Everything You Wanted to Know About Credit Default Swaps -- But Were Afraid to Ask

Credit default swaps have been getting a tone of ink lately for a variety of reasons. To hear some people talk about them you'd think they were the second coming of the anti-Christ. I was recently on a conference call with George Soros who doesn't like them at all. However, people once thought the same thing about options which are now a standard method of hedging risk. So, let's see what all the hubbub is about.

Let's assume that a money manager buys a GE bond, that matures in exactly 5 years and has a coupon of 5%. It pays interest semi-annually. This is a standard trade for a ton of money managers. Let's assume the manager wants to hedge the downside risk on the bond -- that it, he wants an insurance policy in case GE goes belly-up. Before CDS this didn't exist unless the bond itself was actually insured -- that is it was backed by AMBAC or MBIA or a similar bond insurer. However with a CDS the manager can now insure against the downside risk. How? I'm glad you asked:

In a CDS, one party "sells" risk and the counterparty "buys" that risk. The "seller" of credit risk-who also tends to own the underlying credit asset-pays a periodic fee to the risk "buyer." In return, the risk "buyer" agrees to pay the "seller" a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, bankruptcies and credit rating downgrades (For a more detailed list of CDS credit events see the Commonly Established CDS Credit Events table below).

This is not a very complicated issue. The person who wants the insurance pays another party for insurance. The "insurer" guarantees to pay the "insured" X amount of dollars in the event the bond defaults. The cost of the insurance will depend on a host of factors such as the credit worthiness of the bond issuer, the interest rate (which is also a sign of credit-worthiness), the length until maturity and a few other factors.

The primary criticism against CDS' are best expressed by Warren Buffet:

Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway's annual report to shareholders in 2002, he said "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)." The same report, however, also states that he uses derivatives to hedge, and that some of Berkshire Hathaway's subsidiaries have sold and currently sell derivatives with notional amounts in the tens of billions of dollars.

Let's use a comparison to options as a way to explain what Buffet is talking about. Let's say someone owns 100 shares of GE. If they want to they can sell either a single put or call contract against those 100 shares. This would be a "colateralized" position because there is collateral backing up the options contract the person is writing.

What Buffet is talking about is a "naked contract" where the person writing the contract does not have the underlying security. In the preceding example, it would mean the person writing the GE options does not own any GE stock. That means that everything is great until the person has to actually provide the GE stock to the party who bought the option. This is why the person's underlying credit is so important. If he has good credit than he either has the money to buy the stock or can borrow the money to buy the stock. However, if he doesn't have a good credit rating, then we're in serious trouble.

And that's where the real rub comes in. According to the latest Flow of Funds report, total corporate credit outstanding is about $6.3 trillion and total corporate borrowing outstanding is about $10 trillion. But, the size of the CDS market is a lot bigger:

The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges. "It could be another — I hate to use the expression — nail in the coffin," said Miller, when referring to how this troubled CDS market could impact the country's credit crisis.

The amount outstanding is far larger than the total corporate debt outstanding. That tells me financial players saw a way to make money and went for broke.

I think CDS are a healthy development. Bond investors have needed some type of option style investment for some time. In fact, I'm surprised it took this long for them to develop.

However, the current size of the CDS market tells there's something fundamentally out of whack right now. I think the main thing that needs to happen is for a CDS exchange to develop where everybody can get quotes on all sorts of instruments. We have the CBOT and the CME why not an exchange that deals is CDS? It's the next logical step.