Divergent views on CDS

Here is a great excerpt Michael Johnson's (M.S.Howells & Co) write-up on CDS. It addresses the fact that many equity and credit investors have highly divergent views of credit default swaps. He points out that a heavily restricted CDS market will make the equity market tank.

The equity market's perception of CDS and its importance to the credit markets is materially different than the opinion of many fixed income professionals. Many equity based investors consider CDS to be destructive while fixed income investors consider it to be one of the most important tools available to manage credit risk. The difference is larger than many fixed income professionals might wish to acknowledge.

Fixed income professionals might not wish to acknowledge the difference because the elimination of CDS - besides likely restarting the credit crisis – would essentially force credit providers to "marry" credit risk rather than date credit risk. For example, equity and fixed income investment committees often require PMs and analysts to specify loss limits on positions that force the firm to reduce their exposure by selling the risk or hedging the position.

Hedging an equity position by using puts or selling short equity in liquid names is a relatively straight forward process. However, without CDS a credit investor can be stuck holding a position for an extended period of time (maturity or death) even as its borrower increases the credit providers risk (drawing down a revolver) without an effective hedging tool.

This is a bigger deal than many might wish to consider. The underwriting process of even the most basic loan agreements are likely to become more restrictive and a larger portion of the economic value that has historically flowed to the equity markets will be captured by credit providers. Zero loss underwriting standards will be rolled out at some firms and that will reduce credit availability. (Zero loss underwriting will become more necessary due to the inability to hedge credit deterioration and potential losses associated with LGD.)

Although many investment professionals will argue that CDS provided banks with a tool that allowed them to become reckless and extend too much credit, it is also critically important to remember that bank losses during the 2008 could have been materially worse if the banks did not have CDS hedges in place.

CDS also provides broker dealers with the ability to hedge large fixed income trading books. The elimination of CDS would require them to reduce their portfolios and could jump start another round of deleveraging... remember how that felt?

Credit markets need CDS to function properly....and the equity markets need the credit markets to function properly... so......CDS is here to stay….