Monday, October 6, 2008

What is Credit Default Swap(CDS)

He called them “the financial weapons of mass destruction”. ‘He’ was ‘Warren Buffet’ and ‘them’ was ‘Derivatives’. Boy, the world’s smartest investor could not have been more right.

For proof, look no further. First, the world’s fourth largest investment bank, Lehman Brothers, went belly up and then the world’s largest insurance company, AIG, needed a bailout in the land of market economy. A principal reason: Losses due to extensive exposure to Credit Default Swaps (CDS).

What is a CDS?


We explain with a simple example.

Stripped of jargon, a CDS is an insurance contract. Okay, the high priests of finance would call it a derivative but that is a piece of minor detail. Now, suppose, Bank X has lent money to various entities which are non-A grade (read sub-prime) accounts.

To cover the risk that these accounts may default, the Bank sells the risk to someone willing to buy the risk. Suppose this buyer is AIG. In effect, the bank is swapping the risk of default (hence the word credit swap) for cash. If the borrowers fail to pay, AIG settles. Of course, for buying the risk (a k a swap), AIG takes a fee.

Some numbers will help us understand this better. Suppose Bank X wanted to de-risk loans aggregating Rs 200 crore. Suppose AIG charges Bank X Rs 5 crore to guarantee the Rs 200 crore exposures. Suppose AIG assumes that there is a 3 per cent probability that Rs 100 crore of the Rs 200 crore would devolve, that is, go bad — it provides 3 per cent of Rs 100 crore, namely Rs 3 crore in its books for estimated liabilities. That leaves it with a profit of Rs 2 crore on the transaction.

So far, so good. But competition does strange things to organisations. Someone like Lehman to out gun AIG may assume a 2 per cent risk of default and, hence, it may do the deal with Bank X for a lower price of, say, Rs 4 crore. At 2 per cent risk, it would provide Rs 2 crore (Rs 100 cr x 2 per cent) only and, hence, report a profit of Rs 2 crore. As undercutting turns rampant, assumptions relating to the underlying credit going bad becomes more aggressive, at some point becoming zero!

Now, if in the end, 7 per cent of the debt goes bad it would lead to a liability of Rs 14 crore (Rs 200 cr x 8 per cent) on Lehman who sold the CDS, whereas Lehman would have provided only Rs 2 crore in the books. Phew.

The growing chain


The story doesn’t end there. It is quite possible that Lehman Brothers to de-risk itself may buy a swap from someone else on the same loans.

This someone is willing to guarantee it for an even lesser fee because he makes more aggressive assumptions as to the outstanding going bad.

The result: a growing chain of CDSs on the same asset, with each one guaranteeing the previous one. And when the debt goes bad, the firm that holds the parcel pays through the nose.

AIG reportedly sold around $440 billion worth of CDS, which ended up in losses far greater than it had assumed. The ease with which banks could sell the risk clearly fuelled lending to bad accounts.

After all, you could do a crazy loan and the cover it with a CDS so long as there would be a greater fool to sell the cover. What got missed out in the race was that the CDS seller itself could, under the weight of CDSs, go turtle. And that was exactly what happened in the US.

A useful tool, through its blatant misuse, has shaken our confidence in the global financial architecture. Imagine what would have happened if these instruments had been further parcelled and sold to retail investors. Small mercies.

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