I find it very scary of the growth of CDS is recent years. I heard it was twice the value of the US Stock Market. An increase in defaults could cause a disasterous chain of events. When there is more money in “insuring” a company then the actual market value…somethings wrong. But if there were to be regulation how would it be done? What do you think of these proposals? All CDS contracts trade on a public exchange and be regulated by the SEC. This bring transparency. A limit on the amount of contracts that can be created vs the outstanding issue’s market value.
You could limit it, but why? What is so magical about the market value of the issue that it should be used as a limit on the number of CDSs written on it? CDS is not just ‘insurance’ though it’s easy to visualize it that way. CDS allows you to short risk on a firm. Especially if cash settlement is used (ie no underlying needs to be delivered to get paid on a default), why does the size of the issue matter?
A little late guys, a little late.
Ed.Markovich Wrote: ------------------------------------------------------- > You could limit it, but why? What is so magical > about the market value of the issue that it should > be used as a limit on the number of CDSs written > on it? CDS is not just ‘insurance’ though it’s > easy to visualize it that way. CDS allows you to > short risk on a firm. Especially if cash > settlement is used (ie no underlying needs to be > delivered to get paid on a default), why does the > size of the issue matter? Because it has been growing like crazy and has put unbelievable risk into the market. We have had a period of low corporate defaults. Now in the past when a wave of defaults occured it only affected the finite individuals who were exposed to the credit or stock of that company. With CDS there is no limit how much risk someone could take out on a company. So now when a default or credit event occurs it in theory could be multiplied several times over. Now I know this is already a big deal with the subprime CDS…but if it spreads to the corporates this could be dangerous.
>> Now in the past when a wave of defaults occured it only affected the finite individuals >> who were exposed to the credit or stock of that company. It’s not clear from your post whether you perceive the danger of CDS’s to stem from their nature or their volume. So I will address both: The exposure of a CDS is no different than the exposure of a bond. “Owning” a CDS doesn’t have a big difference from being short the bond, and selling protection have roughly the same exposure as being long the bond. So no spectacular added risk there. There is of course a difference due to the ability to leverage, but that in and of itself isn’t terrifying. In terms of the sheer amount of outstanding CDS, that number bears closer examination. Say I am a dealer who sold you protection on 1M of GM. I then bought protection on 1M of GM from BosyBillups. This surely registers as 2M of outstanding CDS notional but it doesn’t exactly reflect the amount of risk outstanding. To take the example further, if both you and BosyBillups got tired of (respectively) paying for protection / being long GM, you could sell protection to him on 1M of GM. That means that we register 3M of outstanding CDS on GM but in reality all 3 of us have taken on no risk whatsoever. So I wouldn’t freak out just yet. I wouldn’t be surprised if the amount of unhedged risk due to CDS out there is lower than the risk of owning the debt outright.
Ed.Markovich Wrote: ------------------------------------------------------- > >> Now in the past when a wave of defaults occured > it only affected the finite individuals > >> who were exposed to the credit or stock of that > company. > > It’s not clear from your post whether you perceive > the danger of CDS’s to stem from their nature or > their volume. So I will address both: > > The exposure of a CDS is no different than the > exposure of a bond. “Owning” a CDS doesn’t have a > big difference from being short the bond, and > selling protection have roughly the same exposure > as being long the bond. So no spectacular added > risk there. > > There is of course a difference due to the ability > to leverage, but that in and of itself isn’t > terrifying. > > In terms of the sheer amount of outstanding CDS, > that number bears closer examination. Say I am a > dealer who sold you protection on 1M of GM. I then > bought protection on 1M of GM from BosyBillups. > This surely registers as 2M of outstanding CDS > notional but it doesn’t exactly reflect the amount > of risk outstanding. It accurately reflects the amount of counterparty risk created. The problem with the mountain of CDS out there is not the underlying credits; it’s the added counterparty risk that these have created tied to the underlying credits. >To take the example further, > if both you and BosyBillups got tired of > (respectively) paying for protection / being long > GM, you could sell protection to him on 1M of GM. > That means that we register 3M of outstanding CDS > on GM but in reality all 3 of us have taken on no > risk whatsoever. > Except that’s not true. All of those contracts are separately enforcable without (probably) any netting arrangements and there would surely be no third-party netting. If I sell you CDS protection and then you sell me slightly different CDS protection, I can go bankrupt and default on my obligations but you still have to abide by yours. > So I wouldn’t freak out just yet. I wouldn’t be > surprised if the amount of unhedged risk due to > CDS out there is lower than the risk of owning the > debt outright. Neither would I and I would never call for SEC regulation and especially not SEC regulation that calls for CDS to be traded only on an exchange. Yuck, yuck, double yuck. The counterparty risk problem might turn out to be interesting if we get a wave of defaults and provides an excellent route for corporate credit problems to move to other credit problems.
Joey - Do you think there solution to stem the growth of CDS or should it just play itself in the market will major burn victims.
thepinkman Wrote: ------------------------------------------------------- > Joey - “should it just play itself in the > market” I almost always think that’s the right solution. While I’m thinking about it: a) The comparison of the notional size of CDS positions vs notional size of bonds outstanding is nearly irrelevant or more irrelevant than is usually supposed. Leaving aside speculation for a second, the risk of a corporate default or other CDS credit event is felt by more than just bondholders. For example, if I was building a tire factory to supply GM with tires under some long-term contract my risk under that contract is a lot like the risk felt by GM bondholders. I might want to hedge some of that risk in the CDS market. b) Delivery problems in the event of a default could be pretty orderly even if the CDS exposure is much bigger than the available bonds. I can make up a scenario in which we get short squeezes (or whatever they would be called in the CDS market) without any easy remedy but they seem far-fetched to me. More than likely the bonds would just be passed around, resolving the problem. c) Futures markets routinely have open interest larger than available supply and it is usually healthy. From an economic standpoint, Merrill Lynch paying some hedge fund on a corn bet has little usefulness except that Merrill and the hedge fund provided liquidity for legitimate hedgers. In futures markets, 95% of volume is done by speculators but that activity is justified by the economic gains of providing liquidity for easy risk transference for hedgers. The same thing should be true for CDS markets (and yes I’m aware that the CFTC regulates futures markets in the US but nobody regulates CDS markets).
Bump. Look at the date…Pinkman was on it.
February 08? Maybe Pinkman would be on it in February 05.
I’m joking.