The recent collapse of the mortgage market has been well documented. But subprime collateralized mortgage obligations are only the tip of a colossal iceberg of credit securities that are beginning to go sour. The next crisis could involve the $62 trillion market of credit default swaps.
Credit default swaps (CDS) are credit derivatives or agreements between two parties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection, a kind of insurance, and is called the "buyer." The second party gives credit protection and is called the "seller." The third party, the one that might go bankrupt or default, is known as the "reference entity."
CDS became popular as credit risks exploded during the last seven years in the United States. Banks argued that with CDS they could spread the credit risk.
CDS resemble an insurance policy, as they can be used by debt owners to hedge, or insure, against a default on a debt. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes.
Warren Buffett once described derivatives bought speculatively as "financial weapons of mass destruction." In his Berkshire Hathaway annual report to shareholders he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man."
Like many exotic financial products that are extremely complex and profitable in times of easy credit, when markets reverse, as has been the case since August 2007, in addition to spreading risk, credit derivatives, in this case, alsoamplify risk considerably.
No Regulation
A chain reaction of failures in the CDS market could trigger the next global financial crisis. The market is entirely unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults.
The U.S. Federal Reserve's bailout of Bear Stearns Cos. on Mar. 17 was motivated, in part, by a desire to keep the unknown risks of Bear'sCDS from setting off a global chain reaction that might have brought down the financial system. The Fed's fear was that because they didn't adequately monitor counterparty risk in credit default swaps, they had no idea what might happen.
Those counterparties include J.P. Morgan Chase& Co., the largest seller and buyer of CDS.
The CDS market has been mainly untested until now. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody's Investor Services. But Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide was on companies or securities that are rated below investment grade, up from 8 percent in 2002.
A surge in corporate defaults will now leave swap buyers trying to collect hundreds of billions of dollars from their counterparties. This would complicate the financial crisis, triggering numerous disputes and lawsuits, as buyers battle sellers over the technical definition of default—this requires proving which bond or loan holders weren't paid—and the amount of payment due. Some fear that could, in turn, freeze the financial system.
Experts of the CDS market believe now that the crisis may start with hedge funds unable to pay banks for contracts tied to at least $150 billion in defaults. Banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. However, many of the funds won't have enough cash to meet the banks' demands for more collateral.
The main issue is that sellers of protection aren't required by law to set aside reserves for the debt they have guaranteed. While banks ask protection sellers to put up some money when making the trade, there are no industry standards.
In essence, it is the equivalent of a licensed insurance company selling insurance protection against hurricane damage with no reserves against potential claims.
Basel Worried
The Basel Bank for International Settlements, the supervisory organization for the world's major central banks, is alarmed at the dangers of CDS. The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.
"It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred,'' the report said. "It can be difficult even to quantify the amount of risk that has been transferred.''
Counterparty risk can become complicated in a hurry. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then re-sell the same protection to another bank, and such dealing will continue, sometimes in a circle. Such trades create a huge concentration of risk.
Traders, and even the banks that serve as dealers, don't always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDS, some far more complex than others. More than half of all CDS cover indices of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company's debt or collateralized debt obligations.
Banks usually send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, as there is no regulated exchange to prices the market or to insure against loss. To find the price of a swap on Ford Motor Co. debt, for example, even sophisticated investors might have to search through all of their daily e-mails.
Last year, the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDS. So far, that planhasn't taken off. It has been boycotted by member banks, which prefer to continue their trading privately.
F. William Engdahl is an author that has written on subjects such as politics, economics. He also does work as a consulting economist. For more information on this and many more topics visit his web site at www.engdahl.oilgeopolitics.net.
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