A Minyanville Primer: Credit Default Swaps

This post first appeared on Minyanville.

Fear, today, is not in short supply.

Of the myriad fears racing around Wall Street, one of the greatest is what will happen to the tangled web of credit default swaps, or CDS, that tie the global financial system together like a team of spiders hopped up on amphetamines.

It was to protect this market that the Treasury Department backed JP Morgan's (JPM) purchase of Bear Stearns this March. With news of Lehman Brothers' (LEH) bankruptcy filing late last night, traders will now be forced to unwind bets they hoped they'd never have to sort out.

The durability of this massive, unregulated market is about to be tested: trillions of dollars in contracts have been triggered in the past week, first with the siezure of Fannie Mae (FNM) and Freddie Mac (FRE), and most recently by Lehman's collapse.

Credit Default Swaps, or CDS, offer financial firms a quick way to offload part or all their exposure to debt backed by state and municipal governments, corporations, or structured debt tied to consumer loans. A CDS is an agreement in which two parties agree to trade, or ‘swap’ risk for a default event that may happen in the future.

Lets say for example, The Bank of Boo owns corporate debt issued by Daisy’s Department Store.

If Daisy has a strong balance sheet, good cash flows and a long track record of making her debt payments, credit ratings agencies such as Moody’s (MCO) and Standard and Poor’s are likely to rate her debt well, making her bonds available for purchase by a wide range of financial institutions, including the Bank of Boo.

Boo’s primary risk is that Daisy falls on hard times and stops making her interest payments. Credit ratings help Boo determine the chances of this. A higher rating indicates lower risk, and therefore a lower potential return. Conversely, Boo can make a higher return for buying lower rated pieces of Daisy’s debt that are the first to go sour if she has financial troubles.

Enter the CDS.

If Boo lends Daisy $1,000,000 at 5%, he earns $50,000 per year in interest plus a repayment of principal over the life of the loan. To protect this investment, Boo may buy a Credit Default Swap from Sammy’s Structured Products, a financial insurer setting up shop in Minyanland. The CDS contract stipulates that Boo pays Sammy a fee, while Sammy is obligated to step in and make Boo whole if Daisy is unable to make her payments.

CDS contracts are priced in basis points, or hundredths of percentage points. So, Boo may pay 100 basis points, or 1% of the notional value of the loan for his credit protection. Although this insurance reduces Boo’s potential income by $10,000 per year, in the event Daisy defaults, Sammy is obligated to pay up and make sure Boo doesn’t lose his investment.

CDS contracts can be written for any type of debt product, and during the golden years of cheap leverage -- now long since gon -- were actively used as speculative tools rather than simply as credit protection

Suppose a news story breaks that Daisy is being investigated for unsavory business practices and her future profitability becomes questionable.

If Hoofy’s Hedge Fund owns the same bonds the Bank of Boo does and goes to Sammy to buy a CDS contract for protection, the now higher risk of default means Sammy will charge a higher fee, say, 200 basis points for the same CDS he sold Boo for 100 basis points. More risk, more chance Sammy will have to pay up, so he charges more to back Daisy's now sketchier debt.

But Boo already bought the same CDS for 100 basis points, and if he believed Daisy were still a good credit, he could turn around and sell his contract for twice what he paid for it -- the new market price.

In the market for securities backed by subprime mortgages, CDS protection for owners of the riskiest tranches of debt has skyrocketed in value. Since the height of the subprime lending boom in the middle of the 2006, the cost of CDS protection on BBB rated (low quality) subprime mortgage backed securities has risen by over 2000%.

It's easy to see how investors such as John Paulson won big with short-side bets in this market. And since CDS prices move in the opposite direction as the value of the bonds they protect, it is also easy to see how financial firms like Merrill Lynch (MER) saw the value of mortgage backed securities portfolios plummet.

Regulators claim to have drawn a line in the sand, backing up tough talk that firms must fail in order for the free market to punish bad decision makers. We're about to find out if the multi-trillion dollar market for credit default swaps is, in fact, too big to fail.