Arnold Kling  

The CDS Debate Continues

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John Dizard takes my side. Felix Salmon doesn't. He writes,


If you buy a bond, you get a steady income stream, while running the risk that you might lose substantially all your money. If you sell default protection, you get exactly the same thing: the only difference is that in some (but not all) cases, you don't have to put all your money up immediately.

That "only difference" creates another difference. If I buy a bond, and the probability that the bond will default goes from .00005 to .005, nobody can make me post collateral. If I sell default protection, apparently my counterparty can make me post collateral. That is because I did not have to put up all my money immediately.

Look, I don't think that Dizard or Salmon or Kling or anyone else is in a position to draw rock-solid conclusions about credit default swaps. The history of their existence is just too short for that.

I'm not saying that government should abolish them. As with mortgage-backed securities, I think government should just sit back and let them die a natural death.


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COMMENTS (5 to date)
Soumik writes:

Though I do know of bond funds who are working overtime, trying to unwind their CDS positions, I don't think the instrument will die a natural death. Apart from being one of the most liquid and actively traded securities, and a hedge against credit risk (albeit not the most efficient one in these times), CDS allows an investor to efficiently short a credit.

Even if you discount its other advantages, it is hard for an investor to ignore a CDS when he wants to short a credit. This is because it is not only more difficult to short a cash bond, but it also exposes the investor to the same counterparty risk that Arnold is talking about, since the investor has to enter into a repo transaction to short the bond.

Counterparty risks will always remain in financial markets, one way or the other, and will come to the fore in these exceptional times. I only hope the regulators don't end up killing an efficient instrument when they should really be penalizing irresponsible risk taking and greedy profit-making tendencies of managers of large FI's including a company like AIG.

"If I buy a bond, and the probability that the bond will default goes from .00005 to .005, nobody can make me post collateral. If I sell default protection, apparently my counterparty can make me post collateral."

That's not right. Most single-name CDS have a "Minimum Transfer Amount" that has to be exceeded before the protection buyer can make a margin call. On a $10m reference, the MTA is usually $250K (although sometimes it's $100K). Essentially, protection buyers can't make margin calls of less than $250,000. That means spreads have to widen 250bps before the protection seller has to post collateral.

Also, in your testimony you said:

"I am concerned that leading policymakers do not understand how credit default swaps are creating excess demand for safe assets. The problem is that buyers of swaps demand that sellers post collateral. The only collateral that buyers will accept is short-term Treasury securities."

That's also wrong. Not only are T-bills not the only form of collateral accepted, but they're not even the most common form of collateral used, by a long shot. Cash, Treasuries, and Agencies are all accepted as collateral in virtually every CDS, and around 83% of all posted collateral is cash (per the latest ISDA survey). T-bills only account for 14% of posted collateral. Anything other than cash is usually subject to a haircut when you post it as collateral.

The CDS market isn't perfect by any means, but it isn't nearly as dangerous as you seem to think.

James A. Donald writes:

When Iceland went down, a gigantic amount of money, the CDS market operated smoothly, even though the world shook - evidence that government intervention creates instability, and markets do not.

Joe writes:

Posting additional collateral on a losing position is not a new or systemically hamful concept. The same rules apply for short positions or any leveraged bet. Simply removing leverage from the financial markets cannot solve its problems, but better information can help.

Arnold,

I forgot to mention that your concern about CDS sellers being forced to post collateral when the probability of default increases from .00005 to .005 is also misplaced.

Most CDS include thresholds that the CDS seller's exposure has to exceed before the CDS seller has to start posting collateral at all. Typically thresholds are around $8-10M. Sometimes thresholds are tiered, so that a credit downgrade triggers a lower threshold. A few CDS dealers will set the threshold at zero, but not many; and when they do set the threshold at zero, they almost always include a Minimum Transfer Amount. In any case, margin calls that result from changes in extremely low probabilities of default aren't a problem in the CDS market, if only because the amount of collateral demanded is way too small to have systemic consequences.

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