Credit-default swaps

What are Credit-default swaps?

The current European financial crisis is once again bringing credit default swaps to the public’s attention. But what are they? What do they do?

A credit-default swap (CDS) is a form of insurance policy that anyone can take out on any type of loan product such as government bonds and home mortgages, whether or not they have a connection to it.

Creating a CDS involves a risk assessment process using formulae which can be quite complex with some types of loans. The holder of the CDS will then pay a premium, usually every quarter.

As CDSs are developed from and their value is dependant on basic financial instruments, such as loans, they are known as derivatives.

How large is the CDS market?

A breakdown of the type of derivatives held by US banks in 2008 shows that CDS accounted for just under 10% of the total.

The largest market for CDSs are actually corporate bonds, this market is around eight times larger than that for government (sovereign) bonds.

As an aside, although it’s difficult to be certain, the total size of the derivatives market by 2009 was estimated to be worth somewhere around $1 quadrillion. To put that into context, global GDP in 2009 was $58.26 Trillion.

Influence of the CDS market on sovereign debt

It is in relation to sovereign debt that CDSs most often hit the news, but how much influence and what is the nature of their influence over sovereign debt?

The proportion of CDSs of most countries debt is surprisingly small given their publicity. For the current crisis in Greece, sovereign debt stands at just under $500 billion of which CDSs provide cover for about $5 billion, around 1%.

Where CDSs exert their greatest influence is when it comes to obtaining loans. Issuers will normally only grant loans that they can insure or afford to insure. In this respect CDSs are a barometer of risk, the higher the risk the harsher the terms of the loan, if it’s granted at all.

This presents a twin problem for countries such as Greece, Ireland and Portugal carrying large amounts of debt. Servicing existing loans becomes more difficult because of the increased cost of new loans. In addition to this, with an absence of real economic growth to increase revenues, a positive feedback condition can occur that accelerates a country to a debt default.

Moral Hazard

A more malign influence can come into play from those taking out CDSs if they have no vested interest in the original loan or stand to gain more financially if a loan is defaulted on. They may be tempted into actions that deliberately bring about failure. This is commonly referred to as moral hazard. This issue attracted a lot of attention during the financial crash. So much so that Germany legislated against ‘naked short selling‘. It is arguable how much damage this sort of activity does and is probably more analogous to deterring vultures circling a kill rather than preventing the kill in the first place

The reality is that there are limits to the power of the CDS market beyond the pricing of risk. While not a particularly socially useful activity, on balance CDSs probably do far less damage than commodity speculation.

Gary Hollands – November 2nd 2011.

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Free Bank Shares for all?

Nick Clegg, UK deputy Prime Minister, has caused a minor stir with his idea to give away shares of the nationalised banks to voters.

There has been some opposition saying that the banks should be sold off with the proceeds going to the government to help pay off the deficit.

This argument would mean that in essence, the banks, after sucking huge amounts of taxpayers money to prop them up, would be able to buy themselves back cheap. A sort of pawnbroking deal you can get with someone really bad at pawnbroking. To add insult to injury, the proceeds are then handed by the treasury straight over to the bondholders who are mostly, the banks! Genius plan if you’re a banker!

Others, feeling that there are those among voters who are ‘undeserving‘, propose that only tax payers should be given free shares.

There is however, one teeny weeny flaw in this plan to grab more shares for the ‘deserving‘. While it’s obvious that it’s income tax payers who are the intended beneficiaries, income tax is not ring fenced. It’s thrown into a great big pot along with all the other taxes such as VAT. Taxpayers in this case would include the ‘undeserving’ and, incidentally, also include any child that has ever bought an ice cream…

Nick Clegg’s asserts that his idea would democratise the banks with the participation of legions of small investors. Experience shows with previous privatisations that this would just end with the dictatorship of the institutional investor.

My preferred option? Tempting though the offer of free money is, the caveat is that we would only get above what the government paid for the shares originally anyway. So I’d prefer a more transparent and democratic solution. Sell off the gambling arms of the banks to any mug that’ll buy them at an over-inflated price. Consolidate the rest into one single bank, rationalising the product ranges to save the costs of duplication. The management would be made up of representatives of the bank’s employees, the government and representatives from interested consumer groups. Now that would be more like a true ‘Peoples Bank’.

Pundits Prescribe 10 Years of Pain for Greece

The Greek people have found themselves assailed from all sides to pay for a crisis of someone else’s making. They have protested in their hundreds of thousands against the austerity programme of cuts, mass redundancies and the fire sale of state assets, the proceeds of which would end up in the pockets of banks and bond holders.

A line-up of pundits and economists blithely playing the role of perverse doctors, declare that the Greeks will have to take ten years of pain to pay for the crisis. They point to the corrupt hiring practices for government posts, state ownership, tax avoidance as reasons for the Greek predicament.

What they don’t explain is, why in that case did the Celtic Tiger of Ireland collapse into near bankruptcy? Neither do they explain why the austerity demands would work for Greece whereas in Ireland, those policies have lead to a destruction of the growth that would have paid for its debts. They are strangely silent on the example of Ireland, which has done everything the ECB and the IMF demanded of it. In a sign that the Irish crisis is set to deepen, the Allied Irish Banks, one of the bailed out banks, has defaulted.

The Greek crisis is poised as a Mexican standoff between the Greek masses, the bond holders and banks, the CDS market, the IMF/ECB and their proxy, Greek PM George Papandreou.

George Papandreou has won his vote of confidence today and it is likely that he will be able to get a new austerity package through parliament. This will only be the first step, but as the Greek masses have made absolutely clear, the final say rests with them.

Economic and Financial Tidbits

Calculating Bond Yields

Talk of bond yields can be confusing, especially when financial announcements excitedly mention rises in yields straight after delivering gloomy economic news. So, what are bonds? What are yields?

A bond is an IOU issued by organisations such as governments and corporations. At their simplest all bonds have the following in common:

  • Face or Par value. This is the loan amount that has to be paid back.
  • Maturity. Date on which the loan has to be paid back
  • Interest rate or Coupon. The interest is usually paid annually.

Yield is the rate of return on the bond that you have bought, it is also a measure of risk. This risk can take many forms, which themselves can interact to make risk assessment quite difficult. The most obvious risk is the bond issuer going bankrupt, or in the case of a sovereign state, defaulting. Inflation rate rises are also a risk factor in that that they devalue the face value of the bond and also the interest paid on the bond.

The risk associated with a bond is expressed in two ways. Firstly in the change in its yield as the bond is traded and secondly, comparing its yield with that of bonds from similar organisations. The greater the risk, the lower the selling price of the bond which in turn increases the yield.

The calculator below shows how changing the values that make up a bond affect the resulting yield.

Face Value
Sale Price
Interest
Yield = %

Javascript Commodity Pricing Calculator

This example is intended to demonstrate the impact that currency fluctuations have on commodities that are traded on international markets.

The Commodity Pricing Calculator calculator is still being worked on, some differences in answers are due to minor rounding effects.

Commodity investment calculator
Item Purchasing Selling
Enter figures in the boxes, the answers will update automatically. Accuracy +- 0.5%
Investment £ $
Exchange Rate £ to $ $ to £
Price per Unit $ $
Total currency $ £
Total Units    
ROI Total £
ROI %  
Unit Price ROI

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This work is licensed under a Creative Commons Attribution-ShareAlike 3.0 Unported License.