Credit default swap fact of the day

…the CDS [credit default swap] positions of large US banks during 2001–06 grew at an average compounding annual rate of over 80%.

That’s from a very good paper by Darrell Duffie.  There is more:

Of all 5,700 banks reporting to the US Federal Reserve System, however, only about 40 showed CDS trading activity and three banks – JP Morgan Chase, Citigroup and Bank of America – accounted for most of that activity.

The net transfer of credit risk away from banks is estimated to account for 30 percent of the market.  Furthermore a bank may go short on the credit risk of a company it is lending to.  A CDS is then a substitute for selling or securitizing the loan.  If you think securitization is overdone, CDS has this benefit namely that it is a potential substitute. 

A bank also can short the credit risk of a company by dealing in its bonds and other securities.  But these other security markets are regulated and replete with restrictions on short sales and the like.  The CDS markets don’t have comparable restrictions.  You can think of the CDS market as, in part, an attempt to circumvent regulations and trading costs in other securities markets.

Here is the single best paper on CDS that I know.  Enjoy.


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