What is a Credit-Default Swap (CDS) - The Torpedo That Could Sink the Ship!

First, a formal definition of a credit-default swap (CDS) from InvestorWords.com: a CDS is a specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.

The value of the definition above is it includes all the buzz words used when talking about a CDS.

A CDS in plain English is an insurance policy. Let us say that you lend somebody money to purchase a house (a mortgage). You want to sell that debt to someone else, but they want you to assume the risk on the debt if the borrower defaults on the morrtgage. Using the definition above that makes you the lender and the person that borrows the money is the third party. If you have to assume the risk that if borrower defaults on the debt you are assuming the third party credit risk. So what you do is you go to an insurance company and you purchase a credit-default swap (CDS). This does two things: 1) it makes the person that purchases the debt from you feel better because they do not have to worry about the credit risk and 2) you don’t have to worry about the credit risk because you have insurance for it. You have in essence transferred the credit risk to the insurance company (the counterparty). The drawing below from the WSJ is a good description of a CDS.

Sounds pretty good so far, right? So what is the big deal?

The big deal is that CDSs are a barely regulated market in which banks, hedge funds, and just about anyone else including speculators can buy these financial contracts. It is estimated that the current number of contracts is about $45T (T as in trillion), which is roughly equivalent to all the bank deposits in the world.

The CDS market is perfectly legitimate and has been used for years to guarantee municipal bonds. For example, if a small town with basically no bond rating needed a sewage plant they could issue municipal bonds, guarantied with a CDS from an insurance company with a AAA rating and all of a sudden the small town with no rating is borrowing at the rates reserved for AAA credit risk companies. However, since 2000 CDS contracts have been increasingly used to guarantee the assortment of complex debt obligations coming from the banks and hedge funds. The chart below from the WSJ shows the growth in CDS obligations in the last seven years.

There are not that many insurance companies providing CDS contracts. The larger ones are Ambac and MBIA with a smaller one being ACA.

The problem that is arising is since last summer the declining mortgage CDO market is putting pressure on the insurance companies because they may have to pay on some of their CDS contracts. This is requiring Ambac, MBIA, and ACA to bolster their capital reserves in some way. If the capital reserves cannot be increased the rating agencies are threatening to decrease their credit ratings. As a matter of fact, Fitch decreased the credit rating on Ambac from AAA to AA last Friday. One can tell that these three companies are having troubles by looking at their stock prices. Ambac and MBIA have both gone from about $60 per share six months ago to prices in the lower to middle teens. ACA has fallen in the last six months from $15 per share to a price below $1 today.

However, this is not the real problem. The real problem lies within the commercial banks, investment banks, and hedge funds. If a bank is holding a bond supported with a CDS contract and the seller (Ambac, MBIA, or ACA) of the CDS has its credit rating decreased the bank must take additional losses to accommodate the lower credit rating. In other words if a bank has a CDS contract with an insurer that formerly had a AAA rating but now has a AA rating the bank is exposed to additional risk due to the lower rating so it must take additional writedowns in the affected portfolios. This can turn into very sizeable sums. For example, Merrill Lynch has been forced to writedown $3.1B in securities and Citigroup has been forced to writedown $935M in additional losses in anticipation of the insurance companies not being able to perform under the CDS contracts. So there are a number of financial institutions that could suffer very dire consequences if the CDS markets collapses. As a matter of fact I recently received an investment letter from a friend of mine with the following comment:

I want to impress upon my clients and readers that this is a very serious financial situation. Everyone who reads this needs to be familiar with the term credit default swap (CDS). It will soon be in the news and a major topic of conversation. This $45 trillion market has the potential to collapse our financial system. If our financial system collapses then 750 (the S&P 500 index) will not be the bottom of this bear market.

A good description of how the CDS contracts are involved in the complex world of debt and derivatives can be found in the WSJ and the NY Times.