Friday, 10 October 2008

Credit Default Swaps Weapons of Financial Mass Destruction

By Gary Dorsch

The latest downward spiral in the global commodity and stock markets, coinciding with several high profile bank failures, is conjuring up fears of the calamities of the Great Depression of the 1930's. European and Asian stock markets are plunging as terror and panic hits Wall Street. The US Congress finally passed a massive $700 billion rescue package to unclog the credit markets, yet US stock markets have continued to plummet, shedding $1.5-trillion in value last week.

Hindsight is the best sight, but the chaos gripping the markets started with US Treasury's reckless decision to allow Lehman Brothers (LEH) to fail, which set-off an unstoppable chain reaction that unleashed a torrent of panic selling on global stock markets, and froze the European and US banking systems. LEH left its creditors holding $150 billion of near worthless bonds, and common and preferred shareholders were completely wiped out. “Until the day they put me in the ground I will wonder, why we were the only one that was not rescued,” former Lehman chief Larry Fuld told Congress on Oct 7 th .

However, there were also huge losses for companies who wrote credit protection on LEH's bonds over the past five-years. Those sellers of credit protection are now staring down the barrel of billions of dollars in claims, and are scrambling to raise money by selling anything they can get their hands on, including commodities and stocks. Warren Buffet has referred to these credit defaults swaps CDS's, as “weapons of financial mass destruction,” and the fuse on the time-bomb has been lit.

Many financial companies are on the hook for risky credit-default swaps, or private contracts that let firms bet in a completely unregulated market, on whether a borrower is going to default. When a bond default occurs, one party pays off the other for the principal amount. However, in an unregulated market, no one knows which bank issued these swaps. For OTC contacts, buyers of insurance rely on the counterparty to make good on their promises. Ominously, c redit-default swaps have mushroomed to $55 trillion today, up from $144 billion a decade ago.

In contrast to the clandestine world of OTC trading, the Chicago Board of Trade launched a cash-settled and highly transparent credit default swap contract in June 2007, with the ticker “CX,” tracking the top-50 North American Investment Grade Bond Index. Hedge funds were particularly fond of selling these CDS contracts, when corporate defaults were at record lows over the past few years. That made selling CDS contracts a very profitable endeavor.

However, with the meltdown in the S&P financial sector, XLF, the CDS insurance for top investment grade companies at the CBoT has risen 50% in the past four weeks to around $363,000 per contract, reflecting the heightened risks from a sharp downturn in the US and global economy. Elsewhere, average high-grade corporate bond spreads hit an all-time high of 510 basis points over Treasuries this week, while junk spreads reached a record 1,300 basis points. Worse yet, the cost to insure $10 million of Morgan Stanley's 5-year bonds is $1.9 million plus $500,000 a year.

AIG, formerly the world's largest insurance company, had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products. Last year, when sub-prime mortgage delinquencies triggered default swaps that AIG had insured, the firm was forced to book large write-downs. That spooked investors, who reacted by dumping its shares, and made it impossible for AIG to raise the capital it needed to survive. Without a Fed rescue for AIG, the CDS nuclear bomb would have exploded.

The New York Fed is aiming to rein-in the nuclear CDS market, by establishing a centralized credit default swap market with the Chicago Mercantile Exchange and London 's Intercontinental Exchange. The LEH bankruptcy has revived calls to move CDS trading onto an exchange trading floor, to remove the system risk posed by a counterparty failure, provide greater price transparency and offer simpler, more standardized settlement of contracts when an issuer defaults.

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