Credit Default Swaps, CDS.

(I love to party, but hate the hangover)

A Credit Default Swap (CDS) is a type of insurance contract whereby I pay you a premium and you restore me to my previous whole position, if my insured asset drops in value. Although a CDS sounds like an insurance contract, issued by an insurance company, it is not. The largest parties in the CDS market were Banks, Securities Firms and Funds (Hedge, Investment, Mutual, etc).

JP Morgan was a leader in developing Credit Default Swaps in the late 90's. They represent a vehicle for generating new revenue (for the seller), shifting risk to another party (for the buyer) and for sidestepping regulations (everyone).

CDS contracts allow buyers and sellers to speculate on an entity’s performance and adjust the risk in their investment portfolios. The entity can be a company or a sovereign. Suppose RHC (Rottkamp Holding Company) invests $1MM in NewCo. Hearing rumors of a change in senior management, RHC believes NewCo is in jeopardy of default on its senior debt and subsequently purchases $1MM (the notional) of CDS protection from MacGreedy's Buyer Protection Inc (MBP Inc). Terms of the negotiated contact are; 2 year duration, LIBOR plus a risk factor of 5%, quarterly invoicing, specified triggers and a 24 hour cash delivery requirement (not mark to market bonds). Triggers alter the terms as follows: if there is no change in management, the premium remains the same. However, if there is a change in CEO, CFO, COO or CIO, then the premium RHC pays to MBP Inc increases to LIBOR plus 15%. RHC states MBP Inc to hold 10% of the insured value in escrow, and buyer protection "whole" payments due within 24 hours. A payment trigger is defined as a 5% decrease in stock value, sustained for a period greater than 30 days. LIBOR at contract origination date is 5%. All transactions are in USD. Although bond settlements are typical, RHC negotiated a cash delivery.

Over the 2 year term, there are a few possible outcomes:

• If NewCo did not change senior management or default on its debt,RHC paid MacGreedys $200,000 (10% per year). RHC traded cash for risk.
• If NewCo defaulted into bankruptcy, then MacGreedy's paid RHC $1MM within 24 hours.
• If NewCo changed senior management, then RHC premium increased per contract terms.

Implied in these contracts are counterparty, asset class and knowledge risk. RHC assumes MacGreedy has the cash in escrow and they will deliver within 24 hours, while MacGreedy assumes RHC will continue the premium payments, on time. In the above example, RHC owned the underlying stock, but the contract could have been based on stock Options. In the event of a payment trigger & delivery, RHC could 1) hold the cash in reserves, 2) purchase more stock or stock options, 3) distribute cash to stakeholders or 4) do whatever it wanted with the cash. If MacGreedy repackaged and sold their portion of the CDS, RHC would have no knowledge of the sale or, risk associated with the new buyer.

In the above example, I merely stated the risk factor percentages. In reality, the percentages are based on mathematical modeling of recovery rates, bond ratings and probabilities of downgrade, default, economic demand, etc. In the case of a cash settlement, a calculation agent would determine the entity’s (company or sovereign) value and mark to market value’s.

There are two different models to price a credit default swap: the probability model and the no-arbitrage model proposed by Duffle and Hull-White. The probability model considers the issue premium, recovery rate, credit curve and LIBOR, while the no-arbitrage model utilizes the differences between the asset spreads, hazard rates, volatility, recovery rates, etc. Reference the work of Hull and White below.

Now that you have a basic understanding of this unregulated Trillion dollar market, change MacGreedy to AIG. They have thousands of contracts as buyers and sellers, and trade worldwide. Enlarge their market to include general Credit Default Obligations that include swaps, swap options, mortgages and loan obligations. One day, Lehman calls AIG and informs them of ‘triggers’ worth $400B…. Oops….. Old Mother Hubbard went to the cupboard and couldn’t find a dollar to spare. The rest is history.

Two useful web sites are listed below. Mr. Paddy Hirsch does a great job of explaining financial concepts on a whiteboard, while the research folks at YieldCurve have several presentations and white papers available for download.

For more information:

1. White Board explanations by Marketplace Senor Editor Mr. Paddy Hirsch
   http://marketplace.publicradio.org/videos/whiteboard/credit_default_swaps.shtml
2. YieldCurve.com
   http://www.yieldcurve.com/Mktresearch/index2.htm
3. The Valuation of Credit Default Swap Options, John Hull and Alan White, September 2003, Revised January 2003
   http://www.rotman.utoronto.ca/~hull/DownloadablePublications/HullWhiteCDSoptionspaper.pdf
4. Credit Derivatives Explained. Market, Products and Regulations. Lehman Brothers, Structured Credit Research, March 2001
   http://www.investinginbonds.com/assets/files/LehmanCredDerivs.pdf
5. Valuing Credit Default Swaps 1: No Counterparty Default Risk, John Hull and Alan White, April 2000
6. International Swaps and Derivatives Association, http://www.isda.org/
7. Attend the NJHFMA June Quarterly
8. Gamblers Anonymous

Opinions expressed in articles or features are those of the author(s) and do not necessarily reflect the view of the New Jersey Chapter of the HealthCare Financial Management Association, or the Publications Committee. The HealthCare Financial Management Association and the Publications Committee assume no responsibility for the accuracy or content of any article or feature on the website.

Published 04 June 2009