Credit Default Swaps: Useful, Misleading, Dangerous?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Richard Portes, in a recent VOXEU communique (April 30^th), asks this question about the use of Credit Default Swaps (CDSs).  In particular, the use of naked CDSs may actually increase rather than decrease systemic risk.

 

CDSs are derivatives – financial instruments sold over-the-counter (OTC) that transfer only credit risk (corporate or sovereign bonds) to a third party.  The purpose of the CDS contract is to provide a form of insurance for an asset held by investors against default losses.  These contracts offer payment on default of a financial instrument, even if the buyer of the contract does not own the asset – a “naked” position.  This has evolved from the original use of the CDS contract that provided insurance against unexpected losses due to default by a corporate or sovereign entity. 

 

The CDS buyer who desires this protection pays a premium of the asset’s nominal value, in basis points, to a counterparty or protection seller expressed as a spread.  European politicians blamed the CDS market for destabilizing Greece.  As a result, a new EU regulation was implemented that restricts the use of “naked” CDS positions on sovereign debt. 

 

The gross notional value of these contracts stood at US$15 trillion during the third quarter of 2011, with the majority held on corporate debt.  Portes notes the CDS market is a useful innovation when it can provide efficient isolation of credit risk, and is not dominated by naked speculative CDSs positions that are not being used for hedging purposes.

 

CDS contracts can provide a useful function for price discovery and hedging positions.  However, he notes that early research on CDS markets were done with limited data and produced mixed results on how the market functioned.

 

Portes notes that price deviations can exist in the short-run as CDSs adjust more quickly to news than the cash market.  He notes that the derivative CDS market usually moves ahead of the bond market in price discovery, both before and during the financial crisis.  In addition, he noted that deviations from a long-run equilibrium could persist between market prices than would normally be anticipated. 

 

Like most financial innovations in recent years, naked CDSs are said to be beneficial in a move toward more complete markets.  However, a key lesson from the financial crisis is that innovations can be dysfunctional and dangerous.  In this case, naked CDS positions, however, may increase systemic risk.   Perhaps the lesson is that by making instruments more complex, we can increase risk and need to limit their use until we have a better understanding of how this market functions.

 

For more on this follow the link:  www.voxeu.org/index.php?q=node/7922

Confronting and Managing Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The recent confrontation between Greece and EU officials provide a good lesson for risk managers.  EU officials continue to minimize potential risks, fail to take realize their magnitude and communicate the problems, and take the necessary steps to remedy the situation.  These are all symptoms of a failure of risk management.  

 

Greek Prime Minister Papandreou made a stand, against the proposed Greek debt restructuring, and even though he was forced to backpedal, Wyplosz argues that he did the Eurozone a favor by providing it an opportunity to change course.  The Greek government has largely been following the dictates of EU officials to not restructure their debt, but this might have been the least costly remedy if done in a timely manner.  

 

The Greek revolt, even if short lived, is good news on the European crisis front – it might provoke the long-awaited policy turnaround that is necessary to end the Eurozone crisis.  It may finally awaken Eurozone leaders to the futility of the path they’ve chosen.  One way or another, a disorderly Greek default is in the cards with its attendant contagion for all of the rest of the PIIGS (Portugal, Ireland, Italy, and Spain) and maybe even France.  The cost of a default could be much larger than delaying the inevitable Greek restructuring.

 

Dazed and Confused?  Eurozone officials took the wrong path in early 2010, because they did not fundamentally understand the nature and depth of the problem.  Perhaps, they did not want to deal with it and brazenly assumed things would revert back to normal.  However, the seriousness of the surging debt and slow growth revealed all the flaws hidden in the euro’s first ten years.  There is a cost for their negligence. 

 

At that point a real solution is inevitable – one that requires Eurozone leaders and the ECB to play on the same side with credible rules for all.  An ECB backstop for Eurozone bonds will be required, but this does not mean underwriting banks and sovereigns. The ECB guarantee should be set to protect the ECB and to force a debt restructuring for countries that face unbearably high interest rates. 

 

Banks will have to be bailed out, possibly with EFSF resources, but in a way that minimizes moral hazard and maximizes taxpayer protection.  That means wiping out shareholders and, if need be, unsecured bondholders.  The cost of the bailout could reach into the hundreds of billions and does not include recapitalizing financial institutions.  A long-term cost is the sustained period of sub-trend growth resulting from the overhang.

 

Can we learn anything for risk management?

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/7222

Issues that need to be addressed to reduce European sovereign risk

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by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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European leaders face a deadline this Sunday to implement policies to help resolve the sovereign debt crisis.  A review of these issues is summarized in a recent commentary.

 

A deadline for solving a deadly Eurozone sovereign debt crisis (Guillermo de la Dehasa, VOXEU October 20^th) Time is running out for EU leaders to put an end to the Eurozone crisis.  European leaders face the following issues: 1. find a definitive solution to Greek insolvency, 2. isolate solvent countries from possible Greek contagion, 3. improve EU governance by creating a true European Parliament and 4. refocus on a pro-growth policy mix. 

 

Eurozone leaders must reach a clear and definitive solution to Greece’s insolvency without triggering a credit event.  Private sector involvement is not the best solution since “voluntary haircuts” can be an oxymoron and impede decisions.  Haircuts can be imposed on banks and a Brady-like swap program can be implemented for Greek bonds into European Financial Stability Facility (EFSF) bonds of longer maturities.  A challenge for policymakers is to isolate solvent members from contagion.  The can be implemented through a backstop for Eurozone member debt, such as a leveraged EFSF.  The guarantee is implemented in return for debt consolidation and structural reforms. 

 

Long-term, the present structure of European governance and crisis management needs to be addressed.  This issue can be resolved by amending the treaties and moving away from the current system where council decisions need unanimous approval within national governments.  Long-term, the EU needs to move to a federal system of governance by a true European parliament.  It should set up an independent European treasury to monitor states compliance to debt limits and structural reforms.  Lastly, policymakers need to implement a policy where Eurozone growth rate can exceed the real interest rate on its debt.

 

European banks will need to be recapitalized.  However, this will only be a stop gap measure without addressing the other issues.   Otherwise the concept of the euro will be at risk.