Spencer Whitworth
Ryan Scoville
Austin Gray
CTP 1: Credit Default Swaps

With the financial crisis behind us, it is worth asking whether Credit Default Swaps (CDSs) were a positive development in our economic system. Many blamed the interconnections generated by primary and secondary CDS trading for the implosions that occurred in 2007, when the underlying assets on which the majority of CDSs were based - mortgage-backed securities - began to default. The media agreed, labeling CDSs with terms such as “weapons of mass financial destruction.” There are a number of aspects to CDSs, however, that skeptics and pundits overlooked. While history and intuition suggest important risks associated with CDSs that issuers, owners, and regulators must consider, there are a number of unexpected ways CDSs improve debt capital markets and our economy as a whole. On balance, these benefits shed optimistic perspectives on the merits of CDSs. If markets can learn from past mistakes, the advantages of CDSs render them indispensable financial instruments that contribute to better financing and information-gathering capability in our economy.

Contrary to popular belief, the conceptual underpinnings of credit default swaps (CDSs) are surprisingly similar to those of traditional insurance policies. CDSs arose out of an ordinary transaction: a 1994 deal between J.P. Morgan, the European Bank of Reconstruction and Development (EBRD), and ExxonMobil. In return for an insurance-style premium to the EBRD, J.P. Morgan received full compensation in the case that a loan given to ExxonMobil fell into default (Anthony). Coined the “credit default swap”, the instrument grew to extraordinary popularity in ensuing years. Problems with CDSs arose in 2007-2008, but why? Did growth in CDS balances necessarily doom the U.S. economy for a downturn?

All things considered, CDS instruments in themselves are not to blame, but rather poor CDS underwriting standards. Because risk of human error can be interpreted as a cost to CDS use, we treat underwriting issues later in this paper. Yet if we are to speak of intrinsic merits, one is forced to admit that CDSs bring a number of advantages that cannot be easily discounted. One of the powerful characteristics of market economies is that they facilitate instruments that allow agents to transfer risk. If an agent cannot transfer risks, it often cannot allocate resources to its most efficient use. CDSs allow agents to transfer credit risk in the same way that insurance allows individuals to transfer risk on their companies, lives, and property. Instead of assuming all risks associated with a debt-issuance, debt holders can use CDSs to shift risk to parties willing to speculate. Through CDSs, lender protection exists against default that would not otherwise be available. The economic consequences of this protection mechanism cannot be understated. As demonstrated in a 2013 study by Saretto and Tookes, banks hedging loans with CDSs can provide capital to firms where debt could not previously be extended. Measured across 3,618 firm-year observations from 2002-2010, the study found that companies with debt on which CDSs were sold had more leverage and longer debt maturities than their peers (Saretto). The study reached this conclusion even after weighing potential questions of causality raised by credit ratings and other derivative holdings. Put another way, CDSs increase a firm’s financing capability, a critical aspect of economic growth.

Quickly, the critics say, “what if firms shouldn’t get the extra financing capabilities CDSs provide?” Empirical evidence from Ashcraft and Santos can ease their worries. Once CDS trading starts, their study found that credit becomes more expensive for risky borrowers and cheaper for safe borrowers. The theory behind this phenomenon is simple: CDS prices transmit information about a firm’s likelihood of default, functioning as implied ratings comparable to those issued by established agencies such as S&P and Moody’s. Unlike official credit ratings, however, CDS prices are dynamic, responding to new information at the market’s breakneck pace. CDS trading naturally generates information that debt issuers can use to make better credit decisions. Aggregated, the effect of these more informed decisions is improved resource allocation through capital diversion away from poor uses and towards promising investments (Ashcraft).

Moreover, the benefits provided by CDS-gathered information are not limited to corporations. The spread on a CDS - essentially the cost of insurance - acts as a market-based indicator of the current state of credit profiles, a figure with valuable uses on community, regional, and national levels. For example, Neel Kashkari, a former leader in the U.S. Treasury Financial Stability Department, used the indicator in a congressional report, stating, “one indicator that points to reduced risk of default among financial institutions is the average credit default swap spread for the eight largest U.S. banks” (Wallison). With a chart of CDS spreads in hand, regulators can quickly and accurately identify trends in an entity’s credit strength. Alternative measurements such as stock prices and interest-rate spreads are comparable but indirect gauges, often swayed by factors not closely tied to creditworthiness. Apart from their inherent value as hedging instruments, then, CDSs can help decision-makers at firms and regulatory agencies better understand their economic environment.

Of course, as with other financial instruments such as insurance, options, and futures, poor management choices regarding CDSs have led to significant historical problems, prime among them being poor assessments of default risk. From the year 2000 to 2007, the CDS market grew from $2 trillion to over $60 trillion, 10 times larger than outstanding loan balances at the time (Hutchinson). Many of these CDS policies were underpriced, providing too much compensation given their spreads and the actual risk of corporate default. Because underestimation of default was almost universal, markets did not panic and grew rapidly for a time. But in 2007, the corporate default rate unexpectedly increased to 13%, reflecting poor performance across a broad swath of industries. Underwriters, failing to calculate the true risk of their CDSs, saw reserves quickly fade away; many fell into bankruptcy. The devastating consequences of CDS market collapse contributed to the 2008 government bailout, which cost 182 billion tax dollars. Without government aid, the dangers associated with the CDS market may have led to complete economic collapse. Clearly, more careful (and better yet, time-tested) methods of calculating default risk are necessary to protect the CDS market, for when defaults catch underwriters completely by surprise, nations suffer significant economic consequences.

Another key lesson learned from the financial crisis is that consideration must be made for counterparty risk in CDS regulation. Counterparty risk refers to the chance that a party involved in a contract may either choose to default or be unable to meet its obligations. In cases of default both on a corporate bond and on a CDS, CDS holders can suffer tremendous losses and even potential bankruptcy. In the early 2000s, lack of appropriate regulation in the CDS market lead to reckless underwriting behavior. AIG, for example, underwrote more than 440 billion dollars of CDSs with less than 100 billion dollars in current assets available (actual reserves were far lower). The collapse of AIG forced the Government to intervene in order to prevent its shortage of funds from reverberating throughout the financial system.

CDS underwriters must also be aware of the correlated nature of default events. In quite a few ways, CDSs are similar to insurance. However, unlike the independent payout events on which most insurance policies are based, corporate default events are often connected. If a major oil company defaults, for example, oil refineries are likely to default as well. During the financial crisis, underwriters were caught by surprise by this connection principle, allowing a few unexpected default events to escalate into a figurative snowball of overwhelming payment obligations. The hard-learned lesson from 2008 is clear: to avoid payouts that underwriters cannot handle, correlated risk needs to be appropriately factored into CDS prices.

It is too simple to classify any complex financial instrument, CDSs included, as an exclusively positive or negative invention, not for lack of study, but because each is created under varied conditions and are used in various ways. Truthfully, the only safe conclusion with CDSs is that they are both useful tools and lurking dangers. Irresponsible creation of CDSs has led to financial catastrophes in the past and could lead to problems in the future. It is up to underwriters to choose how CDSs will be used. With proper pricing and reserve policies in place, however, much of the economic dangers from CDSs can be eliminated. Hopefully, an alignment of public and private goals will stoke healthy CDS growth, adding value to stakeholders across the financial system through greater access to debt, a unique economic indicator, and a mechanism that enhances resource allocation decisions.

Bibliography

http://www.namexijmr.com/demo1/wp-content/uploads/2015/04/2013_july-dec_9.pdf (Anthony)

http://www.ny.frb.org/research/staff_reports/sr290.pdf (Ashcraft)

http://www.motherjones.com/kevin-drum/2010/03/problem-credit-default-swaps (Kevin Drum)

http://moneymorning.com/2008/04/02/credit-default-swaps-a-50-trillion-problem/ ( Hutchinson)

https://www.bus.miami.edu/_assets/files/faculty-and-research/conferences-and-seminars/finance-seminars/Tookes%20Paper.pdf (Saretto)

http://cluteinstitute.com/ojs/index.php/JBER/article/viewFile/700/686 (Terry Young)

https://www.aei.org/publication/everything-you-wanted-to-know-about-credit-default-swaps-but-were-never-told/ (Wallison)