What Are Credit Default Swaps, How Do They Work, And How They Go Wrong

Updated: 10-6-2021: The Intrinsic Value Of Bitcoin, Calculated Using Sovereign Credit Default Swaps. What Are Credit Default Swaps, How Do They Work, And How They Go Wrong

Bitcoin is incredibly cheap, considering it provides insurance on the U.S. financial structure, as well as all fiat currencies around the world.

I reference my thesis on the intrinsic value of bitcoin in this piece, originally published in Bitcoin Magazine in April 2021. It represents my view on the value of BTC as the anti fiat, fiat is the Ponzi, and how everyone needs insurance against the Ponzi collapsing.

As Voltaire famously said, “Paper money eventually returns to its intrinsic value — zero.”

As Charlie Munger famously said, bitcoin “is rat poison squared.” Well, Charlie, have your pill, because fiat is the rat.

The basis of my paper is that BTC is insurance on the decaying credit quality of fiat-issuing sovereign nations. As such, it is credit protection on a basket of fiats.

When you own insurance, you own volatility. Similarly, when you are long credit, you are short volatility. Most assets/investment mandates are short volatility.

Accordingly, the investing world is short volatility, and it desperately needs to offset that risk with insurance (or being long volatility).

In my paper, I calculated the intrinsic value of BTC at the then current credit default swap (CDS) rates and total liabilities of the G-20 nations. This dynamic calculation will increase in value as the price of the insurance increases.

An increase in the price of insurance is reflected in a widening of CDS spreads. Well, spreads have widened for a number of reasons.

For example, China CDS has widened due to the contagion from the Evergrande fallout. Canada CDS has widened because we have irresponsible politicians who have just been re-elected, yet they “don’t care about monetary policy.”

And U.S. CDS has widened because, well… there are four or five reasons, but the most concerning is that the political elite are playing word games with the potential of defaulting.

Wake up people, this is not a drill. Contagion risks are increasing due to potential global stagflation (see the excellent article by Dylan LeClair and Sam Rule, published in Deep Dive issue #072).

The intrinsic value of BTC has increased from the beginning of this year when I originally calculated the value to be over $150,000 per coin.

I am going to take a different tack this time. I will run through the calculation of the value of BTC on just the U.S. financial situation. You will see that the market cap of BTC should be far in excess of $1 trillion.

What that says is that you are effectively getting default insurance on the U.S. at a discount to intrinsic value, and you are getting protection on all the other fiats for free.

Is it any wonder why I believe BTC to be the best asymmetric investment opportunity I have seen in my 32 years of trading risk? Giddy up.

The Methodology

Five-year CDS for the U.S. just traded at 17 basis points (bps). For the common person, this esoteric measure means that it costs $17,000 to insure $10 million of U.S. Treasury debt (UST) against default. Remember that in 2006, it cost $9,000 to insure $10 million of Lehman Brothers (LEH) debt against default.

That insurance contract became very valuable since when LEH finally did default, the contract was worth over $6 million. The sellers of LEH protection were picking up nickels in front of a steamroller. Are the current sellers of U.S. CDS doing the same?

I don’t believe there will be a short-term default by the U.S. The costs would be astronomical. However, the kids are playing games. Yellen is dangerous in her lack of understanding of true risk markets.

Powell is a well-intentioned lawyer who has never sat in a risk chair. These are our leaders, and their pristine backgrounds don’t cut it within the trading pits.

Remember, you don’t have to experience a default in order to make money on the change in spreads in a CDS contract. The mark-to-market function will account for the wider spreads, and you could close out the contract in advance of the five-year maturity and make a profit.

Adjusting The CDS Contract For A 20-Year Term

If five-year CDS is at 17 bps, what would 20-year CDS trade at if it was a freely-traded contract? (Note: In my paper I used a 15-year CDS term, but have since reconsidered the necessity to have longer-term insurance.

The value of small incremental annual tenor changes would bring in longer-term buyers. Moreover, if the U.S. was smart it would drastically increase its average term of debt issuance.

If the ducks are quacking, you should feed the ducks, and it sure seems like there are a lot of foolish bond investors who are picking up nickels in front of the steamroller).

In order to get that number, you need to do a tenor calculation. This is a somewhat “finger-in-the-air” exercise, but here it goes. Five-year CDS costs 17 bps or 3.5 bps per year.

If we effectively do a linear regression on extending CDS to the 20-year term, the cost would be 70 bps per year. My gut tells me it would be wider due to all of the variables that the U.S. and the world will face over the next 20 years.

In fact, I am pretty sure I would get lifted on an offer of 20-year CDS on the U.S. at 100 bps per annum (if anyone would take Foss as counterparty risk, which is unlikely).

Thus, for the sake of argument, let’s say that 20-year U.S. CDS is between 70 bps and 100 bps per annum.
The Current Funded and Unfunded Obligations Of The U.S.

According to the excellent website, USDebtClock.org, total funded plus unfunded liabilities of the U.S. equal $29 trillion plus $158 trillion. This monumental total of close to $190 trillion needs to be multiplied by the 20-year CDS premium to calculate an intrinsic value of insurance on the U.S.

$190 Trillion X 70 Bps = $1.33 Trillion

$190 Trillion X 100 Bps = $1.9 Trillion

Now What?

The Current Market Cap Of Bitcoin

Using my favorite BTC dashboard, bitbo.io (created by two really solid Canadians: Chris Gimmer and Marc Chouinard), the trading market cap of BTC as of this writing just inched past $1 trillion (at a price of $54,7000 per coin).

How To Interpret The Results

If you compare the current market cap of BTC to the value of insurance on total U.S. liabilities ($1.33 trillion to $1.9 trillion), BTC is clearly cheap for providing protection on the U.S. alone. And you get protection on all other failing fiats for free.

Good golly, Miss Molly. Markets can be irrational, and in my opinion, BTC is far too cheap. Yes, current prices are a rounding error compared to my long-term target price, but this methodology gives me comfort that we are still sooooo early.

How are your hedges doing, Charlie? And hedges are not just for gardeners. Buckle up. Volatility is gurgling. Buy your insurance when it is cheap.

BTC is insurance on crumbling fiat credit quality with no counterparty risk. The U.S. will likely be the last fiat to fail, but ultimately, all fiats fail. Hat tip, Voltaire. by Greg Foss.

Updated: 3-13-2023

Credit Risk Surges As Investors Fear Bank Failures Threaten Markets

NEW YORK (Reuters) -Credit risk indicators flashed red on Monday, as investors worried about contagion risks across corporate debt markets after the collapse of Silicon Valley Bank (SVB) and New York’s Signature Bank in the space of 72 hours.

An index of credit default swaps (CDS) on U.S. investment-grade companies rose to 90.2 basis points, its highest since November, after U.S. action to guarantee deposits at tech-focused lender SVB failed to reassure investors that other banks remain financially sound.

The equivalent index for CDS on junk-rated companies fell in price to 98.8 on Monday, its lowest since November. In Europe, the cost of insuring exposure to European junk bonds on Monday posted its biggest jump in three months.

Rising CDS spreads signal investors are hedging bets on a deterioration in credit quality.

“Unfortunately these things tend to rarely be isolated,” said Jordan Kahn, president and chief investment officer at ACM Funds in Los Angeles.

“This is a really ugly credit event that’s happening and the Fed and the Treasury have come out to backstop it, but even if there is some relief period after this, (my concern is) that it will spread to other things,” he said. “There are other types of credit events that are likely to unfold.”

Investment grade credit spreads, which indicate the premium investors demand to hold corporate bonds over safer government debt securities, have also been widening.

This indicates that SVB’s collapse last week, the second largest bank failure in U.S. history, has sparked broader concerns over whether companies can still fund themselves in a higher interest-rate environment.

Spreads for investment grade bonds widened about 15 basis points last week “in the worst week for credit spreads since the peak of pandemic stress,” Daniel Krieter, director of fixed income strategy, BMO Capital Markets, said in a report.

The BlackRock Investment Institute said that after recently trimming its ‘overweight’ recommendation for investment grade credit, it was reassessing its view due to tighter financial conditions. “We prefer short-term government bonds for income,” it said in a note on Monday.

In money markets, a closely watched indicator of credit risk in the U.S. banking system edged up on Monday.

With investors worried about possible bank runs, the Federal Reserve on Sunday unveiled a new program to ensure banks can meet the needs of all their depositors.

The Bank Term Funding Program should alleviate funding concerns, but it “will not likely stop deposit migration into the largest U.S. depository institutions,” said BMO’s Krieter.

Some bonds issued by Silicon Valley Bank were trading at around 40 cents on the dollar on Monday, down from nearly 90 cents early last week.

“Hedge funds are probably the ones that are buyers in this case,” said Dan Bruzzo, a strategist at Santander US Capital Markets. Other banks with California exposure were taking the brunt of the sell-off in the debt capital markets, he added.

Updated: 3-29-2023

What Are Credit Default Swaps, How Do They Work, And How They Go Wrong

When credit default swaps are in the news, it’s usually a sign that something has gone haywire in the markets. These derivatives, known as CDS, are similar to insurance that pays out if a company or country defaults on its debt.

Investors often use them as a hedge, because they offload default risk to a third party. CDS can also be used for speculation, to bet on a borrower melting down, for example.

Warren Buffett once famously called these and other sophisticated derivatives “weapons of financial mass destruction,” foreshadowing the outsize role CDS linked to mortgages would play in the 2008-2009 financial crisis.

A series of bank troubles in March sent lenders’ CDS surging, as more parties sought to protect themselves against the possibility of a financial company defaulting. Soon after, one CDS trade tied to Deutsche Bank triggered a global market selloff.

1. What’s A Credit Default Swap?

CDS are a type of derivative, which is a contract whose value is derived from price movements of an underlying financial asset, index or instrument. In this case, the value is tied to the risk that a company or country will default on its debt.

A buyer of a credit default swap receives a payout from the seller if a borrower fails to make good on its obligations.

2. How Do Credit Default Swaps Work?

Purchasers of a credit derivative, usually debt investors, make payments to a seller, who provides a payout if a borrower fails to make good on its obligations.

If the borrower skips an interest payment or otherwise fails to pay debt, the International Swaps and Derivatives Association, a trade group, determines if the swap pays out.

3. What Are They Used For?

Derivatives can be used as hedges — tools for reducing risk — or for making bets. A lender might want to insure against a default by buying a credit default swap that would pay off if the loan went sour.

With the advent of credit default indexes two decades ago, CDS investors had an easier way to bet on market movements. CDS tied to those indexes are now the most liquid credit derivatives in the market.

4. How Have CDS Gotten Investors Into Trouble?

An October 2008 episode of 60 Minutes famously called credit derivatives “the bet that blew up Wall Street,” and George Soros said the instruments are “instruments of destruction” that should be outlawed. Wall Street professionals can debate how prominent a role credit derivatives played in the financial crisis, but CDS clearly contributed to the meltdowns.

Traders and money managers used credit derivatives to bet against trillions of dollars of subprime mortgage bonds and related securities, as documented in the book and movie The Big Short. American International Group Inc. had sold some of that protection, and as the US housing market deteriorated, it had to post more and more collateral on its positions.

Those collateral postings, combined with AIG’s losses on other holdings, forced the US government to rescue the firm. The Financial Crisis Inquiry Commission, appointed by Congress to investigate the causes of Wall Street’s meltdown, later found that credit derivatives helped amplify the housing crisis.

5. What Role Have CDS Played In The Latest Bank Crisis?

After a run on Silicon Valley Bank prompted regulators to take it over in March, the price to insure the debt of banks of all sizes jumped, though to well below 2008 levels, with European banks emerging as a particular point of worry.

Investors sometimes see CDS as a measure of fear, so the spike stoked further worries about whether banks were sufficiently capitalized.

In this way, CDS prices can sometimes become untethered to the fundamentals and become self-fulfilling — a particular problem for the banking industry, which relies on the confidence of depositors to survive.

The European Central Bank said regulators should review the market after the latest turmoil. Regulators have zeroed in on a roughly €5 million ($5.4 million) bet on swaps tied to Deutsche Bank junior debt that they suspect kick-started a global selloff in late March.

What Are Credit Default Swaps, How Do They Work, And How They Go Wrong

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