The birth (and troubled life) of CDS

IFR 2000 issue Supplement
16 min read

If some interpretations of the events of the past few years were to be believed, an alternative headline for this story would be “something wicked this way comes”. But the truth about CDS is more complicated, writes Christopher Whittall.

Towards the end of the 1980s, one large lender approached Bankers Trust with a thorny problem. The bank in question was extending a multi-billion dollar lending facility to one of its most important blue-chip customers and was going to struggle to warehouse the entire loan.

There was a catch, too: it didn’t want to syndicate the loan to other banks, but instead keep it on its balance sheet and sell on the exposure synthetically.

This was music to the ears of the nascent swaps desk at Bankers Trust, which was then housed in a no-man’s land between trading and banking, trying to convince clients of the exciting potential of derivatives.

“For me, that was the start of the credit derivatives market,” said Gay Huey-Evans, a member of that team, who later went on to chair ISDA and head the UK FSA’s markets division. “That transaction never took off, but it got people thinking.”

It was a familiar problem after all. Internal limits curbed banks’ ability to lend to companies, spurring a search for ways to free up capital without damaging relationships with key clients. Moreover, the Bankers Trust swaps team had spotted a natural client-base for these exposures.

In the days before monetary union, large US companies were deterred from tapping European capital markets due to the fragmentation of currencies across the Continent. For their part, European institutional investors balked at the notion of holding US dollar-denominated assets, but were frustrated that they couldn’t gain any real exposure to high quality US companies.

This presented a great business opportunity for investment banks: lend money to high-grade US corporates, then sell slices of the credit exposure in synthetic format to European investors in their own currency.

“European investors wanted more exposure to these American firms, so we syndicated a bit of a loan synthetically. This reduced the credit exposure to that specific corporate name, which would enable us to maintain an ongoing relationship with the corporate, and extend more credit when necessary,” said Huey-Evans.

At this stage the documentation was very basic. The concept of default was not even included in most contracts given the high creditworthiness of the underlying companies – pay out events were linked to ratings downgrades instead.

But the building blocks were all there for what would later morph into the credit default swap market. Bankers Trust had created a synthetic exposure to an underlying credit that could be sold on to investors as an alternative to holding the physical securities.

“It wasn’t known as CDS – it was just a structured transaction. We’d ask investors what credit they’d like, and they’d say: ‘What credits do you have?’ It was very specific,” said Huey-Evans.

The next year Bankers Trust began originating baskets of credits and also introduced financial underlyings, which were more liquid and therefore easier to hedge. John Crystal, who later switched to Credit Suisse Financial Products, took the reins of the new business, seeing the potential to build a tradable market.

Enter JP Morgan

He was not the only one. In 1994, a group of derivatives bankers from JP Morgan congregated in Boca Raton, Florida, to bounce ideas off one another about derivatives and how to better manage the firm’s credit exposure.

Shortly afterwards, Blythe Masters and Bill Demchak, two rising stars based in the firm’s New York offices, began sketching out these ideas into a firmer structure, which eventually became the Bistro (see related story). Meanwhile, in the firm’s London offices, Bill Winters went about establishing a liquid, tradable market in credit derivatives.

“We had a dual process going at JP Morgan. We were developing a generic CDS market in London at the same time as a more strategic one out of New York looking at moving the firm’s own credit risk,” said Winters, who later went on to become co-chief executive of the investment bank at JP Morgan.

Perhaps rather prophetically, given all that has happened since, JP Morgan began trading sovereign first-to-default baskets, executing its first trade in 1996.

“Those were hedging transactions, helping banks free up some concentration risk we had while offering investors some healthy yield pick-up,” said Winters.

Other banks had also identified sovereigns as the perfect launch pad for the CDS market, while the less liquid credit exposures of blue-chip corporates continued to be traded on a more sporadic basis.

An EM thing

Over at Goldman Sachs, Athanassios Diplas joined a small emerging markets team in 1997 that was intent on ramping up CDS trading. Emerging markets were the perfect area for the fledgling product to flourish given the growing universe of interesting instruments such as Brady Bonds. There was also the very real danger of sovereign default in these markets.

“It created the need for an instrument specifically focused on credit risk, without mixing in interest rate or funding risk. That was the appeal of CDS – it was a pure credit risk transfer instrument,” said Diplas, who later went on to design much of the architecture around the CDS market.

The Asian financial crisis provided CDS’s first real test and subsequently was identified as a seminal moment for the product. In 1996, many had cast doubt on CDS’s ability to weather a storm. But while cash markets imploded during the deepening Asian crisis in 1997 and 1998, CDS desks remained open for business and provided a vital source of liquidity.

“There were many illiquid versions of credit risks in the market – loans, bonds, counterparty risk, country risk and so on – that could be hedged with one liquid product that captured all of the information of that particular credit. People soon realised it was a tremendously useful instrument to hedge risk and allow for orderly risk transfer,” said Guy America, global head of credit markets at JP Morgan, who joined the bank’s swaps desk in 1994 and covered EM during the Asian crisis.

It’s not insurance, OK?

In a major coup for the market around this time, the industry successfully argued that CDS should not be regulated as insurance – a development that would have stopped the market in its tracks. Lawyers pointed out that unlike insurance, CDS contracts were liquid, involved an exchange of cashflows and paid out immediately.

The industry, led by ISDA, also began to flesh out the documentation backing the trades to avoid lengthy negotiations and to encourage a more liquid, tradable market.

“Market participants used to fax over a 12-page document at the very start of the single-name market – you could maybe do two or three trades in a day as you’d have to negotiate every individual contract. Standardisation was crucial for a quicker and clearer understanding and management of the risk of the product,” said America.

ISDA published the first credit definitions in 1997, followed by another set in 2003.

“Because EM had already experienced so many defaults, we had a lot of the test cases of how CDS should work, and what credit events should be included. The 2003 definitions included more experience from corporate bonds around restructuring and then, with indices coming on the scene as well, volumes suddenly rocketed to trillions of trades from almost nothing,” said Diplas.

Around the turn of the millennium, the corporate CDS market started to gain real traction, aided by more participants joining the fray on both sides of the market.

Some financial firms saw the earning potential of selling single-name CDS protection, injecting a wave of supply into the market. One of the first movers was Primus Guaranty, a breed of institution known as a credit derivative product company. These firms garnered the highest ratings, and managed to persuade banks to transact with them without posting collateral to cover mark-to-market gains and losses.

“The big question was, would Primus be an acceptable counterparty to the banks,” said Tom Jasper, a former Salomon Brothers executive, who helped found ISDA, and started and headed Primus from 1999 onwards. “It took protracted negotiations, but ultimately the Street was keen to allocate a lot of resources to credit, as CDS could generate them significant revenues.”

Most banks eventually signed up with Primus and other CDPCs, unleashing a flood of liquidity into more esoteric CDS names that had previously been off-limits.

“Timing is everything,” said Jasper, noting that Primus set up shop shortly before a credit sell-off in 2003, when spreads widened and his firm, which didn’t have to mark positions to market, could step in.

“These special-purpose pools of capital were hugely influential in creating liquidity and developing these markets,” he said.

Hedge funds enter the fray

This coincided with increased interest from hedge funds, which had begin to grow in popularity and size. CDS’s unfunded format proved very attractive as it provided an easy way to secure leverage. If a fund wanted to own a bond, it had to deploy its own money to buy and park it on its balance sheet. Selling credit protection on the company allowed them to get the exposure without spending cash in the process.

“It was a chicken and egg situation with CDS and hedge funds. Hedge funds needed an efficient, synthetic way to take a view on the market. Without these players getting involved, you would never have been able to generate enough liquidity to attract real-money investors,” said Eraj Shirvani, co-head of global credit products at Credit Suisse and another former ISDA chairman.

As the structured credit boom ramped up, CDS volumes rocketed, peaking at US$57trn in notional outstanding at the end of 2007.

The mushrooming market spurred the industry and regulators into action. In 2005, the New York Fed under Timothy Geithner forced the industry to deal with the huge backlog of trades, while ISDA began work on standardising the market further and facilitating the shift of the product towards central clearing.

Crisis time

It wasn’t a moment too soon. The market had hit its height just as the credit cycle was turning, and the product faced its biggest test yet. A financial crisis looming on the horizon added a keen sense of urgency to proceedings.

“During peace time, CDS looks like an interest rate swap: you just exchange coupons. It’s during war time when you have defaults that it becomes really interesting,” said Diplas.

Terms were standardised in what became known as the Big Bang; the auction process for determining payouts was introduced and a Determinations Committee for deciding credit events was created.

The bursting of the structured credit bubble brought with it a litany of negative headlines around the product.

Certainly, credit derivatives technology was at the heart of the dodgy structures that transmitted sub-prime mortgage credit throughout the financial system. This financial engineering enabled subprime assets to become nestled in the balance sheets of the world’s major banks alongside (and to be treated as if they had the same risk-characteristics as) other Triple A rated assets such as government bonds.

The darker side of the credit derivatives story is epitomised by AIG Financial Products, which sold billions of protection on pools of sub-prime mortgages to the Street. It is not hard to see why a US$85bn US government bailout so that the ailing insurer could make good on CDS contracts with counterparties such as Goldman Sachs inspired taxpayer ire.

In contrast, the liquid, tradable CDS market for the most part weathered the financial crisis relatively well, even if from a PR perspective it was tarred with the same brush as the kind of nefarious business conducted by AIG.

There were some notable blips – recovery for Freddie Mac and Fannie Mae sub debt was fixed at higher levels than the senior, for example – but the auction process generally held up well, while the vast majority of ISDA DC decisions were unanimous.

The main issues for CDS arose well after Lehman Brothers had filed for bankruptcy. The Greek debt restructuring in 2012 and bail-in legislation exposed crucial flaws in the contract, which ISDA is addressing in its first re-drafting of the credit definitions for a decade.

An uncertain future

Still, lawmakers have made no secret of their distaste for the instrument, particularly in Continental Europe, where it is now illegal to hold outright short positions on European government debt and ISDA, Markit and 13 banks face a probe for collusion. Given the regulatory onslaught, some believe the OTC CDS will eventually peter out.

“It’s a pretty good bet that in a few years’ time, the over-the-counter CDS market as we know it will barely exist and the vast majority of vanilla flow business will be executed through standardised futures contracts on exchanges,” said CS’s Shirvani.

There is frustration in the industry at policymakers’ intolerance of CDS, but some argue that the industry could have helped itself by moving faster on clearing. Winters notes that some banks’ trading desks were aware of counterparty credit risk, but they didn’t charge for it because it would have eaten into profits.

“Why would those banks invest in central clearing and have transparency increased and profitability reduced?

It was a classic misalignment of management, which was derelict, and shareholder interest,” he said.

So, given everything that has happened over the past 25 years, has CDS changed the world for the better?

“To me, the underlying value of CDS is the ability to move risk around the market efficiently without being constrained by the existence of physical securities. It was a good idea at the outset, and it’s a good idea today,” said Winters.

“And like most things that have useful purposes, it was abused. Net-net, the world is probably better off with CDS, but the extension into subprime mortgages and the contribution to the bubble that wreaked havoc was pretty dramatic, so it’s a close call.”

IFR Review of the Year 2008