Part 5: The Other 'CDs': Credit Default Swaps 

What is a credit default swap?
A credit default swap (CDS), as its name suggests, is a transaction in which one party, the beneficiary, “swaps” the credit risk on a specified asset (for the purposes of this discussion, a pool of subprime assets) for a guarantee of another party, the guarantor. CDSs were devised by J.P. Morgan & Co. in the early 1990s to hedge its loan risks; by some accounts, the CDS market now includes US$65 trillion in contracts. [i] CDS transactions are done in the Over-the-Counter (OTC) market.

The following graphic illustrates how a CDS works. Financial Institution A pays Financial Institution B a certain number of basis points on the par value of the reference asset, either quarterly or annually. In return, Financial Institution B agrees to pay Financial Institution A an agreed-upon amount if there is a default, based on a formula delineated in the contract. [ii] 

Credit Default Swap

What is the Over-the-Counter (OTC) market?
The OTC market is a market in which market makers negotiate over telephone or computerized networks instead of through an organized exchange. The main participants of the OTC market are investment banks, commercial banks, government sponsored enterprises and hedge funds.
 
How did the credit default swap market further strain market conditions?
The credit default swap (CDS) market has been estimated to range from US$35 billion to more than US$65 billion in notional or face value. This market has grown massively in the last five to 10 years as market participants sought further derivative financial instruments to use as a means to manage (or exploit) credit risk. The buyer of a CDS generally is looking to mitigate credit risk exposure triggered by a default or other defined negative event. Sellers assume the default risk for a premium generally by executing a transaction in the OTC market (these instruments are not exchange-traded).

With the continuing credit deterioration in the financial markets, CDS spreads continued to widen, with spreads on certain financial services companies moving from basis points in the mid-20s in February 2007 to the high triple digits in late September 2008. This resulted in significant mark-to-market losses for the issuing financial institutions and diminution of capital, as well as a series of margin calls that put further pressure on liquidity positions of affected institutions. These factors, combined with the opaqueness and complexity of these instruments, contributed to further concerns over the creditworthiness and financial wherewithal not only of a number of market-making issuers, but also of those buying institutions that were relying upon those instruments to mitigate credit risk exposure in their own portfolios.

What is the outlook for the regulation of the credit default swap market?
In late December 2008, the SEC and the Commodity Futures Trading Commission announced the licensing of clearing houses for credit default swaps. The establishment of these central clearing parties is intended to provide greater transparency to the market, improve information available to market participants and regulators, and reduce counterparty risk. While many would view this as a positive development, these actions alone are not likely to preempt future congressional debate on credit default regulation. In Europe, debate continues over the requirement of central clearing for credit default swaps.

Next week: Part 6: Global Reach and Impact

To view the full Protiviti bulletin: The Current Financial Crisis: Frequently Asked Questions 

[i]Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults,” Evans, David, Bloomberg.com, last updated May 20, 2008, available at www.bloomberg.com.

[ii] Federal Reserve SR 96-17, Supervisory Guidance for Credit Derivatives, August 12, 1996, available at www.federalreserve.gov.