How the CDS global financial time-bomb may explode?

June 2nd, 2008

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Back in Potential global economic black hole: credit default swaps (CDS), we first introduce credit default swaps (CDS) and warned that it is a potential global financial time bomb that is waiting to explode. Should it explode, we will see another major panic in the global financial system, possibly even surpassing the panic back in January this year. So far, the CDS market has not yet been tested through a trial of fire and the risk is that it may turn out to be a house of cards when put under stress.

Satyajit Das, a character whom we introduced back in Is the credit crisis the end of the beginning?, has this to say about CDS in The Credit Default Swap (?CDS?) Market – Will It Unravel?:

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

As we explained before in Potential global economic black hole: credit default swaps (CDS), the buyer of a CDS is basically buying insurance against the default of a debt. The problem is that how do you define what a “default” is? If a defaulted debt cannot fulfil the technical conditions to satisfy the trigger of insurance payment, then the insured party may find themselves in danger of insolvency. As Satyajit Das wrote,

The CDS contract is triggered by a ?credit event?, broadly default by the reference entity. The buyer of protection is not protected against ?all? defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan.

As a result, this will have widespread systemic implication:

A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract.

As with most financial crisis and panic, decisions that make sense at an individual level will result in catastrophe if repeated en masse. If enough businesses are pushed into bankruptcies in order to fulfil the technical requirements of default, then losses will be exacerbated, triggering another around of credit deflation.

Then there is another problem. Since CDS is a derivative, the buyer of a CDS need not necessary owns the bond (debt asset). But in order to receive insurance payment for the debt payment, the bond has to be delivered. But what if there is more CDS than bonds (this may happen due to securitisation)? Then when the bond defaults, there will be a mad rush among the CDS holders to grab a slice of the defaulted bond (figuratively speaking), which pushes up the price of the bond. As a result, the CDS holder may not be as fully hedged as assumed to be.

If you think this is complex, this is because the murky world of derivatives is complex. Even central bankers do not understand it all.

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