CDS and their perils

Interesting article by Prof. Figlewski and Prof. Roy Smith on Credit Default Swaps or CDS and how they wrecked the system. Prof. Smith often talks in class about how these instruments were supposed to diversify risk and be good for the system, only to be abused and misused beyond repair.

Reproduced in verbatim from the Forbes.com

Commentary
Credit Default Swaps Are Good For You
Stephen Figlewski and Roy C. Smith, 10.20.08, 12:55 AM EDT
What is dangerous is their misuse.

Warren Buffett has said that "derivatives are financial weapons of mass destruction," and in a credit crisis like the one we're in, many people think he wasn't kidding.

Recently, an auction was held to determine the size of the settlement on "credit default swaps" (CDS) that were written on the outstanding debt of Lehman Brothers. Each of these swaps was a contract between one party wanting to insure against the risk of a Lehman default and another willing to sell that insurance. (Lehman had nothing to do with the contracts, but the over-$600 billion of debt for which it was responsible had attracted about $400 billion in outstanding swap contracts).
About 350 different counterparties to the Lehman CDS contracts attended the auction, where it was determined that Lehman's debt would be worth only 8.62 cents on the dollar in bankruptcy. Those who sold insurance against Lehman's default (the "protection sellers") therefore must pay out 91.38 cents for each dollar of debt they insured. This is the largest payout ever in the $55 trillion credit default swap market. After netting out offsetting positions, cash payments will be approximately $270 billion, a huge amount even for this crisis, which has seemed to know no limits on the size of write-offs. And all this for just one default!
What Buffett didn't say was that while derivatives come in many sizes and shapes, every one of them is a zero-sum game for the users--for every loser, there is always a counterparty who wins an equal amount. Such contracts don't eliminate risk, and they don't increase it. They just transfer risk from one counterparty to the other. But this enables those who bear a risk to protect themselves against it, and considering the huge volume of risk-taking that occurs daily in financial markets, the ability to redistribute risk has to be seen as very useful.

Receiving the payments on the Lehman CDS contracts (which offset losses they had insured against) were a number of banks, brokers and other financial intermediaries. They had extended credit to Lehman but wanted to hedge the risk that it might default, an unlikely event at the time perhaps, but one with serious consequences if it occurred.

On the other side of the contracts, making the payments, were end-user investors such as insurance giant AIG [NYSE: AIG], PIMCO, the world's largest bond fund, and Citadel, a large hedge fund group. They took on the Lehman credit risk in exchange for a regular quarterly payment that seemed at the time to be a fair premium for insuring a default that probably would never happen.

For diversification, protection sellers maintain large portfolios of credit default swaps, just as an automobile insurance company insures a lot of cars. They lose on those that crash, but make it up on those that don't. Apparently none of these insurers have been buried by their Lehman exposure. But if there had been no credit derivatives and the banks and other intermediaries had been unable to hedge the risk, they would either refused to lend to Lehman at all or, more likely, they would now be adding these losses to the others they have already endured in this unusually difficult credit cycle.

Banks and investment banks function as both market makers, which requires them to carry inventories of risky securities for brief periods, and also as proprietary investors. They manage credit exposure in a number of ways, including hedging with credit default swaps. This transfers the risk to other investors, often outside the banking system (whose safety and soundness may benefit). A competitive market in credit default swaps contributes to the transparency of price-setting and thus to the efficiency of the whole process. This lowers the cost of financial risk management in general.

The vast majority of transactions in the credit default swap market are straightforward, insurance-type transactions. But losses on ordinary insurance contracts are sometimes much higher than expected, for example, when an unusually severe storm causes a lot more damage than was provided for when the homeowners insurance premiums were set. Such a storm may wipe out the insurer's reserves and even its capital, as appears to be AIG's unfortunate experience with its financial products insurance business. But that's the risk of providing insurance on events with low probability of occurring, but which result in large losses when they do.
A big problem in the over-the-counter credit derivatives market is the risk of counterparty default. The protection seller may be unable to fully cover the loss it is insuring against. To mitigate this risk, the protection seller may have to post collateral, but amounts and terms are negotiated between the counterparties and not standardized. When AIG's credit rating was cut from AAA to A in mid-September, it was suddenly obliged to post more than $14 billion in collateral against its CDS positions. This is what drove them over the edge. When Bear Stearns was teetering on the brink, the Fed examined the extent to which the firm was connected to other firms through their extensive web of OTC derivatives contracts and decided that it would be too disruptive for the market to let Bear fail.

These problems are significantly reduced for exchange-traded derivatives like futures and options. The exchange and its Clearing House establish high standards for the contracts, provide a centralized marketplace for them, establish and enforce rules on posting collateral and making payments and act as a guarantor that trades will be money-good and that users will not have to rely on individual counterparties to pay what they owe.

The over-the-counter credit default swap market needs such an exchange. Over-the-counter markets are too fragile, too loosely regulated and too opaque for such an important financial derivative as credit default swaps. What makes these swaps dangerous is misuse; an orderly exchange would help make them safer.
There have been informal efforts by the industry to organize such an exchange, which would have to operate globally in view of the size and breadth of the market, but so far, the effort has not been successful. It would benefit greatly by having the governments of the leading banking countries--which will soon be taking up a broader regulatory framework for banks after the current crisis--to require one to be established and regulated banks and broker dealers to participate in the credit default swap exchange.

Stephen Figlewski and Roy C. Smith are professors of finance at the Stern School of Business at New York University