Speculators always seem to be looking for ways to have their cake and eat it to. Speculators in credit default swaps are no different. When a speculator sells a credit default swap, he is using an extreme amount of leverage to try and boost his returns. He knows this is a risky thing to do so at the same time he is looking to take on more risk to make a larger return, he is also looking to offload that risk onto someone else so he can enjoy his profits without having to worry about losing everything he has. This process of taking on risk and then offsetting that risk by transferring it to someone else is called netting. It is called netting because, in essence, the speculator is netting out his risk. He takes on risk and then offsets it. Here’s how it works.

[VIDEO] Netting and Credit Default Swaps

Netting Credit Default Swaps

Imagine a hedge fund manager has a fund with $1 million ($1,000,000) in assets, and he is looking to boost his rate of return by selling a credit default swap to an investor who is looking to hedge his exposure to $10 million ($10,000,000) worth of bonds he has bought. The two investors get together, and they decide to create a credit default swap with a face value of $10 million and a spread of 3 percent. This means the investor who has bought all of the bonds is going to pay the hedge fund manager $300,000 ($10,000,000 x 0.03 = $300,000) every year for a credit default swap that will ensure his $10 million bond investment.

In the hedge fund manager’s eyes, this deal is incredible. He doesn’t have to do anything if the company that issued the bonds remains solvent and doesn’t default on its bonds, and in return, he gets to collect a cool $300,000 every year—which is a 30 percent return on his $1,000,000 in assets. Of course, if the company that issued the bonds does default on its bonds, the hedge fund manager is in a world of hurt because he is on the line with the bond investor for $10 million in coverage and he only has $1 million in assets. You can see that this is an incredible shortfall. Recognizing this, the hedge fund manager goes out looking for someone else who he can pass the risk along to. In his search, the hedge fund manager is able to find a second hedge fund manager who is willing to sell him a credit default swap on the same bonds at a spread of only 2 percent. This means the hedge fund manager, who now has a risk burden of $10 million after selling his credit default swap, can transfer—or net out—his risk to someone else by buying a credit default swap that costs him $200,000 ($10,000,000 x 0.02 = $200,000) per year.

The first hedge fund manager is jumping for joy at this point. In theory, he is no longer exposed to any risk, and he gets to keep $100,000 each year. Remember, the hedge fund manager receives $300,000 each year from the investor to whom he sold the credit default swap, and he only has to pay $200,000 each year to the investor from whom he bought the credit default swap—leaving him with a $100,000 ($300,000 – $200,000 = $100,000) profit. Sounds pretty good, doesn’t it? This hedge fund manager just made a 10 percent return for his fund ($100,000 ÷ $1,000,000 = 10%) by doing nothing more than negotiating two credit default swap contracts.

To review things up to this point, let’s take a look at each person’s position in this chain:

– The bond investor owns $10 million worth of bonds and is paying $300,000 per year for insurance on those bonds via a credit default swap

– The hedge fund manager has $10 million in exposure but also receives $300,000 per year for the credit default swap he sold. Plus, he is paying $200,000 per year for another credit default swap to offset the risk he has taken on by selling a credit default swap.

– The second hedge fund manager has $10 million in exposure but also receives $200,000 per year.

Problems with Netting

Netting seems to have worked well for our hedge fund manager in this example. He is making money and appears to have offset his risk. However, what if the second hedge fund manager decides he wants to net out his risk and finds a third hedge fund manager to buy a credit default swap from. Now imagine that the third hedge fund manager does the same thing—and on and on the chain goes. Pretty soon, hundreds of investors and speculators are connected in the huge chain, or net, of credit default buyers and sellers.

Here’s where it gets tricky. Now that everyone in the chain is connected, if anyone at any point in the chain ends up defaulting, it could bring the entire chain down. For instance, if the company that issued the bonds in our example defaults on those bonds, the bond investor is going to go to the first hedge fund manager and ask for $10 million. At that point, the first hedge fund manager is going to go to the second hedge fund manager and ask him for $10 million. If the second hedge fund manager defaults on his credit default swap, the first hedge fund manager will be forced to default on his credit default sway and the bond investor will be left with no coverage for his bonds—even though he has been paying for that coverage.

The credit default swap market is so interconnected that disruptions in any part of it could cause ripple effects throughout the entire system.