Everything You Wanted to Know about Credit Default Swaps
About This Event
Credit default swaps (CDSs) have been cited as either a great advance in risk management or a source of systemic risk. They have been alternately described as no more complex or risky than commercial loans or as financial weapons of mass destruction. The CDS market has grown from almost Listen to Audio

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nothing ten years ago to at least $25 trillion today, though critics say it is just a global gambling casino for hedge funds and other financial players. Legislation has been introduced in Congress that would limit the use of CDSs or force this over-the-counter market into a clearinghouse or an exchange. Despite all the heat generated by this market-based innovation, little light has been shed on how CDSs actually work and why they have attracted so much interest in the financial community.

At this AEI event, two financial experts will outline opposing views. Mark C. Brickell, the CEO of Blackbird Holdings, a derivatives trading platform, and a former chairman of the International Swaps and Derivatives Association, will present the case for CDSs. R. Christopher Whalen, a financial analyst, consultant, and writer, will offer the case against these derivatives. Following the formal presentation, there will be a general audience discussion of the benefits or dangers of credit default swaps. AEI's Peter J. Wallison will moderate.
Event Summary

WASHINGTON, FEBRUARY 27, 2009--Credit default swaps (CDSs) have been much maligned in recent months. In the words of R. Christopher Whalen of Institutional Risk Analytics at an AEI conference on February 23, these instruments are some "of the least understood, but potentially among the most damaging factors contributing to the crisis in global financial markets." However, proponents of these derivatives, such as Mark Brickell--the CEO of Blackbird Holdings, a derivatives trading platform, and a former chairman of the International Swaps and Derivatives Association--claim that CDSs are no riskier than loans and that they have helped to build "a more diverse, robust risk management industry." Which view is correct?

AEI's Peter J. Wallison, author of a recent Financial Services Outlook tantalizingly entitled "Everything You Wanted to Know about Credit Default Swaps--but Were Never Told," explained how a CDS operates. A lender, "B," buys a bond or makes a loan to "A." If B decides that it does not want to assume the risk that A might default--either because A is too risky or because B wants to diversify its portfolio--it can enter into a CDS with a swap dealer, "C." The CDS is essentially a contract in which C agrees to reimburse B in the event of a default of the loan to A. In exchange, B agrees to pay a quarterly or annual premium to C that is based on how risky A is perceived to be. If A defaults, there are three possible outcomes:

  • B will seek recompense from C
  • If C defaulted before A, B would have already found protection from a new dealer
  • If C defaults after A, then B loses its protection

No matter what the outcome, Wallison explained, "you have to remember that this starts with a loan. And that is the total amount of risk that is created by the market in that transaction." The risk does not increase with CDSs--it simply changes hands.

Whalen challenged Wallison's assumption that a CDS is no different than a loan, saying that counterparties fail to conduct thorough due diligence when evaluating a CDS and do not "do work on the probability of default independently." Instead, they rely on models based on inaccurate data from rating agencies or broker-dealers. "The problem with securitization," Whalen explained, "is that you're breaking the borrower-lender relationship," and the dealer who buys the risk is not going to do due diligence a second time. "We need to devolve the agency problem," he stated, because lenders do not have an incentive to make good loans to borrowers when they can simply transfer the risk of a bad loan to a third party through a CDS.

Wallison countered that if "[lenders] can't make the credit judgment on a swap, they shouldn't be making it on a loan." Speaking from the perspective of an industry insider, Brickell added that "with credit default swaps, you're taking the same risks [as with loans] and assessing risks in the same ways. Banking supervisors are examining [CDSs] the same way you evaluate the loan." Additionally, he said, "swaps guys are not models guys." Though they refer to models, dealers primarily rely on market information to make decisions about swaps. "We enter into a contract at a price that will allow us to [profitably] buy protection from someone else," Brickell explained.

Brickell also observed that many of Whalen's complaints about CDSs seemed to be issues with the financial market in general, not the CDS market in particular. He noted that, "systemically, we have misjudged the risk contained in home mortgages" and that "this problem is broader than credit default swaps." Few lenders, whether they were involved in basic home loans or in intricate CDSs, knew the true risks of the loans they were making. Risk management models were based on historical home prices--data "tainted by federal policies that [drove] up the price of homes year after year." Brickell suggested that policymakers address the underlying cause of the crisis (the riskiness of certain mortgage lending) rather than focus their vitriol on a symptom (the problems in the CDS market). He also recognized that "we are not talking about a perfect system here. No financial transaction or system of risk management can prevent all investment losses. Good judgment remains the essential element in sound financial management."

Whalen replied that "even if the problem is housing, we'd have an easier time untangling this mess if there were fewer swaps." He argued that these "derivatives are essentially designed to generate supernormal returns for a relatively small group of global banks which traffic in these officially-sanctioned, private gaming communities. . . . The sole benefits [of these risks] seem to be providing speculative opportunities for a certain class of market participants . . . and generating commission for CDS dealer banks." He conceded that there is a real purpose for CDSs if they support real commerce, but "the financial market isn't satisfied with that because the real economy doesn't grow fast enough." Because the CDS market is growing faster than the real economy, Whalen worried, the growth is only being fed by speculation, and CDSs are not generating any real value.

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Speaker biographies

Mark C. Brickell is the CEO and a director of Blackbird Holdings, a global trading system for privately negotiated derivatives. Widely regarded as a leader in the derivatives industry, Mr. Brickell joined Blackbird after twenty-five years at J.P. Morgan, where he most recently served as a managing director. During his time at J.P. Morgan, Mr. Brickell helped to build one of the world’s foremost derivatives businesses and supported the growth and advancement of the global derivatives industry while helping to shape a more favorable public policy environment. From 1988 to 1992, Mr. Brickell also served as chairman of the International Swaps and Derivatives Association; he was vice chairman for two years and on the board for more than a decade. He was part of the team that authored the influential 1993 Group of Thirty study, Derivatives: Practices and Principles, and has served on the board of directors of First Command since 2006.

Peter J. Wallison
holds the Arthur F. Burns Chair in Financial Policy Studies at AEI, where he codirects the Institute's program on financial market deregulation. He previously practiced banking, corporate, and financial law at Gibson, Dunn & Crutcher in Washington, D.C., and New York. From June 1981 to January 1985, Mr. Wallison was general counsel of the U.S. Treasury Department, where he had a significant role in the development of the Reagan administration's proposals for deregulation in the financial services industry. He also served as general counsel to the Depository Institutions Deregulation Committee and participated in the Treasury Department's efforts to deal with the debt held by less-developed countries. During 1986 and 1987, Mr. Wallison was White House counsel to President Ronald Reagan. Between 1972 and 1976, Mr. Wallison served first as special assistant to Governor Nelson A. Rockefeller and, subsequently, as counsel to Mr. Rockefeller when he was vice president of the United States.

R. Christopher Whalen
is the cofounder and managing director of Institutional Risk Analytics, where he is responsible for sales, business development, and editorial activities. He has worked as an investment banker, research analyst, and journalist for more than two decades and has covered a variety of industry sectors, including technology and financial institutions. In addition to editing the newsletter The Institutional Risk Analyst, Mr. Whalen contributes regularly to publications such as Barron's, The International Economy, and American Banker. He is a member of the Professional Risk Managers International Association, volunteers as a regional director of the association's Washington, D.C., chapter, and chairs its speakers committee.

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