Credit Default Swap Clearinghouse

by

The term “Credit Default Swap (CDS)” is not a household term.  Politicians almost never mention it.  I have never heard it explained on Good Morning America, or even on the Jim Lehrer News Hour.  Unrecognized by the public, the unregulated CDS market has grown huge, and threatens the stability of the entire capitalist system. The AIG CDS inventory is one of the core reasons that the U.S. government felt obliged to take over AIG and extend $85B in Federal Reserve loan guarantees.  AIG had a CDS inventory with a notional value of over $400 Billion.  That was too large an amount for the U.S government to let unravel in a chaotic bankruptcy.  Yet that amount is small compared to the total CDS market.

To be more specific, under the Bush Administration laissez faire policy toward the financial industry, the notional value of the Credit Default Swap market has grown from approximately $900 Billion at the end of the year 2000 to a total of $62.2 trillion at the end of 2007 (according to the International Swaps and Derivatives Association).  That is more than four times the U.S. Gross Domestic Product and larger than the entire world stock market.[i] 

Credit Default Swaps are derivative instruments intended to insure losses to banks and bondholders when companies fail to pay their debts.   A CDS is a private contract between two parties, in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default or a government takeover. A CDS can be sold, on either end of the contract, by the insurer or the insured. 

There is no standard form for these contracts, they are not regulated, and the market is so large that even sophisticated computer accounting systems have trouble keeping track of who the counterparties are.  During the credit market upheaval in August 2007, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties to the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.  In general, there is a risk that if a one counterparty tries to collect on a CDS obligation, it may be difficult to determine who owes the payment due (i.e., who the other counterparty is).  Furthermore, because there is no public market for these derivatives, it is difficult to determine what their value is at any point in time (e.g., at the end of the accounting quarter).  That is why the market size is described using the term “notional value”. 

There was a precursor to this week’s problems that led to the AIG bailout.  In the first week of February 2008, AIG said that it had incorrectly valued some of the swaps it had written and that sharp declines in some CDS’s had resulted in $3.6 billion more in losses than the company had previously estimated.[ii]   This week, the U.S. Treasury and the Federal Reserve clearly worried that a disorderly AIG bankruptcy could result in a chain reaction of losses at financial institutions, creating a liquidity crisis that would plunge the country into a severe recession. 

There are no legal reporting requirements, although the Federal Reserve Bank of New York has urged financial institutions to inform other counterparties of a change of ownership.  There is a risk that some entity E could purchased a CDS from insuring counterparty A (e.g. J.P Morgan Chase) insuring against a default on a bond bought from party B (e.g., Washington Mutual) and may not be informed that the insuring counterparty sold the CDS liability to counterparty C (e.g. AIG).  If counterparty C (e.g., AIG) goes bankrupt, followed some time later by party B’s default, the insured counterparty E would have difficulty collecting what it was owed on the CDS, and might not have known that it should have been on the list of creditors involved in counterparty C’s bankruptcy proceedings.

This example is not trivial.  Barclays analysts estimated in February that if a financial institution that had $2 trillion in credit-default swap trades outstanding were to fail, it might trigger between $36 billion and $47 billion in losses for those that traded with the firm. That doesn’t include the market-value losses investors face as the cost to protect companies against a default widens.[iii]  So, assuming linearity, the bankruptcy of AIG could have resulted in between $7 billion and $10 billion in losses for its counterparties.  Since investment banks are often leveraged at 20 to 1 or higher, the asset sales necessary to maintain a leverage of 20 to 1 could have been of the order of $140 billion to $200 billion. 

Large commercial banks (e.g. JP Morgan Chase and Bank of America) use CDS as part of their risk management.  However, many speculators, including hedge funds, use these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.[2]  In times of market turbulence, such as we have seen recently, undercapitalized participants could have trouble paying their obligations.  This perceived threat adds to the instability and lack of liquidity in the financial markets.

There are many cases of more CDS contracts being written than there are bonds to insure.  If the bond issuer defaults, there will be a scramble of insured parties to find bonds to deliver to the insurer counterparty, in order to collect.  There have been bankruptcy cases in which the holder of naked CDS contracts received a fraction of the bond value.  If the naked CDS was valued on the insured counterparty’s books at the face value of the bond, there could be a large problem if the insured counterparty is highly leveraged and needs to raise capital as a result of an accounting loss.  This problem was well described by Gretchen Morgenson in the New York Times on February 17, 2008 [2].

The policy implications are clear.  The U.S. government needs to regulate derivative markets such as the CDS market.  There needs to be a centralized CDS clearinghouse, privately managed by the financial industry, but regulated.  The CDS clearinghouse would provide a standardized CDS contract with rules for reporting counterparties to a transaction, price, and settlement terms.  All CDS transactions would be required to be made through the CDS clearinghouse, so that counterparties would be known, minimum capital requirements could be established and enforced, and CDS value could be determined for mark-to-market accounting rules. 

What is the appropriate regulatory agency?  Not the toothless Commodity Futures Trading Commission (CFTC)!  Not the Federal Reserve, which is already overloaded in dealing with monetary policy formulation and implementation, as well as ongoing financial crisis management.  Legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets.  The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency. 

 

The regulatory principles needed to underpin this new regulatory authority, as well as the details of the legislation to establish it, are yet to be decided.  The International Swaps and Derivatives Association will probably oppose this recommendation.  However, the collapse of Lehman and the nationalization of AIG have provided impetus to the establishment of a clearinghouse for credit derivatives.[iv] Let the debate begin.

 


 

[i] http://en.wikipedia.org/wiki/Stock_market

[ii] http://www.nytimes.com/2008/02/17/business/17swap.html?scp=4&sq=Credit%20Default%20Swaps&st=cse

[iii] http://marketpipeline.blogspot.com/2008/09/lehman-collapse-spurs-call-for-credit.html

[iv] http://marketpipeline.blogspot.com/2008/09/lehman-collapse-spurs-call-for-credit.html

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10 Responses to “Credit Default Swap Clearinghouse”

  1. Jack Kloskowski Says:

    While I am amateur in the world of swaps and CDS, it seems that it is unsustainable for this market to continue in current shape of things. I believe CDS are relatively new instrument and w/o such proposed and regulated clearinghouse where all such contracts could be tracked this market will descend into chaos and, possibly, will litigate itself out of existence (see UBS CDS Lawsuit: Harbringer of Things to Come.

    However, i believe there are other ways to insure against the credit risk via bond isnsurers – is it not a better way of achieveing the same thing? Not sure if after current CDS fiasco this instrument will still exist in the future. Please comment.

  2. Jack Kloskowski Says:

    All right, seems like CDS Clearinghouse is coming soon in form of Chicago-based Clearing Corporation and it will have banking licence which places it under Federal Reserve oversight. For more datails on CDS Clearing facolity read more here.

  3. Bur Says:

    As a retired engineer with a policy concentration in business school, I do not qualify as an expert on Credit Default Swaps. However, I received several compliments from financial industry experts and no disagreements on my post when I attended a Democratic Pary fundraiser yesterday evening. Thanks for the additional reference.

  4. Jack Kloskowski Says:

    Bur,

    Allow me to join others with my sincere congratulations for well written article. Personally, I have found it very informative and interesting. I am sure others will too.

  5. Bur Says:

    The Streetwise Professor has written an interesting article on the idea of a Central CounterParty (CCP), which is essentially the same thing as a Credit Default Swap Clearinghouse. Here is an excerpt:

    “some market participants (especially big, highly creditworthy players–like AIG before its collapse’-) may oppose the formation of a clearinghouse because a CCP levels the credit playing field. The biggest, most creditworthy firms have a competitive advantage in a non-cleared OTC market, and a CCP might undermine this advantage. The big guys may therefore not want to participate. And if they don’t play, the clearinghouse will never get off the ground.

    Moreover, to the extent that a systemic event caused by a chain of defaults has costs that affect parties other than the intermediaries–a plausible hypothesis–the contracting parties do not internalize all of the costs of their decisions. They therefore do not fully internalize the benefits of the formation of a CCP–and hence may not agree to its creation.

    These arguments suggest that the mandatory creation of a CCP would be welfare improving.

    There are arguments, however, that suggest that there are substantial costs to the formation of a CCP.”

    My response is that there is enormous public costs in not regulating the financial industry, and a clearinghouse for swaps, although complicated, is a necessary part of regulating these new derivatives. The Streetwise Professor is looking at the problem from the industry point of view, whereas in this blog I am taking the public policy point of view.

  6. Bur Says:

    Sorry, I forgot the link to the StreetWise Professor in the previous comment:

    http://streetwiseprofessor.com/?p=492

  7. Jack Kloskowski Says:

    After more reading about the subject, I strongly agree with the immediate need for regulation of CDS market via clearinghouse that is regulated by government body, for example Commodity Futures Trading Commission or Securities and Exchange Commission as urged by it’s Chairman Christopher Cox. In an interesting twist to the subject, New York Governor David Paterson moved to regulate part of the CDS market by requiring entities selling CDS contracts to have New York State Insurance license (effective January 2009). In comments published by Bloomberg, David Paterson urged federal government to regulate rest of CDS market.

  8. Christina Says:

    CDS’s have been explained on Lehrer News Hour which is the only reason I understand what they are. Sort of.

  9. Bur Says:

    This article titled “Credit Default Swaps Clearinghouse”, dated September 19, 2008, has been the most viewed post yet on this blog. The Lehrer News Hour segment by Stephanie Dhue on CDS’s, which mentioned the size of the market and the need for regulation, was aired on September 23. Gretchen Morgenson deserves a lot of credit for identifying the CDS threat to market stability six months before the Lehman Brothers bankruptcy triggered the freezing of the credit markets and the current stock market crash, turning a mild recession into a severe recession that may be worse than anything since the 1970s. Let’s hope the Obama Administration can turn the economy arouond so that it does not become worse than the 1970s.

  10. Bill Hodgson Says:

    Some comments:

    Regulation:
    All OTC products are traded within regulated legal entities. No one will execute an OTC trade with an offshore unregulated firm, unless they pass the full KYC & AML regulations required by the on-shore regulators. The only firms who place themselves offshore are usually hedge funds and asset managers. All the major banks are on-shore, and regulated. Each regulator can ask for details of each banks OTC trades should they wish to.

    Notionals:
    The notional value of a trade is not the market value, but a number used for other cash flow calculations. An Interest Rate Swap would have a typical notional value of $100m – not the price you pay for the trade, but the number used for the interest calculations.

    In addition, the size of the CDS market in notional value, is not a meausure of the net market risk, but just the quantity of business being transacted.

    Standards:
    More or less 100% of CDS contracts are now matched and processed on the DTCC Trade Information Warehouse, making them very much a standard product.

    Notification / Selling / Change of ownership
    You refer to trades being ‘sold’ – this in the industry terms is a Novation or Assignment. In 2005 the paper based way of tracking these was broken, hence the recommendation by Tim Geithner at the New York Fed that firms make use of the DTCC Deriv/SERV platform to automate the process. This was achieved, and since then a great deal more automation has been provided for this process.

    Pricing / Mark Value
    All CDS trades are re-priced daily, to enable firms to call margin between each other under the terms of their ISDA (CSA) margin agreements.

    Bond underlying
    ISDA and the industry have more or less completed a move away from physical settlement of a CDS contract to avoid the squeeze you describe when buyers of protection have to deliver the impaired bond to the seller. During 09 ISDA intend to hard wire this into the standard CDS contracts processed by the Warehouse (and anywhere else).

    I these comments help, Bill.

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