This is from an old post by Naked Capitalism:
Despite the use of the term "swap," CDS are really insurance contracts. A protection seller (effectively, the insurer) agrees to make a payment to the protection buyer if specified bad things happen (a "credit event" usually defined as bankruptcy or failure to pay) to a "reference entity" which can be a company ("single name") or an index. See here for more detail. Now while it may look like the risk being traded here is default risk, there is a second risk: counterparty risk. CDS are the largest credit derivative product, and they are traded solely over the counter. That means that the CDS agreement is only as good as the protection seller that wrote it.
What seems odd, given all the foregoing, is that Swiss Re, admittedly a new player but one with a small book, is the only concern to have reported CDS losses. Someone has to be on the other side of the eyepopping trades entered into by Paulson & Co. and for that matter, Goldman, which has been short mortgage-related credits. That raises the question of how much latitude financial firms have in marking their derivative books (and auditors have no hope of getting to the bottom of their economics).The other open question is what happens to the CDS market as banks continue to shrink their balance sheets? CDS have become integral to the way a lot of players measure and manage credit risk, but if the market becomes illiquid, there will be a lack of reliable price information and a dearth of protection sellers to write new contracts.
The link in the above post is also useful. Posted in 2007, it looks almost prescient now and the blogger holds his own against comments from CDS traders. (Yes, a little sensationalist as some have commented but now...)
1. There are too many CDSs being written by speculators against relatively few borrowers, just as the probability of default events is increasing sharply. Therefore, the possibility of a generalized financial infection through the CDS medium is substantial and rising.
2. CDSs are equity substitutes carried at zero margin, masquerading as credit instruments. They create a feedback loop mechanism to equity markets that results in reducing volatility when things look good and increasing it when they don't. In other words, they work as risk amplifiers and not as risk attenuators.
Putting the above two points together, we have the potential for a financial viral disease of pandemic proportions. The CDS market is so new that it has never been tested on the downside of the credit/business cycle. We simply have no inkling of how it will behave under real life duress, when major credit events occur with increased frequency and magnitude.
From Seeking Alpha in June of this year:
Participants in modern derivatives markets may not have devoted sufficient time, resources and systematic thought to the subtleties of the theory of counterparty credit risk, OxAn says:
"The concept of ‘wrong-way risk’ is as old as the modern derivatives market. Yet in part because its systemic effects are relatively difficult to model, the threat it poses in particular derivatives transactions — and to the financial system more generally — is often overlooked."
"Over the past year, wrong-way risk has chiefly been a problem on credit derivatives markets. However, it could easily worsen, or spread to other markets — such as energy derivatives."
This variety of counterparty risk can be effectively priced and modelled, but this is very time consuming, expensive and often does not fit well with other forms of mathematical risk modelling, OxAn says. The risks associated with wrong-way risk have not been dealt with effectively, and are increasing.
Moreover, the most pernicious type of counterparty risk — the danger that counterparty transaction risk might increase for all counterparties, simultaneously — has become systemic. This threat, known as ‘wrong-way risk’, has become a chronic problem in the developed world.
"This situation represents both a failure of risk management modelling and a failure of imagination."
The trouble with credit derivative hedges emerged due to the parlous financial health of some derivative dealers and the monoline insurers that, in effect, act as credit insurers. Dealers and banks are facing the unsettling thought that the credit default swap (CDS) hedges that they had entered into with monolines to help manage risk on their structured credit origination activities will become worthless if these troubled counterparties themselves lurch into bankruptcy.
OxAn says the key to quantifying wrong-way risk is to model correlation between contract values (across a portfolio of derivatives) and counterparty credit quality. The most common generic theoretical approaches include :
-simulation of counterparty default and exposure jointly;
-simulation of exposure conditional on counterparty default; and
-adjusting the expectation of (unconditional) exposure in order to approximate the risk expectation conditional on default.
Significantly, when wrong-way risk is modelled, it is often done via the last approach, due to the fact that it is less computationally expensive and time consuming, and it generates measures of exposure that risk managers find easier to incorporate into their overall risk management framework. However, given the gravity of the crisis, this approach may have been insufficient, OxAn says.
And finally, from Angry Bear after the collapse of AIG:
My thoughts on Credit default insurance.
1) You can hedge against default on bonds by buying a diversified portfolio of bonds
2) Prudential regulations do not take account of this fact, but rather include restrictions on total assets as a function of capital and on the types of assets which entities can own.
3) Credit default insurance makes it legal for regulated entities to own bonds whose rating is low. 4) it is no more effective in avoiding risk than is plain diversification, because a nationwide crisis will bankrupt the insurer.
5) it exists as a means of evading prudential regulation.
... What is the point of pooling pools of mortgage bonds and making new tranches ? Much money was made by taking the middling seniority tranches of pools of mortgage bonds and reslicing them to make senior (AAA) tranches and equity tranches. Was there really any more diversification to be done ? Or was this a way to game the bond ratings ? If the original pools were already well diversified, they would be almost perfectly correlated so all tranches of the pool of pools would be middling risky (mezzanine). Were the original pools poorly designed or was the aim to get an AAA rating for a risky asset ? Even assuming the bond rating agencies are honest, they must work according to rules. I think it very likely that everyone knew that the senior tranches of pools of pools were risky (they paid higher than standard AAA rates) and that entities which weren't allowed to buy risky bonds didn't care.
That this was not a way of diversifying risk but a way to evade prudential regulations.
Transparency strikes me as something that ought to be easier to achieve. I would start with a centralized clearing house for reporting all derivative contracts and collateral pledged for them, and requiring financial statements such as annual reports to communicate clearly the specific exposures that those entail. Perhaps there's a fear that if we had a clear communication of exactly who is holding the bag, that could exacerbate the kinds of destabilizing capital flights with which we've been fighting. But I think the uncertainty itself may be even more destabilizing.
Since the CDS and CDO markets are over the counter, this seems sensible but I suspect that requiring annual reports as a way of making things clearer while is a start is probably not going to be as helpful as we would hope. Didn't Enron issue annual reports?