Credit Default Swaps – A Disastrous Unwind

Although mortgage backed securities and mortgage related assets has plagued the financial sector for the past 12-14 months, the sector is about to come under considerable pressure because of a uniquely structured product called a credit default swap or CDS.  The government’s decision to allow Lehman Brothers (LEHMQ.PK) to fail last month may be just another decision in this stressed market that is about to come back to haunt them.  The problem is that a lot of Lehman Brothers’ debt was secured or insured by credit default swaps.  After Lehman failed and defaulted on their debt, writers or insurers of these CDS products will be forced to pay up on their contracts.

What is a Credit Default Swap (CDS)?

In layman’s terms, a credit default swap is essentially a contract that is purchased to insure or protect against a company’s default on their debt.  The buyer of the CDS receives the protection on their credit risk of holding a firm’s debt, where the seller of the swap is insuring or guaranteeing that the firm the contract is for will not default on their debt.  In an event that the firm would default, the writer of the contract would be responsible for paying back the buyer of the CDS their losses for holding the debt.

On a “60 Minutes” show earlier this month, Former staff member of the Commodity Futures Trading Commission, Michael Greenberger described a credit swap in brief: “A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails. It is an insurance contract, but they’ve been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a ’swap,’ which by virtue of federal law is deregulated.”

If a credit default swap is essentially an insurance product, why isn’t it regulated?  The current way that credit default swaps are structured does not allow it to be regulated by government agencies.  Technically CDS are “swap” contracts and are not sold as insurance products, but merely swapping the risk in the event of a default for a fee.

Typically credit default swaps are quoted in $10 million dollar corporate debt increments.  Also, credit default swaps usually last for a period of 5 years, although other time structures may also be agreed upon.  For example, if an investor in corporate debt wanted to protect himself/herself against default on a $10 million investment they would enter into an agreement that would usually provide them protection for 5 years for some fee.  Fees generally ranged from 1-5% depending on the credit quality of the underlying company.  In recent market conditions, these spreads increased to ridiculous levels that have never been seen before.  For this example let’s assume that the fee is 1%.  The investor would then pay the writer of the CDS $100,000 for protecting their $10 million in the event of a default.

Size of CDS Market and Uses

The value of the market is largely un-known as financial institutions who participate in these securities may submit their holdings in a voluntary survey.  The notional value is estimated to be between $54-60 trillion, which is 4 times the size of the U.S. debt.  This market has grown very rapidly over the past 7 years from less than a trillion in 2001 to its current levels of over $50 trillion.

It is mainly a private market with many participants such as AIG (AIG), Lehman Brothers, Merrill Lynch (MER), Bear Stearns, hedge funds, other investment funds, and other large investment and commercial banks who participated in these products for numerous reasons.  These are the same companies that have been under pressure recently and a few of them have either gone bankrupt or been bailed out in some form.  These financial institutions that issued or structured CDO’s, or collateralized debt obligations, also provided investors insurance on these CDO’s through credit default swaps to provide assurance to the investor that their investment would be “safe”.  Essentially it was pitched as a risk saving device for buying a risky asset.

Credit Default swaps are frequently used for hedging purposes by a variety of funds and companies.  They can be used to hedge against existing or new exposures and may also be used for speculation purposes.  Owners of corporate debt may seek to hedge their exposure in the event that the company would go bankrupt or default.  By purchasing a credit default swap, the owner of the corporate debt is essentially reducing their investment risk.  Hedge funds have also played a huge role in this market as they have been able to speculate about changes in a company’s credit rating or quality.  One does not need to own the underlying corporate debt to purchase a credit default swap.  As long as there is someone on the other side of the trade, the transaction can be executed.

Credit default swaps are de-regulated according to federal law because of their product structure as a swap.  If it was insurance then they would need to have capital reserves to make sure that they had adequate capital in the event of a default.  This has caused many problems and will cause many problems in the near future as many institutions who sold these contracts did not adequately price in the risk that there would actually be defaults on debt from the firms they provided insurance on.  Because many institutions would sell these contracts at a relatively low price, because of the perceived risk of default, many of these institutions sold a lot of contracts to make money on the price that investors would buy them for.  Systematic risk, globalization, and a credit squeeze were also not factored into their risk models.  These risks were at the heart of the recent catastrophic events to the financial sector that have resulted and will result in large losses.

Warren Buffet, CEO of Berkshire Hathaway (BRK-A), is now famous for getting out of the derivatives market as he described in an annual report to shareholders in 2002:  “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 Problem that with Lehman’s Default

On October 10th, Lehman’s debt was sold for approximately 8.625 cents on the dollar.  Since the settlements sold at 8.625 cents on the dollar during the auction, this means that the firms who sold the credit default swap contracts on this debt will be forced to pay up the remaining 91.375 cents on the dollar.  This loss 91.375 cents lost on the dollar isn’t completely accurate as firms were paid fees on average of about 8 cents on the dollar to take this side of the bet.  Estimates on losses from debt insured by credit default swaps have been rumored to be somewhere between $350-400 billion.  This is an incredible amount if you compare these losses to the US government’s $700 billion bailout plan.  Settlements for the credit default swaps on Lehman Brother’s contracts are on October 21st.  With over $350 billion of losses that will be recorded from just one financial institution failure, this is sure to spread throughout the industry and cause further defaults.

What this large loss will do will essentially lead to further write-downs by the firms who sold the contracts.  As explained above, the firms who wrote these contracts such as investment and commercial banks, hedge funds, and large as well as small insurers and re-insurers may not be adequately capitalized to take these losses.  This will stem to further failures and bankruptcies by these institutions.  These institutions probably also have credit default swaps that were issued to protect in an event that they would go bankrupt and default on their debt.  This viscous circle could continue on and on until someone is adequately capitalized to take the hit.  An un-wind could occur in the CDS market which would have effects that aren’t even possible to predict.  I would bet that counterparty risk would be more of a problem than before and banks would freeze their lending to protect their own balance sheets.  With such a large notional value of $54 trillion, it could lead to severe and even more catastrophic problems than we have seen.

Who will this most likely affect the most?  I would stay away from insurance compananies, especially monoline insurers like Ambac Financial (ABK) and MBIA Inc. (MBI).  AIG may also be in trouble as they are rumored to have their foot the deepest in this mess.  They have already borrowed over $70 billion of the US government’s $122.8 billion that they have allowed AIG to borrow up to.  The government was forced to increase their original loan to AIG of $85 billion by about $30 billion as they underestimated the troubles at AIG.

Future Regulation

If an un-wind of this magnitude were to happen, the federal government would almost have to step in to prevent a nation wide bank run.  Customers of banks would be in fear that the institution their money was in may not be around for them to claim their money.  Even though the FDIC protects many depository customers from this type of an event, the FDIC does not have the balance sheet to protect everyone against an event like this.  Smart investors may also move U.S. dollars out of the U.S. and into countries that are more stable.

Even if an un-wind doesn’t result, expect the next president to move quickly on this huge un-regulated security.  Wall Street has already been scrutinized enough for the cause of the underlying mortgage securitization problem, and the risk of this market blowing up is not worth taking.  The OTC or a new government agency is the most likely option in regards to who will be responsible for regulating this large market in the future.  Expect the insurance industry to be required to hold a certain percentage of reserves against the credit default swap contracts that they hold.  This will significantly hurt their future profitability as they will need to hold more assets on their own books.  Also expect some type of a clearing house to take care of all of the trading in this market.  Because it is largely unregulated, no one knows who owns what.   This is a important step to allow the enforcement of new regulation to take place.

Disclosure:  The mutual fund the author is associated with has interests in Berkshire Hathaway.

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