Another Piece of the Current Moral-Hazard Puzzle?
CDS are essentially a form of insurance against default on debt securities. The insured party pays premiums in exchange for a payoff upon a debt default. The contract usually lasts for five years and payoff is triggered by such events as a bankruptcy, failure to pay, or debt restructuring on the part of the institution issuing the underlying debt security. The seller of this protection will either take delivery of the defaulted debt for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the debt (cash settlement). Good descriptions of CDS are at Wikipedia and Pimco.
The amount of credit default swaps now outstanding is reported to be an astonishing $45 trillion. (This number refers to the par value of debt insured and not the trading value of the contracts themselves.) Compare that with $22 trillion for the U.S. stock market or $13 trillion for mortgages. Because you do not have to hold the protected security to purchase CDS insurance, and because the contracts are negotiable on both sides, they have created a very liquid market in default-risk. It is analogous to me being able to take out fire insurance on your house and then re-sell it at a profit when a heat wave increases the likelihood of fire.
Here is a brief discussion of one way of speculating or hedging with CDS, and here is a report on the recent decline in the CDS premiums (or spreads) on the debt (not covered by deposit insurance) of major commercial and investment banks. As this Bloomberg article from over a month ago reveals, you can even purchase CDS protection in this over-the-counter market for U.S. Treasury bonds, which will be a great way to short Treasuries as that glorious day of federal government default finally approaches. :-)
Some of the media have been raising a hue and cry over the alleged dangers from credit default swaps and calling for government regulation. See these articles from the NEW YORK TIMES and TIME MAGAZINE.
Yet credit default swaps should help increase market efficiency in an unregulated and unsubsidized market. The problem, however, is that commercial banks are among the biggest players in this market, both as insurers and insured, to the tune of an estimated $14 trillion. Of that, JPMorgan Chase accounts for $7.8 trillion, Citibank for $3 trillion, and Bank of America for $1.6 trillion. To the extent that banks are providing the insurance, this constitutes a major avenue through which the moral hazard caused by deposit insurance can spread the under-pricing of risk well beyond the banking system. At the same time, this exposure is off balance sheet, evading much regulatory scrutiny. Not to mention that among the debts insured by CDS are mortgage-backed securities, although I haven't been able yet to find out how much.
I am vary wary of conspiracy theories, but Gretchen Morgenstern in the NEW YORK TIMES intriguingly suggests that JPMorgan Chase may have had a good deal of CDS exposure to Bear Stearns before the recent bailout. Bear in mind (no pun intended) that JPMorgan Chase is a bank holding company, owning (1) JPMorgan Chase Bank, National Association, with branches in 17 states; (2) Chase Bank USA, National Association, a credit-card issuing bank; and (3) JP Morgan Securities, an investment bank. The first two, of course, enjoy the pernicious and insidious deposit-insurance subsidy.