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Judging Credit Default Swaps' True Value


Would they really provide protection in the case of a sovereign default?

Editor's Note: This article was written by Edward Hoofnagle of Ebusinessware Thought Leadership.

Have you ever really taken a moment to think about the implications of a thriving Credit Default Swap (CDS) market on sovereign debt?

First, a word about the Credit Default Swap market size. Because Credit Default Swaps are private bilateral agreements, there's really no single source to determine the outstanding notional amounts.

However, much has been done to centralize trades, and the Depository Trust & Clearing Corporation has illustrated a view of market size with some figures that the Financial Times published yesterday in "Bets rise on rich country defaults".

As per the Financial Times, the Gross Notional of CDS outstanding on developed and emerging sovereign debt, by my simple count, was well over $500 billion. Of course, there are many trillion in outstanding sovereign debt, so $500 billion is a small position, but still, it's a large enough number to take pause.

In my opinion, the CDS market can do some good things, but I think it can also lead to some strange behavior. I will argue today in the case of Sovereign Debt CDS, that it may lead to the mis-perception of risk.

It's useful to remember that credit risk is not like market risk. Market risks have been subject to risk analysis and measurement, which has a random normal assumption. Even though this has been hotly debated, the general sense that markets go up and down with equal likelihood has an intuitive appeal despite the statistical inaccuracies.

The purpose of my note is not to start a debate of market risk, nor to advocate for random walks; rather, my goal is to contrast market risk with credit risk.

Think in lay-person terms -- I buy a government bond and hold to maturity. Either I get a small gain (especially these days) from the interest, or there's a default and I may lose the principal.

Now, let's leave aside currency devaluation, inflation, and other more subtle forms of debt destruction to keep it simple. The facts are that taking on credit risk results in a relatively smaller dispersion of gains compared to losses, and that's the main point I want to highlight -- credit risk has some low probability, but really bad outcomes in comparison to its upside -- interest payments.

Many would agree that credit risk follows a Poisson distribution, not a random normal distribution. In simple terms, when we apply this distribution to the dispersion of returns on credit risk, it means that there's a large "tail" or a lot of "remote" chances for very large losses whereas the upside gains are limited.

Enter the Credit Default Swap. Thanks to this derivative contract, I can purchase insurance against the uglies. I can buy "protection" from a bank to pay me in case the government defaults on its bonds. So, I can cut off that nasty long tail that comes along with credit risk.

Again, my long-winded note is to highlight that this kind of thinking can lead to a mis-perception of risk. While the insurance has a nominal coverage in case of the bond default, one must wonder whether a CDS would truly provide the protection in case there really were a sovereign default.

One hypothesis is that, in the event that a sovereign default were to happen, then uncertainty would be too great and the markets would be in too much systemic turmoil for these contracts to be useful.

As we learned with AIG (AIG), when I try to chop off default risk, I get counterparty risk in return -- I get the risk that the company from whom I bought the swap protection can't make good on their promise.
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No positions in stocks mentioned.

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