Week of September 21, 2009

Trading CDS

vs.

We not talking about trading music CD’s, but something very different. Last year at this time we were hearing a lot about credit default swaps or CDS. A CDS is a contract where the buyer makes payments to the seller and in return receives a payout if the underlying credit instrument goes into default. The riskier the underlying loan or bond, the more expensive the premium the buyer must pay to the seller. Both the buyer and the seller of the CDS are free to sell their side of the transaction to a third party, who also is free to trade the CDS. Investors thought of CDS contracts as insurance, but they were not. Insurance only allows someone with an insurable interest to purchase insurance, and the insurer must have reserves on hand to cover any potential loss. A CDS contract is merely a freely traded contract based on an underlying instrument. Kind of like a futures contract or an ETF (Exchange Traded Fund). The difference is that exchange-traded contracts are guaranteed by the exchange and the clearing members represented in the transaction. In the free-wheeling world of CDS trading, swaps were neither insurance, where reserves are on hand, nor were they exchange-traded with all of the inherent protection an exchange provides. CDS contracts were pioneered by JP MorganChase in the 1990s and were squeezed through the same loophole that ENRON used to escape regulation with Commodity Futures Modernization Act of 2000. By 2008, AIG had become the biggest player in the market, but we all know what happened when the excrement struck the oscillating device. The collapse of the sub-prime mortgage market meant that AIG and other CDS sellers were being called on to payout on their swaps. Well they had no reserves, and since they weren’t marked-to-market like an exchange-traded instrument, they were simply unable to pay and the buyer of the CDS were unable to collect on their “insurance”. That meant that another set of dominos was about to fall. Enter you and me and all the other taxpayers. We paid off for AIG.

Now in 2009, CDS contacts have been standardized by international agreement and two clearing houses, one in the US and one in Europe, have been established. The US clearing operation is operated by InterContinental Exchange (ICE). At the end of last week, the CME Group Inc. entered the picture when they announced they had won the backing of five major asset management firms. Those firms, as well as an undisclosed number of large banks and Chicago based investment giant Citadel Investment Group are founding members of CME’s entry into the $27 trillion dollar CDS market. Yes that’s a 27 trillion dollar market ! A secure exchanged-traded CDS market will do a lot to restore confidence and liquidity into the world’s credit markets. And whichever exchange gets the majority of the business It will probably be what we call a “great trade”. Meaning an active and liquid market with great potential for profit for experienced professional traders. You know, like you – if you take our course.