Lehman Brothers: a primer on Credit Default Swaps

The bankruptcy of Lehman Brothers was a credit event which triggered a massive liability to participants in the large and potentially dangerous Credit Default Swaps (CDS) market. This is a market that represents the “weapons of financial mass destruction” label which Warren Buffett gave to the derivatives.

Below, I will attempt to explain, with much help from Wikipedia, what Credit Default Swaps are, how the market functions and why it is THE derivatives market that needs to be regulated before systemic risk threatens the global financial system.

This is how Wikipedia describes a Credit Default Swap:

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the “buyer” makes periodic payments to the “seller” in exchange for the right to a payoff if there is a default[2] or credit event in respect of a third party or “reference entity”.

In the event of default in the reference entity:

  • the buyer typically delivers the defaulted asset to the seller for a payment of the par value. This is known as “physical settlement”.
  • Or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation. This is known as “cash settlement”.

While little known to most individual investors, credit default swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults — a buyer doesn’t necessarily have to own a bond to buy the credit default swap that insures it.

Banks and other institutions have used credit default swaps to cover the risk of default in mortgage and other debt securities they hold.

Wikipedia

In essence, a CDS is an insurance contract against corporate default, much like auto insurance or home owner’s insurance. But it is also a derivative, which is a financial instrument that derives its value not from its own intrinsic worth, but from the underlying value of another asset. The best simple example of a derivative is a equity call option. Here the buyer of the option retains the right but not the obligation to buy a publicly-traded stock at a specific price. The value of this option to buy the stock at the specified price is derived from the price of the underlying stock, how long the option is valid and how likely the stock is to reach that price.

Now, a CDS is a more complicated instrument, as you can see from the definition above. Moreover, the CDS contract is over-the-counter i.e. it is not regulated by a formal exchange like equity options are. This means that no one knows what the exposures of specific financial institutions to specific credit defaults are. Only those institutions themselves know, there is no mandatory disclosure law, and it is not in the institutions’ best interest to disclose. Moreover, this market is not very liquid because the contracts are not standardized as they would be if traded on an exchange. The contracts are two-party negotiations, often with very specific terms and are, therefore, illiquid — not interchangeable with other contracts, even for the same company and debt issuance.

The CDS market is enormous, one reason for its enormous implications or the health of global finance. Again from Wikipedia:

Credit default swaps are the most widely traded credit derivative product.[3] The Bank for International Settlements reported the notional amount on outstanding OTC credit default swaps to be $42.6 trillion[4] in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). By the end of 2007 there were an estimated $45 trillion [5] to $62.2 trillion [6] worth of credit default swap contracts outstanding worldwide. On September 23, 2008, Christopher Cox, Chairman of the U.S. Securities and Exchange Commission, placed the worldwide CDS market at $58 trillion, and stated it was “completely lacking in transparency and completely unregulated.”[7] The U.S. Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from reporting banks to be $16.4 trillion at the end of March 2008. (For reference and perspective, the U.S. GDP for 2007 was $13.8 trillion[8], while the world’s GDP for 2007 was estimated at $54.3 trillion [9])
Wikipedia

These are enormous sums of money, an order of magnitude bigger than the underlying securities that the CDS market serves to insure. Therefore, large credit events in the CDS market can have very bad implications for the health of our global financial system. Lehman Brothers’ bankruptcy presented us with the first test case of what kind of implications this market could have.

When Lehman Brothers declared bankruptcy, it triggered the transfer of large sums in the CDS market to insure buyers of Lehman credit default risk protection against all losses from that event. The sellers of these contracts received the Lehman debt and in return they were obligated to pay the contract buyers (the insured parties) enough money to make the buyers “whole” i.e. to give them their full investment in the bonds back as if they had never bought the Lehman bonds.

The auction for Lehman’s debt occurred on Friday afternoon and the final auction price was $8.625. This means that for each $100 initial par value, the debt is only worth $8.625. The sellers of Lehman CDSs are obligated to pay the insured counterparties 91.375% of the bonds’ face value and, in return, they will receive the bonds.

Because Lehman has hundreds of billions of dollars of debt outstanding, this had been a large worry for the market. In fact, it as because of large exposure to the CDS market
that the U.S. authorities did not allow AIG to fail. In the end, we seemed to get through his one just fine so far. However, the Lehman process demonstrates the potentially devastating problems the CDS market can create for sellers of CDS insurance like AIG.

In the future, the monetary authorities like the SEC cannot let a large derivatives market like this go unregulated. These contracts must be disclosed, standardized and controlled via an exchange like the Chicago Board Options Exchange. My hope is this will be a lesson that U.S. and G-7 policy makers take on board in order to prevent crises of this nature in the future.

Related post
Initial results of Lehman CDS auction

Sources
Credit default swap – Wikipedia
Lehman Brothers auction results – Credit Fixings

Related articles
Credit Default Swaps: The Next Crisis? – Time

7 Comments
  1. Mark Wadsworth says

    “In the end, we seemed to get through this one just fine so far.”

    Exactly. It is something that the powers that be should be aware of – possibly even concerned about – but CDS themselves are not particularly important in the grander scheme of things. They all net off to NIL and will disappear in a puff of smoke.

  2. Wag the Dog says

    Confessing the obvious: I’m a newbie at economics, but the About Us of this blog says it’s aimed at people like me.

    Unfortunately, if it weren’t for recent videos such as Paddy Hirsch’s CDS tutorial, I wouldn’t have made it past the first sentence in the wikipedia article. No offence intended to the blogger, but this explanation is still only a marginal improvement.

    I’m confused how the CDS can both be illiquid (cannot be exchanged for other CDS derivatives — does that mean not fungible?) and yet it ends up being “the most widely traded credit derivative product”. How did such an illiquid product get to become so popular?

    Also, was there anything in Hirsch’s whiteboard tutorial fundamentally flawed? Did he leave anything crucial out?

    Given what is happening, it is crucial that the often impenetrable world of global finance be laid out for the public in more easily understood terms, now more than ever. Otherwise you risk alienating those layman (like me) who are searching for answers in the wake of economic shocks that destroy one’s prior view of the world. They are left vulnerable to possibly harmful ideologies and will end up choosing the answers that are most easily assimilated, exploiting inherent fears, biases, and prejudices.

  3. Edward Harrison says

    wag the dog, I wish I had the ability to call it as well as Paddy Hirsch does. Thanks for that. I watched the first few minutes and was impressed. I will tune in for the rest shortly. As for the liquidity of the CDS, this is what I can say:

    Imagine you are a bank and I am a bank. Say you have a bond that pays you a good return but you’re worried the company is riskier than people think. So you strike a deal with me where I say I’ll take that bond off your hands if the bond goes bad for a price. You’ll get your money back and I get the bond.

    Great!

    The problem is that the contract we make is non-standard in terms of maturity, amount, and other key features. It’s just a specific deal between you and me. That means, as you say, it’s not fungible.

    But, everybody’s doing it. Just because the individual contracts are not fungible any more than the insurance on my car or my boat or my house is fungible doesn’t mean it’s not big business. These individual contracts are plentiful but not necessarily fungible. Again, thinking of them as insurance, you can understand that they are specific to specific circumstances and non-fungible.

    Now, Mark Wadsworth thinks that’s no big deal. It certainly is no big deal in normal insurance. But, it is a big deal in Catastrophe insurance.

    https://en.wikipedia.org/wiki/Catastrophe_bond

    And the same problems there are inherent here:

    “Michael Moriarty, Deputy Superintendent of the New York State Insurance Department, has been at the forefront of state regulatory efforts to have U.S. regulators encourage the development of insurance securitizations through cat bonds in the United States instead of off-shore, through encouraging two different methods — protected cells and special purpose reinsurance vehicles.”

    The point being that single event losses could be so large as to wipe out the insurer of the bond. That’s not the case in normal insurance. This is the problem with the CDS market in my opinion. Single events can wipe out the insurer, setting off a potential cascade of problems as that insurer is also party to a number of other large private transactions which effectively become null and void when the insurer goes bankrupt.

    Is this a problem? Maybe. I think it needs to be regulated. Mark says no. The risk is overblown. There you have it.

  4. Wag the Dog says

    First I’d like to thank you for the all the effort you put into this blog especially in this time of crisis. This public service is greatly appreciated.

    I am beginning to understand your explanations of the CDS situation. All the dumbing down in the mainstream media doesn’t really help much and is rather condescending. Even the PBS explanation glossed over the mass destruction aspect, the mechanism behind which Hirsch attempted to explain in his video.

    An initial trigger, defaults in mortgage backed securities say, causes payouts on associated CDSs. The resulting down rating forces the insurer to back their remaining CDSs with more assets. Those without enough assets go under, causing those CDSs to “disappear in a puff of smoke”. The risk that they had carried instantly gets transferred back to the insurees who get spooked and start dumping the bonds for which the CDS had originally been agreed. This triggers further credit events that force more insurers to payout, get downrated, put up more assets to back their remaining CDSs, making the insurer more at risk of “disappearing in a puff of smoke”. The downward cycle then self sustains. Bonds get dumped along with many other asset classes. And since private banks are themselves heavily exposed to the CDS market, they stop lending to each other and cease to perform their function of turning the central bank’s short term loans into long term capital for main street business.

    Am I understanding this correctly?

  5. Who is Misti Ko? says

    I don’t understand how the CDS market can be an order of magnitude larger that the value of the underlying securities. If it’s like mortgage insurance, why would anyone buy insurance for ten times the value of their mortgage? That means they pay ten times the premium, but when the mortgage is defaulted, they only get their mortgage paid off once. It doesn’t make sense.

  6. Edward Harrison says

    misti, that’s a really good uestion. I believe the only realistic answer is “speculation.” The related article from Time has a good quote hat gets to the heart of the matter:


    Credit default swaps were seen as easy money for banks when they were first launched more than a decade ago. Reason? The economy was booming and corporate defaults were few back then, making the swaps a low-risk way to collect premiums and earn extra cash. The swaps focused primarily on municipal bonds and corporate debt in the 1990s, not on structured finance securities. Investors flocked to the swaps in the belief that big corporations would seldom go bust in such flourishing economic times.

    The CDS market then expanded into structured finance, such as CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. “They’re betting on whether the investments will succeed or fail,” said Pincus. “It’s like betting on a sports event. The game is being played and you’re not playing in the game, but people all over the country are betting on the outcome.”

    Any- and everyone can bet on this ‘game’s’ outcome and that is what balloons the notional value of the market. But, note, while the notional value is large, Mark Wadsworth is right — the contracts all net to zero.

    The next big CDS auction, BTW, is for WaMu on the 23rd of Oct.

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