential mortgage loans to borrowers who are or were considered below-prime quality (i.e. subprime quality or more risky than a typical prime borrower). While there is no universal definition of what exactly makes a borrower prime or subprime, generally speaking, classifications such as FICO credit scores in the USA above 700, may be used to classify prime versus subprime. In other countries, there may be different types of criteria or credit scoring levels used to make this distinction. For example, in the UK, mortgages are often classified as conforming or non-conforming rather than prime or subprime based on similar types of criteria. Again, like a regular corporate bond, the subprime bond can also miss (or be perceived to have a greater chance of missing) expected payments of interest or principal which will cause the subprime bond’s price to fluctuate. Since CDS contracts can be created to protect or insure any kind of bond, credit default swaps can also be (and have already been) created to protect or insure subprime bonds.

CDS (a credit-default swap) is not an interest-rate swap

Interest-rate swaps (IRS) are based on an underlying interest-rate such as the Federal Funds rate or the London Inter-bank Offered Rate (LIBOR, which is the interest-rate that banks in London use to charge to lend US$ amongst themselves). While CDS and IRS are both “swaps”, and hence both derivatives, the underlying value of the two products are derived in entirely different ways. CDS derive their value from changes in a company’s or individual bond’s credit risk which, usually over the short-term, is mostly changing independently of any larger-scale macro-economic policies, such as monetary or fiscal policies, that governments and central banks may be pursuing which often have an effect on interest rates – and by extension interest-rate swaps.

CDS is a type of derivative

CDS is one of many different kinds of derivatives. A derivative merely derives its value from something else. A credit default swap derives its value from the expected or perceived credit risk associated with lending money to someone or something and not getting paid back. This credit risk has often been quantified by calculating something called the credit spread. Credit spreads are measured by calculating the difference between the yield (or interest-rate) on a (risky) bond minus the yield (or interest-rate) on a risk-free government bond. For decades, the general level of credit risk as measured by credit spreads has been derived from bond prices. That was until the advent of CDS. Credit default swaps have now become a common, if not more important method in some cases, of measuring the credit spread or credit risk. Although CDS prices or spreads may not always be exactly equal to the calculated credit spread from a bond price, they are often fairly close and in cases where they are not, the difference can often lead to a profitable arbitrage opportunity or be foretelling of other specific issues that warrant investigation.

Other types of derivatives that investors may be familiar with include stock options that may be used to pay employees as part of their compensation or puts and calls that can also be traded on an options exchange such as the Chicago Board Options Exchange (CBOE). Another example of common derivatives include futures on commodities such as crude oil or gold traded on futures exchanges such as the Chicago Mercantile Exchange (CME) or New York Mercantile Exchange (Nymex). Futures are often used as a benchmark for quoting and pricing certain commodities or commodity-based products which regular consumers consume such as the price of regular unleaded gasoline at the local gas station. Derivatives have been developed to serve a purpose which is generally believed to be the mitigation or hedging of risk for various parties who engage in such derivative transactions. Like any other product or service which can be wrongly exploited or taken advantage of for the wrong reasons, some players in the derivative markets may have wrongly or improperly used derivative instruments but that does not necessarily make all derivatives bad.

Derivative users generally fall into two groups: hedgers and speculators. Hedgers often use derivatives to continue the smooth operation of a business or reduce risk of an underlying commodity or other asset’s price or performance which they actually have a real financial stake in protecting. A corn farmer, for example, has a real interest in protecting or locking-in the amount of money that they can get from their harvest (or output) at a current price which protects them in case corn prices decline a year from now, when the corn harvest is ready to be sold, to a price that may be below the cost of producing corn over that time. In this case, the corn farmer may agree to sell a future to a corn user such as an ethanol producer who also wants to protect or lock-in the price of their input (corn) required in making ethanol profitably. A natural user of CDS was described in Part 1 of this report in the case of a bank who wants to reduce exposure to a potentially large client who could cause problems for the bank and the rest of its customers in the event of a default.

A speculator, on the other hand, does not necessarily have a real financial stake in the underlying source of derivative value and merely tries to bet on the direction of future prices or arbitrage differences in prices. While speculators do serve a role in promoting fair pricing and market efficiency, too much speculation or uncontrolled speculation can also lead to problems which may be partially true in the CDS markets where the large growth from both uncontrolled and unknown speculation may have distorted the smooth functioning of the CDS and other financial markets. This problem is not limited to the CDS or financial markets, however, and may have also occurred in other markets such as crude oil and agricultural commodities. While a CDS is a relatively new derivative product, there are other types of derivative products such as commodity futures that have been in existence for decades and even centuries. All indications would point to the conclusion that CDS, like futures, do have a legitimate and useful purpose in certain situations.

Understanding what CDS is (or is not) is critical for investors, politicians, bankers and corporations alike in understanding how the financial system is evolving and being able to control it or prevent future crises. Given some of the problems that have already appeared during the past credit crisis that began in 2007 or 2008 depending on who you talk to, it seems that the current setup would need to be reformed to prevent future problems. Government, regulators and industry officials have already begun the process of bringing more structure, order and transparency to the CDS markets with initiatives such as centralized clearing, market data repositories and governmental oversight.

Credit Lime Financial News Bureau