So lacking in transparency are CDS that they cloak themselves with standardised docs and definitions

By Welshcake

Credit default swaps are evil. They must be, because journalists don’t understand them. So evil are CDS, in fact, that they lurk in the realms of complex things journalists hold no obligation to investigate properly or elucidate for their readers — a stance vindicated by recent narrowly tailored reporting.

So lacking in transparency are these instruments of fear that they cloak themselves with standardised documentation and definitions that are widely available to every market participant. And they are so cunning and capricious that any disputes they engender are efficiently dealt with by a murky Determinations Committee (DC) cabal of fully identified sell- and buy-side representatives who go to great lengths to ensure legal exactness.

Fortunately, evil ultimately defeats itself. Lately CDS have been rocked by results at Vodafone-Ziggo and Sears Roebuck Acceptance Corp that were completely unpredictable unless one fell into the trap of studying how CDS work.

With Ziggo, journalists gleaned some notion about CDS having been orphaned without hope of a successor, making them worthless for protection buyers and exposing a shenanigan. But imagine the greater scandal when it transpired the credit definitions had evolved in 2014 to avert this outcome and CDS buyers were indeed protected.

Sears was even more devastating for market integrity, since it featured investors with opposing points of view on deliverable obligations, who exercised their right to present these opinions and found almost equal DC support. If this was not bad enough, both sides were then able to submit their arguments publicly to an external review panel, leading inevitably to a strengthening of the CDS product. Heaven forbid!

Such tales of ignominy underscore that CDS is unfairly biased towards sophisticated, specialist market players who are able to perform independent credit analysis, assess corporate structures, read legal documentation and calculate likely recovery values. Luckily, a journalist never has to go far to find a noble advocate against CDS who picked the wrong side of a trade.

It was always so. Anybody reading the financial press in a cursory manner can ascertain that CDS were toxic during the 2008/09 financial crisis — so much so they managed to have precious little to do with the underlying problem in subprime mortgages. Corporate CDS, for example, were conspicuously absent from the line-up of suspects. CDS indices and options were equally nowhere to be found in the root cause of global meltdown. It was all very convenient.

But as financial journalists intuited, this was because CDS were waiting for an opportunity and rubbing their little toxic hands together deviously.

Credit derivatives’ key deception was convincing the first wave of nuance-impervious journalists to conceptualise them only as a form of insurance, rather than the tradeable flow investment product they unmistakably were. That wisdom has been passed down as lore by the old masters to successive generations of novices, accompanied by sage advice never to look too deeply into the CDS lest it look into them.

With each rite of passage comes a sacred touchstone of editorial reassertion that the Sith-like International Swaps and Derivatives Association (Isda) wields ultimate power over the DC. Any protestations Isda makes to the contrary or any number of communiqués about handing its secretary role to someone else are never allowed to get in the way of a good story.

Once upon a time, journalists complained that CDS was like buying fire insurance on a house without telling the owner. But these days they can complain instead that the subjects of the insurance, like Sears, have figured out their value in the equation and are beginning to play protection buyers and sellers off against each other, almost like a proper market participant.

Of all its crimes, CDS’s worst abomination is thus to have corrupted the erstwhile innocence of corporate treasury officials who would never have stooped to using such divisive tactics elsewhere — pitting bondholders against loan providers, perhaps, or issuing debt to buy back shares and boost their stock price.

Dark times indeed. Thank goodness for the studiously preserved innocence of journalists.

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TAGS: CDS North America Europe Credit derivatives