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CDS: Was It Good for You, Too?


High-profile debacles (WaMu, anyone?) expose perils.

Credit default swaps (CDSs) are complex and powerful financial instruments with frequently have unforeseen consequences for market participants and the financial system as a whole. As former New York Federal Reserve President Gerald Corrigan told policy-makers and financiers on May 16, 2007: "Anyone who thinks they understand this stuff is living in la-la land."

Was it Good for You, Too?

The CDS contract is triggered by a credit event; broadly, this equates to default by the reference entity.

CDS contracts on Fannie Mae (FNM) and Freddie Mac (FRE) were triggered as a result of the "conservatorship."

This may seem odd, given the government actions were specifically designed to allow Fannie and Freddie to continue fully honoring their obligations. However, conservatorship is specifically included within the definition of bankruptcy in the CDS contract, resulting in a "technical" triggering of the contracts. This necessitated settlement of around $500 billion in CDS contracts with losses totaling $25 to 40 billion.

The triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default.

The CDS market is also complicating restructuring of distressed loans, as all lenders don't have the same interest in ensuring the survival of the firm. Different legal forms of economically similar actions can lead to entirely different outcomes under the CDS contract, complicating significantly the effects of the contract and its efficacy as a hedge.

Observing Protocols

In recent years, practical restrictions on settling CDS contracts has forced the use of protocols - where any 2 counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller makes a payment to the buyer of protection to cover the loss suffered by the protection buyer, based on the market price of defaulted bonds established through an auction system.

Recent cases highlight some of the issues with respect to the protocol and auction mechanism. The auction prices in the settlement of CDS on Fannie and Freddie (paid by sellers of protection) were as follows:

Fannie Mae: around 8.49% for senior debt and 0.01% for subordinated debt.

Freddie Mac: around 6.00% for senior debt and 2.00 % for subordinated debt.

Holders of subordinated debt rank behind senior debt holders, and would generally be expected to suffer larger losses in bankruptcy. The lower payout on the subordinated debt probably resulted from subordinated protection buyers suffering in a short squeeze, resulting in their contracts expiring virtually worthless. The differences in the payouts between the 2 entities are also puzzling, given the fact that they're both under identical conservatorship arrangements and the ultimate risk in both cases is the US government.

In other CDS settlements in 2008 and 2009, the payouts required from sellers of protection have been highly variable and large, relative to historical default loss statistics. This may reflect poor economic conditions, but is more likely driven by technical issues related to
the CDS market.
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