Credit Default Swaps–yet another shoe

February 16, 2008

…..that will drop, that is. A fascinating and very readable piece by Gretchen Morgenson in today’s NYT gives the lowdown on systemic risks posed by credit default swaps.

Credit Default Swaps are highly complex derivative securities that, in the simplest of terms, function like insurance contracts created to protect bond owners from default.

If you buy a bond and want protection in case the borrower defaults, you can purchase a credit default swap that promises to pay you back.

The tricky, and very dangerous thing about this market is that is is completely unregulated. In the regular insurance business, insurers are required by law to carry sufficient reserves to cover losses. Sellers of credit default swaps face no such requirements. You, the buyer of a credit default swap, pay premiums to a counterparty who, in the end, may not have the capital to pay you back.

Moreover, CDS sellers can exit their “position” by selling it to another, who can sell it to a third person and so on. It’s entirely possible that you, the buyer of protection, may not even know who’s on the other side of your trade when the underlying issuer defaults and you seek to cash-in your insurance policy. It’s as if State Farm could resell your auto insurance policy to Nationwide, who could sell it to Allstate who could sell it to Geico……none of whom have to inform you that your insurance policy was transfered. If you get in a bad wreck and don’t know who to call, what do you do?

[Insurers can by reinsurance to protect themselves from loss, but they can’t just sell your policy to another company. At least I don’t think they can….again: I’m no expert on insurance.]

To give you an idea of the risk posed by the anonymity of these trades, Morgenson includes this item:

During the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.

Here’s a handy graphic from the Times article that may help you understand the relationships involved (click on it to make it larger):

So far we’ve encountered two big risks with CDS:

  • The complexity/anonymity of the relationships between buyers and sellers
  • The lack of regulations requiring that sellers of protection maintain sufficient capital to pay back buyers of protection in case of default.

Add to this list a third risk, the sheer size of the market, which has grown from $900 billion in 2000 to $45.5 trillion today.

Of that amount, approximately a third provides insurance against a particular corporate debt issuer. Another third provides protection against a basket of bonds. And 16% protect holders of CDOs……

Ominously, this market has never really been tested under stress, what with corporate default rates hovering at record lows for most of the past few years. But CDOs have started to default, exposing the first signs of trouble in the CDS world itself.

Just last week, insurer AIG disclosed “material weaknesses” in the valuation of its CDS portfolio. It seems they hold CDSs that serve as protection against $62 billion worth of CDOs. Turns out their CDS portfolio lost $3.6 billion in November alone.

And now one academic expert predicts junk bond default rates will leap 9-fold to 4.64% in 2008 from a historic low of 0.51% last year. Combined with the continued implosion of mortgage securities, the spike in corporate defaults will put unprecedented stress on the heretofore untested CDS market.

Morgenson gives us a feel for some of the exposures at major Wall Street banks:

Commercial banks are among the biggest participants — at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter.

JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.

Commercial bank capital levels are already under significant strain as writedowns have forced many to seek capital infusions from abroad.

But perhaps a scarier thought is that the other large players in this market tend not to have any spare capital at all. In fact, they tend to be overlevered themselves. Who’s are these other players you ask?

Hedge funds.


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