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.

Comments

three banks – JP Morgan Chase, Citigroup and Bank of America – accounted for most of that activity.

All of these institutions of course weathered the storm seemingly fine, so what is the significance of their CDS activity? If the Government had allowed AIG to fail, would the workout of its CDS positions have unraveled these banks as well?

"most" for the top 3 means they "control" 92% of all derivatives and 97% of credit derivatives. In both i.r. derivatives and credit derivatives, the big 3 are basically flat i.e net exposure is negligible in relation to notional value.

It's true that the limitations of securities markets are one part of the need filled by CDS's, as you mention. But the overwhelming function of CDS's is that they separate credit risk from all the other risks associated with bonds, for instance. Also, CDS's have similar trading costs, and have counterparty risk, a risk not shared by the securities. I guess I'm saying that you appear to be overestimating the motivation to avoid regulation, but I don't know how much you mean when you say 'in part.'

It's true that the limitations of securities markets are one part of the need filled by CDS's, as you mention. But the overwhelming function of CDS's is that they separate credit risk from all the other risks associated with bonds, for instance. Also, CDS's have similar trading costs, and have counterparty risk, a risk not shared by the securities. I guess I'm saying that you appear to be overestimating the motivation to avoid regulation, but I don't know how much you mean when you say 'in part.'

If JP Morgan Chase, Citigroup and Bank of America were doing a lot of CDS activity, and are RELATIVELY fine [Citi??] ... what firms were, in general, selling these?

Is that side of the business similarly concentrated in, say AIG and federal bailout players to be named later?

The market treats regulation like damage and routes around it.

I think cb is more to the point. It's not really about going around regulations; asset swaps achieve credit risk transfer, too. Also, i don't know what the papers say, but a CDS is a bilateral OTC contract - it's more like an insurance contract btwn insured and insurer (with the novelty that the insured does not need to own the asset) than a securitization. Yes, a synthetic CDO uses CDS to tranfer credit risk, but as credit asset cashflows aren't being parsed into waterfall, not sure it's helpful to view them as securitizations per se.

The key traits of a CDS are:

(i) pure exposure to credit risk; i.e., the writer of CDS is like the bond buyer, but the bond buyer is exposed to funding, currency and interest rate risk. But the short CDS is long only the credit risk.
(ii) unfunded insurance, unlike a CLN. Enter counterparty risk
(iii) protection buyer does not need to own reference asset. This gives risk to notional protection many multiples of the original.

I had some comments on Partnoy and Skeel too, having just read it. The big one is: when they say that there seems to be some very large fundamental mispricing/inefficiency in the CDS/CDO creation markets, is there any way to interpret this in context that doesn't essentially mean "massive ripoff"? If that's correct, why are they (and you, Tyler) so relaxed and upbeat about the whole thing?

Overall, they make a good case that the standard methods for evaluating the CDS/CDOs are very very blunt (standard 0.3 cross-industry correlations? what the $%@#?) if not completely inadequate. Phrases like "swindle", "fraud" and "grotesque incompetence" kept coming to mind while I read their review of the downside.

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