Understanding Credit Default Swaps
by Ryan Litchfield
Estimates of the size of the Credit Default Swap (CDS) business range from $38 to $62 trillion and they are part of the global derivatives market estimated at $684 trillion. The financial meltdown of the global economy was largely on the back the Credit Default Swaps, which floated like guarantees against risks that were never supposed to materialize.
In layman’s terms, Credit Default Swaps are derivatives used to hedge against losses or to speculate on a company's ability to repay their debt. The swaps pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent. Or in simpler terms, they are an insurance policy. If the risk is perceived to be low, the insurance is cheap. However "in the unlikely event of a water landing" they exist and are traded in giant amounts.
The push to promote subprime loans in the United States to get more people in homes swelled the size of the mortgage market and the paper was packaged and sold around the world, with assurances of little perceived risk. In fact, Franklin Raines, head of Freddie Mae testified that the required 4% reserve was far too harsh and they should only be required to hold 2% because the "risk was so low."
Well, when unqualified buyers could not keep up with adjusting payments, the shock wave went out that there may be risk in the U.S. mortgage paper. U.S. mortgages were in the huge blocks of securities that had been sold and resold and resold and guaranteed by Credit Default Swaps and no one knew if the "bad loans" were in their portfolio. This caused widespread panic as the implication was almost too big to imagine.
When the values of your assets are discounted, your solvency is questioned. Lehman Brothers was the first shoe to drop because they had so many Credit Default Swaps in their holdings. Their $613 billion bankruptcy (biggest ever in United States) sent shock waves and, without definitive proof, the fear spread from institution to institution like a plague. To date no one knows how many mortgages were really bad, because the fear of bad mortgages devalued the portfolios requiring bankruptcies and mergers and government takeovers. Fear is potent and palatable and perception is reality. Could the banks have survived the number of actual defaults if the panic had not exploded and exacerbated the problem? Many believe the market could have absorbed, and survived and even benefited by letting it take its course. We will never know.
So the world economy melted down and governments stepped to the rescue because the institutions were "too big to fail" and now the financial landscape has forever changed. But the Credit Default Swaps are still out there and they need to be traded and cleared (processed) and the banks tend to do this between each other. Enter the Chicago Mercantile Exchange and the Intercontinental Exchange.
About 40 years ago, Leo Melamed (emeritus CME chairman) created the first contracts in what would become the financial futures markets. He helped drive the electronic exchanges, which propelled his CME Group to become the dominant force in U.S. futures trading. Last year they, along with the younger Intercontinental Exchange (ICE), fought for and received approval to be a clearing house for the $30 plus trillion Credit Default Swaps market. But as of now, CME has yet to clear $1 of CDS trade. Meanwhile, ICE has used it to pad their earnings and grow by 50% since March, while CME has grown 30%.
CME Group has fallen behind its competitor because of the initial decision to make clearing customers also trade with the exchange. ICE has placed no such restrictions. The Wall Street banks don’t want to give away the lucrative business, but they may be persuaded in pieces. The CME and ICE have different attitudes and CME’s Melamed admits they messed up. In an April 22, 2009, interview, he said, “We started a little wrong. We said you had to trade with us to go to our clearinghouse. That was wrong. We’ve now adjusted that.” So while CME is in talks to try and get started clearing Credit Default Swaps, ICE has cleared 875 CDS deals, guaranteeing $98 billion in contracts.
The top five holders of Credit Default Swaps are: JPMorgan Chase (JPM ) $7.8 trillion, Citigroup (C) $3 trillion, Bank of America (BAC) $ 1.6 trillion, HSBC Bank (HSBC) $1.1 trillion, and Wachovia (WB) $400 billion.
No doubt CME will come on strong and the two exchanges will be the central forces, but they have yet to really scratch the surface and both have their eyes on getting into the lucrative ($684 trillion) "over-the-counter" market that banks now control. Credit Default Swaps are the hors d’oeuvres and a lot will hinge on how they handle the CDS clearing. Their ability to woo the banks into turning this business over to them may be a big part of the growth potential for both exchanges in the future.
Ryan Litchfield trains students to read charts, control their emotions and trade patterns. ICE and CME are both stocks that have patterns and make large profitable moves. They are discussed often in his twice-weekly Traders Talk online classroom, which is available to BetterTrades students on a subscription basis.
Spend two days with Ryan at the Trader's Forge and learn how to take the emotion out of your trading. You'll get 10 months worth of trading experience in a 48-hour period, which will speed your learning curve and provide the support you need to be successful. The next Trader's Forge will be June 18-19 in Philadelphia.
If you can't get to the Trader's Forge, check out Ryan's two-hour online class called "Listen With Your Eyes." It is packed with information that will help improve your ability to read and interpret stock patterns on a chart.
To register for any of Ryan's classes or workshops, call Customer Support at 1-800-676-4410.
