Has Buffet gone senile?

Since BRK has not been required to post collateral on their short puts, the counterparty is hedging their exposure through the CDS. As the puts go more in the money, there is more mtm p/l exposed to BRK credit and so more protection must be purchased. Watch for the CDS to collapse once we rally off the lows.

30 year swap spreads negative

Some people have taken note (namely alea most recently here and John Jansen daily) of the 30 year swap spread which has gone very negative recently. Sure there are definitely technical factors at work here, but perhaps the market isn’t being completely crazy. 

How is this possible? Well what if AAA multinationals are being priced as less risky than treasuries at this duration? There is the possibility of a US default (see: treasury CDS at 40 bp+). We can’t default? Really? In a situation where US simply forces certain treasury holders to take no or lower payments rather than the expected inflation-based default, any large corporations that are able to survive with non-USD revenues could very well be a safer bet.

Jump Risk and Dangers of CDS

Felix asks why people feel CDS is the main culprit even though other markets (IRS, currency fwds, etc.) have much larger notional (and likely net) outstanding exposures — why would regulating CDS into an exchange solve the problem when these other markets are so much bigger and still unregulated? All OTC markets are run pretty smoothly, with standardized contracts (ISDA) and pretty strict collateral requirements and counterparty risk control (with the exception of allowing AAA counterparties to go without collateral posting).

I think the crowd is generally right in that CDS are inherently more dangerous OTC derivs than the others, but for the wrong reason. The main risk in these markets is a jump in value (overnight, or even intraday) of widely held contracts which would require large amounts of collateral to be posted with very short warning. This massive demand for cash destabilizes the system.

CDS are essentially corporate bonds, the main cause of jumps here is sudden risk of default — this is very common.  Can IRS or currency forwards jump also? Of course, exotic IRS is an obvious but the notional here is much smaller than the vanilla (these values can jump like crazy, consider barriers near expiration, for example). Vanillas can jump during flight to quality, sometimes. Currency forwards are more likely to jump, this happens every time a country is at risk of default and/or there is a currency panic (most recently, pretty much every major country, and to the extreme in Iceland, etc.)

But, there are other factors which tilt the majority of the destabilization risk towards CDS. Correlation tends to be very high here (although this applies to currencies as well during contagion). Defaults tend to cluster, just like volatility.

Finally, and this factor differentiates CDS with OTC currency contracts, CDS exposure is very concentrated. Let me explain what I mean. When currencies explode in a certain direction, banks tend to be hedged off pretty well, leaving counterparty risk with what tend to be a diversified set of non-financial counterparties (just typical companies using forwards to hedge currency exposure). When CDS explodes, the banks are pretty well hedged off, but counterparty risk remains towards the writers of protection, and the primary writers are monolines, AIG, etc. ie, highly leveraged institutions, undercapitalized for a correlated jump and the resultant collateral demands.

This is where the destabilizing risk comes from: bank exposure to concentrated leveraged counterparties with high JUMP RISK. This is the CDS market. Moving to an exchange will put the burden of handling margining into a central party with visibility of all contracts, and with the benefit of hindsight will set collateral and leverage requirements with the understanding that these will jump in a correlated fashion. In my opinion this can be done without moving to an exchange, but it will likely improve the market overall in the long run.