Credit Default Swaps and the battle for regulation

Deepak Shenoy
Atlas Invested
Opinions - IN

A week of fantastic weather and gridlocked traffic in Bangalore makes the old garden-city-dweller in me long for the Bangalore of a distant past: how the last 10 years have changed it from a lazy retiree town to an info-tech powerhouse, and in the process introduced it to multi-hour traffic snarls and high levels of pollution. While growth has had its good points, the city's infrastructure just hasn't been able to keep up.

The downside of superfast growth was reflected in a book I read: "Fool's Gold", by Gillian Tett on the way greed worked itself through the credit derivatives and banking market in the US. The history of the "credit default swap" - the derivative most often quoted in credit-derivative land - involved Exxon and J.P. Morgan Bank during the Exxon Oil Spill (mid-90s). Exxon wanted a $4.8 billion loan from JPM, and was facing a potentially massive damage ruling against it because of the spill. Ordinarily, a JP Morgan banker would hear such a request, excuse himself from the room, laugh his head off in the corridor, return and say "No".

But you don't do this kind of thing with a big client like Exxon; you risk losing their future business, and competition will make inroads. But the risk of the loan was still too high. So, the good folks at JP Morgan decided to lend Exxon the money, but then pass the risk of the loan over to the European bank of Reconstruction and Development. Meaning: If Exxon defaulted in paying J.P. Morgan back, the E.B.R.D. would make it up. A "credit default" meant that the liability was "swapped" to someone else. E.B.R.D. would be paid a sum of money that made it worth their while, as a premium. Thus, a Credit Default Swap was born.

When the Exxon default risk was taken out, J.P.Morgan now did not have to reserve money against the loan - a regulatory requirement for any loans that involve a risk of default - so they could lend their money to more creditworthy borrowers, and still keep Exxon happy.

The Credit Default Swap (CDS) market then started to grow, as banks realized they could optimize capital reserves if they hived off the risk to someone else. They lent, they bought CDS protection and that freed tied-up reserves to do even more lending. As an example: a bank that might have $100 of capital and could lend, say, upto $1,000 using a 10% reserve system, could buy credit default swaps for $600 worth of loans, and then lend that $500 to someone else. They now ended up with $1,500 worth of loans, $500 worth CDS (for which they have paid some premium) on the same capital base of $100. This was "okay" under regulation, and in principle would have helped the system by diversifying risk.

As the market scaled, CDS prices became more important. Where markets would price default risk in falling prices of bonds (for example, a Rs. 100 bond trading at Rs. 70 might mean people expect to be paid only 70% of the loan back) such default assumptions might be reflected in increasing CDS prices. A "proxy" for default risk, and a tool to diversify - a win-win proposition?

Not entirely true. You can buy or sell CDS without owning the underlying debt, in effect speculating on a default or the lack of it. If there's no default, a buyer will lose some premium - of the order of2-3% of the total amount he has bought CDS for. A default may give him, say, 30 to 50 per cent of the amount insured. So I could buy a CDS on $10 million worth of a company's debt, by paying $300,000 per year - and if the company defaults, I might get back $3 million.

A 10x return on investment is the kind of leveraged bet that attracts traders - and in effect, a lot of people buying CDS will push up the prices, and therefore give the "appearance" of a higher risk of default. In a world increasingly focused on posturing rather than action, this is considered bad - even European politicians decried "naked CDS" traders as being responsible for worsening the Greek crisis. But what it really means is that CDS prices aren't very good indicators of actual default, or that the worsening CDS prices might have prompted anti-default action that would otherwise have not materialized.

The other issue with credit default swaps was the underlying debt itself. A company or country default is a simple thing - if the entity fails to pay back principal or interest, it's considered a default. But this wasn't satisfying enough - after a while, everyone wants to sell insurance on the good companies and buy it on the bad ones. Bankers then decided to move the concept to "securitized" loans - where they would pool the loans of multiple companies together and sell bits and pieces of the merged loans as securities to other entities like pension funds.

A straight securitization would mean interest would flow equally to all holders, and any default would hit everyone equal. But that wouldn't fly with investors - some wanted higher returns for higher risk, and most just wanted a good return for very low risk. Financial innovation came in again: Enter the Collateralized Debt Obligation (CDO). The pool was sliced into "tranches" - designed such that the defaults would first hit the lowest tranches, and only then flow upwards. After all, with a large number of loans you may not ever see very high default rates, so the higher tranches are safe (just like you don't usually see all the people in a city have an accident at the same time, unless you are in Bangalore where it's very likely) In a pool of 1,000 loans worth $100 million, you might expect only 15% defaults - that means the first 15% was "risky" and the tranches above them lesser so. In return, the highest tranches got the lowest interest rates. These tranches were rated by the rating agencies, whose inputs were primarily computer models because there was really nothing else available.

Credit Default Swaps were used to offset the risk of most such tranches. The highest ("super-senior") tranches would have such a low CDS premium that banks preferred to retain them on their books (though a number were sold to AIG). Bank books were now bloated
The market took off substantially, not just in the corporate debt area, but in the mortgage debt space (where the pools were made of housing loans). Banks did not just offset risk; there was so much demand for such instruments that they could charge hefty fees when they created CDOs.

Growth became so huge that when it wasn't possible to lend more, bankers would take the risky tranches - that no one wanted to buy direct - and mix them in another CDO, and tell people that the highest tranches of THOSE CDOs were less risk. Using complex mathematical formulas and with limited default history, this concept also sold.

And all of this was in a period of low interest rates, where pension funds desperately needed to make more than the standard non-risky avenues offered.

The consequences: When you can give loans and "sell" the risk away through such instruments, you don't really have to bother about the actual risk of the loan - something the banks were supposed to be doing. As a result, horribly bad loans were originated and sold away. The rating agencies were earning substantial fees from rating the higher tranches of the CDOs, and therefore reacted as late as possible to downgrade when defaults increased. Banks were supposed to have been beneficiaries; instead, they tanked up on the CDOs and CDS liabilities themselves, leaving themselves exposed to the massive increase in defaults when it actually happened. Regulators refused to curtail these markets and banks grew so big that their failure would threaten the world economy.

When defaults grew, those who sold CDS contracts suddenly found themselves in a spot - their complex computer models told them this should not happen, yet this was happening. A number of them defaulted, yet others like AIG were taken over by the government in a rescue. (It's a different matter that those who got rescued were top banks that had bought CDS contracts from AIG) It eventually ballooned into a worldwide financial crisis, and we are still seeing the repercussions.

Credit default swaps are blamed for worsening the crisis; even legendary trader George Soros has at asked to outlaw them or at least, make them only available to people owning the underlying debt. The "must-own-bond" concept does hold some water; any unbridled speculation should only be possible on regulated exchanges with strict leverage and position limits. The industry's working hard in both directions - some to create and others to stymie regulation in their otherwise unfettered world. Let's see who wins.

Deepak Shenoy trades the Indian markets and writes at Capital Mind. He's also working on an upcoming stock market site. You can reach him at deepakshenoy@gmail.com or@deepakshenoy.