Literature Review on Credit Derivatives Swaps (CDS)

Credit derivatives swaps (CDS) are the main pillars in the credit derivatives market and represent about half of its volume (George Spentzos, 2005). A CDS is a bilateral contract between a protection buyer and a protection seller that exchanges the credit risk of a specific issuer. The protection buyer pays a premium to the protection seller to assume the risk associated with a particular credit event.

Credit default swaps are traded in over the counter markets, and indices exist which are averages of CDS contracts on various firms. CDS are priced such that the price reflects the likelihood of default and losses associated with default, and because they are not directly related to funding, this market became more liquid than the market of the securities that are insured by using CDS contracts. Further, CDS can be bought and traded by investors on assets that they do not own.

In their true sense, CDS should contribute to make the financial system efficient by separating the credit risk and cost of investing and thus shifting the credit risk to those willing to take it. This should not only reduce firms’ cost of capital, but also facilitate investors at large to gauge a company’s credit risk (rather than the market where firms’ securities are traded) (Stulz 2010, p. 75).

But it is also believed that CDS lower the incentives of lender to monitor their borrowers because they can hedge against the risk of default by borrowers. Although the counter argument holds that because banks can reduce their risk by entering into CDS contracts, hence firms in the economy would now receive larger amount of credit that otherwise possible. However, in 2005 only U.S. banks had utilized credit default swaps to insure only 2 percent of their credit exposure on average (Stulz 2010, p. 76). Further, these CDS contracts can also substantially change investor psyche by reversing the dynamics of investment for him. E.g. if an investor is approached to suggest a restructuring of debt of a company he has invested in, now if he has insured his debt by CDS and he can make a gain under bankruptcy of the company, his verdict may be affected than what he would decide otherwise (Yavorsky 2009). Thus, CDS directly or indirectly affects the psyche of financial intuitions’, be it institutional investors or lending houses.

Turning to what is claimed as the most sounding reason of financial crisis: the subprime mortgages, we need to know how the use of credit derivatives influenced the market dynamics. Subprime mortgages are securitized i.e. securities are issued against a pool of mortgages in the form of trenches, reflecting their seniority in payments. When mortgages default, the lowest rated trench suffers from the default loss the most with the loss stepping upwards to highest rated trench. ABX indices on subprime securitizations were introduced in 2006 based on average of credit default swap for a particular seniority tranche. Fall in the value of these indices would mean a fall in the value of subprime securities, and this is what happened in 2007. The fall of ABX index signaled to the market the declining worth of these securities (Stulz 2010, p. 76). But the Bank of England also states that ABX indices over-reacted to exacerbating subprime market conditions. If this is true, it can be implied that even these instruments are harder to price and understand and fall back on, if they can overstate or understate the risks inherent in the system.

Further, if the concept of credit derivatives is applied in true sense, this would suggest that by using CDS, the ultimate credit risk should have been resting with those best equipped to face it. However, the issuers of CDS were insurance companies traditionally in the business of municipal bonds or even if we talk of AIG, these firms were not able enough to take on the credit risk they took by issuing series of credit default derivatives (Stulz 2010, p. 78). Financial risk was not well placed in the system. Also, the myopia that results when one hedges by using credit derivatives might actually result into even more credit risk taken by investor.

So, if these derivative instruments put the investors in a false safety net of hedge which was not a true reflection and safeguard against the risk, these credit instruments can be said to be the reason of a too much build up of subprime exposure. Although it can be argued that these inefficiencies are not related to the characteristics of the instrument rather with the market inefficiency, it can be counter-argued that even market inefficiency would diminish if these instruments were easier to price and true reflection of inherent risks (Stulz 2010, p. 79) .

The use of CDS also directly flows from the fact that banks have to hold less regulatory capital if they package their loans into securities and keep senior tranches of securities. Thus, holding CDS meant less regulatory capital for the bank.

The fact that there exist intense linkages across the financial system implies that there is a network of exposures across the system and if one entity of the chain breaks, it leads to a chain reaction across the system. Things can worsen if a major financial institution fails. Although collaterals are used as the last resort in the event of default and they actually reduce the volume of loss, the use of collateral is not a hundred percent guarantee of recovery. As it was witnessed in the second half of 2007, when collateral prices went down drastically to its peak. International Swaps and Derivatives Association reports that only 63 percent of derivative contracts had such provisions in 2007, while the number was much low (30 percent) in 2003 (Stulz 2010, p. 81) . Hence, even the use of collateral does not eliminate the possibility of contagion, and contagion is what led to such financial distress.