Credit default swaps have been in the news quite a bit lately, so I’m posting some links to articles:
Credit Default Swap (CDS) Primer, Nomura, May 2004
The CDS Market: A Primer, Deutsche Bank, 2004
Bloomberg article on Insider Trading (hat tip Bill Cara) Note: it’s not clear to me why these changes in the CDS levels did not leak into the bond market via arbitrage of the basis.
Update, 2007-7-29: There’s a good introduction at the Accrued Interest blog.
Update, 2007-9-13: There are some good downloadable papers at John Hull’s website. Hull & White, 2000 is the basis for the Bloomberg CDSW screen.
Update, 2008-01-28: Hu & Black discuss the problems inherent in “debt decoupling” – if the owner of a bond is fully, or even more than fully, hedged via CDSs, this block of bonds might be voted in a manner that is predjudicial to the economic interest of that class of creditors.
There are also several sources of qualitative evidence. One is the recent tendency for credit default swap contracts to require the protection buyer, if it is also a creditor, to act in the interests of other creditors. This suggests concern that the protection buyer might not otherwise do so. How this obligation can be enforced, however, without disclosure of either votes or hedges, is anyone’s guess. We have also heard from bankruptcy judges that they sometimes see odd behavior in their courtrooms, which empty crediting might explain. For example, one judge described a case in which a junior creditor complained that the firm’s value was too high, even though a lower value would hurt the class of debt the creditor ostensibly held.
There is some commentary at Naked Capitalism.
Update, 2008-2-6: More warnings via Naked Capitalism: CDSs may not work as advertised due to operational issues, the ascendency of Sales over Risk Management, and the relative amounts of notional vs. deliverable bonds.
Update, 2008-3-30: Another risk with CDSs is a potential disparity between the cash-settlement price and the ultimate recovery price, as has happened with Delphi. See AleaBlog and Felix Salmon.
Update, 2008-4-3: It’s linked in the comments, but I should highlight the February 21 review of some BoC Research into CDS Pricing.
Update, 2008-9-4: See also CDS Recovery Locks.
Update, 2009-3-12: Risk Weight of Credit Default Swaps.
[…] PrefBlog Canadian Preferred Shares – Data and Discussion « Credit Default Swaps: Links to Primers […]
[…] According to this wrap-up, credit derivative swaps on HCA blew wider by 102bp to 555bp, while GMAC LLC was 94bp wider to 480bp. I do not profess to be an expert on CDS history – or even to have a huge amount of expertise in the field – but it seems to me that this kind of move, in the absence of company specific news, must be some kind of record. We are in the panic phase, and spreads might even go as high as they were in 2001! […]
[…] – written Credit Default Swaps against a portfolio of mainly mortgage backed securities and pledged the term deposits as security (note that writing a CDS gives you exposure and, hopefully, yield basically equivalent to what you wrote the CDS on) […]
[…] Basically, the idea is … well, we we all know what a CDS is, right? consider, on one hand, a portfolio composed of (1) a short position (i.e. selling protection) in the CDS of a company and (2) a long position in a risk free bond. On the other, consider an outright long position in the company’s corporate bond, all with the same maturity and par and notional values of $100. These two investments should provide identical returns, resulting in the CDS spread equaling the corporate bond spread. […]
[…] He also highlights the issue of insider trading, mentioned in the CDS Primer: The Journal also mentions regulatory issues: This market poses challenges for would-be regulators. It isn’t clear, for instance, how securities laws on fraud and insider trading would apply to credit-default swaps, because it’s not clear in what way they are even securities; they are private contracts. […]
[…] There were some very interesting tid-bits of news today. Naked Capitalism posted an article regarding some of the unintended consequences of Credit Default Swaps. I have commented on this news more thoroughly on the PrefBlog CDS Primer Post. […]
[…] Look – there has clearly been a screw-up. I must say, I’m not sure why bond insurers come under the purview of regulators, but let’s assume there’s a good reason … which is a hell of an assumption to make, but otherwise we’re left to mumbling libertarian slogans to each other. In the first place … just how is insuring a municipal bond different from writing a CDS? Not much, is the basic answer. There might be some legal differences in the bankruptcy games (mentioned in a recent update to the CDS Primer); credit risk is (almost certainly) greater; structural risk and analysis is (almost certainly) more complex. But what of it? Analysis of these elements and comfort-offering to potential investors who don’t want to do it, are what monolines do for a living. […]
[…] 3. Rating agencies do not speak with the voice of God and it is a mistake to take them too seriously. It is also a mistake to take them too lightly. Think of credit ratings from major agencies as having the same relevence as market prices … inefficient, yes, and it is entirely rational to disagree with them from time to time … but if you are going to disagree with them, you’d better have a pretty good reason and be prepared to be wrong a lot of the time! They move slowly … perhaps too slowly. A recognized form of bond portfolio management is “Credit Anticipation”, in which you attempt to recognize fundamental changes in companies’ risk profiles before they are highlighted by the rating agencies and subsequently reflected in market price by those who did not anticipate the rating change. One thing that is happening now is that the CDS market is going nuts speculating on which bank holds the most toxic waste … anticipating future changes to rating as the sub-prime situation clarifies. […]
[…] At best, this study represents a good try – the data for determining the value of a CDS through a cycle simply does not exist. Despite my interest in the asset class, I’m not convinced that the CDS market is ready for prime time. If their main attraction is the ability to lever up a portfolio significantly, then a huge degree of uncertainty is introduced into pricing, in addition to the uncertainty introduced by debt decoupling. I continue to wrestle with the idea, but these twin, undiversifiable uncertainties probably introduce a required risk premium that makes inclusion of these instruments, long or short, in a fixed income portfolio uneconomic. […]
[…] to happen is more real-money bond investors willing to write covered CDS as a synthetic bond. As has been noted, though, there are counterparty and convergence problems with such a process so, if it ever […]
[…] Interest has come out in favour of Exchange Traded Credit Default Swaps in a new post:Bailouts, Wall Street, and the Bad Motivator, although he does not go so far as some […]
[…] how the auction mechanism might work. The question of short squeezes upon a credit event has been previously discussed (update of 2008-3-30); there must be some wiggle-room for protection buyers to delay delivery, […]
[…] sub-debt has been discussed on PrefBlog before, as have Credit Default Swaps. The place of sub-debt in a bank’s capital structure has been mentioned in a review […]
[…] the primer on plain vanilla Credit Default Swaps is getting a little messy, so here’s a dedicate post to recovery […]
[…] hedge it by buying protection (via Credit Default Swaps) … not necessarily on each individual name, it might be, f’rinstance IG […]
[…] the primer on CDS I referred to a paper by Hu & […]
[…] losses like big boys and learning from the experience. As I have stressed many times on this blog, debt decoupling can result in strange things happening … particularly in a rinky dink $29-million […]
[…] owners of common who also have a long position in the non-voting shares. In the bond world, this is known as debt decoupling, where as bondholder you vote for a bad deal so that your Credit Default Swaps will pay […]