Understanding the Demon in CDS

This is a response to Charles Davi's post at The Atlantic Business Channel. You should read it before reading this post.

Davi writes: I often note that derivatives cannot create net losses in the system. That is, they simply transfer money between two parties. If one party loses X, the other gains X, so the net loss between the two parties is zero.

This argument implicitly assumes government subsidization of “too big to fail" banks. All derivative contracts create counterparty risk, which is just another name for the credit risk associated with the derivative. Because sudden price movements (such as we have seen regularly in financial markets lately) may force the debtor counterparty to default on the CDS (and declare bankruptcy) before enough collateral has been transferred to the creditor counterparty to cover the obligation, one needs to consider what happens in the circumstance that the debtor (or losing) counterparty defaults suddenly: then not only does X contribute to the debtor counterparty’s unpayable obligations, the creditor counterparty does not gain X. Conclusion: not only can “poorly underwritten mortgages can create net losses,” but a poor choice of CDS counterparty can also create net losses – and be evidence of inefficient allocation of capital

The only way to avoid net losses as a potential outcome of trading derivatives is to make it impossible for debtor counterparties to go bankrupt. Effectively that is what the government has done by guaranteeing the debt of the major money center banks. The fact that Davi’s argument can be sustained is not a function of the nature of derivative markets, but rather of State intervention in derivative markets.

I can agree with Davi that the ability “to express a negative view of mortgage default risk” contributed to the popping of the mortgage bubble that was created by the securitization process. However, the fact that popping the bubble took a long time (specifically from January 2006 to August 2007) meant that "too big to fail" financial institutions were able to rack up huge losses by selling CDS insurance (often indirectly through off-balance sheet entities) before the bubble was good and truly popped.

When Davi writes “depending on whether the synthetics are fully funded or not, the principal investment will go to the Treasuries market or back into the capital markets respectively,” he exhibits a fundamental misconception about the nature of CDS that David Harper has pointed out repeatedly on Davi’s Derivative Dribble website.

It is obvious to anyone who compares the size of the CDS market with the size of securities markets in the US (and indeed the world) that “the principal investment” (i.e. the notional value of the CDS) does not get invested in Treasuries or capital markets. When synthetics are not funded, they are backed only by the promise of the protection seller to make good on the contractual obligation – that is, they are pure counterparty (aka credit) risk.

The buyer of protection sold by a partially funded synthetic or hybrid CDO is short the credit risk of the entities referenced in the CDS sold by the CDO and long the credit risk of the super senior counterparty. (The super senior tranche of a synthetic or hybrid CDO is almost always an unfunded CDS.)

Davi makes this claim: “Only when interest rates on MBSs drop low enough, along with the price of protection on MBSs, will protection buyers enter CDS contracts.” This is true only if the efficient markets theorem holds and interest rates instantaneously reflect expectations of default. In general, when expectations of MBS default rise, protections buyers will enter CDS contracts over time driving up the price of protection on CDS and mortgage interest rates. As noted above it took a year and half for this process to play out in financial markets.

The problem with CDS is not intrinsic to the derivative contract itself, but the fact that "too big to fail" banks were allowed to sell protection (when the buyer did not have an insured interest) in the market.