Point one: You are making one very common mistake, which is thinking that CDS is a SECURITIES type market where extant contracts are traded in a public, transparent marketplace. This is an INSURANCE market were pricing is a reflection of the willingness of one counterparty to write new contracts. Sometime these contracts are assigned to other parties, but that does not change the fact that most of the extant stock of paper does not trade. Merely fixing the clearing aspect or even having a central counterparty does not change this dynamic.

Point Two: pricing. The current yield on the underlying bond is not an accurate way of pricing the default risk. That is why I believe it will be very hard to convince the clearinghouses to take the risk of being a central counterparty because the pricing of these contracts is all screwed up!! Remember, the central counterparty must stand behind all trades and they (and the clearing members of the exchange) will only do this if the contracts actually work in an economic sense. I submit that CDS is broken as a securities type model and will only work as an insurance product, with far higher “margin” requirements (i.e statutory reserves) and capital that is normal on a futures exchange. If you had to post a LC to demonstrate your ability to pay out on CDS, would you use the product? NFW.

As defaults rise next 24 months, we’ll see this demonstrated — my view.

Chris

I don’t think anyone disagrees that there will be failed collections during a CDS settlement, the question is the magnitude of the failures. Since most of the CDS market is traded through dealers, presumably (and it’s a big leap of faith given what’s happened) the dealers were hedged on the trades and failures on either side approx. cancel each other out. The issue with AIG is that they became too big of a counter-party to the system and their failure would have caused all the dealers to go down, etc…

I think the solution to the issue is what many having suggested, which is to move it on to an exchange. If that could be done efficiently and quickly, I think the CDS market will continue to exist. As a comp, the CME E-mini SP500 market is >$10 trillion in *notional* size (and this is just contracts on one index).

My question on the interest rate swaps is directed more at the leverage and change in value on these swaps that has taken place over the last two months. What if the net value has changed 2 percent on the 600T notional swaps? ( or 300T or whatever DTCC is saying ), Assume everyone has a true hedge and has traded the same hedge 20 times, ok they are all netted to 0. In an era where counterparty risk is being contained only by the Fed supporting AIG and C, what if only 1 per cent of 6 trillion change in value is not hedged?

My understanding is that not all I/C swaps provide an exchange of value between participants.
My understanding is that some are used speculate on the future yield curve and are subject to a probability of mispricing calculations such as made by AIG, LMTC and others. Hello, we have not only had a Black Swan event in mortgages, CDS, etc etc, we have had a Black Swan event in interest rates and currencies.

The issue with the gross vs net notional is important. Some of the $50 trillion notional is mitigated by netting, especially among dealers, but this does not mitigate the bilateral risk that remains between dealers and end users, both long and short. I have seen a lot of estimates one way and another, but to me if the net is say two zeros less than the gross, then why are we bailing out AIG and Goldman Sachs?

A certain tall economist I know is quite worried about a default by GM and the resulting mess, a concern I share. That’s when we find out whether the gross or the net is important. GMAC will be right behind em.

The $6 billion number from the Lehman auction, from what I understand, is the correct number for contracts that participated in the auction. I don’t think that number is comprehensive, but I cannot document the rest. We wrote about a certain German bank which did not participate in the cash settlement auction held by DTCC because they wanted the bonds. My personal view in the smooth process with Lehman results from a) the dealers are continuing to clean up the mess as funds with net obligations to pay die and b) it was not a huge issue in terms of CDS. But I don’t think we’re done with the Lehman CDS story, even after the bankruptcy court grants en mass novation as we described above.

Agree on point on AIG. It is a black hole. A friend who worked with me at the Fed years ago asked an interesting question. AIG lost a lot of money on securities lending. Did AIG Financial Products borrow those bonds from another member of the AIG group? Maybe from the regulated insurance underwriter? Don’t know the answer, but happy to hear any comments from this thread in that regard.

Chris

Thank you for your piece but one of the things that I’ve been wondering about is your response to Andy Muldoon’s comment, namely that the gross notional value is irrelevant and the focus should be on the net exposure (which was small and manageable for the LEH settlement). I’d appreciate your comments on that. Thank you.

CDS on the other hand are “barrier options” to quote one of my buddies in the CDS world and really are fundamentally different from true swaps. Part of the reason I have done a Ritholtz past week on Paulson/Geithner is to use these technocrats as a canvass upon which to educate el pueblo on CDS.

I am pretty sure the most of the US financial elite does not understand the degree of mis-pricing that exists throughout the markets, a problem now made acute as we skew the other way. But it all comes down to Alan Greenspan and the financial economists who populate the Fed staff not understanding the true nature of CDS, namely that it is insurance on highly correlated, that is, high beta risks. This is also, my view, why Citi and the other financials are under seige.

The folks at ISDA used the legal and functional template of the IR/currency swap world to construct the Frankenstein Monster of CDS, but because what we are pricing is not a rate-driven exchange of cash flows or currency, but instead the probability of default, using bonds and their spreads as the underlying basis for pricing CDS is madness. That, in a nutshell, is the problem with CDS. The premiums of past five years were woefully inadequate to cover the normal default rates in a recession, much less the supranormal default rates we are seeing and will see for next couple of years. As one of my PRMIA colleagues said at an invitation-only CRO Summit last week sponsored by E&Y, we’ve never seen CDS go through a typical recession much less sustained downward trend in global GDP.

Chris

Oh, I forgot. To the folks from Citigroup who keep calling me, asking to spend time discussing our analytical methodology and comments on CNBC today regarding Citi being in Open Bank Assistance and headed for full nationalization next year, Barack Obama as Chairman, etc., a couple of points.

First, we do not publish Sell Side research, make recommendations or earnings estimates.

Second, we have never been short Citi nor any other troubled bank.

And finally, I’ll be happy to spend time with you, but you’ll pay our consulting rates and wait in line like everybody else.

PS: Give our love to Raul Salinas de Gortari when you see him.

At the time of his departure, he was in his mid 50s, was a Vice Chairman and a member of JPM’s three person Office of the Chairman and its Executive Committee. His expertise and responsibilities at JPM included capital markets and risk management.

Is there a possibility that he was too conservative for JPM or did he resign at his own volition?