This may be a General Question, but these things can be politically charged. I had always thought of CDSs as a simple insurance policy on a bond. It turns out that I was wrong. The original owner can sell the policy to anybody who can cough up the dough. The buyer doesn’t have to be able to cover a default. It is probably be in their interest to do so in case they get caught holding the bag, but maybe they are just a cowboy counting on finding a greater fool. Furthermore, unlike your bog standard insurer, the current owner of the CDS is not necessarily in the insurance business and may not be able to accurately assess the default rate of their holdings. Also, the original purchaser of the insurance is counting on the fact that he will be paid if whatever he is insuring goes belly up, but now the original vendor, who may be rock solid, is no longer on the hook for any claims. Presumably they know how to contact the current holder (otherwise they wouldn’t know where to send the check), but I understand this can be difficult in practice (although it shouldn’t be if they know where to send the check).
Ultimately, what is the utility of letting people liquidate CDSs? What changes have been/should be made to the CDS market? Reserve requirements for the purchaser? Maximum exposure requirements?
While not technically an insurance policy, isn’t a CDS simply a mechanism for mitigating risk? The main difference from insurance is that the holder of a CDS doesn’t need to own the underlying debt instrument or suffer an actual loss.
It also allows speculation on the underlying entity’s credit-worthiness.
Sure, but what is the utility? Purchasing a CDS as insurance against the underlying debt instrument certainly has value, but what good does a secondary CDS market provide? It essentially nullifies the risk mitigation the CDS was supposed to provide in the first place.
The secondary market in CDSs provides liquidity, but do they need to be liquid? I guess they do, since they are sort of like bonds, so maybe they should be regulated in so far as the purchaser should be able to cover the risk. How onerous (and by extension, how much more illiquid would it make the CDS) would such regulations be?
It provides liquidity and price discovery. How much should the spread on XYZ Corporation be? That is, how much should I charge for the insurance? The secondary market can provide clues. Also, it’s a market indication of potential credit downgrades heading this way for that company, well in advance of the ratings agencies taking any action.
I believe that they are fixing almost everything that was wrong with teh CDS market by making CDS’s go through a central exchange or clearinghouse.
The reason the secondary market was important was that it is cheaper to buy an existing CDS than originate a new one (mostly because the originators were price gouging a bit). Lets say you originate a CDS to hedge some bodns you own. Then you sell the bonds but the purchaser doesn’t want the CDS, shouldn’t you be able to sell the CDS too?
Like insurance, CDS’s have moral hazard. I recently saw a story about how blackstone bought a boatload of CDS’s and then enticed the underlying creditor to pay their loan interst a few days late.
The clearinghouse is the counterparty of every short of long position holder, this mitigates credit risk. The clearinghouse finds a buyer for every seller and a seller for every buyer. It establishes margin and collateral rules for trading. And forecloses on accounts that fail to meet margin calls.
One of the biggest problems with CDS trading pre-2008 was that people were trading these things with little to no regard for the creditworthiness of the counterparty. It was assumed that the (sometimes thin) margin account was sufficient to cover any credit issues. The problem was that margins were insufficient or worse yet, held by the counterparty.
It also standardizes the contracts so that mitigates risks associated with these custom built contracts that have obscure provisions that allow credit risk to creep in.
I’m not sure that blackstone is telling us everything. The article sounds like they are saying that they lent money to Codere to convince Codere to pay interest to Blackstone late so that Blackstone could collect on its CDS obligations. How exactly would this entice any other debt holders to renegotiate the debt, why not collect their own CDS payments when Codere defaults on all of them?
Broadly, Cds provides protection against principal loss in the case of default. The provider of such protection would charge more if they could not actively manage their risk (I.e. unload/add exposure as they wish). This extra amount would not reflect the credit risk of the underlying and would make the instrument less efficient.
CDs is moving over to exchanges for a host of reasons that often deal with structural aspects of the market (e.g. which prices to liquidate netted positions in a “margin call” or liquidation situation)that can be generalized as an attempt to standardize market convention and establish what happens when shit hits the fan.
The utility of cds itself is another involved discussion.
The gso/codere situation is particularly involved and requires an understanding of both credit and market structure to see what they did. Just remember that management, company ownership, and lenders all have opposing interests which only get worse when a company goes (or is in danger of doing so). Also keep in mind that there are different classes (e.g. seniority, security, strategic objectives) of lenders that also have divergent interests.
The utility of the entire arrangement is to try to get companies the cheapest financing possible. Sometimes this is not cheap relative to other companies due to distress. The alternative, however, would be more expensive (closure or even more onerous financing).
NB: the daily show is comedy and not news. Few financial journalists are particularly savvy. I propose Stewart et all are even less so
Well, here’s the problem, see. All the smart boys who play the markets fucked up about as badly as they possibly could have, leading to the crash of 2007-2008. So, you have a credibility problem when you go around criticizing OTHERS as not being particularly savvy. Clearly, the whole financial industry has not been particularly savvy. In fact, one might say they have been greedy idiots. So, I tend to doubt the mantle of “savvy” when applied to anyone in the finance industry. I’m sure that term was applied to most of the individual and firms that so “savvily” maneuvered the world economy right over the cliff with such brilliant business acumen.
At this point, I am inclined to trust John Stewart much more than Jamie Dimon.