Saturday, January 17, 2009

Keeping a CDS clearinghouse in perspective

A central clearinghouse for credit default swaps (CDS) will undoubtedly provide benefits to the CDS market: increased transparency, a reduction in counterparty risk, efficient multilateral netting, a uniform valuation method, etc. But commentators seem to believe that a CDS clearinghouse is a "solution" to the problems in the CDS market. It is not. Steven Pearlstein, who virtually embodies Washington Establishment thinking on financial matters (and that's not a compliment), provides a perfect example of this sentiment:

The top priority ought to be on setting up a new clearinghouse for those credit-default swaps that everyone's heard about but few understand. ... It would offer the advantage of finally bringing credit-default swaps out from the shadows and into a regulated marketplace where they can be standardized, traded and priced in a way that everyone can see. The logic is simple: better to have the government bail out the CDS market, and finally bring it under government regulation, than be put in the position of having to bail out a dozen more AIGs out of a fear that their failure would also take down the CDS market.
Let's be clear: AIG would have failed even with a CDS clearinghouse in place. If you think that AIG's failure proves that the CDS market needs to be regulated, and that a well-regulated clearinghouse is the solution, then you're sadly mistaken. A central clearinghouse will only clear standardized single-name and index CDS. No clearinghouse will clear CDS on structured products like mortgage-backed securities (MBS) or collateralized debt obligations (CDOs). AIG's failure had nothing to do with the single-name and index CDS that a clearinghouse will handle, and everything to do with the CDS it had written on structured products, particularly MBS and CDOs. This Wall Street Journal piece illustrates the crucial difference:
As of Nov. 5, AIG had posted $37.3 billion of collateral to its trading partners on the CDO swaps, but just $2.6 billion on the other two types [single-name CDS on corporate bonds and European banks].
Setting up a central clearinghouse won't have any effect on CDS on MBS or CDOs, which are what brought AIG down. AIG would have been subject to the same crippling collateral calls even if a CDS clearinghouse had been in place in September, because no clearinghouse would have cleared the CDS contracts that were the source of the collateral calls. I'm all in favor of a CDS clearinghouse, but it's important to remember exactly what kinds of benefits a clearinghouse would provide. And of course, this assumes that we'll ever actually get a meaningful clearinghouse, which, as I've said, I'm not convinced we will.


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