Credit Default Swaps are supposed to be Weapons of Mass Destruction, so where is the Mass Destruction???

Recently the financial markets were shrieking in fear of the settlement of Lehman and Washington Mutual credit default swaps. Yet the settlement dates have past and there seems to be no impact apparent to the market. What happened? Is the CDS question overblown? Are the risk controls in place that the market is discounting?

There a few reasons to believe that the issues are still looming large in the market…

1) Just like the LTCM meltdown, it is not the settlement but the collateral requirements that will kill you

The OCC reports that investment banks believe they are hedged up to 85% of notional value of CDS.

This means the last 15% can swing in as a profit or loss, assuming no counterparty risk. For many of these hedge funds and banks, particularly for AIG, as market falls the collateral requirements on their positions must raise parabolicly. In the case of 123B loan from the US government to AIG, “tens of billions of dollars to post collateral with other financial institutions, as required by A.I.G.’s many derivatives contracts”. The "assets in a box" with the clearing bank will need to be replentished. But where will that come from in an environment like this? I am sure there are firms that are dead right now but just waiting on the banks to come seize assets on loans that are not performing.

2) Creditor will vampire the dead firms rather than kill them

The last thing any prime broker or bank needs is exposure that another client is not performing. Thus any attempt will be made to defer the inevitable while doing everything they can to obtain as much collateral before the fall. Look at how the home builders like Beazer have continued operations with no prospects of returning to profitability in the next few years. In the book Traders, Guns, & Money, the Das recounts how mid sized Indonesian firm, facing huge losses, created follow on agreements to amortize the debt with interest over longer periods of time. Whenever possible, this deferred payment plan disguised as an additional trade will be the best option for many of the major banks if they think the party will be able to last through the crisis.

3) The counterparty risk makes hedging calculations dubious

Take the UBS vs. Paramax court case where we find that UBS propped up a hedge fund and then bought CDS protection from them. The idea that hedge funds, as leveraged parties, can hold significant quantities of these securities creates a systemic risk. So if banks have 15% directional exposure, and additional 10% risk due to possibility of counterparty failure, then what are the real capital requirements that the banks need to call themselves solvent? I don't think any of the major credit default swap brokers have achieved this level of captial safety.

4) Lack of transparency to risk concentration is a riddle in itself

Yes, there were only $72B of Lehman CDS to be settled, and only $5B of that changed hands. But we do know there are 63T CDS outstanding amongst all banks. JP Morgan, BofA, C account for 15T by themselves. The 15% exposure of this notional value is worth more than the market cap of all of these banks combined. So what that we turned over one shell in this shell game and there was less than what we expected? Later we might turnover a shell and find more than what we expected. Or we find a case like AIG where they took only the side of writing protection?

The risk is very real.

In conclusion: Stronger transparency to collateral requirements will make the CDS market viable in the future when risk assessment criteria is formalized and enforced. But over 90% of existing CDS contracts span in length from 1 to 5 years. Thus there will be tremendous risk that will need to be flushed through the market that will keep the environment tenuous until industry can be considered viable, stable corner of the capital market.

This article is written in response to Felix Simon’s article “CDS the less you know the worse they look?”