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Credit Default Swaps rearing its ugly head once more.

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October 27, 2008 – Comments (0)

Banks and Insurance companies fear Credit Default Swaps rearing its ugly head once more.

Tuesday, 21 October 2008
Meltdown 101: Credit default swaps
Ellen Simon - The Associated Press
http://www.heraldextra.com/content/view/285139/36/  

11The swaps -- which were intended either as insurance on debt or side bets, depending on the buyer -- are completely unregulated, prone to sloppy documentation and traded without a central clearinghouse.
Sound bad? Here's worse: No one knows how big the market is. Estimates range as high as $62 trillion.

Here are some questions and answers about the swaps and the role they've played in the financial crisis.

Q: What are credit default swaps?

A: A credit default swap is a contract, usually between banks, that acts as insurance on debt. Under the contract, the seller, for a fee, agrees to make a payment to the buyer if something bad happens to the debt the buyer has insured with the swaps.

For instance, a bank that holds another bank's bonds could insure those bonds against loss by buying swaps. If a bond held by an investor lost so much value that it was worth only 8 cents on the dollar, the holder of that investor's credit default swap would owe him 92 cents for each dollar covered by the swaps.

A less charitable characterization is that they're side bets on how debt securities will perform, since you don't have to own a security to buy a credit default swap based on its performance. For instance, you can make a bet on the default rate on a subprime mortgages without buying a penny in mortgages. If those mortgages defaulted and were worth 8 cents on the dollar, you'd make 92 cents on each dollar of the mortgages -- the same money you'd collect if you were an actual holder of the debt who'd bought the swap as insurance.

It's not clear how much of the total market falls into each category, but it is widely estimated that far more swaps fall into the "bet" category than the "insurance" category.

Q: What are the risks posed by credit default swaps?

A: The first risk is their sheer size. Writing in Sunday's New York Times, Christopher Cox, chairman of the Securities and Exchange Commission, estimated there were $55 trillion in credit default swaps outstanding, which is larger than the combined gross domestic product of every country on Earth.

By comparison, as of the second half of this year, there was only $6 trillion in outstanding corporate debt and $7.5 trillion in mortgage-backed debt, according to data from New York state's insurance regulator.

Since the market for the swaps is so much larger than the initial loans they were meant to insure, credit default swaps have magnified risk exponentially, compounded every injury the financial markets have suffered.

A compounding risk is the murkiness of the market, thanks to the lack of a central clearinghouse or a regulator.

Think about what stock trading would look like if there were no stock exchanges, no company ever filed an annual report, most trading were done over the phone and each trader entered his trades in pencil in a notebook on his desk, which no one outside his firm ever saw.

"You would think that Wall Street would have computerized this when the market started taking off a few years ago," The Wall Street Journal wrote in a 2006 article, which detailed what Wall Street firms were doing to police their own credit-default trading.

"But deals were, and often still are, done by telephone and fax. Detailed confirmations, important in avoiding nettlesome disputes later, weren't completed. One firm confessed in June that it had 18,000 undocumented trades, several thousand of which had been languishing in the back office for more than 90 days."

Q: What role did they play in the financial crisis?

A: They've played more than one role.

The swaps have magnified each crisis, because most of the largest players in finance have bought swaps to protect debt they hold, and have also sold swaps, meaning they could owe money if other banks default.

Also, credit default swaps are secured by the assets of the seller -- the business equivalent of using your home to back a fleet of car loans. So if Bank A sold a hefty amount of swaps on Bank B's debt and Bank B files for bankruptcy, Bank A is suddenly facing a monstrous series of payments -- enough to push it into bankruptcy, too.

"When we were dealing with finding a solution for AIG, we knew the company had written almost half a trillion dollars in swaps, but we had no idea how much swaps had been written on AIG itself or by whom," said Eric Dinallo, superintendent of the New York State Insurance Department, in Senate testimony last week. "That meant we did not know what the broader effect of an AIG bankruptcy would be."

That meant that if AIG -- more formally called American International Group Inc. -- filed for bankruptcy, it would set off tidal waves in financial markets whose size would be completely unpredictable. That's one of the reasons why the federal government lent AIG $85 billion.

After Lehman Brothers Holdings Inc. filed for bankruptcy in September, sellers demanded more collateral on existing swaps. That's sucked away cash that could have been offered up for loans or invested elsewhere -- one of the many factors that helped put credit markets into a coma.

Q: What's the history of credit default swaps?

A: Credit default swaps came into being in the late 1990s, when they were seen as a way to manage risk by transferring it to more than one institution. In 1996, the Office of the Comptroller of the Currency estimated the size of the market was "tens of billions of dollars."

It's grown over the last decade, especially the last two years, as mortgage defaults rose and investors soured on buying pools of mortgages called mortgage-backed securities. Because banks could no longer sell the mortgages, they held them, loading up on credit default swaps to protect themselves against loss. They bought those swaps from other banks, which held mortgages of their own.

This was "a classic case of wrong-way risk because those firms already had significant exposures" to the mortgages, said Delora Jee, a top regulator at the Office for the Comptroller of the Currency, in a speech last week.

Q: Is anyone saying we could just erase all these contracts?

A: Financial commentator Ben Stein has said that's just what the federal government and the New York State government should do. (Most U.S. credit-default swaps are sold in New York.)

"After all, there was no insurable interest in most cases, which tends to void insurance contracts, which is what a CDS (credit-default swap) is," he wrote in a column on Yahoo's financial web site.

Because of the murkiness of the market for credit default swaps, it's hard to know who would take a financial hit if the swaps were erased.

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