The Incredible Shrinking Credit-Default Swap Market
Five years after almost blowing up the global economy and eight years after making fortunes for Wall Street traders, the credit-default swap market is quietly fading. Rules introduced in the wake of the financial crisis by U.S. and European regulators have led investment banks to withdraw from the market and made trading credit-default swaps and other derivatives more expensive. And with the Federal Reserve keeping interest rates near historic lows, fewer borrowers have defaulted, which means less demand for debt insurance. As a result, outstanding credit-default swaps on individual companies declined by about half, to $13.2 trillion, from 2007 through June 2013, according to the Bank for International Settlements. Dealers once offered $5 billion trades; now $500 million is more typical.
Firms that built their reputations by trading credit-default swaps, such as BlueMountain Capital Management and Saba Capital Management, are struggling to find profitable ways to invest money in the CDS market. Traders at investment banks and hedge funds are abandoning the field for better opportunities. “It did feel like the situation was a bit of a dead end,” says Dmitry Selemir, who left his job trading structured credit at BlueMountain in June to concentrate on Scriggler.com, a website he co-founded to host essays and discussions of ideas. “I found it increasingly difficult to be excited about what I was doing.”
Bankers at JPMorgan Chase invented credit-default swaps in the 1990s as a way for investors to protect themselves against loans going bad: One party makes regular payments to another in return for a guarantee to be made whole if a borrower defaults on its debt. What started as a simple hedging tool evolved into a playground for hedge funds and bank proprietary trading desks to speculate on debt, from corporate bonds to subprime mortgages. Banks packaged and traded indexes of the swaps, then sliced up the indexes and traded the slices. Investors made and lost money as the value of the swaps rose and fell, regardless of any actual defaults. “Derivatives were in the center of the storm” that led to the $182.5 billion government bailout of American International Group in September 2008, one of the largest credit-swap users at the time, the Financial Crisis Inquiry Commission said in its final report in 2011. The next year, CDS trades made by JPMorgan’s Bruno Iksil—the London Whale—ended up costing his bank $6.2 billion.
Investors who once focused on CDS are diversifying in search of better returns. Boaz Weinstein, who founded Saba in 2009, saw money flood in after he outperformed rivals in the CDS market in 2011 amid Europe’s sovereign debt crisis. Later he profited by trading against Iksil. Since 2011 he’s increased his holdings of commercial mortgage bonds and closed-end funds.
BlueMountain co-founder Andrew Feldstein, who helped create the CDS market at JPMorgan, also made money trading against Iksil. Big, profitable opportunities like that one are getting scarce, he says. BlueMountain has been hiring equity traders and putting more money into stocks. The firm has about 60 percent of its assets invested in credit products, down from 80 percent in 2006, according to Feldstein. Trading stocks is not as sexy as big CDS trades, he says, but it isn’t going away anytime soon.
While the market for CDS on the debt for individual companies has shrunk, the use of CDS indexes has grown. Firms such as BlueMountain also got business from banks seeking to sell or unwind CDS portfolios. Most of the swaps the banks hold expire by 2017.
The disappearance of CDS would have only minimal impact on the hedge fund business, according to David Kelly, a former risk manager at JPMorgan who is now director of financial engineering at Calypso Technology. “Nobody’s going to cry about it,” he says. “To feel sorry for them because they don’t have toys to play with—who cares?”