Credit Default Swap - Criticisms

Criticisms

Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation and that, because all contracts are privately negotiated, the market has no transparency. Furthermore, there have been claims that CDSs exacerbated the 2008 global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG.

In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced confidence in the bank and ultimately gave it further problems that it was not able to overcome. However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the reality that the company was in serious trouble. Furthermore, they claim that the CDS market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their default.

Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations during the 2009 General Motors Chapter 11 reorganization, because certain bondholders might benefit from the credit event of a GM bankruptcy due to their holding of CDSs. Critics speculate that these creditors had an incentive to push for the company to enter bankruptcy protection. Due to a lack of transparency, there was no way to identify the protection buyers and protection writers.

It was also feared at the time of Lehman's bankruptcy that the $400 billion notional of CDS protection which had been written on the bank could lead to a net payout of $366 billion from protection sellers to buyers (given the cash-settlement auction settled at a final price of 8.625%) and that these large payouts could lead to further bankruptcies of firms without enough cash to settle their contracts. However, industry estimates after the auction suggest that net cashflows were only in the region of $7 billion. because many parties held offsetting positions. Furthermore, CDS deals are marked-to-market frequently. This would have led to margin calls from buyers to sellers as Lehman's CDS spread widened, reducing the net cashflows on the days after the auction.

Senior bankers have argued that not only has the CDS market functioned remarkably well during the financial crisis; that CDS contracts have been acting to distribute risk just as was intended; and that it is not CDSs themselves that need further regulation but the parties who trade them.

Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway's annual report to shareholders in 2002, he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)."

To hedge the counterparty risk of entering a CDS transaction, one practice is to buy CDS protection on one's counterparty. The positions are marked-to-market daily and collateral pass from buyer to seller or vice versa to protect both parties against counterparty default, but money does not always change hands due to the offset of gains and losses by those who had both bought and sold protection. Depository Trust & Clearing Corporation, the clearinghouse for the majority of trades in the US over-the-counter market, stated in October 2008 that once offsetting trades were considered, only an estimated $6 billion would change hands on October 21, during the settlement of the CDS contracts issued on Lehman Brothers' debt, which amounted to somewhere between $150 to $360 billion.

Despite Buffett's criticism on derivatives, in October 2008 Berkshire Hathaway revealed to regulators that it has entered into at least $4.85 billion in derivative transactions. Buffett stated in his 2008 letter to shareholders that Berkshire Hathaway has no counterparty risk in its derivative dealings because Berkshire require counterparties to make payments when contracts are inititated, so that Berkshire always holds the money. Berkshire Hathaway was a large owner of Moody's stock during the period that it was one of two primary rating agencies for subprime CDOs, a form of mortgage security derivative dependant on the use of credit default swaps.

The monoline insurance companies got involved with writing credit default swaps on mortgage-backed CDOs. Some media reports have claimed this was a contributing factor to the downfall of some of the monolines. In 2009 one of the monolines, MBIA, sued Merrill Lynch, claiming that Merill had misrepresented some of its CDOs to MBIA in order to persuade MBIA to write CDS protection for those CDOs.