A number of authors have suggested that credit default swap pricing be used as a basis for setting deposit insurance premiums for banking firms. We re-examine this proposal in this note, the sixth of a semiannual series of reports on credit default swap trading in U.S. bank and bank holding company reference names. This note updates the prior Kamakura Corporation report on credit default swap trading on U.S. banks for the 181 weeks ended December 27, 2013. We find that MBIA Insurance Corporation and Bank of America Corporation were the institutions traded most heavily in the credit default swap market over the 2010 to 2014 period.
This updated report also confirms the conclusions of the five prior reports: that there is trading only in the largest or most troubled bank holding companies in United States and that the credit default swap market does not provide a credible basis for pricing deposit insurance of U.S. banks.
Using data reported by Depository Trust & Clearing Corporation during the 207 weeks ending June 27, 2014, there were credit default swaps traded on only 14 reference names among U.S. banking firms. No new U.S. bank reference names were traded during the last 26 weeks. The 14 traded reference names are given here:
• ALLY FINANCIAL INC. (ALLY)
• AMERICAN EXPRESS COMPANY (AXP)
• BANK OF AMERICA CORPORATION (BAC)
• CAPITAL ONE BANK (USA), NATIONAL ASSOCIATION (COF)
• CAPITAL ONE FINANCIAL CORPORATION (COF)
• CITIGROUP INC. (C)
• CITIGROUP JAPAN HOLDINGS CORP. (C)
• ISTAR FINANCIAL INC. (SFI)
• JPMORGAN CHASE & CO. (JPM)
• MBIA INC. (MBI)
• MBIA INSURANCE CORPORATION (MBI)
• MERRILL LYNCH & CO., INC. (BAC)
• MORGAN STANLEY (MS)
• WELLS FARGO & COMPANY (WFC)
These 14 reference names represent 11 consolidated corporations. We have omitted, somewhat arbitrarily, names like Goldman Sachs (GS), MetLife (MET), and Prudential Financial (PRU) on the grounds that they were not considered banks prior to the financial crisis and that they had the financial strength to weather the crisis without bank holding company status. During the 207 weeks of data on all live trades in the DTCC credit default swap trade warehouse, there were no trades on any other of the 6,730 banks insured by the FDIC in the United States as of March 31, 2014.
Credit default swap trading volume on the 14 firms listed above is based on data from the Depository Trust & Clearing Corporation and calculations by the Kamakura Corporation. We assume that each firm has a percentage of dealer-dealer trades equal to the 72.48% of all trades in the DTCC trade warehouse that were between dealers on January 10, 2014. The trading volume for the 14 reference names is summarized here:
There was an average of only 3.00 non-dealer credit default swap trades per day during the 207 weeks ended June 27, 2014 for the 14 banking entities listed above. None of the banks listed above averaged more than 8 non-dealer trades per day over the 207 week period studied. Five of the 11 firms listed are in a conflict of interest position as major dealers in the credit default swap market: Bank of America, Citigroup, JPMorgan Chase, Morgan Stanley, and Wells Fargo. Dealer-dealer trades made up 72.48% of live trades in the DTCC as of January 10, 2014. The dealers would be setting deposit insurance rates for themselves if credit default swap pricing were used to determine FDIC insurance premiums. The histogram below shows the distribution of the 14 observations on the daily average number of non-dealer trades over the full 207 week period:
There were 14 names x 207 weeks or 2,898 potential observations of credit default swap contract volume on U.S. banks. 2,658 of the observations were non-zero. 240 of these observations, 8.3% of the total, were for zero contracts traded during the week.
Trading Volume for MBIA Insurance Corporation
The largest single week of trading recorded was for 959 contracts, the equivalent of 52.8 non-dealer trades per day during that week. That volume was for MBIA Insurance Corporation during the week ended May 10, 2013. The graph below shows weekly gross trading volume for MBIA Insurance Corporation for the 207 weeks ended June 27, 2014:
The next graph shows the notional principal of credit default swaps traded on MBIA Insurance Corporation from the week ended July 10, 2010 to the present:
Trading volume in the parent company MBIA Inc. is summarized in the chart showing all U.S. bank reference names. Details are available upon request.
Bank of America Corporation
The number of credit default swaps traded on Bank of America Corporation traded during the 207 week period are summarized in this chart:
The total notional principal associated with those trades on Bank of America are shown in the chart below:
Trading volume in Bank of America Corporation subsidiary Merrill Lynch is available upon request.
Analysis of All Weekly Observations
Next we look at all of the individual weekly observations for the 14 reference names over the 207 week period, not just the average of the 207 weeks of data for the 14 firms. The distribution of the daily average non-dealer trades is shown here:
The data in the chart reveals these facts:
- The median number of non-dealer trades per day for these U.S. banks was 2.64 per day over all weekly observations.
- The average number of non-dealer trades per day was 3.56 trades.
- For 75% of the observations, there were 4.73 non-dealer trades per day or less.
- For 95% of the observations, there were 9.90 non-dealer trades per day or less.
- For 99% of the observations, there were 16.90 non-dealer trades per day or less.
Our conclusions from our report on the 181 weeks ended December 27, 2013 remain unchanged. Credit default swaps are not a practical basis for pricing bank deposit insurance for a number of reasons:
- The use of credit default swaps is analytically incorrect as a method of determining the probability of default for any reference name, as pointed out by Robert Jarrow in the Journal of Fixed Income.
- The number of reference names traded over the 207 weeks ended June 27, 2014 is only 14, but 6,730 banks in the United States were insured by the FDIC as of March 31, 2014.
- Almost half of the reference names traded are major dealers in the credit default swap market, so they are in a conflict of interest position.
- There is a risk of collusion that is similar to the risks of collusion in the Libor market, and lawsuits alleging such collusion have been filed by institutional investors in boththe United States and in Europe.
- Credit default swap pricing is affected by the probability of a bail-out of senior debt holders , so CDS pricing understates the true risk of failure for a bank that is “too big to fail.”
Donald R. van Deventer
Honolulu, July 11, 2014