CDS and capital relief November 1, 2011 at 8:55 am
It is with a heavy heart that I tackle this – but given recent events, the question of what risks purchased CDS protection on a bond hedges against cannot be ignored.
Here’s the issue. Suppose I buy a bond, and I buy CDS to maturity of the bond. Then if the bond defaults, the CDS pays out right?
Well, kinda. First clearly I have counterparty risk on my CDS provider. That can be managed with collateral, so assume I have enough of that too.
Second when do I get a payout on the CDS? The answer is ‘When the ISDA determinations committee votes that a credit event has happened’. Sadly we know from the example of Greece that some things that look a lot like default to the naive observer aren’t in fact credit events. Now certainly caveat emptor applies here: before buying a CDS I should have understood exactly what kind of thing it is. (See here for a nice discussion from FT alphaville on the evolution of CDS documentation.)
But now flip things around and suppose I am a regulator looking at this situation. Clearly the bank I am supervising can take a loss on a sovereign bond and does not get a corresponding CDS payment. I might reasonably argue that this means that the bank should not get full capital relief for the CDS. (Indeed, this principal has been established for the similar situation of corporate bond restructuring, which is why European regulators require CDS to have restructuring as a credit event before granting capital relief.)
Unfortunately, Basel is finding it difficult to do the right thing here. If it takes away the benefit of CDS hedges, especially sovereign CDS hedges, it will be the beleaguered large European banks who will suffer. And the Basel Committee will look like idiots; Basel III recently entrenched the role of CDS by making single name default swaps the main way of reducing capital charges on CVA risk. An about face on that issue would be embarrassing, so I think it is more likely than not that the Committee won’t be prudent. Which, frankly, is not a big surprise.