CDS Market: Contributor, not Cause of Economic Woes

School of Management finance Professor Mark Williams, a former Federal Reserve Bank examiner, feels strongly that the Credit Default Swap (CDS) market definitely shares some blame, but it isn’t justified to make it the latest scapegoat responsible for the economic meltdown.  Nonetheless, there is a crying need for regulation of the CDS market and creation of a strong CDS clearinghouse as a direct response to a real and growing financial danger.

CDS Market: Contributor, not Cause

By Mark T. Williams

The Credit Default Swap market shares some blame, but it isn’t justified to make it the Beltway’s latest scapegoat responsible for the economic meltdown.  There is, however, a need for its regulation and a strong CDS clearinghouse as a direct response to a real and growing danger.  One or two more defaults from CDS protection sellers could roil this already fragile market. 

The fact that the CDS market continues to function  is not proof alone that it is healthy and doesn’t need fixing.  Unfortunately, today’s financial crisis can trace its roots back to elevated risk-taking fueled by CDS.  The real question is, Would banks have still lost over $1 trillion in the current credit debacle if the CDS market had not existed? 

In less than 10 years, this market has grown from a tiny, strictly inter-bank market for hedging credit risk to a highly speculative market with a multitude of counterparties.  This growth is understandable, as CDS created a cheaper form of betting on company defaults without requiring sizable cash outlays.  Since 1997, this market has grown from under $1 trillion to $60 trillion.  Although the way the market uses these product today has changed dramatically, the same unregulated OTC trading structure has remained. 

While it is true that the net CDS payouts of over $6 billion, triggered by the Lehman Brothers bankruptcy, was relatively smooth, it is important to realize that this represented only one credit shock.  Would the CDS market have continued to function if AIG, Freddie Mac, and Bear Stearns had not been rescued? 

The weakness of the existing CDS market is that a few players dominated the field, and as long as their credit stayed strong, the market also was strong.  Once creditworthiness declined, investor confidence quickly eroded. 

What would happen to this market if corporate defaults by larger CDS protection sellers (such as Citigroup, Bank of America or Morgan Stanley) defaulted?  The fact that this critical question cannot be answered with absolute certainty suggests that we need to exercise caution and require more, not less, reporting and regulatory oversight.  A centralized CDS clearinghouse would also help to alleviate credit fears by spreading risk among a broader participant group. 

While still standing, the CDS market is wobbly.  Investor confidence is waning and many participants, including hedge funds, have been forced to unwind and deleverage their holdings.  Although individual credit events haven’t knocked out the CDS market yet, there is much credit uncertainty as the economy continues to deteriorate.  As a safeguard, putting in place smart regulation and a clearinghouse will help backstop credit concerns and restore investor confidence.  Without such needed changes, as more investors flee this market, CDS will be the next domino to fall.

(Mark T. Williams is a finance professor at Boston University’s School of Management and former Federal Reserve Bank examiner.)

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