November 2011
Ivan Obolensky

I have heard a lot of talk about Credit Default Swaps and how bad they are. On the other hand, not many people know how they work, and why they might serve a useful purpose. The Greece situation has put such financial products center stage again.

Let’s start with the idea of a swap. A swap is a contract between two parties where they exchange the features of one financial instrument for the features of another financial instrument for mutual benefit.

An example might be as follows:

A company is looking to borrow money. While shopping around, it comes across a lender that can give them a long-term loan at a low interest rate. It looks like a match but the lender thinks interest rates may rise so they want a bigger payment if that is the case. They want the borrower to accept a low variable interest rate payment pegged to a short-term interest rate index that can rise quickly if their interest rate forecast proves correct.

Normally, the borrower may shy away from this type of loan because it means their expenses fluctuate and are no longer predictable. Some companies in a business with very low profit margins must be extremely vigilant on expenses because even small increases can mean the difference between profit and loss. In this case with a large loan and the potential for interest rates to double or even triple, a variable interest payment could create severe financial stress. On the other hand, the variable rate means that the company will initially pay much less but with no guarantee of how much in the future.

Another company has a higher fixed rate and wants a lower rate but cannot get it due to contractual agreements with their lender; they are locked-in to that loan for several more years. Their costs are too high, and they are willing to risk a variable interest payment provided it is initially lower than the one they have.

In this case, an intermediary such as bank, aware of the needs of both companies proposes an interest rate swap.

The company with the high fixed rate swaps its payment for a lower variable rate while the company with the low variable rate swaps its payment for a slightly higher fixed rate. The intermediary bank handles paying the original lenders the agreed-upon amount and gets paid a fee to do the processing and the arranging.

In essence each company gets what they want and that is the essence of a swap.

Another way to look at it is that each swapped certain risks. The company that is swapping their fixed rate payment for one with a lower variable rate is taking on the risk that interest rates and their payment will rise in exchange for an initial lower payment. The company that is taking on the fixed rate loan is taking on the risk that interest rates will stay low and that they will have overpaid for their loan in the long run in exchange for predictability.¹

This brings up the subject of risk. What is it?

“Risk”, according to the Oxford dictionary, is “the possibility of loss, injury, or other adverse or unwelcome circumstance.”

It originally had to do with sea trading and the loss of ships and cargos.

The groundbreaking idea was that risk, the possibility of loss, is independent of the actual occurrence of the event.

An example is the sinking of a ship and all its cargo. Normally the owner would have to absorb the loss of both the cargo and the ship; but what if that risk had been transferred to someone else for a price? This is what insurance is all about. The insurance company accepted the possibility of a loss in exchange for a sum of money. The possibility of an unwelcome circumstance normally connected with operating ships at sea was detached and assumed by someone other than the operator.

How is that possible?

It is possible because risk ultimately is subjective. It is expectation and therefore it is something we as humans assign to events. It is not inherently part of them.

For example, the fact that we view the flip of a coin as an event with a 50% probability of heads or tails is something we as observers do. It is not necessarily inherent in the coin itself. It is something we assign to the coin toss in the way of expectation.

The coin could in fact have heads on both sides but we would only know that after we had either flipped it many times, or we had looked at it. The coin never changed but our perception and expectation most assuredly did. We expected the coin to be fair and have a heads and a tails. We noticed there did not seem to be any tails coming up and then saw that there were heads on both sides. We now say the risk of flipping a tails is zero. Our idea of the coin changed, not the coin, itself. This also explains why we can say we did not understand the risks. We simply had a wrong expectation of reality. Reality did not change. How we viewed that reality did.

The fact that risk and expectation could be transferred paved the way for insurance.

Insurance, as we know it, started after the great fire of London in 1666 as a mutual aid society. Each member of an insurance pool paid in a small amount of money which was invested and set aside to rebuild a house in the event of a fire. The cost of rebuilding a single house was borne by a large group of members paying in small amounts every year. By doing so the cost of an individual having to rebuild was transferred to many. The risk of an individual’s financial catastrophe from fire was transferred and assumed by the group.

Later with the rise of the use of statistics in the eighteenth and nineteenth century, it was discovered that it was possible to predict with uncanny accuracy how many deaths would occur in a large population. The beginning of such a survey was started by John Graunt in London in 1662 as an effort to warn if the “Black Death” was returning to the city by observing the number of deaths in normal times and comparing them to the numbers when the plague showed up.

Over time, using the mathematics of compound interest and knowing the probability of death allowed precise payments to be calculated and made life insurance possible as a viable business. Insurance premiums became a household word.

Risk was connected with the idea of loss of some kind until the mid-twentieth century.

Risk and insurance changed particularly in the financial industry in the late ’60s and early ’70s. Originally put forward by Harry Markowitz, the new idea of risk had to do with how to maximize the rate of return for a given amount of “risk”. But in this case risk was no longer defined as potential loss but the size of the day-to-day or yearly movement of the price of a financial product such as a stock price or a bond. This movement is called volatility. When it was high there was lots of movement up and down, and this is considered to be risk in a financial sense. Risk is not loss but the amount of movement of price in a given period of time. Risk is volatility. The change from the original definition is subtle but profound.

I remember a story told to me in New York when I first became a stockbroker, about how Harry Markowitz single-handedly saved Wall Street and won a Nobel Prize. He introduced the idea that if one took two very risky or volatile assets like an emerging market stock index and the index of the smallest US companies and mixed them together it was possible to reduce the overall volatility (and hence the risk) of the portfolio. Further, it was also possible to add several types of investments together and reduce the risk still more.

According to the theory, add several risky investments together and one gets a portfolio that is less risky. Further, one gives up only a fraction of the total return of owning a single one.

This is because each investment moves independently of each other, and the overall up and down of the total is reduced; hence lower volatility, or risk. The combination of risky types of investments that yields the maximum return for the least amount of risk is called “the efficient frontier”, and the concept could not have happened at a better time.

The great bear market of the early ’70s had been devastating to Wall Street and almost every investor had been severely hammered over a period of several years. At last, here was a monster sales idea! It was like adding bubbles to white wine and getting champagne.

Markowitz’s efficient frontier concept gave economic and mathematical validity for investors to buy new uncorrelated risky investments to help reduce risk immediately in already existing portfolios.²

It was told to me that it was this idea of taking on risk to reduce it floated to various financial institutions and large investors, started the stock market up again, and it never looked back. This became the foundation for modern portfolio theory, and why everyone in the industry talks about diversification. Of course this all works until everything goes south at the same time. But that was not really understood until 1987—but that is another story. For the moment just remember risk is not loss. It is volatility.

By thinking of risk as price movement one can understand the idea of balancing that risk by owning another asset that offsets it by moving opposite. This is risk management at work. One has heard about how banks are supposed to have whole departments that are supposed to help manage risk. This is what they do and this has relevance in the latest Greek debacle. A CDS, or Credit Default Swap, is used to offset risk.

So what are Credit Default Swaps?

Let’s use an example:

A pension fund has 500 million to invest. It likes the idea of investing in sovereign debt of a particular country because for the most part it has been relatively safe. Just the same, the investment committee is aware that sovereigns defaulted in the 1930s and again in the 1980s. To be on the safe side and because it is a pension fund and has to be conservative, the investment committee decides to insure their investment using a Credit Default Swap.

The pension fund goes to a bank or insurance company and purchases fifty 10-million-dollar Credit Default Swaps in five-year contracts for a premium of 0.5% a year or $2,500,000 paid quarterly, whereby in the event of a default, or a credit event (the sovereign fails to make an interest payment or the debt is restructured) the Credit Default Swap is activated and the pension fund must submit the issue to the insurance company and the insurer will give the pension fund 500 million dollars. Exactly how and when this occurs is laid out specifically in the contract or confirmation—and that is a typical Credit Default Swap. It is called a swap because default risk is being swapped for an expected stream of quarterly payments.

The pension fund swaps a five-year contracted payment for a much less chance of losing money and the insurer swaps the small risk of a default for a guaranteed stream of money.³

Credit Default Swaps have been issued on many kinds of debt. They originated in the 1990s with the Exxon Valdez oil spill, as a way for JP Morgan to free up some of its reserves which were used to secure the 4.8 billion dollar credit line extended to Exxon. Purchasing the swap meant they no longer had to keep as much cash reserves to secure the credit line. The Credit Default Swap helped do that by balancing that default potential with the swap as opposed to cash. This markedly improved the bank’s balance sheet.⁴

The market for these securities has expanded by leaps and bounds. As an example:

An investment bank has taken a position of owning a hundred million dollars of the debt of Greece. Because it owns the Credit Default Swaps, one has offset the sovereign debt default risk in one’s portfolio. Usually most banks have a risk officer who is aware of how balanced or unbalanced the overall position of the bank is. Each bank is required to know what risks it has assumed and how it has offset that risk so as to remain in business in the event something goes wrong.

In the news the other day, it was reported that Merkel and Sarkozy went across the street from the EU Summit to talk to the bankers and told them that they needed to take a voluntary 50% write-down on all Greek sovereign debt. Further it was worked out that because the write-downs are voluntary, at least publicly, no credit event would be triggered and therefore the Credit Default Swaps would not be activated.

Can you think how based on the above this might have unintended consequences?

Suppose one had a homeowner’s policy that insures your house in case of a loss of over five thousand dollars. The roof is blown off but now your insurance company says the house has to be completely destroyed before the policy can be triggered. What would you think about your insurance now?

This is somewhat the same situation the credit default market finds itself in. What is being said is that it might not be possible to insure against defaults of sovereign debts in certain circumstances. In other words if one held the debt one could not realistically offset it with another asset that balanced it. This has the potential to reduce those who might participate in the sovereign debt market since it might not be possible to fully balance the sovereign debt with a CDS since terms could be altered after the fact. Buyers might need much higher interest rates as an incentive to consider buying sovereign debt of countries that are already over-leveraged. Only time will tell.

In conclusion, it is possible to create synthetic financial products that move opposite to an index or a portfolio and thus reduce portfolio volatility or risk. Credit Default Swaps are such products. They do have uses.

The only problem is that as the world gets more interconnected and markets move in lockstep, how does one own assets that are not correlated? One can only do so synthetically.

As an observation, it seems that volatility or risk can only temporarily be reduced. If one is a bank when everything crashes, the only thing balancing the crashing asset may be a synthetic artificial asset backed by an insurance company or another bank, and one can only wonder how they are balancing that risk. This is what is called counter-party risk.

And this may be the real story of modern finance: What if the counter party cannot pay? Now what?

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¹ ISDA. (n.d.). Product Descriptions and Frequently Asked Questions. Retrieved November 8, 2011, from http://www.isda.org/educat/faqs.html

² Bernstein, P. L. (1996). Against the Gods: The Remarkable Story of Risk. New York, NY: John Wiley & Sons, Inc.

³ Ibid.

⁴ Lanchester, J. (2009, June 1). Outsmarted: High finance vs. human nature. The New Yorker. Retrieved November 8, 2011, from http://www.newyorker.com/arts/critics/books/2009/06/01/090601crbo_books_lanchester

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© 2011 Ivan Obolensky. All rights reserved. No part of this publication can be reproduced without the written permission from the author.