Systemic Counterparty Confusion: Credit Default Swaps Demystified

It Is A Tale Told By An Idiot

The press loves a spectacle. There’s a good reason for this: panic increases paranoia, which increases the desire for information, which increases their advertising revenues. Thus, the press has an incentive to exaggerate the importance of the events they report. As such, we shouldn’t be surprised to find the press amping up fears about the next threat to the “real economy.”

When written about in the popular press, terms such as “derivative” and “mortgage backed security” are almost always preceded by adjectives such as “arcane” and “complex.” They’re neither arcane nor complex. They’re common and straightforward. And the press shouldn’t assume that their readers are too dull to at least grasp how these instruments are structured and used. This is especially true of credit default swaps.

Much Ado About Nothing

So what is the big deal about these credit default swaps? Surely, there must be something terrifying and new about them that justifies all this media attention? Actually, there really isn’t. That said, all derivatives allow risk to be magnified (which I plan to discuss in a separate article). But risk magnification isn’t particular to credit default swaps. In fact, considering the sheer volume of spectacular defaults over the last year, the CDS market has done a damn good job of coping.  Despite wild speculation of impending calamity by the press, the end results have been a yawn . So how is it that Reuters went from initially reporting a sensational $365 billion in losses to reporting (12 days later) only $5.2 billion in actual payments? There’s a very simple explanation: netting, and the fact that they just don’t understand it. The CDS market is a swap market, and as such, the big players in that market aren’t interested in taking positions where their capital is at risk. They are interested in making money by creating a market for swaps and pocketing the difference between the prices at which they buy and sell. They are classic middlemen and essentially run an auction house.

Deus Ex Machina

The agreements that document credit default swaps are complex, and in fairness to the press, these are not things we learn about in grammar school – for a more detailed treatment of these agreements, look here. Despite this, the basic mechanics of a credit default swap are easy to grasp. Let’s begin by introducing everyone: protection buyer (B) is one party and swap dealer (D) is the other. These two are called swap counterparties or just counterparties for short. Let’s first explain what they agree to under a credit default swap, and then afterward, we’ll examine why they would agree to it.

What Did You Just Agree To?

Under a typical CDS, the protection buyer, B, agrees to make regular payments (let’s say monthly) to the protection seller, D. The amount of the monthly payments, called the swap fee, will be a percentage of the notional amount of their agreement. The term notional amount is simply a label for an amount agreed upon by the parties, the significance of which will become clear as we move on. So what does B get in return for his generosity? That depends on the type of CDS, but for now we will assume that we are dealing with what is called physical delivery. Under physical delivery, if the reference entity defaults, D agrees to (i) accept delivery of certain bonds issued by the reference entity named in the CDS and (ii) pay the notional amount in cash to B. After a default, the agreement terminates and no one makes anymore payments. If default never occurs, the agreement terminates on some scheduled date. The reference entity could be any entity that has debt obligations.

Now let’s fill in some concrete facts to make things less abstract. Let’s assume the reference entity is ABC. And let’s assume that the notional amount is $100 million and that the swap fee is at a rate of 6% per annum, or $500,000 per month. Finally, assume that B and D executed their agreement on January 1, 2008 and that B made its first payment on that day.  When February 1, 2008 rolls along, B will make another $500,000 payment. This will go on and on for the life of the agreement, unless ABC triggers a default under the CDS. Again, the agreements are complex and there are a myriad of ways to trigger a default. We consider the most basic scenario in which a default occurs: ABC fails to make a payment on one of its bonds. If that happens, we switch into D’s obligations under the CDS. As mentioned above, D has to accept delivery of certain bonds issued by ABC (exactly which bonds are acceptable will be determined by the agreement) and in exchange D must pay B $100 million.

Why Would You Do Such A Thing?

To answer that, we must first observe that there are two possibilities for B’s state of affairs before ABC’s default: he either (i) owned ABC issued bonds or (ii) he did not. I know, very Zen. Let’s assume that B owned $100 million worth of ABC’s bonds. If ABC defaults, B gives D his bonds and receives his $100 million in principal (the notional amount). If ABC doesn’t default, B pays $500,000 per month over the life of the agreement and collects his $100 million in principal from the bonds when the bonds mature. So in either case, B gets his principal. As a result, he has fully hedged his principal. So, for anyone who owns the underlying bond, a CDS will allow them to protect the principal on that bond in exchange for sacrificing some of the yield on that bond.

Now let’s assume that B didn’t own the bond. If ABC defaults, B has to go out and buy $100 million par value of ABC bonds. Because ABC just defaulted, that’s going to cost a lot less than $100 million. Let’s say it costs B $50 million to buy ABC issued bonds with a par value of $100 million. B is going to deliver these bonds to D and receive $100 million. That leaves B with a profit of $50 million. Outstanding. But what if ABC doesn’t default? In that case, B has to pay out $500,000 per month for the life of the agreement and receives nothing. So, a CDS allows someone who doesn’t own the underlying bond to short the bond. This is called synthetically shorting the bond. Why? Because it sounds awesome.

So why would D enter into a CDS? Again, most of the big protection sellers buy and sell protection and pocket the difference. But, this doesn’t have to be the case. D could sell protection without entering into an offsetting transaction. In that case, he has synthetically gone long on the bond. That is, he has almost the same cash flows as someone who owns the bond.