CDS Question

Someone who knows more about this than me explain: We had a guy in our office today raving about the notional CDS exposure out there (he put the figure at $45T), and proceeded to say if we get just a few percentage points of default on that figure it would wipe out all financial institutions capital in the US. Even assuming the institutions dealing in this stuff haven’t properly hedged themselves, if there’s a default and the short leg has to pay out, do they just have to make the long whole? As in, someone long senior debt might get 50%-80%+ in bankruptcy, how much does the short CDS pay? Any other insights appreciated.

Settlement Options from the Fabozzi text 1. Physical Settlement - The protection buyer physically transfers the security to the protection seller in exchange for cash valued at the securities par value. This is the way 86% of the CDS are settled. 2. Cash Settlement - (11% settled this way) The security is quoted in the mkt by a specified mark-to-market price. Then the seller pays the difference in cash par value of the security and the mark-to-market price 3. Fixed Settlement Amount Rare (3%) where an agreed to price is agreed b/t the two parties. One thing to note, banks are buying protection on certain companies that exceeds their actual ownership. Say they have a $50MM exposure to GM yet they buy 200MM in CDS as they believe that they will have a credit event. This poses a problem (besides the use inside information that’s likely occuring.). If GM had a default, those owning the stock would hurt but the issue would be relatively contained. Now if GM defaults (has a credit event) b/c of all the people selling protection, the loss magnitude would far exceed GM’s respective MKT Cap. If there are a rash of corporate credit events…its lights out for the protection sellers. Another thing…I was looking at a trustee report today that had a regular cash security labeled as a CDS. I was like WTF this isn’t synthetic. I call them up and they say CDS for them sometimes stands for Collaterized Debt Security. I was like, “could that be any more confusing. Everyone knows CDS is a Credit Default Swap!”

So are counterparties the next to get a ratings downgrade? If so, what does that mean to the holders of short and long CDS?

OK, but like I said, if it’s senior debt it’s likely not wiped out in a “credit event”. So how much does the CDS pay?

HSA - Could you rephrase your question? I am not sure what you are asking when you’re asking how much the CDS pays.

one way or another the protection seller pays 1-recovery rate if there is a credit event. 50-80% sounds high to me. 40% is market convention for pricing. I think the work Moody’s did on historical defaults shows about a 38% recovery rate for senior obligations, on average. when you think about systemic impacts, when defaults tick up losses will increase but so will gains for protection buyers. i’m not naive enough to think that these will cancel out, as the risk can’t be evenly distributed across the system. so, i think how bad it gets will come down to counterparty risk management and collateral policies. which is a little scary.

I was asking whether the short CDS has to pay the full notional in the event of default, or whether they only pay the notional net of all recoveries. It appears BN has confirmed the latter.

I’m not an expert, but it looks like they pay full par value minus the present value of whatever is recovered. In the cash settled case, what the protection seller recovers is just the market value of the bonds; in the physicals case, they hold the bond and hope to recover something, and if it doesn’t look like anything is recoverable, or it will take too long, the seller can sell in the market for roughly the same as the cash settler guys. Don’t know about that 1% of other cases.

To a Martian, this conversation would seem a little weird - “So there are all these insurance policies out there to insure people against defaults, but if people start defaulting, this risk transference is going to bring down the world?!” I have to believe that notwithstanding the pinkman’s absolutely true point that CDS ultimately spread out risk more than create it. Having lots of defaults is definitely bad news, but it won’t be the CDS to blame for the problem (although some people will certainly be smacked who otherwise wouldn’t be if there were no CDS).