Sunday, September 21, 2008

Credit Default Swaps: 89 Times Bigger Than $700 Billion

A couple of years ago I took an interesting course called “Credit Risk Management” where we learned how to calculate some of the more arcane derivatives such as interest rate caps, floors, and swaps, and credit default swaps. It's an extremely fascinating science in risk mitigation.

Credit default swaps (CDS) are a risk mitigation technique. A CDS is an insurance policy against bankruptcy. More specifically, an entity enters into a CDS contract to insure against another entity’s debt (credit) becoming worthless. To calculate a CDS, you must know the entity’s probability of failure and probability of survival for each period of the CDS contract. Throw in t-bill yield curves, future rates, spot rates, discount functions, and you can begin to calculate the basis point spread (margin) between what the debt (bond) is currently trading for, and what you think it “should” trade for given its bankruptcy risk.

A scary document from the ISDA (here)

According to International Swaps and Derivatives Association, the notional value (essentially, the face value or underlying value) of CDSs was $62.2 trillion and growing rapidly. Said another way, if all the companies listed on the stock market went bankrupt tomorrow, someone (like AIG, or now the American people) would have to pay out $62.2 trillion dollars even though the entire worldwide stock market is valued at between $20 and $30 trillion. By comparison, the mortgage market – which has caused the greatest economic crisis since the Great Depression
is a mere $7 trillion and falling. (Source). Another scary number on that ISDA document: $382 trillion – the notional value (the underlying value at risk) of all interest rate derivatives outstanding. On their most basic level, think of an interest rate derivative as the transaction you went through to fix your variable mortgage or student loan. On a whole the derivatives market is around $450 trillion dollars (or 12 times larger than all the economies on earth put together).

So what happens when that $450 trillion starts sloshing around? What happens when an interest rate lowers or raises higher than expected, or when mortgage backed securities go belly-up, or when major companies begin to go bankrupt? I can’t think of anything less than economic catastrophe. We're already seeing companies that pay out CDSs beginning to go bankrupt, and the SEC declared no short selling financial stocks to keep other companies that pay off CDSs from going bankrupt like AIG. AIG was the largest backer of CDSs. Check out an article from February of this year (here). Then follow that up with an article from last week (here). People spoke about AIG’s exposure to CDSs earlier this year, and sure enough, AIG went bankrupt this month.

I encourage others to read more about CDSs, about AIG, and about the dollars associated with these derivatives. It makes you quickly realize that President Bush’s $700 billion is 1) directed precisely at the derivatives market, and 2) grossly and incomprehensibly under funded. $700 billion is 1/645th of $450 trillion. Now I realize what Bush, Bernanke, and Paulson mean when they say: “There is a much greater risk to doing nothing.”


Dougie Fresh said...

Glad to see you weighing in on the events of the last week. Even though that was all pretty far over my head, it's fascinating nonetheless!

Jude Broussard said...

I plan to read more about the ISDA report this coming weekend so that I can fully understand your post but I need to sound off a little. Both of you are two people that I think would respect my view. The bailout is WRONG! I just see this as a way to bailout people and businesses with bad credit. People don't want to pay market rates of return - because now they are higher. Everyone wants cheap money. Now the markets are requiring risk premiums that are more in line with the level of risk assumed. These overspending jerks still want cheap money so they can buy stuff they don't need or deserve. The markets are still great for people with good credit scores. I used my credit card yesterday without a problem (little dig at the Treasury secretary's overdramatic comments.) The question really is: should I be required to help subsidize lending to people that overextend themselves? Seems to be the ultimate slap in the face to someone like me.

Robert and Rachel said...

I enjoyed the president's speech to the people last night, though it was a little dramatic in its tone. If we do put hundreds of billions into the private sector to take over these assets, we need to 1) buy them at the cheapest price possible (like a reverse auction where the winning bid is the lowest price), and 2) take an equity position in the companies that use the bailout fund / or allow the government to realize the gains on the assets (CDOs) as they reach maturity. I know that's considered something like "socialist capitalism" but oh well. If we're providing hundreds of billions of our dollars, call it communism for all I care.

Finally, 3) no golden parachutes for execs who use the fund. If they use the fund, it should be tantamount to their company going bankrupt (from an executive compensation point of view)

Comming soon - I plan to post a "how to make a forward curve of interest rates using T-bills or Libor" story. Should be extremely fascinating to me / pretty boring to others :-)