Credit Default Swaps: Dont throw the baby with the bath water!

Last updated on Nov 8, 2008

Posted on Nov 8, 2008

A lot has been said about the Credit Default Swaps and the derivatives.  These instruments are seen as major villains in the current melt-down.  It is easy to keep denouncing the instruments without properly and objectively understanding the causes that led to the issues because of them.  For, without dispassionate analysis, one could proverbially “throw the baby with the water out of the bath tub”!

So what are Credit Default Swaps?  As the need for higher and higher interest rates on bonds grew so also was the preponderance of corporates willing to issue debt for higher interest rates.  This was also so because companies from countries that did not have good sovereign ratings entered the global business and wanted to compete.  It was, therefore, in a sense the instrument that was creating the “level playing field”.

Although these companies were offering higher rates, their credit-worthiness was suspect at times – specially given their lower credit ratings (diminished by lower sovereign debt or other factors).  So, the debt or bond investors wanted an insurance that such companies would indeed have enough money to pay them the interest.  Thus arose a need to insure the debt interest.  On one side of the transaction was this investor in the bond and on the other??  It was basically a speculator, who would speculate on the health of the company itself.  While equity models were good to understand how a company is going to grow and thrive, at times they were not as well tuned to know if a company would be able to pay off its creditors.  CDS is a required instrument for spreading risk.  In fact.. critical.

If the market had remained controlled and had a clearing house as well as the investments done based on positions in underlying debt, then the things would not have spiralled out of hand.

What really happened was that many parties made CDS contracts for speculative purposes, without actually owning any debt for which they wanted to insure against default.  Many contracts were made on the debt of several companies to satisfy the speculative hunger of OTC speculators.  This meant that on many companies there is now a much larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations.

Any reforms now have to address two main things:

– Creation of a Clearing house
– Market for the Derivatives needs to be made more transparent

In 1987 also equity futures were the villain as the financial investors were using these futures to protect against the falls in their stock portfolios.  Read the explanation of the main cause for the 1987 crash below.  Does it give a sense of deja vu?  If yes, then there is a reason – it is called regulation.

The most popular explanation for the 1987 crash was selling by program traders.  U.S. Congressman Edward J. Markey, who had been warning about the possibility of a crash, stated that “Program trading was the principal cause.”  In program trading, computers perform rapid stock executions based on external inputs, such as the price of related securities. Common strategies implemented by program trading involve an attempt to engage in arbitrage and portfolio insurance strategies. The trader Paul Tudor Jones predicted and profited from the crash, attributing it to portfolio insurance derivatives which were “an accident waiting to happen” and that the “crash was something that was imminently forecastable”. Once the market started going down, the writers of the derivatives were “forced to sell on every down-tick” so the “selling would actually cascade instead of dry up.”

The following were the causes of the crash and reforms after the crash:

Causes of the Crash:

1.  No Liquidity
During the crash the markets were not able to handle the large volume sell orders.  Most common stocks on the NYSE were not traded until late in the morning of October 19th.  No one knows why investors all wanted to sell at the same time.

2. Stocks were overvalued
Stocks were trading at a historically high P/E ratio.  Though from 1960 – 1972 stocks were also trading at a high P/E ratio yet no crash happened.  So high P/E ratios don’t always trigger a crash.

3.  Computer Trading and Derivative Securities
Large institutional investing companies used computers to order to automatically order large stock trades when certain market trends prevailed.  Some analysts also claimed that index futures and derivatives securities buying were to blame.

Reforms after the Crash

1.  Uniform Margin Requirements
This was done to reduce the volatility for stocks, index futures and stock options.

2.  Computer Systems
It use to take 20 – 25 keystrokes to enter a trade.  With new computer system a trade could be done with one keystroke.  And if something were wrong, the system would just reject it.  This increased data management effectiveness, accuracy, efficiency and productivity.

3.  The NYSE and the Chicago Mercantile Exchange also instituted a “circuit breaker” mechanism by
which trading would be halted on both exchanges for one hour if the Dow Jones average fell more
than 250 points in a day and for two hours if it fell more than 400 points.

What has happened today now, is EXACTLY the same!!  The regulation, the transparency and a clearing house that manages and monitors the trades is essential to the future of using the good of Credit Default Swaps while eliminating the negatives of the effects of unregulated trading!

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