Sunday, May 23, 2010

Naked Credit Default Swaps--the Role of Dealers

Posted on Credit Slips by Adam Levitin:

CDS are often done through dealers, and a naked position for a dealer is different from a naked position for an end-user. A CDS dealer's swaps desk is unlikely to have any stake in the underlying asset. Instead, if the swaps desk is well run, it will only execute perfectly matched swaps, so that it will never have any exposure itself to the underlying assets, only counterparty risk. (And dicey counterparties have to post collateral). If naked CDS were banned without a dealer exception, covered CDS would become quite difficult to arrange and execute. much harder to execute.

To illustrate the role of dealers, consider the Abacus deal. It is usually presented as Goldman Sachs simply arranging a swap between Paulson and the CDO. That's the economic essence of the deal, but not how it worked technically. The deal was actually structured as two completely separate swaps. (I think this is what Goldman means when it says it was just a market maker--it means it was a dealer.) Swap 1 was between the CDO and Goldman. Goldman took the short position on the CDS on the underlying CDO assets. Swap 2 was between Goldman and Paulson. These two swaps were separate deals, in that they did not formally reference each other or depend on each other.

In reality, Goldman would never have done Swap 1 with the CDO unless it could hedge its risk in that deal through Swap 2 with Paulson. (Some of this is surmise, as, to my knowledge, only the documentation from Swap 1 is publicly available.) Of course, in the Abacus case, Goldman did not have perfectly matched CDS, and it got screwed (luckily for its sake, as that helps its defense).

The point here, is that dealers play a critical role in the swaps market, and if they happen to have a position in the underlying asset, that is completely by the chance of what an affiliated proprietary investing desk is doing. A naked position by a dealer is different from a naked position for an end-user.

Also, I'm not sure that I'd agree with Stephen [Lubben] that "credit is not a commodity." A bespoke corporate loan is not, but what about when that corporate loan is bundled into a CLO and churned out as securities? Or how about the consumer context, where there are standard form contracts, frequent resales of the debt, and sometimes no collateral involved (e.g., credit card debt)?

And click here for the ISDA analysis of all the permutations and combinations of the BaFin ban: www.isda.org/c_and_a/pdf/BaFin-decree-Summary-of-key-issues.pdf


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