Tuesday, June 3, 2008

A Great Primer on Credit Default Swaps

Last week, Moody's published a great report on Credit Default Swaps entitled Credit Default Swaps: Market, Systemic, and Individual Firm Risks in Perspective (free registration required).

I highly recommend it if you are looking to gain a better understanding of the product. It will also give you a greater appreciation of why the Fed stepped in to prevent the failure of Bear Stearns. It also provides a better understanding of why the Fed is aggressively providing liquidity to banks and investment banks during the current credit crisis.

There has been a significant amount of exaggeration relating to the risk that Credit Default Swaps pose to the the markets and the overall economy. This report provides a much better explanation of the actual risk than most other discussions.

The continued media references to the $62 Trillion notional value of outstanding Credit Default Swaps don't convey much in the way of information. Moody's suggests that the gross replacement value of just over $2 Trillion (not a small number, but much more reasonable) is a better indication of the value of the market (which is a starting point for potential losses).

The notional value is the total of the face value of the debt underlying all swaps. If an investor has a matching book on a $5 million loan (long and short $5 million of the same CDS), the position has $10 million of notional value even though the only risk is that of a counterparty failure (on one of the two swaps)!

Gretchen Morgenson of the New York Times stated "The nominal value of the insurance outstanding is now $62 trillion, up from $900 billion in 2000. Although this figure, also called the notional amount, overstates the risk in the market to a degree ... that risk is real — as well as very, very large." in an article in this past Sunday's paper.

The Moody's report brings a bit more perspective.

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