Bull Bear Report Feb 12 2010

Credit Default Swap Surge: Will the Notorious CDS Lead a Finance Recovery?

By kyle stock

Here's a contrarian career play: bet on credit-default swaps. After falling off a cliff in 2008, they're on their way back, and hiring may follow.

Measures to ban and closely regulate these much-maligned products have gained little traction in Washington, D.C., and some experts expect the demand for such instruments to surge as investors look for ways to reduce risk in a still-shaky economy.

IntercontinentalExchange Inc., an Atlanta-based derivatives dealer that started clearing CDS trades in March, has signed off on almost 43,000 such deals to date.

More recently, CME Group Inc., which operates the world's largest futures market, cleared its first CDS trade Dec. 15. Its list of sell-side founding members is essentially the entire bulge-bracket, while giant institutional and hedge-fund investors like BlackRock, Citadel, D.E. Shaw Group and PIMCO balance the equation on the buy-side.

Default swaps proved a valuable tool in the downturn, despite their notorious status on Capitol Hill. In the first half of last year, there were $31.2 trillion of credit-default swaps outstanding, a 43% decline from the year-earlier period, but higher than 2006 levels, according to survey data from International Swaps and Derivatives Association, a trade group that covers CDS activity. At least 80 U.S. companies were still in the CDS game in the first half of last year.

Under some prodding by the Federal Reserve and the Securities and Exchange Commission, a rash of exchanges have started clearing credit-default swap deals, even though those who buy and sell the instruments still are not required to go through intermediaries. Among other things, the exchanges collect collateral from swap sellers to mitigate counter-party risk.

"We, as well as the entire industry, really embraced the notion of bringing to the core of the market a clearing solution that would reduce systemic risk," said Laurent Paulhac, managing director of CME's over-the-counter business. "The crisis really acted as an impetus to clear up some of these things."

Paulhac said CME is hiring "a good number" of workers with experience on CDS deals, although he declined to provide more detail. Paulhac was previously chief executive of CMA, a derivatives data provider, which CME bought in 2008.

In theory, credit-default swaps are relatively simple risk-management tools. An investor makes a series of payments to a counterparty to hedge against a bond or other form of debt. If the borrower defaults on the debt, then the counterparty must pay the investor the full value of the debt. They help institutions lay off risk while allowing some investors, like John Paulson, get very rich, by putting up a nominal amount of cash for a huge potential gain.

Dealers like AIG got into trouble when they did not hedge sufficiently against the risk of their pledges or hold enough capital in reserve to make good on them. Regulators, in turn, did not require CDS sellers to post collateral. Likewise, it did not require CDS buyers to hold bonds issued by the company that it was buying protection on. In other words, when investors saw a company like Bear Stearns flailing, they could (and did) "pile on" it via CDS deals, tarnishing its reputation much like short-sellers can.

In the fall of 2008, SEC Chairman Christopher Cox called CDS activity a "regulatory black-hole."

Goldman Sachs used similar language in a recent SEC filing explaining risks to its business, noting that the market is relatively new, "extremely volatile and currently lacks a high degree of structure or transparency."

Robert Pickel, executive vice chairman of the International Swaps and Derivatives Association, said that the stigma of AIG has made CDS "a bit of a conversation-stopper." "There's been a lot of headline attention, but unfortunately awareness does not always equate to understanding," he added.

However, little about the regulation of the product has changed. Lawmakers have left credit-default swaps out of the regulatory reform bills that they hammered out in recent months and clearing services are still only recommended by the government, not required.

"Even in the worst of the crisis, people were continuing to do CDS trades," Pickel said. "The volatility was greater and the spreads were wider, but protection was available for people who wanted to buy it. I don't know that we saw as much outright fear as we did in a lot of the cash markets."

Paulhac at CME said that clearing services were demanded by its clients before there was talk of any government mandates. "Our clients want it; they've told us that," he said. "It's important not just for them as an institution but their shareholders and their board."

Meanwhile, Pickel's association introduced a new contract in April that standardizes the pricing and settlement of default swaps and formalizes the steps to a payout in the case of a default. The group is still gathering data for the second half of 2009, but Pickel said that CDS contracts are likely growing as investors maneuver to mitigate the risks fomented by a still shaky economy.

Barclays, for example, is a champion of the new credit-default swap contracts and clearing services. Jason Quinn, co-head of high-grade and high-yield flow trading at the firm, said that the recent changes have made CDS easier to understand and will eventually attract a wider range of investors.

Ultimately, Quinn believes that CDS will make for a more vital and liquid bond market.

"People had a much harder time actually mitigating risk around the time that Enron and Worldcom defaulted," he said. "Their only option was selling the bonds that they were long (on). There was no way for them to hedge and that ultimately hurts credit creation."

In other words, default swaps, blamed for such economic carnage, may play a big part in getting U.S. finance back on track.

What It Takes
Want to get into the CDS business? There are just a few things you should know, and debt is definitely one of them.

Some finance firms have separate CDS desks, while others have their workers handle both the bonds and CDS of an industry of handful or companies.

Both models require familiarity with credit pricing, yield curves and default probabilities. In other words, if you know debt, you have a chance to get in the game.

Write to Kyle Stock

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