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     Apr 8, '14

Ultimate foolishness
By Martin Hutchinson

The Financial Times revealed this week that trades in index credit default swap (CDS) options had managed to avoid being listed on exchanges, with all the transparency requirements that brings, instead being allowed to continue to be traded on an over-the-counter basis.

The amount outstanding is relatively small in relation to the US$25 trillion of CDS outstanding, but lack of transparency is likely to

hide a deep underlying problem. I had thought that CDS themselves represented the ultimate in unmanageability by conventional risk management. But index CDS swaptions are worse, being even more leveraged and hence even more liable to excessively large tail risks that can crater the world's banking system.

Let's start with a little background, for those who never read our 2010 book, Alchemists of Loss, or who have forgotten it. CDS were invented in the 1990s as a way to hedge/bet on credit risk. As an instrument, they have a number of problems, one of which (significant for these new gambling chips) being that there's really no good way to determine how much the thing will pay off in a bankruptcy.

The CDS bankruptcy "auction" in which a few million dollars' worth of defaulted debt is put up for auction, to determine the price of instruments worth billions, is far too easily gameable. That's why, when swap market practitioners like myself had looked at the possibility of CDS in the 1980s, we had decided there was no practical way to create a sound product.

In managing CDS positions, the biggest problem is their huge amount of embedded leverage. A typical CDS will sell for perhaps 70 cents annual premium for $100 of 5-year credit insured. It is thus leveraged about 30 to 1 in one direction ($3.50 potentially gets you $100 if you're a buyer) but very little in the other, since even if the credit improves and the CDS value goes to $0.40 per annum you only make $1.50 on your $3.50 short position if you're a seller. More ...

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.

(Republished with permission from PrudentBear.com. Copyright 2005-14 David W Tice & Associates.)




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