Credit default swaps and novation requests

I am going to do my best tonight to procrastinate and generally not do work , so I figured I would school you gentlemen (and whoever else reads this tomfoolery) on something I'll bet you've heard of if you've followed the Wall Street meltdown.

Imagine you buy $100 million in 10-year bonds from Google. The buyer of a bond is said to take on "credit risk,", the risk that the borrower cannot pay off bond in a timely manner.

You (the buyer) decide to call up Goldman Sach's and ask for insurance on $100 million notional of GOOG 10-year bonds in order to protect yourself from losing money on a (potential) Google default. Some number crunching is done by the quants, and they give you some percentage, say, 100 basis points (100 basis points == 1 percent). This means that every year that Goldman provides insurance against Google defaulting on their debt, you pay them .0100 * $100 million = $1 million per year.

Now, that 'insurance' you just bought is actually called a credit default swap. You pay them for taking on Google credit risk, and they pay you back if Google defaults. When the price of a credit default swap increases, that means that people are betting that a company has higher likelihood of collapsing. Here's a chart of Lehman CDS right up to their bankruptcy.


So now let's say that Google goes bankrupt because it hires too many young, inexperienced programmers from Stanford, and it defaults on its debt. Let's say their bonds drop in price to $0.20 on the dollar, which means that people expect that only 20 percent of the value of the bond will be recovered in bankruptcy court. Had you not bought the CDS, you would be out $80 million. But because you were paying GS for the insurance on the debt, they pay you the difference between what you paid, and what the bond is currently worth. In this case, they pay you $80 million, and you have no net loss.

Here's another hypothetical situation: Let's say you're quite sophisticated, and decide to sell a CDS to Morgan Stanley on $100MM 10-year GOOG bonds. Since you've both bought and sold an identical CDS, your position nets out to zero. Here's why: If GS pays you $80MM because of a Google default, you would have to pay the exact same amount to MS because you're providing them insurance on the same default.

But here's the new novelty: What if YOUR firm goes bankrupt? What happens to GS when you can't pay the $1MM premium? And what about MS paying for protection on the GOOG debt? They're paying you for nothing?

This is precisely what happened to Lehman and Bear Stearns: nobody knew what would happen to their CDS trades. What resulted was "novation requests", where buyers and sellers of CDS would try to find offsetting trades (such as the one above) and eliminate the guy in the middle. In our example, GS and MS would eliminate YOU as the counterparty in the middle and deal directly with each other. The first ever Sunday trading session occurred so that traders could match trades and issue novation requests to eliminate Lehman from the middle of CDS trades.

Don't you love derivatives? Warren Buffet calls them "financial weapons of mass destruction"