Sunday, October 5, 2008

An Idea To Prevent The Next Credit Default Swap Illiquidity Crisis

In order to prevent this financial massacre from happening in the future there must be capital and collateral ratio requirements that CDS counterparties must follow in order to sustain their ability to honor existing swap obligations if portfolio holdings get distressed. I'm sure Lehman, AIG and Bear had risk controls in place, but they obviously did not factor in any type of credit disaster risk. If anyone reading this knows about CDS risk management practices please comment. Credit ratings agencies and institutional buyers thought these pooled mortgage backed securities diversified away risk, however too much bad risk (sub-prime debt) was concentrated in these securities and cash stopped flowing in, so the A rated securities were written down to distressed levels.

These counterparties must have the ability to honor existing swap obligations or be forced to sell the obligation to another party or raise additional capital. There must be liquid collateral posted to the par value of these obligations to easily calculate a ratio breach.. If there were conservative ratios in place I'm sure these forced bankruptcies and counterparty ripple effects would have never happened. If these swap counterparties violate a conservative CDS Obligation/Liquid Collateral Value ratio (kind of like how the home builders breached their debt/tangible net worth ratio bank covenants when they kept writing down land values) they must transfer the obligation to another party within a certain time period, or be forced to raise capital or post additional liquid collateral to cover the ratio breach. I'm sure there could be ways to incorporate the underlying securities if they were to be swapped in a default, incorporating CDS par value-underlying market value into the ratio. Again I'm not sure how these transactions are structured. I'm wondering if this could work and what affect it would have on the CDS market and spreads. I also want to know how the illiquid CDS obligation would be transferred to another party since it could bring massive risk to a new party. What if nobody wants it and they can't raise capital?? Could it be transferred in pieces?

This would force financial institutions to deal with their liquidity problems quickly and efficiently, instead of creating a cross-default domino effect like we saw last month. Indirectly these banks were not hedging away their default risk which needs to be addressed for the future health of the CDS market, and the next debt security crisis, when everyone wants to buy an aircarhome in 2108..

Here's an interesting write up on SeekingAlpha: How Banks Hedge Counterparty Risk


Anonymous said...


Fed Planning Credit Default Swap Marketplace

Avatar said...

Do you have a Private mortgage insurance (PMI) policy? If you do have one your PMI insurer passes their risk to others by bundling 100 policies together and selling them as a credit default swaps (CDS). They do this in order to protect themselves by large payment to mortgage providers such as insurers in the event your home is repossessed. In the mortgage industry this has been the case for decades. If you bought a PMI to protect your lender then you are building the CDS market. To avoid this put at least 20% down on your home or pay what it takes now to get rid of the PMI policy.

Distressed Volatility said...

Interesting, yea I actually do not have a PMI policy. I was looking at this at the counterparty risk perspective, since it could've been a house of cards if AIG was left to go bankrupt. From the hearing today, one of the senior officials said they sold $20 Billion CDSs to Goldman Sachs....And from this bloomberg article below other I-banks were exposed because they provided $441 billion in backing to Wall Street and when the Gov gave them the emergency capital, $37 billion went to the investment banks.. If AIG failed it would've created a domino effect of cross-defaults and these companies were already so distressed at the time...So how could it have been prevented????

There has to be a way to have CDS obligations conservatively calculated on the books with liquid collateral and strict capital ratios in place to make sure a ratings downgrade or a rapid write down wouldn't effect a counterparty's HUGE obligation.. Bascially to protect the whole system when there's a distressed asset crisis. I bet Paulson would've bailed out Lehman if they had as many obligations as AIG, but maybe they did, who knows..

Distressed Volatility said...

Oh yea and also if the CDS seller breaches a capital ratio, they'd have to liquidate liquid collateral, raise additional capital, or somehow transfer the total obligation somewhere else...Just to make sure the situation would be taken care of quickly. If I'm reading this correctly, I think that's what this exchange is for,

CME, Citadel Launching CDS Exchange

"By putting the swaps on an exchange, speculators could participate, allowing it to function like a futures market and mitigating the risk."

"Regulators and major brokerage houses have been pushing for a centralized clearing solution to eliminate counterparty credit risk in order to free up capital for lending."