Credit default swaps (CDS) are term insurance contracts written on the notional value of an outstanding bond. In the paper, The Economics of Credit Default Swaps, forthcoming in the Annual Review of Financial Economics, I study the economics of CDS using the economics of insurance literature as a basis for analysis. The first CDS were traded by JP Morgan in 1995. Since that time, CDS trading has grown dramatically. CDS contracts trade in the over-the-counter derivatives markets which is only loosely regulated. The CDS market exhibited exponential growth between 2001 and 2007. At its 2007 peak, total outstanding notional for CDS was over 62 trillion dollars. After the crisis, however, these numbers have halved to just over 30 trillion dollars in 2009. Most of this change in outstanding notional has occurred through “portfolio compression” as demanded by the regulators where long and short credit derivative positions on the same underlying credit entity held by the same institution are netted. The reduction is not due to decreased trading activity in CDS. This assertion is supported by the relatively stable outstanding notional of equity and interest rate and currency derivatives over this same time span.
Insurance contracts on debt existed long before the start of trading in CDS. Municipal bonds are commonly insured by private insurance companies and individual mortgage loans often have mortgage insurance initiated by the lenders, especially those mortgages that are issued with high loan to value ratios. And of course, for decades Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac have all provided insurance for residential mortgage loans.
It has been argued in the financial press that the unregulated trading in CDS was a key contributor to the severity of the credit crisis. For these reasons, recent financial regulation reform aims to control and/or to limit the use of these derivatives. To understand the truth or falsity of these allegations and the effectiveness of the proposed regulations, one must first understand the economics of CDS. This is the purpose of this paper. In fact, to understand the economics of CDS, one must first understand the economics of insurance, more generally. Then, one can apply these insights to the specifics of CDS.
The paper’s key conclusions are as follows:
- The trading of CDS increases the welfare of the traders in financial markets via the optimal allocation of risks, thereby lowering debt costs.
- The trading of CDS reduces market imperfections in the trading of debt, especially enabling the taking of short positions. This reduction in market imperfections facilitates the access to more debt capital, thereby lowering debt costs.
- The possibility of CDS seller default, analogous to insurance company failure, reduces the welfare increasing role of trading CDS. Government regulation of the CDS collateral requirements and CDS seller equity capital is needed to maintain the benefits of trading CDS.
- CDS defaults have a systemic risk component, which in the aggregate, might lead to the failure of financial markets. This negative externality is not currently priced into the contracts. If it exists, regulation in needed to correct for this negative externality in the trading of CDS.
- CDS spreads can be decomposed into (i) the expected loss, plus (ii) a default risk premium, plus (iii) asymmetric information monitoring costs, plus (iv) a liquidity risk premium due to a quantity impact of trades on the price. Of course, these components are interrelated.
- The valuation of CDS must take into account counterparty risk in the execution of the contracts. This depends on the collateral requirements and credit worthiness of the CDS seller.
- For over-the-counter CDS, posting 100 percent of the notional in collateral using riskless securities will completely remove counterparty risk and the negative externality due to systemic risk and the failure of financial markets. Due to the cost of posting 100 percent collateral, this suggestion has not been made in either the financial press or in the regulatory arena. An alternative clearing mechanism is a central clearing counterparty (CCP). A CCP will reduce, but not eliminate the risk of financial market failure.
- Exchange traded CDS will also reduce, but not eliminate the risk of financial market failure. This is true unless the exchange traded CDS become futures contracts, with daily settlement of gains and losses. Exchange trading has the additional benefits that it should reduce trading/liquidity costs and increase transparency in both pricing and trading activity.
- A centralized collateral authority which monitors and regulates (as necessary) collateral positions across CDS market participants can both reduce counterparty risk in customized CDS contacts and reduce the risk of financial market collapse.
- Rating agency error in evaluating correlated default risk generated two distortions in the computation of equity capital, which was a key factor in creating the financial crisis. One, it generated the perception of nearly riskless securities (AAA rated) with high yields, against which little equity capital was required (e.g. Bear Stearns subprime hedge funds). Two, it enabled highly rated firms to sell CDS with little or no collateral and insufficient equity capital (e.g. AIG, see Congressional Oversight June Report (2010)).
It should be noted that conclusions (1) and (2) reduce a firm’s cost of capital, which in turn increases aggregate investment. This is a positive real effect on the economy from the trading of CDS. To maintain this positive real effect, however, government regulation is needed to control the failure of the sellers of CDS contracts (analogous to the failure of insurance companies). And, of course, if it exists, governmental regulation is needed to minimize the negative externality in (4).
The full paper is available for download here.