In an effort to understand the so-called economic tsunami, I’m trying to figure out what a Credit Default Swap is an how it fits into this whole subprime lendng crisis… There’s just so much jargon to try to absorb overnight. And for what reason? No particular one… Still, this entry from Wikipedia seems instructional… The chunk of language that jumps out at me (after the sentence that Texas scumbag Lindsey Graham engineered the scam with the willing cooperation of Bill Clinton) is”Before the Act, the CDS markets value was 900 billion. By the end of 2007, the CDS market had a notional value of $45 trillion, of which the corporate bond, municipal bond, and structured investment vehicles market totaled less than $25 trillion. Therefore, a minimum of $20 trillion were speculative “bets” on the possibility of a credit event of a specific credit asset not owned by either party to the CDS contract. [13]” The concept seems to be if you dress up a pile of rubbish nicely enough, you can resell it over and over and over again indefinitely without ever telling the person holding the bill of sale that what they’re buying is rubbish. The entire subprime crisis was beautifully articulated by this video that my dad sent to me.

from the entry for Credit Default Swaps on Wikipedia:

History

[edit] Conception

Credit Default Swaps were invented in 1997 by a team working for JPMorgan Chase[7][8][9]. They were designed to shift the risk of default to a third-party, and were therefore less punitive in terms of regulatory capital.[10]

Credit Default Swaps became exempt from regulation with the Commodity Futures Modernization Act of 2000, which was also responsible for the Enron loophole. U.S. Sen. Phil Gramm (R-TX) introduced the Act on behalf of financial industry lobbyists. The Modernization Act was rushed through Congress as a companion bill to the omnibus spending bill, the last day before the Christmas holiday[11]. It by-passed the substantive policy committees in both the House and the Senate so that there were neither hearings nor opportunities for recorded committee votes [12]. The omnibus spending bill, which was 11,000 pages long, is the financial plan the government requires for everyday operations. President Clinton signed the bill into Public Law (106-554) on December 21, 2000.

[edit] Market growth

The Modernization Act allowed for even more regulatory bypasses. It became difficult to determine the financial strength of the sellers of protection. CDS came to be issued for Structured Investment Vehicles, which did not have a known entity to follow to determine the strength of a particular bond or loan. The market became rampant with gambling as sellers and buyers of CDS were no longer owners of the underlying asset (bond or loan). Before the Act, the CDS markets value was 900 billion. By the end of 2007, the CDS market had a notional value of $45 trillion, of which the corporate bond, municipal bond, and structured investment vehicles market totaled less than $25 trillion. Therefore, a minimum of $20 trillion were speculative “bets” on the possibility of a credit event of a specific credit asset not owned by either party to the CDS contract.[13]

As the market matured CDSs were increasingly used by investors wishing to bet for or against the likelihood that particular companies or portfolios would suffer financial difficulties; rather than to insure against bad debt -see above. The market size for Credit Default Swaps began to grow rapidly from 2003, by late 2007 it was approximately ten times as large as it had been four years previously. [14]

[edit] Market as of 2008

Composition of the United States 15.5 trillion US dollar CDS market at the end of 2008 Q2. Green tints show Prime asset CDSs, reddish tints show sub-prime asset CDSs. Numbers followed by “Y” indicate years until maturity.

Proportion of CDSs nominals (lower left) held by United States banks compared to all derivatives, in 2008Q2. The black disc represents the 2008 public debt.

Credit default swaps are by far the most widely traded credit derivative product.[15] the Depository Trust and Clearing Corp, which maintains a database holding around 90% of all credit derivative transactions, held $29.2 trillion of outstanding CDS trades as of 26 December 2008.

It is important to note that since default is a relatively rare occurrence (historically around 0.2% of investment grade companies will default in any one year[16]), in most CDS contracts the only payments are the spread payments from buyer to seller. Thus, although the above figures for outstanding notionals sound very large, the net cashflows will generally only be a small fraction of this total.

Regulatory concerns over CDS

A number of large scale incidents occurring in 2008 drew considerable attention onto the CDS.

In the days and weeks leading up to the collapse of Bear Stearns, the bank’s CDS spread widened dramatically, indicating a surge of buyers taking out protection on the bank. It has been suggested that this widening was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its access to wholesale capital which eventually led to its forced sale to JP Morgan in March. An alternative view is that this surge in CDS protection buyers was a symptom rather than a cause of Bear’s collapse; i.e. investors saw that Bear was in trouble, and sought to hedge any naked exposure to the bank, or speculate on its collapse.

In September the bankruptcy of Lehman Brothers caused a total close to $400 Billion to become payable to the buyers of CDS protection referenced against the insolvent bank. However the net amount that changed hands was around $7.2 billion [17] This difference is due to the process of ‘netting’. Market participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them from their hedging positions. Dealers generally attempt to remain risk-neutral so their losses and gains after big events will on the whole offset each other.

Also in September American International Group (AIG) required a federal bailout because it had been excessively selling CDS protection without hedging against the possibility that the reference entities might decline in value, which exposed the insurance giant to potential losses over $100 Billion. While the CDS on Lehamn were settled smoothly, and its arguable that other incidents would have been as bad or worse if less efficient instruments than CDS had been used for speculation and insurance purposes, the closing months of 2008 saw regulators working hard to reduce the risk involved in CDS transactions.

In 2008 there was no centralised exchange or clearing house for CDS transactions; they are all done over the counter (OTC). This led to recent calls for the market to open up in terms of transparency and regulation[18]. In November, DTTC, which runs a warehouse for CDS trade confirmations accounting for around 90% of the total market[19], announced that it will release market data on the outstanding notional of CDS trades on a weekly basis.[20] The data can be accessed on the DTCC’s website here: [3] The U.S. Securities and Exchange Commission granted an exemption for Intercontinental Exchange Inc. to begin guaranteeing credit-default swaps.

The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental. Its larger competitor, CME Group Inc., hasn’t received an SEC exemption, and agency spokesman John Nester said he didn’t know when a decision would be made.

[edit] Market as of 2009

The early months of 2009 saw several fundamental changes to the way CDSs operate, brought on by concerns of the safety of the instrument after the events of the previous year. According to Deutsche Bank managing director Athanassos Diplas “the industry pushed through 10 years worth of changes in just a few months” By late 2008 processes had been introduced allowing CDSs which offset each other to be cancelled. Along with termination of contracts that have recently paid out such as those based on Lehmans, this had by March reduced the face value of the market down to an estimated $30 trillion. [21] U.S. and European regulators are developing separate plans to stabilize the derivatives market. Additionally there are some globally agreed standards falling into place in March 2009, admistrated by International Swaps and Derivatives Association (ISDA). Two of the key changes are:

1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face.

2. The internatinoal standardisation of CDS contracts, to prevent legal disputes in ambiguous cases where its not clear what the payout should be.

Speaking before the changes went live , Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York, stated

“ A clearinghouse, and changes to the contracts to standardize them, will probably boost activity. … Trading will be much easier, … We’ll see new players come to the market because they’ll like the idea of this being a better and more traded product. We also feel like over time we’ll see the creation of different types of products. ”

In the US central clearing operations began in March 2009 , operated by InterContinental Exchange (ICE). A key competitor also interested in entering the CDS clearing sector is CME Group. CME spokesman Allan Schoenberg didn’t immediately respond to a request for comment.

Details for a European clearing are still being hammered out.

Government Approvals Relating to Intercontinental and its competitor CME

The SECs approval for ICE’s request to be excempted from rules that would prevent it clearing CDSs is the third government action granted to Intercontinental this week. On March 3, its proposed acquisition of Clearing Corp., a Chicago clearinghouse owned by eight of the largest dealers in the credit-default swap market, was approved by the Federal Trade Commission and the Justice Department. On March 5th, the Federal Reserve Board, which oversees the clearinghouse, granted a request for ICE to begin clearing.

Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs Group Inc. and UBS AG, received $39 million in cash from Intercontinental in the acquisition, as well as the Clearing Corp.’s cash on hand and a 50-50 profit-sharing agreement with Intercontinental on the revenue generated from processing the swaps.

SEC spokesperson John Nestor stated

“ For several months the SEC and our fellow regulators have worked closely with all of the firms wishing to establish central counterparties. … We believe that CME should be in a position soon to provide us with the information necessary to allow the commission to take action on its exemptive requests. ”

Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and LCH.Clearnet Ltd. Only the NYSE effort is available now for clearing after starting on Dec. 22. As of Jan. 30, no swaps had been cleared by the NYSE’s London- based derivatives exchange, according to NYSE Chief Executive Officer Duncan Niederauer. [22]

Clearing House Member Requirements

Members of the Intercontinental clearinghouse will have to have a net worth of at least $5 billion and a credit rating of A or better to clear their credit-default swap trades. Intercontinental said in the statement today that all market participants such as hedge funds, banks or other institutions are open to become members of the clearinghouse as long as they meet these requirements.

A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of a counterparty defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded, participants are exposed to each other in case of a default. A clearinghouse also provides one location for regulators to view traders’ positions and prices.

Other changes and debate on CDS in 2009

There is ongoing debate concerning the possibility of banning “naked” speculation by requiring buyers to have a stake in the underlying entity that the CDS pays out on. This means the CDS buyer would have to own some of the bonds or loan that triggers a pay out on default. Or in the case of CDSs where a pay out is triggerd by a companies bankruptcy, credit rating downgrade etc. the buyer would have to own some of the companies shares. [23]