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.


33 thoughts on “Systemic Counterparty Confusion: Credit Default Swaps Demystified

  1. Pingback: Alea | Derivative Dribble

  2. Pingback: Links: In difesa dei Credit Default Swaps | Michele Berti

  3. Synthetic shorting…….way too cool!

    Now let me get this right. Lehman was a middleman, living off the spreads between buying and selling protection? So unlike AIG, it wasn’t net synthetically long by a huge amount? (5.2 Billion)

    If I understand you correctly,at the moment of Lehman’s collapse, about 365 billion notional, would have been unhedged. Would that be correct?

    Would I be right in assuming that as a protection seller, your potential loss in the event of a trigger event is equivalent to your net long position with regard to the protected entity?.

    Ok then, suppose B has entered into a contract to protect A. However he is concerned about having to limit his losses to A so he assumes a net 5%long position with regard to a A by buying protection from c, c does likewise with d and so on. A trigger event occurs, and A receives 100% from B who receives 95% from C, who receives 90% from D, and so on.

    A is made whole by the trigger event, but B, C, D, have all incurred a loss. Would this be correct?

    If this is so, when someone like GM goes down, the buyers of protection will eventually be made whole by stockholders and taxpayers from various parts of the world. Or in other words, protection basically comes about from the whole of the financial system.

    Now, if a trillion dollars of global capital supports twelve trillion dollars of global debt and suppose there are a trillion dollars worth of protected writedowns in the U.S alone, would that mean that the world’s capital would be vaporised bu U.S losses.?

    Help a brother out. Great blog.

  4. Slumlord: kind of. If you break it down, the dealers have very little net exposure, the primary sellers of protection turn out to be insurance companies (like AIG) and more specifically monolines (like ABK). So they will be the primary losers, and as we have seen these losses will likely be nationalized.

  5. Gary,

    You are right that AIG and the monolines were not running hedged books. But your statement that they were the “primary” (as in majority) sellers of protection in the CDS market seems a bit bullish. I don’t know if that’s true. If you know this to be the case, could you provide a link to the relevant data? That would be great. Thanks.

  6. What if one company who has plenty of equity but a liquidity problem defaults when there is much more CDS outstanding than actual bonds? Say the par value is $100. I would imagine that these might only drop to say $70 since everyone knows they will get their principle back in a short period of time. However if all of the CDS buyers have to locate these bonds for physical delivery, they might not be able to buy enough of them. That would drive the price up, right? I would think that it could even go above par if the supply/demand imbalance was that large. In that case, maybe the two parties could decide to settle the deal differently. The seller does not profit if the buyer pays $150 for the bond and then gives him a bond really only worth $70 in exchange for $100. Likewise the buyer loses money as well. So maybe the two would decide to settle this at some other price. Maybe for example the seller could just pay $20 and be done with it. Does this kind of thing happen?

    I can also imagine a funny scenario where someone corners the market for some risky bond and then sells CDSs on it requiring physical delivery. When it defaults, the seller could charge whatever they want for these bonds since they are the only owner and the buyers need to buy them for delivery. Has anything like that ever happened? Just like corners in the days of Cornelius Vanderbilt.

  7. David,

    Very clever thinking. However, the problems you pose have already been considered and taken care of. The International Swaps and Derivatives Association (ISDA) sets up auctions that address the liquidity issue that is at the center of both of your concerns(not enough bonds to settle). ISDA is an industry group composed of the big swap dealers. So, the “auction house” I mention in the above article actually exists.

    I was going to write something about ISDA auctions, but honestly, it’s a rather boring and complicated subject.

  8. Hi TBrander,

    I did mention that parties are required to post collateral. To be more specific, typical CDS agreements have provisions that require collateral on a dynamic basis (based on credit quality of the counter parties, one side being in-the-money, etc). So, counterparty credit risk is dealt with in the agreements.

    That said, if a party is dramatically downgraded (like AIG) and can’t post collateral, then we run into trouble. But that’s not unique to the CDS market. Dramatic downgrades affect all kinds of agreements, even plain vanilla loans. So, again, the CDS market is not the culprit – rather, bad decision making is.

  9. Unfortunately I am an AIG shareholder and learned this the hard way. I had a pretty good understanding of the valuation of their CDS portfolio, but I didn’t really understand the liquidity issues well enough. I guess I just figured that they would never get downgraded because I thought the ratings agencies would work with them to make sure they raised enough capital to avoid the downgrade. Of course, I never realized that the collateral calls could lead to the situation where they would need a hundred billion dollars of capital. I guess not many other people did either.

    I have been buying AIG at these low levels too but it is a different investment now. Lets hope there are not more lessons for me to learn.

  10. “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.”

    This just looks like insurance.

    A. If AIG defaults, B has to go out and buy $100 million par value of AIG bonds.
    B. B has to pay out $500,000 per month for the life of the agreement and receives nothing.

    Why couldn’t this transaction be tied to anything? Wheat, currency, anything that I’d have to buy if it’s devalued? In other words, if you don’t own it, peg it to anything. Is there some reason to peg it to bonds or mortgages, as opposed to anything else?

    If my question doesn’t make sense, don’t answer it. If you don’t want it on the blog but can answer me, please email me. Thanks, Don

  11. Hi Don,

    Great name! Yes, it does look like insurance. At at a bilateral level, it is. However, insurance regulations don’t work in swap markets. Here’s why:

    Derivative contracts can indeed be linked to any objectively observable and measurable event, e.g., the occurrence of a hurricane. These types of things exist. They’re called “weather bonds.”

    I’m writing a piece on “synthetic instruments” which will discuss things like this so keep an eye out for it!

  12. Derivative Dribble,

    Thanks so much for this website that explains these transactions so well. I wonder, in the CDS market, is possible for party D (the proctection seller) to actually be an indirect broker for the reference seller ( AIG in this case ), and hence make the protection seller the same as the bond issuer? Seems like this kind of situation could be seriously problematic if the seller has access to info from AIG that the buyer does not.


  13. Although I’m not totally clear on what you’re asking, I’ll assume that you’re asking whether or not a broker for AIG bonds could also sell protection on AIG obligations. I don’t know for sure, but I do know that under the securities laws, swaps are not securities. So, it would seem to follow that there’s no need to abstain from trading in swaps based in inside information. I would poke around the web and see if any brokers are also protection sellers.

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  15. >>what if D goes bankrupt ?

    There are two parts to a CDS trade:
    Buyer: Pays a stream of fixed coupon payments
    Seller: Pays out in the event of a default

    So from a simple perspective, if the Seller (D) goes bust:

    Buyer: Doesn’t pay any more coupons
    Seller: Can’t pay out on the CDS contract because A) they’re bust and B) no event occurred to trigger a payout


    The probability of the reference entity going bust (the thing you bought protection on) is rarely if ever zero, so using a pricing curve you can measure the probability of default at the time the seller went bust, multiple by the amount of protection, and get a value for the sellers payment to the buyer.


    Buyer: Fixed coupons stream to maturity = $X
    Seller: Probability of default * notional = $Y

    Net $X & $Y to get value of the contract $Z. If Z is positive to you, claim it from the liquidators, if $Z is negative, don’t answer the phone, you owe money.

    >>> And how are accounted for the 500.000 $ monthly payments in the books of B and D ?
    A CDS contract isn’t insurance and isn’t regulated, so it’s like paying for electricity, just another cashflow in your accounts.


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  26. If looking to purchase a CDS, am I correct in assuming that a person seeking to hedge its exposure would only buy a CDS if the premium was less than the annual coupon yield from the underlying bonds?

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