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IMF analysis of CDS spreads show them to be well behaved

IMF analysis of CDS spreads show them to be well behaved Anthony Harrington

In a press conference back in April on the analytical chapters in its latest Global Financial Stability Report, the IMF explained why it had opted to devote a chapter to considering whether or not credit default swaps (CDS) pose any special risk to global stability. CDSs are basically a way of insuring large amounts of debt, usually sovereign debt or large corporate debt, though they can be traded in their own right by third parties. The supposed threat to global stability comes simply from the scale of the CDS market, which runs to trillions (as I said, it's about insuring large debts).The background to any current report on CDS is inevitably the collapse and subsequent multi-billion bail-out of the giant US insurance conglomerate, AIG. I dealt with this topic in a blog back in September 2010, when the ratings agency Fitch, surveyed the attitudes and expectations of players in the derivatives market to the anticipated regulation of the derivatives market. At the time I wrote:

"Fitch notes that respondents to the survey, which included the top bank and broker CDS protection sellers and buyers, were generally surprised by the extent of the blame for the 2008/2009 financial crisis attributed to derivatives. Players felt that market commentators such as the media and politicians, were confused over the differences between structured financial products such as residential mortgage backed securities (RMBS) - a fundamental vehicle for spreading the contagion of the US sub-prime housing debacle through the global financial system - and credit default swaps (CDS)."

In other words, you're only worried about the CDS market if you are clueless about it. That was not exactly a satisfactory position for the technical wonks at the IMF, so they decided to take a closer look at whether the CDS market really was sufficiently responsive to increases and decreases in debt risk. The problem that blew AIG's feet off was that it wrote massive amounts of CDS contracts without really taking account of how it would meet the liabilities it was racking up if things went against it. It's a bit like someone with £10 in the bank selling you fire insurance on your house and pocketing the premiums. Nice money for them until your house burns down and you turn up with a claim, and then its goodnight and goodbye to their business - and probably to your hopes of getting compensation for your destroyed house. With a blot like that on the CDS balance sheet, so to speak, it is no wonder that the IMF decided to take a look at how well the CDS market is functioning. Of course, the AIG management-asleep-at-the-back-of-the-shop scenario is supposed to be taken care of, going forward, by more committed and searching regulatory efforts, guided by Solvency II. But still, posing the question of whether or not the CDS market has its oars in the water, was worth doing.

The result of the IMF's investigations? Sit back and relax. The sovereign CDS market is doing its job. It is providing a reasonable indication of the state of sovereign credit risk, flexing in the appropriate direction at the appropriate time, and it is acting as a useful hedging instrument. True, CDS pricing tends to overshoot and undershoot on the risk front from time to time, but then perfect markets only exist in the dreams of economists. On the question of whether the CDS market is "prone to speculative excesses", leading to higher funding costs for sovereigns, the IMF team find that sovereign CDSs behave pretty much in line with sovereign bond markets and can in fact convey information about increasing or decreasing risk more rapidly than the bond markets. That is no mean feat for the CDS market to achieve. In particular the IMF does not see any need to prevent people from trading in CDSs without actually owning them (so called "naked CDS trading"). Market participants knew this all along, of course, but they will be pleased to hear the IMF giving them a vote of approval.

Further reading on CDS and derivatives

Tags: AIG , CDS , credit default swaps , Global Financial Stability Report , IMF , International Monetary Fund , swaps
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