We hear and see the alphabet of the derivatives world thrown around with gay abandon, like so much confetti at… … the Brides third (and definitely for the last time, she insists) wedding.

Often the word “bond” is thrown into the mix, just to spice up the play, not unlike the bridesmaids, who at 2 and 0 for successful marital bliss, scrum down for the prize of catching that bouquet one more time to hope for a third attempt.
For some people though the world of derivatives is not a wedding made in heaven. So for those readers lets take a condensed walk through what is a Credit Default Swap. (CDS)

What is a CDS?
First and foremost a CDS is not a bond. It is a derivative based on a bond or basket of bonds as the underlying asset. (think CFD and Shares). The CDS is used to transfer credit risk to another party and because its a derivative the original underlying asset is kept by the owner. The bond paper stays in the vault and on the balance sheets.

How does it work?
An agreement is drawn up by 2 parties where the first is seeking to buy protection against a credit event that would adversely affect the underlying asset (lets say bond from now on) and the second party who is willing to sell that protection. Just like insurance, the buyer has to pay a premium to the seller, whilst the seller has to cover losses in case of an event. Again, like insurance, those events that could qualify for a payout are drawn up in the agreement.

What is a credit event?
As mentioned above its a list of circumstances, agreed by both parties, that would invoke a loss to the protection buyer. That loss of course is on the bond, held in the vaults, that was issued by a third party, the bond originator. An event could include debt restructuring whilst in administration or, in the US under bankruptcy laws, insolvency, debt default, failure to service the debt, non payment or even a change in credit rating of the bond.

Why are CDS used?
As well as straight forward insurance on the bond, the CDS can also be used reduce exposure to an adverse turn in credit market conditions, to enhance performance of a basket of bonds or to trade on events that may happen to bonds that the buyer of protection doesn't own. Of course for every buyer there has to be a seller of protection who will want a premium that reflects the risk of insurance. This also opens up the possibility of arbitrage trades and allow the trading of differing spreads and ratings on bonds.

What are the risks?
Like all trading the most apparent risk is over-exposure to a particular event for the protection sellers and not enough coverage for the bonds held (partial hedge) for the buyer. Other risks include a lack of research on the bond issuer where the risk is not reflected in the bond rating, including a reliance on mathematical models that do not reflect the probability of an event accurately. Another risk to the protection buyer is his exposure to the possible bankruptcy of the protection seller, leading to a default in cover.

What happens if the bond issuer defaults or goes bankrupt?
As long as the event is covered in the agreement the protection seller has to pay the amount agreed to the protection buyer, who has to deliver the bonds covered. In an orderly market or a market where cover of the bonds is equal to the amount of bonds that exist then the transaction is straightforward. However if the cover purchased exceeds the amount of bonds that were issued then the protection buyer will either have to buy more bonds or pay cash to the market value of the outstanding bonds for delivery to the protection seller. This is what happened with Delphi in the US last year and why the bond prices rose after Delphi sought protection under bankruptcy.
The original idea of Credit Default Swaps was sound. A two way contract taken out to cover a third party liability. The complications arise when the CDS is used in ways that have not been stress tested in theoretical or actual market conditions. With that test now upon us it is a good thing that as many people as possible understand what may or may not occur.

Although not a comprehensive and in-depth brief, I hope the above has helped with the understanding of CDS.

Market Snippets

As quoted: 2008 AFP Business Outlook Survey finds: financial professionals do not expect a recession in 2008 but do predict a slowing in the economy – with GDP growth projected at a median of 2.5%. The worst of the credit crisis is not over (66%) but most corporations expect to weather the storm with little impact. 64% of financial professionals expect the growth rate in inflation to increase slightly over recent trends and 59% believe that interest rates will continue to drop during 2008.

From Challenger: “Ongoing troubles in the housing market threaten to greatly weaken the 2008 job market, according to Challenger outlook, which not only foresees a significant slowdown in job creation but warns that next year could see an increase in job-cut announcements. If that occurs, it would mark just the second rise in annual job cuts since 2001. Outlook noted concerns about the economy triggered by the housing downturn and the subsequent collapse in the credit markets are already causing employers to postpone expansion plans and delay hiring.”

Economist Chris Low at FTN says NAHB index is stuck at a record low 19 for a third month. “Housing starts have recently fallen to levels not seen since the early 1990s, which has resulted in almost a year of falling new home inventories. The high-water-mark was 570k in August 2006. Inventories have since fallen to 520k. Still, there's a long way to go before it's a seller's market again. At the end of the last cycle, inventories fell to 320k.”

Commentary by Mick Phoenix

on behalf of An occasional letter from The Collection Agency

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. The views in the article are for informational purpose only.