Skewed CDS settlements do little to help the debt sector

By Satyajit Das Published: March 5 2009 02:00 Last updated: March 5 2009 02:00 At the quantum level, the laws of classical physics alter in intriguing ways. At the derivative level, the rules of finance also operate differently. In October 2008, Alan Greenspan, former Federal Reserve chairman, acknowledged he had been "partially" wrong to oppose regulation of CDS. "Credit default swaps, I think, have serious problems associated with them," he admitted to a Congressional hearing. CDS contracts on Freddie Mac and Fannie Mae were "technically" triggered as a result of their conservatorship, necessitating settlement of about $500bn in CDS contracts with losses totalling $25bn-$40bn. Government actions were specifically designed to allow the companies to continue to fully honour their obligations. The triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default. Practical restrictions on settling CDS contracts have forced the use of "protocols" - where the seller makes a payment to the buyer of protection to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through an "auction" system. For Freddie and Fannie, the auction prices resulted in the following settlements by sellers of protection: Fannie - about 8.49 per cent for senior debt and 0.01 per cent for subordinated debt. Freddie - about 6 per cent for senior debt and 2 per cent for subordinated debt. Subordinated debt ranks behind senior debt and is expected to suffer larger losses in bankruptcy. The lower pay-out on subordinated debt probably resulted from subordinated protection buyers suffering in a short squeeze, resulting in their contracts expiring virtually worthless. Differences in the pay-outs are also puzzling, given that they are both under identical "conservatorship" arrangements. In other CDS settlements in 2008 and 2009, the pay-outs required from sellers of protection have been highly variable and large, relative to historical default loss statistics. This is driven by technical issues related to the CDS market. The auction settlement of Lyondell (around 80-85 per cent) reflected complications from the role of debtor in possession financing and complex collateral allocation mechanisms. Skewed pay-outs do not assist confidence in CDS contracts as a mechanism for hedging. The large pay-outs are placing a material pressure on the price of existing bonds and loans, exacerbating broader credit problems. Low overall net settlement amounts may also be misleading. In practice, there is the "real" settlement, where genuine hedgers and investors deliver bonds under the physical settlement rules and the "auction", where dealers who have both bought and sold protection and have small net positions settled via the auction. In the case of Lehman, the net settlement figure of $6bn that was quoted refers to the auction. Some banks and investors that had sold protection on Lehman did not participate in the auction, choosing to take delivery of defaulted Lehman debt, resulting in losses of almost the entire face value. CDS contracts can amplify losses in credit markets. Lehman defaulted with about $600bn in debt, implying a maximum loss to creditors of that amount. In addition, according to market estimates, there were CDS contracts of about $400bn-$500bn where Lehman was the reference entity. Market estimates suggest only about $150bn of the CDS contracts were hedges. The remaining $250bn-$350bn of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200bn-$300bn) are additional to the $600bn. The CDS contracts amplified the losses as a result of the bankruptcy of Lehman by up to 50 per cent. Ludwig von Mises, the Austrian economist, said: "It may be expedient for a man to heat the stove with his furniture; but he should not delude himself by believing that he has discovered a wonderful new method of heating." As the global economy slows and the risk of corporate default increases, the identified issues are likely to complicate the problems of credit markets and banks generally. Most worryingly, recent proposals to regulate CDS markets show limited awareness of these issues. The writer is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.