Came across this on Forbes.  Its an interesting piece on our latest favorite financial goody, the Credit Default Swap.  Good read for those unfamiliar, though it isn't a complete primer.  Nick, want to chime in?

Who's Afraid Of Credit Default Swaps?
Robert Lenzner, 03.19.09, 6:00 PM ET

 

 

 

Credit default swaps, the "exotic" financial instruments at the heart of the collapse of AIG, are about to be tamed, regulated, rehabilitated and turned into the kinds of debt-based securities that respectable institutional investors will buy, hold and trade. Their frontier days are ending. Welcome to civilization.

One sign of this is that
Warren Buffett, who once called credit default swaps (CDS) "financial weapons of mass destruction" has decided to issue some of his own. Another sign that CDS contracts are coming out of the wilderness is that a nascent, transparent exchange is being built to trade them by Atlanta-based Intercontinental Exchange.

Earlier this month, the Securities and Exchange Commission relaxed various regulations to allow Intercontinental to begin clearing CDS trades. The entry into the market of responsible issuers like Berkshire Hathaway's and the likelihood that the new exchange will remove secrecy from the market could soon make CDS contracts as vanilla as interest-rate swaps.

The CDS market has its origins in the late 1980s, and it grew to enormous size--over $60 trillion in notional amounts outstanding by the end of 2007--essentially without regulation. In their most basic application, a CDS contract is an insurance policy against a corporation defaulting on their debt. Say you own General Motors bonds and are worried about GM's future. You pay an insurance company to issue you a CDS, which will pay you if GM defaults.

Investors who believe that a company will default can buy CDS securities as a way of shorting a company's debt without the hassle and expense of having to borrow the bonds. And they can make big bets. The amount of CDS contracts issued doesn't have to bear any relation to the amount of company debt outstanding, so a trader can effectively short more of a company's debt than the company has outstanding.

For the moment, CDS contracts are a measure of the market's fears about certain company's chance of defaulting on their debt. At the same time, there are widespread concerns that the companies issuing CDS contracts are putting themselves on the hook for defaults. Fifteen percent to 20% of the riskiest debt covered by CDS contracts could default before economic conditions improve. In the longer term, both of these fears should subside, further rationalizing the CDS market.

The cost of protecting Berkshire Hathaway securities is abnormally high at the moment. Right now, the market is pricing the cost of insuring investments in Berkshire fixed-income securities (not common stock) at $435,000 a year to cover $10 million in Berkshire debt. It's a signal of how frightened and volatile, even irrational, the market is right now. Certainly, Berkshire's minimal exposure to other company's debt through CDS contracts isn't a threat to the company's solvency, even if it has to pay out on these obligations.

In all, Berkshire insured $4 billion worth of corporate debt through credit default swaps, for 42 institutional investors. In return, Berkshire receives annual premiums of $93 million. That's a level of exposure that Berkshire can certainly handle--the total value of the CDS contracts it issued are less than 1.5% of the company's assets. AIG , on the other hand, had issued contracts worth 44% of its assets. Berkshire could well prove to be the model of responsible CDS issuance--insure a little debt in exchange for steady cash flow.

"We will always have defaults, and defaults underscore that credit risk is ubiquitous in the economy," says Sunil Hirani, founder of Creditex, the first firm to offer electronic trading of CDS contacts. "It needs to be managed, and there is no better way than with credit default swaps that are transparent, regulated and managed by a central clearing counterparty."

The Intercontinental Exchange, which bought Creditex last summer, has recently begun acting as a central clearinghouse for CDS contacts and for the first time in history, the CDS books of most major banks and dealers, (JPMorgan Chase, Goldman Sachs, Morgan Stanley, among others) are being kept daily and have been made available to regulators. This is an enormous change and absolutely necessary to prevent chaos in financial markets. Already, the notional value of CDS contracts has reportedly fallen by half to $30 trillion, suggesting the bubble in CDS issuance might be abating.

"Access to accurate CDS counterparty exposure data is essential to efficient credit event processing," says a recent report on progress by the Intercontinental Exchange. "Therefore, having all CDS trade information in one centralized infrastructure will make it easier for firms to identify affected trades."

Therein lies the rehabilitation of the CDS market--for now, the Intercontinental Exchange has provided transparency to regulators. Soon, buyers and sellers will demand the same. So no longer can foreign banks and hedge funds say that they didn't understand the counterparty risks involved. It's up to you whether you buy from responsible Berkshire or reckless AIG. But know your issuer. That's the future for CDS.