Some More Facts About How The CDS Market Will Be Misconceived To Death

When you have the House Agriculture Committee getting involved in the regulation of the CDS market, it is only a matter of time before it is game over. When both conventional wisdom, and economists-turned-philosophers like Soros claim that credit default swaps are responsible for the downfall of western civilization, presenting any type of factual information is pretty much useless. Nonetheless, Zero Hedge will fight until the Soros-spearheaded bitter end of "efficient" markets, to prevent what is basically the scapegoating of a risk-mitigating mechanism in order to deflect the public attention from what has been a phenomenal failure in risk-management by a handful of greedy Wall Street fatcats... It is not the market that is as fault - it is the people who abused it (here's looking at you AIG).

As we have noted, the DTCC finally started releasing somewhat detailed data in November about the CDS market. Unfortunately it was too late, and it seems only 3 people in the entire world follow what is says. So let us summarize it simply: 1) the market is already on a death spiral in terms of gross notional, and 2) the net notional of outstanding CDS is woefully inadequate to protect from the upcoming default onslaught in cash bonds.

What is the difference between gross and net notional? The gross number indicates the total notional of CDS contracts without taking into consideration offsetting trades. As the bulk of CDS notional holdings are at broker dealers who (aside from now defunct prop desks) take little principal risk, most of the CDS contracts they hold are offset. This means that for any $10 million CDS in a single name or index a B/D sells to counterparty X, the B/D has to purchase an offsetting $10 million from a different counterparty Y in order to be risk neutral. And so while the two transactions result in gross notional of $20 million outstanding, the net impact is 0. As the CDS data that had been previously available (which was never that much to begin with), was all on a gross basis, it tended to substantially exaggerate the total risk exposure in the market, and might have misled financial titans such as Mr. Soros himself. And as the charts below will show, the size of the net notional CDS market is troubling - in that it may in fact be too little.

While the gross notional size of the CDS market did grow significantly in recent years, there has been a very troubling decline recently in gross amounts. From a peak size of $62 trillion in 2007, gross notional CDS size has dropped to $28 trillion, with a run-rate weekly decline of almost $1 trillion, if DTCC is to be trusted. Interestingly, the gross notional on single names is for the first time on par with the size of the comparable cash bond market, both at about $14 trillion. If one actually were to delta hedge all bonds per the agriculture department's proposal, the argument would go that the market now is in equilibrium... at least based on a gross exposure.

The decline in the gross size is troubling: the overshoot to the downside over the past 6 months is almost as large as the ramp up during the peaking of the credit bubble. Data indicates the bulk of the change is in the index and tranche components of total gross, with single name gross size declining less acutely.

Which leads to the net CDS market exposure. Another way to think of net is how the general public thinks of gross: it is the total amount of cash that would change hands if every single reference entity were to suffer an event of default with a 0% recovery. And the total amount is a paltry $2.6 trillion, at least when juxtaposed to such previous hyperbole as $50 + trillion. Additionally, as the total cash bond market is $14 trillion, one could argue that the net notional does not nearly hedge enough of the cash market in the case of spreading defaults. ZH has shown before how market values of Investment Grade and High Yield indices imply there is a blended cumulative default risk of up to 40% over the next 5 years (assuming a high 40% recovery rate), the (simplified) argument would go that of the $14 trillion in cash bonds, up to $5-6 trillion could default. This number is therefore underhedged by up to 75%: there is a total of $2.6 trillion in total net, but only $1.4 trillion net in singe name CDS (excluding indices and index tranches which are used by index correlation trading desks as trading vehicles, not hedging instruments, and would promptly collapse when defaults start to really pick up).

Zero Hedge argues that CDS has been probably the most efficient way to hedge credit risks in the past 3 years. The fact the insurance companies took Buffett's example 10 steps too far, and just kept on selling and selling protection (kinda analogous to how the U.S. is printing and printing $$$ now) assuming six sigma events would never occur, thereby exposing the entire financial system to systemic risk, is solely their mistake and the appropriate punishment should have been default. An efficient market would have eventually picked up the pieces from AIG's failure, so the course that Paulson departed on when he bailed AIG out just takes that mistake even further as it merely leverages the faulty disbelief in fat tail events. The argument goes that CDS and equity markets are self referential when gossip picks up and companies like Bear and Lehman get shorted to death as fear is rampant. There are many more pieces to this argument, but we think it is totally meritless (in Lehman's case CDS traders would not purchase protection blindly as they were worried a Bear Stearns bail-out type event would reoccur making all CDS contracts virtually worthless; the government is as much to blame for being unable to hold a consistent policy course w/r/t how to deal with bank failures). The flipside is that CDS provide the only mechanism to hedge credit risk, which at implied 40% default probabilities, will need to be hedged even more so in the future.

So what is in store? Granted the death of CDS is an exaggeration, CDS will soon move from trading Over The Counter to a centralized Clearinghouse exchange, maybe in as little as 3 months. Initially this market will support indices (HY and IG) and subsequently move to index tranches and single name CDS. The clearinghouse will eliminate counterparty risk as contracts will be netted multilaterally, not just between two entities. Dealers would face a centralized cash-rich entity: The Clearing Corp (TCC), which would be funded through initial and daily collateral postings and cash flow sweeps on mark-to-market CDS margins. The biggest benefit from this would be the sharing of losses by all counterparties in case of a systemic failure.

Once counterparty risk is removed two things will happen: basis trades will collapse and the overall CDS levels will likely spike dramatically (wider). Due to aforementioned liquidity constraints (here and here), true risk levels are captured by spreads on cash bonds, not CDS. The counterparty premium is manifested by an artificial tightening in single-name CDS vis-a-vis matched maturity bonds (the negative basis trade phenomenon), and represents anywhere between 200 and 500 bps in any reference entity. Thus once a clearinghouse is established, as long as economic fundamentals maintain their scary downward trajectory and defaults are expected to keep rising, CDS will move steadily wider until they catch up with the true risk levels as currently expressed by Z Spreads (or interpolated recovery levels on highly convex names). Bottom line: we recommend purchasing CDS outright in any name that has a marked negative basis as counterparty risk becomes a negligible issue.