The Lower New York Insurance Blog

Are CDS Insurance?

Credit Default Swaps (CDS) are used as insurance for risk protection against defaults of bonds and mortgages. Although they are like insurance they actually are not based on the same principles as insurance. Hence, they are not allowed to be sold as insurance. A slight diversion, rental car protection is never presented by the rent a car dealer as insurance since it is not regulated by the insurance industry. The same is true with CDS, they are not regulated by the insurance industry and even worse, they are not regulated at all at this time!

One stipulation with insurance protection is that you must have an interest in the risk you are insuring. This stipulation is for good reason, would you want someone you did not know take out a life insurance policy on your life? This is quite basic, but believe it or not, CDS coverage can be taken out on securities (bonds and CDO mortgages) which you do not own. It is easily imagined that buyers of CDS will have an interest to have the insured bonds or mortgages fail. As an example, you are not required to own GM bonds, but you still can buy a CDS on GM bonds. And guess what, you would be wanting GM to fail. This is like shorting the stock market but you are shorting the credit market.

Insurance (Property and Casualty) is based on actuary research. Actuaries research assumes variables change over time and areas and they work on averages which are predictable over long periods of time and over wide areas of the insured. An example would be the variable of weather, hurricane risks occur in cycles and in areas. Historic data shows patterns hence allowing actuaries to evaluate risk over a long period of time and over regions. The weather patterns change and hence the variable is re-evaluated and updated. They also assume that the insured houses are not independent variables but rather dependent on each other by the area which they resided and time which losses occur. Hence they model a distribution of risk with dependent variables. The bad modelling of CDS assumed independent variables for each risk, hence not accounting formany defaults in a region or during a period of time.

The insurance industry thus sets aside capital to pay claims for periods when hurricanes are prominent, and for areas where hurricanes are prominent. While losing money in an area where hurricanes hit and during hurricane periods, their capital reserves keep them solvent over the long haul and over a wide insured area. Well that is the game plan!

CDS on the other-hand,assume credit defaults are independent variables. CDS are NOT modelled to assume that risk tends to happen in time and area clusters. The math models for most CDSs seem to have assumed that mortgage risks are independent variables, and risk is evenly spread out over time and area. This was not the case! More failures in California and Florida and more failures in 2008.

A credit default swap(CDS) is a of credit derivative which was intended to behave as an insurance contract, providing the buyer of credit with protection against default risks. The Credit buyers of corporate bond, mortgages buy credit default swaps as insurance to protect against a default by the issuer of the credit.

The buyer of the credit default swap is the Protection Buyer, the seller of the credit default swap is the Protection seller.

The following illustration depicts the credit default swap transaction between the risk seller, and the risk buyer.

Source:Credit Derivatives andSynthetic Structures, John Wiley &Sons. 2001

The CDS Markets are basically divided into three markets: corporate, bank credits and emerging market sovereigns. CDS reference entities may be a single credit entity or multiple credit entities. Multi-credit CDS reference entities may reference a portfolio of credits or a CDS index. A CDS maturity range is from one to 10 years.

WhyCDS?

CDS are sold and bought to reduce risk on credit such as Corporate bonds and Mortgages. There are other events that are non-risk events which buyers seek CDS. In addition to hedging event risk, the potential benefits (this has recently turned out not be as beneficial as once thought) of CDS include:

A short positioning vehicle that does not require an initial cash outlay (a bet-ing proposition)

Access to maturity exposures not available in the cash market

Access to credit risk not available in the cash market due to a limited supply of the underlying bonds (this I find very interesting - virtual underlying credit of bonds are virtual manufactured)

Investments in foreign credits without currency risk

The ability to effectively exit credit positions in periods of low liquidity (did this work? we had low liquidity with many investment banks!)

The performance of credit default swaps, like that of corporate bonds, was planned to be related to changes in credit spreads. This sensitivity was to make them an effective hedging tool for exposure to changes in credit spreads as well as default risk. Well this may have been the idea but Libor spreads have increased recently (until the TARP) and these derivatives did not always protect bonds or mortgages. Credit default swaps have been known to create opportunities to new arbitrage opportunities, particularly in global markets that do not have the transparency or efficiency. Well, in well established markets as in US and Europe, transparency and efficiency must have been lacking also. Recently, the International Swaps and Derivatives Association has released a letter encouraging best practices to help increase transparency and efficiency for CDS markets.

CDS unlike insurance is based on bet-ing. There are always two sides for a bet. This bet-ing became contagious among investors and investment banks to such an extent that therewere not enough mortgages nor bonds to satisfy the demand for CDS! So what did our ingenious banks and investment bankers do? - they created virtual bonds and mortgages!.

When a bet-er wanted to bet on the risk of a bond or mortgage, the bet-er would find a bank or investment bank to buy a CDS, this enabled the bank to create another bond (virtual creation) identical in every respect to the original. But there is one big difference, there was no actual homeowner, borrower or corporate issuer.

Since the existence of an owner of the credit debt did not exist, then what were the underlining assets of these virtual debts? There were none - just virtual assets! These virtual assets were just bets made by the CDS buyer with the investment banker or banker. These virtual bonds and mortgages were in essence sold with the CDS and the buyers were paying an insurance premium, which was similar to the interest on a mortgage, to the bankers. The fact: there was no real mortgage or bond in existence. And guess what? - those interest payments were not virtual! They were in real hard cash. Seems like the bankers do like virtual payments!

The bankers could not find anymore unqualified borrowers to borrow money to buy a house hence they created them out of a virtual finance and they were creating them 100 if not1000 times over. This may explain why the losses are hundred times greater than the outstanding loans. There are 100 of times more CDS contract capitalization than there are of mortgages! Yes virtual capitalization - how could anyone trust this system?

This ability to buy insurance on assets that you have no insurable interest (virtual assets) in, has turned the market into a huge bet-ing game. It is totally unregulated market. Just think of the problem of this system? If someone you do not know is allowed to buy an insurance policy on your home for the risk of fire, how would you sleep at night? It would be to his advantage to have your house torched! Luckily CDS do not insure for homeowner casualties!

One can easily interpolate, that forces in the market place would encourage bad loans so these forces could profit. I woulder if government offices which mandated banks to make bad loans believed that CDS protection would save the credit market from defaults losses? Many people became very wealthy because of the credit market crash from CDS profits which has me wonder if there were planned pressures creating this fall!

Jokingly, I can only hope regulators do not allow CDS to replace life insurance - imagine that someone you do not know is allowed to take out life insurance on your life! This iscurrently not legal thanks to good regulation!

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