here we go again!

Alex Moffatt

I am worried as I have just read an article on page 27 of Fridays Financial Review, courtesy of the London Financial Times, entitled “Hedge Funds pursue esoteric credit risk in bespoke tranches”. The article highlights a rise in investor interest in bespoke tranches, a bundle of risks expressed through credit default swaps. My worrying does not emanate from the re-emergence of synthetic structured credit products but from a response similar to the one which sees North Korea with a nuclear capacity and with the ability to fly a ballistic missile and immediately concluding that that it has nuclear missile capacity.

Please let me explain.

In the run-up to the GFC, the use credit default swaps got out of hand – of which more later – but they are of themselves not at all toxic. They are, expressed as an insurance contract, an agreement that against a payment of an annual premium by the buyer of protection, the seller will make whole the buyer in the event of the insured credit risk defaulting. So it I buy US$10 million of 5 year protection on Daimler Benz at 50 bps, I pay you US$50,000.00 per year for 5 years and you promise to pay me US$10 million if Daimler were to default on its debt at any time during the 5 year period. I do not need to actually hold any Daimler debt in order to make good my claim. Thus a CDS is not a guarantee in the traditional sense but an insurance against an event, priced on the likelihood of it occurring.

Of itself, the CDS is a brilliant invention. If anybody in the world trades as either a buyer or a seller of a Daimler shares they are all talking of only one security, irrespective of what currency they settle the trade in. Daimler Benz Group, however, has 164 bonds outstanding in 11 different currencies and for eight different borrowing entities. Finding a buyer and a seller of the same bond in the same currency for the same borrowing entity at the same maturity and on the same day is a very different prospect and where market makers took on the risk of finding the other side of the trade in time. The price for bridging that time difference, known as liquidity in the bond space, was the bid ask spread. The more likely to find the other side soon, the smaller the bid ask spread, the harder it would be, the wider the spread. This, in bond markets, is known as the liquidity premium.

Credit default swaps are generically priced on a generic entity for a generic maturity, thus offering credit investors something not dissimilar to the risk traded by equity people. The difference is that equities are cash securities while CDS is a derivative which means that the risk is not only on the credit but also on the counterparty who might not be able to meet his obligation if called upon. In many cases during the GFC it was the counterparty, such as Lehman Brothers, which ended up defaulting and not the underlying credit. So if I had bought protection on Daimler from Lehmans....I’m sure you get the message.

Here we go again!


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