CDSs and the web we weave

Covering more that $62 trillion in debt, credit default swaps are a market larger than the value traded on the New York Stock Exchange, but little is known about them - even among those who invest, and worse yet, those who issue the derivative securities.

CDSs are derivatives; they are assets that are synthetically created and how's value is derived from underlying assets - the debt obligations their holders are attempting to protect against default. Unlike your home, which you do not expect to actually burn down and buy insurance against such a rare eventuality just in-case, CDSs are purchased on the worst debt securities - those rated below investment grade. Of course, these too are the very securities are most likely to default when times are bad and, if you hadn't yet noticed, times they are bad ...and getting worse.

It gets worse. The firms selling these insurance policies are not only unmonitored, but are not officially considered banks - including the likes of JPMorgan, Goldman Sachs and many hedge funds. With losses expected to be as high as $150 billion dollars on the first round of defaults, will these firms be able to survive? Moreover, as we saw with Bear Stearns, can the economy afford the collapse of even one such firm or would it spell disaster for the capital markets as a whole? Unlike Bear Stearns, however, the Fed is unlikely to bail-out a hedge fund.

It gets more complicated. To get a handle on the situation, the first step would need to be to properly value the risk that is actually assumed by these various counterparties, but even this first step is not easily accomplished. Firms resell these securities as they would others - if you're having a moment of CDO-inspired Deja Vu, you ain't alone.

Most fundamentally, the CDSs were created with a very useful purpose in mind: to distribute the risk of a default across many firms that could bear that risk. However, with so few firms actually acting as the counterparty in many of these transactions, the very opposite has happened - with much of the risk concentrated. Go figure!

Indexes as Market Indicators

An index is just a collection, usually weighted by some variable, of assets so as to provide an average that observers of that index can use to evaluate general trends in the underlying market for those assets. This implies a very important concept: an trending indicator is not an indicator of underlying value.

For some reason, people (including sophisticated investors) are tempted to view indexes as representative of the value of the assets that they represent. The credit default swaps market and indexes like ABX, CMBX (any kind of X, really) is an ideal example. According to accounting principles, companies must use such indexes to value securities, like swaps, that are traded irregularly or for which there is limited liquidity. Why is this important? Simple. Like any other market index, it is susceptible to volatility resulting from investor speculation; as investor excitement grows for the underlying assets, the value of the index can climb completely unrelated to the underlying growth of the assets that they represent. Of course, the opposite is true as well and this has proven to be a big problem in the face of the persisting troubles resulting from the sub-prime mortgages.

It became a self-fulfilling prophecy. As concerns over mortgage back securities, collateral debt obligations and other new acronyms abounded, investors began speculating the market (and its index) downward. As the index crashed, companies around the globe relying on them as representations of underlying value were forced to write-down the value of their holdings in those assets. A vicious circle emerged with more and more news of write-downs spurring greater and greater downward pressure on the market indexes and even further declines in the representative value of the assets held by financial institutions.

Suddenly, banks were losing tremendous amounts of money and reporting lower performance in their reports. To protect themselves, they started selling-off the assets that caused them problems and, more importantly on an individual basis, began to tighten their lending making it more difficult to obtain loans. As credit shrank, the economy began to slow further when companies could not borrow the funds they needed to finance their growth plans. As banks looked to cover their butts, foreclosures ramped-up driving even greater pressure on homeowners already facing higher prices and growing unemployment.

Fortunately, nothing lasts forever. The price of anything can only fall to zero and no lower; there is a lower limit. Yes, many of these sub-prime mortgages will default, but not all. Eventually the market will stabilize and banks will resume business-as-usual. As this happens, new legislation will be passed and new accounting principles written to help avoid a similarly vicious circle in the years ahead. It's all a learning process for everyone involved. The politicians and policy makers that write the laws and regulations we all follow are only human and they too learn from their mistakes... sometimes.