The Two Faces of Credit Default Swaps: Risk Management Versus Speculation

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EI Principal Jonathan A. Neuberger specializes in financial economics, valuation, and damages analysis in complex commercial litigation assignments across a broad range of industries.EI Senior Economist Stuart D. Gurrea has extensive consulting experience, including analysis of antitrust matters, calculation of damages, and performing financial analyses.

Financial derivatives have been identified as instruments that bear significant responsibility for the speculative boom and bust of the past decade, as they enabled speculators to place low-cost bets both for and against various sectors of the economy and even the economy as a whole. Among these derivative securities, credit default swaps (“CDSs”) have been singled out as particularly troublesome instruments that fueled the housing bubble and facilitated the concentration of investor risk in housing-related assets.

Derivatives, of which there are many types, are financial instruments that derive their value from the behavior of other assets (typically called “reference” assets). Interest rate swaps, for example, involve an exchange of streams of cash flows whose value depends on absolute or relative movements in reference interest rates. Options, such as stock options, give the holder the right to buy or sell an asset at an agreed upon price before an expiration date. Futures or forward contracts consist of an agreement to buy or sell at a certain price at a future date. Credit derivatives, such as collateralized debt obligations (“CDOs”) and CDSs, define payouts and value in reference to the performance of certain debt instruments.

In their simplest form, CDSs resemble an insurance policy – in exchange for paying a periodic premium, the CDS buyer obtains protection against the default of an underlying debt instrument (i.e., the buyer transfers credit risk to the seller). The CDS seller receives the premium and pays out only in the event the reference debt instrument defaults. The “price of protection,” or the CDS premium, is based on the likelihood that the debt issuer will default on the relevant loan. The CDS seller typically is not the issuer of the debt, but is more often an investment bank or other financial institution. There also is no requirement that the buyer of CDS protection actually own the reference debt security.

The earliest CDSs were primarily “single name,” i.e., written against a single reference corporate bond. In these instances, the triggering event for the CDS was clearly defined – the debt issuer had to be declared in default on the bond for a settlement payout to be triggered on an associated CDS. Over time, however, CDS contracts were written on increasingly complex debt instruments, including tranches of mortgage-backed securities, CDOs and other structured-finance products. For these securities, whose cash flows may be supported by thousands of bundled mortgages or other loans, credit risk is far more difficult to assess and a triggering event is far less obvious.

CDSs can be useful tools for managing and hedging risk. For example, an investor who holds a long position in a corporate bond may wish to protect itself against the possibility that the issuer will default on its debt obligations. By purchasing a CDS, the investor can obtain protection against an increase in the issuer’s default risk. In effect, the investor uses the CDS to transfer some of the risk involved in holding the bond to the issuer of the CDS.

While CDSs can be used to manage portfolio risks, several features of these derivative contracts facilitate their use as speculative tools and may actually increase financial risk. CDSs are “over the counter” instruments, that is, they are customized contracts that do not trade on organized exchanges. As a result, there are no centralized parties (like an exchange) to provide transparency, monitor and control credit concentrations, or set appropriate collateral or capital requirements. Instead, a single CDS purchaser may be unaware of the CDS seller’s other financial obligations. Thus, a seller could sell multiple CDS contracts on the same underlying debt instrument, regardless of its financial ability to satisfy all of the promised payouts on these similar contracts in the event of a default. As a result, buyers of CDS protection face counterparty risk, i.e., the risk that a CDS seller will be unable to satisfy promised payouts. The ability to mitigate this counterparty risk by setting the appropriate collateral is further limited by the difficulties in valuing CDSs on complex debt instruments like CDOs.

There are also no requirements that the purchaser of a CDS (or the seller, for that matter) hold any position in the reference debt instruments. As a result, speculators can use CDS contracts to make directional bets on future economic activity. For example, many investors who turned bearish on housing markets in the 2005-07 period purchased CDS contracts on tranches of mortgage-backed securities, not to protect long positions they held in these securities but to bet against housing markets and rising home prices, activity that likely added financial risk rather than reducing or shifting it. Finally, there is reason to believe that CDSs actually may have prolonged the housing bubble by providing alternative ways to create additional mortgage-related assets. By 2005, the rate at which new subprime mortgage-backed securities were being issued had declined, even though there were still many investors willing to bet on continued increases in housing prices. A number of these investors purchased securities derived from CDSs that allowed them to increase their holdings of subprime mortgage-backed securities. These so-called “synthetic CDOs” ultimately enabled investors to hold positions in mortgage assets that were many multiples of the total amount of mortgage debt outstanding.

Financial reform legislation may address some of the potential problems associated with CDSs by standardizing derivative contracts and creating clearinghouses to increase transparency and limit counterparty risk, by restricting the ability to use CDSs for speculative purposes (for example, by requiring CDS holders to own the underlying debt instrument), or by limiting proprietary derivatives trading by banks. At the same time, however, these policies may be relatively blunt instruments that are unable to distinguish between the use of CDSs for risk management purposes and their use for purely speculative reasons. For example, standardizing CDS contracts offers the benefits of transparency and simplified collateral terms, but it may restrict the use of highly customized contracts designed to hedge unique risks. In addition, reforms that limit the overall use of CDSs may ultimately reduce liquidity in credit markets for both hedgers and speculators.