Sub-prime and everything that followed has been pretty bad. However, there seems to be another financial instrument that people refuse to go talk about: Credit Default Swaps.
The estimates on the notional amount, or the total face value, of these contracts ranges from $15 trillion to $54 trillion. An article on the New York Times yesterday estimated the current notional level of CDSs to be at about $30 trillion.
InvestorWords.com defines Credit Default Swaps as follow:
“A specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.”
In general, a credit default swap is an insurance-like financial instrument that can be used to hedge against credit/default risk.
Credit default swaps, like most other derivatives, do not have a good relationship with the media and have been demonized on a regular basis. However, most investors believe that these instruments increase market efficiency and can be highly beneficial if used properly.
So, whats the current problem with this financial instrument?
1. Most of these Credit default swaps were written in a time where Wall Street believed that their party was going to last forever. This means that most CDS sellers probability wrote more contracts than they can currently handle because their risk management models indicated that everything was going to be fine in the upcoming years.
The U.S corporate default rate in 2008 was at around 4% and Moody’s now expects a 15.1% default rate in 2009 (And this number is 45% higher than their prediction in December). Overall, this means that there will probably be more CDS payouts in 2009 than anyone had expected.
2. This higher default rate leads to the second problem which is the under-capitalization of the institutions selling these CDS contracts. This derives from the fact that the CDS market is not regulated and many institutions were able to write unlimited contracts and sometimes with no need to post collateral. This leads to the expectation that many CDS sellers may not be able to honor their contracts. In a $30 trillion market, a high amount of these events could freeze up markets and create a disaster.
3. The last problem is the systemic risk in the CDS market coming from a major counterparty default. Many experts say that the $30 trillion notional amount of the CDS market is not a problem because there are many offsetting positions (e.g. If I sold and bought a contract against the same third party).
However, what happens if we get another AIG-like collapse?
Now that’s a party.
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