Test for credit default swaps (CDS) begins…

September 15th, 2008

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We are supposed to continue from yesterday’s article, What is the meaning of ?oversold?? Part 1: Technical analysis perspective, today. But the latest news on the financial markets takes precedence over the continuation of yesterday’s article.

As you will probably have heard by now, Lehman Brothers, one of the biggest investment banks in the United States has just gone bankrupt. Its peer, Merrill Lynch was bought over by Bank of America at a fire-sale price. Central bankers all over the world are bracing for vicious reactions from the financial markets. In Australia, the RBA had already injected extra liquidity into the financial system (see Reserve Bank injects extra liquidity). The Federal Reserve is intending to already made preparation for accepting stocks as collaterals for loans, as this news article says,

One of the biggest changes the Fed made was to accept equities as collateral for cash loans at one of its special credit facilities, the first time that the Fed has done so in its nearly 95-year history.

As we said before in Central banks and pawnshops,

Traditionally, the Fed would only accept the highest quality assets, US Treasury bonds, as collaterals. But due to the credit crisis, the Fed (along with other nations? central banks- see Reserve Bank of Australia entering the landlord business) is lowering the standards of collaterals to include top-rated residential and commercial mortgages. The Fed?s most recent statement indicates that they are lowering the standards even more (to auto loan and credit-card bonds). Using the pawnshop example, it?s like the pawnshop lowering the standard of the pawns that it will accept, say from gold jewellery to silver jewellery.

By accepting equities as collaterals, the Fed is lowering their standards even more. The central banks may be preparing and bracing for devastating fallout in the debt and equity market, but the question still remains: will the derivatives markets able to stand in the coming test? As we quoted Satyajit Das in How the CDS global financial time-bomb may explode?,

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.

This introduces systemic problems to the financial markets that have yet to be tested. Here are the technical difficulties with CDS:

  1. Who problem– As we explained before in Potential global economic black hole: credit default swaps (CDS), CDS is like insurance against default by a specific entity. Let’s call this entity the reference entity. The problem is, modern companies work through a complex web of entities mainly for tax reasons. What if the reference entity in the CDS does not match exactly with the defaulting entity? Furthermore, what if there is a restructuring, merger, de-merger, sale of divisions, break-ups takeover, etc. The definition of the reference entity becomes murky.
  2. What problem– What events constitutes a “credit” event? The common ones are (1) failure to pay, (2) bankruptcy, (3) repudiation or moratorium, (4) restructuring. But sometimes in real life, “credit” event may not be that straightforward. Restructuring may follow further restructuring, followed by even more… Different countries may have different laws regarding the form, definition and handling of bankruptcy that is at odds with local laws, which in turn put the CDS contract into a conundrum of definitions. As we quoted Satyajit Das in Potential global economic black hole: credit default swaps (CDS),

    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…

    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.

    Imagine the economic mayhem it will create as companies push and jostle each other into bankruptcy at the slightest excuse to protect their own cash flow!

  3. How problem– How do you get paid the insurance payment in a CDS contract? Should you rely on publicly available information and use it as a basis to get paid? What if the reference entity makes a partial payment and then the news wire reported that it defaulted when it is going to pay the rest later?

By now, you can see how the idea of CDS can be mired into complex legal entanglements. This will have systemic ramifications for the financial markets. We will be holding our breath to see how the drama will unfold in the weeks and months to come.

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