Wednesday, December 10, 2008

That’s Certainly Not Why Credit Default Swaps


From the Derivative Dribble blog:

On Monday November 17, 2008, I posted a link to an article by Arnold Kling entitled, “Why Credit Default Swaps,” which forms the impetus for the hackneyed title of this article. At the time, I dubbed it a “good article,” but expressed my reservations about its conclusions. For whatever reason, I read the article for a second time earlier today. Upon closer inspection, with all due respect to Mr. Kling, my reservations have grown into outright rejection of both his facts and his conclusions.

You Forgot To Add The Basel

Kling begins his analysis with the conclusory statement that credit default swaps have no “natural seller.” That sounds brilliant. But what does it mean? Well, my personal opinion is that it means absolutely nothing. Kling seems to think that it means that credit default swaps exist only to evade regulation. You can read more conclusory remarks about the absence of natural sellers in his other article here. Let’s accept for the moment that he is correct. That is, suspend disbelief, and accept that the CDS market exists for the sole purpose of evading regulation. A natural question to ask is, which regulations are these CDS folks trying to evade? Well, Kling boldly states that banks and other unspecified entities “could hold AAA-rated or AA-rated bonds but … are precluded from holding B-rated bonds.” Unfortunately for Mr. Kling, this statement is completely false. But don’t believe me, believe the Bank For International Settlements. After all, they did write the regulations. The full regulatory text, Basel II, is available here. The Basel II risk weighting regulations are here, and I recommend you turn to page 19 of the risk weighting regulations, where they explain exactly how a few classes of B rated bonds are treated under the system.

As is evident, the fulcrum of Kling’s argument, namely the existence of some regulation that credit default swaps were engineered to evade, is a nullity. At this point, his argument falls apart. But we continue onward and analyze the broken pieces to expose more troubling aspects of his argument, namely his economic analysis of how the purported regulatory evasion worked.

Conclusione Confusione

Assume for the moment that banks are precluded from holding B rated paper, despite the fact that reality disagrees. Kling claims that what banks want is the higher returns that a well diversified portfolio of B rated paper offers. And because B rated paper is forbidden fruit in his world, banks use credit default swaps to indirectly obtain B rated paper levels of returns. But how? This is done, he claims, by purchasing protection on B rated bonds, which the regulations allow under his analysis. The protection sellers, he claims, engage in all of the diversification, and although he doesn’t mention it, I presume that the rate of protection these sellers charge is somehow discounted by virtue of this diversification process. Now, as we all know, protection buyers are just that, buyers. That is, protection costs money. In the case of a CDS, the protection buyer pays an amount similar to the risk premium paid on the underlying bond. Thus, the protection buyer gives up some of its returns in exchange for safety. Therefore, buying protection on a bond decreases the returns on a bond. And fully protecting a bond should bring the returns close to the risk free rate, else there would be opportunities for rather obvious arbitrage (though there should be some room for counterparty and liquidity risk). Kling acknowledges this, by saying that the protection seller gets to keep most of the additional returns.

While it is possible that there is some wiggle room to profit from protecting a B rated bond to the point that it’s treated as an A rated bond, there shouldn’t be much, since it’s a rather obvious scheme and arbitrageurs will eventually pick up on it and cause prices to stabilize to arbitrage-free levels. Despite this, Kling places the weight of the entire credit default swap empire on the tiny spread between the price of protection and risk premiums on bonds, which as we discussed, should not be a long term phenomenon.

Finally, as mentioned above, in Kling’s regulatory world, banks are allowed to purchase A rated paper. So why would such an elaborate ruse be necessary when banks could simply invest in an A rated tranche of a CDO comprised of a diversified portfolio of B rated bonds? It would not be. So even in Kling’s hypothetical world, his argument completely fails to explain the existence of credit default swaps.

So, Why Credit Default Swaps?

I will write an article on this topic, soon. It is my personal opinion that the CDS market has transformed credit risk into a product that can be traded like a commodity future. But the short answer is liquidity. That is, corporate bond markets are not very liquid markets. And the market for loans is even less liquid. The CDS market by contrast is a very liquid market with highly standardized agreements that allow credit risk to be sliced up and allocated in ways that are prohibitively expensive if not impossible with ordinary debt instruments.

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