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"Credit Default Swaps" Next Domino of The Global Credit Crunch?

The increasingly large dark cloud looming on the financial markets horizon is the threat of Credit Default Swaps (CDS) derivatives risk, which is likely to dwarf the sub-prime crisis when in full play. The global market for CDSs has rocketed over the past four years as they have been widely utilised by the thinly capitalised off-balance sheet vehicles created and/or utilised by large financial institutions -- banks, insurance and reinsurance groups, hedge and investment funds. The total amount of outstanding CDS derivatives' trades worldwide is notionally USD 46 trillion. This CDS market dwarfs the markets in US stocks (USD 22 trillion), mortgage securities (USD 7 trillion) and US treasuries (4.5 trillion).

Credit Default Swaps (CDSs) are instruments used for loans and bonds, and effectively act as an insurance policy on corporate debt. The trades also allow speculation on a company's ability to repay the debt. Credit default swaps is an area where both counterparty risk is opaque and the insurance in some cases has become increasingly impaired. CDSs have been widely used by the thinly capitalised off-balance sheet vehicles created and/or utilised by financial institutions over the past few years, and so these could struggle to find the money required if the derivative contracts are triggered, creating so-called counterparty risk for those expecting to be paid.

Large financial institutions releasing results are now provisioning for credit default swaps exposure, often linked to troubled bond insurers, alongside sub-prime mortgage debt instruments. Financial institutions have become major players in the credit default swap market over the last few years and problematic exposure is beginning to unravel step-by-step with acceleration.

Bond insurers that started insuring more complex products like credit default swaps and collateralised debt obligations have been hard hit by the falling value of those products. Often a financial institution's deal involves buying a credit default swap (CDS) and then selling it on to another for a small fee. The trade can come undone due to the downgrading of the bond insurer, which is the counterparty risk. Once the counterparty gets into difficulty, the financial institution faces a credit-risk event because it must now insure a big group of companies' bond issues. Typically, it would only lose money if around 20% of those companies fail to pay interest on the bond. Investment banks are now carefully scrutinising their own and other banks' exposure to CDSs as they are relatively untested instruments through a protracted downturn, which is anticipated.

In a complete reversal of historic norms, European financial institutions' -- primarily banks' -- credit default swaps, a good indicator of funding costs, are now trading in aggregate at higher spreads than the Continent's blue-chip corporate borrowers. Many banks are now unable to obtain funding at rates that would allow them to profitably lend to their higher-quality clients. And while the European Central Bank's (ECB) willingness to provide banks short-term funding against loans they are stuck with has helped to avoid an out-and-out disaster, it too leaves "deposit-taking loan-extending" traditional banks with an unworkable business model as they become increasingly unwilling to extend new credits or take on extra risk.

So far, few CDS contracts have been triggered because corporate defaults have been rare. But debt agencies expect the worldwide default rate for junk-rated firms to jump this year from 0.9% to just under 5% -- the historical average -- as the economy weakens. The overall corporate-insolvency rate (encompassing investment-grade and junk debt) is set to return to a historically typical 1.25%. That would trigger around USD 500 billion in default insurance, however, whether the payments will be made is a matter of solvency.

For example, the risk of Asia Pacific corporates and governments defaulting on their debt has risen recently on concern that a proposal to split US bond insurers may spark further credit losses, credit-default swaps show. Over the past couple of days, the Markit iTraxx Asia Index of 20 high-risk, high-yield borrowers increased by 19 basis points to 580 basis points. There are worries about the credit contagion from the US sub-prime and monoline insurance groups spreading to CDSs and beyond.

Since the credit-default swap indices are benchmarks for protecting debt against default, traders have been increasingly utilising them to speculate on shifts in credit quality. A basis point, or 0.01%, is typically equivalent to USD 1,000 on a credit default swap that protects USD 10 million of debt from default, a leveraged protection of 10,000 times. The contracts were originally developed to protect bondholders by paying the buyer face value in exchange for the underlying securities should the borrower default but were not envisaged to become massive engines of speculation themselves. This massive speculative element with CDS derivatives also creates a "Weapon of Mass Destruction" WMD effect in the financial world with unintended and unenvisaged consequences.

Rising turmoil in the Credit Default Swap market could result in a much greater financial crisis in 2008/2009 than that caused by the sub-prime crisis in late 2007. The victims may not just be banks and hedge funds but also insurance and reinsurance companies and the financial arms of many industrials and manufacturers heavily involved in CDS speculation and trades.

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