Credit Default Swaps - What You Need To Know!

Below is a explanation of Credit Default Swaps. I want everyone to understand these cancers which have infiltrated the American financial system and who created them> JP Morgan/Chase.  Also take notice that when Lehman went bankrupt the cost to the system should have been about 145 billon but with the swaps it mushroomed to over 200 billion and still growing see this site: http://www.rgemonitor.com/economonitor-monitor/254052/lehman_cds_payout_on_october_21_360bn_or_6bn . These are time bombs exploding and they need to be deemed illegal and Null&Void immediately.  The purchasers need to take the loses instead of the US taxpayer like any capitalist investor would. It seems to me that Paulson - Bernanke & Co. are robbing the American taxpayer and protecting there friends on Wall Street.

Please Take Note: Do not hit the links within the article for they will take you off the page. To see the entire Wikipedia page go to this link: http://en.wikipedia.org/wiki/Credit_default_swap

Credit default swap From Wikipedia, the free encyclopedia

A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments (premium leg) to the seller, and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults. CDS contracts have been compared to insurance, because the buyer pays a premium and, in return, receives a sum of money if a specified event occurs. However, there are a number of differences between CDS and insurance; the buyer of a CDS does not need to own the underlying security; in fact the buyer does not even have to suffer a loss from the default event.

 Description

Buyer purchased a CDS at time t₀ and makes regular premium payments at times t₁, t₂, t₃, and t₄. If the associated credit instrument suffers no credit event, then the buyer continues paying premiums at t₅, t₆ and so on until the end of the contract at time tn.  However, if the associated credit instrument suffered a credit event at t₅, then the Protection seller pays the buyer for the loss, and the buyer would cease paying premiums.

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default or on the occurrence of a specified credit event (for example bankruptcy or restructuring). Credit Default Swaps can be bought by any (relatively sophisticated) investor; it is not necessary for the buyer to own the underlying credit instrument.

As an example, imagine that an investor buys a CDS from ABC Bank, where the reference entity is XYZ Corp. The investor will make regular payments to ABC Bank, and if XYZ Corp defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive a one-off payment from ABC Bank and the CDS contract is terminated. If the investor actually owns XYZ Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing XYZ Corp debt, without actually owning any XYZ Corp debt. This may be done for speculative purposes, to bet against the solvency of XYZ Corp in a gamble to make money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar to those of XYZ.

If the reference entity (XYZ Corp) defaults, one of two things can happen:

• Either the investor delivers a defaulted asset to ABC Bank for a payment of the par value. This is known as physical settlement.
• Or ABC Bank pays the investor the difference between the par value and the market price of a specified debt obligation (even if XYZ Corp defaults, there is usually some recovery; i.e., not all your money will be lost.) This is known as cash settlement.

The price, or spread, of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of XYZ Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from ABC Bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires, or until XYZ Corp defaults.

All things being equal, a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening.

Uses

Like most financial derivatives, credit default swaps can be used by investors for speculation, hedging and arbitrage.

Speculation

Credit default swaps allow investors to speculate on changes in an entity's credit quality, since generally CDS spreads will increase as credit-worthiness declines, and decline as credit-worthiness increases. Therefore an investor might buy CDS protection on a company in order to speculate that a company is about to default. Alternatively, an investor might sell protection if they think that a company is not going to default.

For example, a hedge fund believes that XYZ Corp will soon default on its debt. Therefore it buys $10 million worth of CDS protection for 2 years from ABC Bank, with XYZ Corp as the reference entity, at a spread of 500 basis points (=5%) per annum.

• If XYZ Corp does indeed default after, say, one year, then the hedge fund will have paid $500,000 to ABC Bank, but will then receive $10 million (assuming zero recovery rate, and that ABC Bank has the liquidity to cover the loss), thereby making a tidy profit. ABC Bank, and its investors, will incur a $9.5 million loss unless the bank has somehow offset the position before the default.

• However, if XYZ Corp does not default, then the CDS contract will run for 2 years, and the hedge fund will have ended up paying $1 million, without any return, thereby making a loss.

Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a certain period of time in an attempt to lock in its gains or losses. For example:

• After 1 year, the market now considers XYZ Corp more likely to default, so its CDS spread has widened from 500 to 1500 basis points. The hedge fund may choose to sell $10 million worth of protection for 1 year to ABC Bank at this higher rate. Therefore over the two years the hedge fund will pay the bank 2 * 5% * $10 million = $1 million, but will receive 1 * 15% * $10 million = $1.5 million, giving a total profit of $500,000 (so long as XYZ Corp does not default during the second year).
• In another scenario, after one year the market now considers XYZ much less likely to default, so its CDS spread has tightened from 500 to 250 basis points. Again, the hedge may choose to sell $10 million worth of protection for 1 year to ABC Bank at this lower spread. Therefore over the two years the hedge fund will pay the bank 2 * 5% * $10 million = $1 million, but will receive 1 * 2.5% * $10 million = $250,000, giving a total loss of $750,000 (so long as XYZ Corp does not default during the second year). This loss is smaller than the $1 million loss that would have occurred if the second transaction had not been entered into.

Transactions such as these do not even have to be entered into over the long-term. If XYZ Corp's CDS spread had widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an offsetting contract immediately and made a small profit over the life of the two CDS contracts.

Hedging

Credit default swaps are often used to manage the credit risk (ie the risk of default) which arises from holding debt. Typically, the holder of, for example, a corporate bond may hedge their exposure by entering into a CDS contract as the buyer of protection. If the bond goes into default, the proceeds from the CDS contract will cancel out the losses on the underlying bond.

For example, a pension fund owns $10 million of a five-year bond issued by Risky Corp. In order to manage the risk of losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million. The CDS trades at 200 basis points (200 basis points = 2.00 percent). In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) per annum in quarterly installments of $50,000 to Derivative Bank.

• If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million back after 5 years from Risky Corp. Though the protection payments totalling $1 million reduce investment returns for the pension fund, its risk of loss due to Risky Corp defaulting on the bond is eliminated.
• If Risky Corporation defaults on its debt 3 years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million (either by physical or cash settlement - see above). The pension fund still loses the $600,000 it has paid over three years, but without the CDS contract it would have lost the entire $10 million.

(Note that the pension fund now has counterparty risk with Derivative Bank; if the bank is in financial difficulties it may not be able to refund the full $10 million to the pension fund.)

 Arbitrage

Capital Structure Arbitrage is an example of an arbitrage strategy which utilises CDS transactions. This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; ie if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price should fall. Techniques reliant on this are known as capital structure arbitrage because they exploit market inefficiencies between different parts of the same company's capital structure; i.e. mis-pricings between a company's debt and equity. An arbitrageur will attempt to exploit the spread between a company's CDS and its equity in certain situations. For example, if a company has announced some bad news and its share price has dropped by 25%, but its CDS spread has remained unchanged, then an investor might expect the CDS spread to increase relative to the share price. Therefore a basic strategy would be to go long on the CDS spread (by buying CDS protection) while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the company's CDS spread tightened relative to its equity.

An interesting situation in which the inverse correlation between a company's stock price and CDS spread breaks down is during a leveraged buyout (LBO). Frequently this will lead to the company's CDS spread widening due to the extra debt that will soon be put on the company's books, but also an increase in its share price, since buyers of a company usually end up paying a premium.

Another common arbitrage strategy aims to exploit the fact that the swap adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical reasons such as specific settlement differences, shortages in a particular underlying instrument, and the existence of buyers constrained from buying exotic derivatives. The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be close to zero. Basis trades can aim to exploit any differences to make risk-free profits.

History

Conception

Credit Default Swaps were invented in 1997 by a team working for JPMorgan Chase^[7][8]. Credit Default Swaps became legal, and illegal to regulate, with the Commodity Futures Modernization Act of 2000. They were introduced and rushed through congress as a companion bill, the last day before the Christmas holiday. It was never debated in the House or the Senate. The bill was 11,000 pages long. Less than a week after it was passed by congress, President Clinton signed it into Public Law (106-554) on December 21, 2000.

Market growth

As the market matured CDSs were increasingly used by investors wishing to bet for or against the likelihood that particular companies or portfolios would suffer financial difficulties; rather than to insure against bad debt -see above. The market size for Credit Default Swaps began to grow rapidly from 2003, by late 2007 it was approximately ten times as large as it had been four years previously.

 Market as of 2008

Composition of the United States 15.5 trillion US dollar CDS market at the end of 2008 Q2. Green tints show Prime asset CDSs, reddish tints show sub-prime asset CDSs. Numbers followed by "Y" indicate years until maturity. Proportion of CDSs nominals (lower left) held by United States banks compared to all derivatives, in 2008Q2. The black disc represents the 2008 public debt.

Credit default swaps are by far the most widely traded credit derivative product.^[10] The Bank for International Settlements reported the notional amount on outstanding credit default swaps to be $42.6 trillion in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). By the end of 2007 there were an estimated $45 trillion to $62.2 trillion worth of credit default swap contracts outstanding worldwide.

It is important to note that since default is a relatively rare occurrence (historically around 0.2% of investment grade companies will default in any one year), in most CDS contracts the only payments are the spread payments from buyer to seller. Thus, although the above figures for outstanding notionals sound very large, the net cashflows will generally only be a small fraction of this total.

There is no centralised exchange or clearing house for CDS transactions; they are all done over the counter (OTC). This has led to recent calls for the market to open up in terms of transparency and regulation. In November 2008, the Depository Trust and Clearing Corp, which runs a warehouse for CDS trade confirmations accounting for around 90% of the total market, announced that it will release market data on the outstanding notional of CDS trades on a weekly basis. The data can be accessed on the DTCC's website here:

This announcement coincides with plans to establish a centralised clearing house for CDS transactions by the end of 2008. US regulators (such as the SEC and CFTC) are monitoring negotiations. Currently two rival groups have announced their plans; one group is made up of a consortium of banks along with DTCC, the ICE and The Clearing Corporation, while the other is a joint venture between the Chicago Mercantile Exchange and the hedge fund Citadel.  A clearing house would become the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face. There are also ongoing discussions in Europe as to whether a separate European-regulated clearing house should be established as well.

 Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association.^[19] The confirmation typically specifies a reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond or government bond. The period over which default protection extends is defined by the contract effective date and scheduled termination date.

The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations (for example necessary if the original reference obligation was a loan that is repaid before the expiry of the contract), and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.

CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not. The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is restructured). This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco's restructuring in 2000 led to the credit event's removal from North American high yield trades.

Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard currency and that it not be subject to some contingency before becoming due.

 Settlement

As described in an earlier section, if a credit event occurs then CDS contracts can either be physically settled or cash settled.

• Physical settlement: The protection seller pays the buyer par value, and in return takes delivery of a debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from a bank on the senior debt of a company. In the event of a default, the bank will pay the hedge fund $5 million cash, and the hedge fund must deliver $5 million face value of senior debt of the company (typically bonds or loans, which will typically be worth very little given that the company is in default).
• Cash settlement: The protection seller pays the buyer the difference between par value and the market price of a debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from a bank on the senior debt of a company. This company has now defaulted, and its senior bonds are now trading at 25 (ie 25 cents on the dollar) since the market believes that senior bondholders will receive 25% of the money they are owed once the company is wound up. Therefore, the bank must pay the hedge fund $5 million * (100%-25%) = $3.75 million.

The development and growth of the CDS market has meant that on many companies there is now a much larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations. (This is because many parties made CDS contracts for speculative purposes, without actually owning any debt for which they wanted to insure against default.) For example, at the time it filed for bankruptcy on 14 September 2008, Lehman Brothers had approximately $155 billion of outstanding debt but around $400 billion notional value of CDS contracts had been written which referenced this debt. Clearly not all of these contracts could be physically settled, since there was not enough outstanding Lehman Brothers debt to fulfill all of the contracts, demonstrating the necessity for cash settled CDS trades. The trade confirm produced when a CDS is traded will state whether the contract is to be physically or cash settled.