The 800 Pound Gorilla - Credit Default Swaps

With credit markets frozen, the equity markets down close to 40% for the year, and looming unemployement and bank troubles, one can easily say that we are in a very troubling economic situation. Over the past two weeks we have seen companies in distress being bailed out by the Government, not only in this country but across the globe. I have heard many debate as to whether a bail out is correct. Should we be using tax payer money to prop up these struggling companies. Maybe we should let them fail, after all capitalism is (in the timeless words of Gordon Gekko) a "do it right or you get eliminated" system.

The reason why a bailout is necessary and the reason why the Government understands that we cannot let these banks and insurance companies and major corporations go under is because of the 800 pound gorilla that is out there that people talk about in hushed, nervous tones; the Credit Default Swaps or CDO's. Now before I get into the not so easy business of explaining what they are let me just say that this problem is HUGE with a capital H. It is a total house of cards or even a pyramid scheme and once any of the cards are removed the whole tower will come tumbling down. Credit default swaps, I believe, is the real reason why we cannot allow for a massive failure, in particular a company that is holding a great deal of these securities such as AIG, AMBAC, and all the major US banks. If one goes, it will start a panic in the credit default markets, one that we cannot cover because this market is larger than the GLOBAL GDP and is in the trillions of dollars!

What is a Credit Default Swap?
Credit default swaps are insurance-like contracts that promise to cover losses on certain securities or bonds in the event of a default. They typically apply to municipal bonds, corporate debt like a bond from Ford Motor Co., and mortgage securities like the ones that are in distress all over the country. CDS's are sold by banks, hedge funds and others.

The buyer of the credit default insurance pays premiums (just like car or home insurance) over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft. So for example, lets say I am an investor and I bought a Ford Motor Co. Bond for 1 million dollars that gives a return of say 8%. I then, want to hedge my investment, or reduce some of the risk so I take out an insurance policy on my investment that says in the event of a default (meaning Ford Motor Co. cannot pay me my money I lent them by buying their bond) you will pay me my money back, and for this I pay a premium just like any other insurance policy. Easy money for banks or insurance companies during good times since the risk for a default is minimal but the premiums are good money coming in! Just like an insurance policy...

Except that it doesn't work like an ordinary insurance policy because banks and insurance companies are regulated; the credit swaps market is not. As a result, these policies or contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security or bond defaults. The instruments can be bought and sold from both ends — the insured and the insurer. So when times are good and there is no real threat of a default, who cares, people put out these policies, get the premiums then make a market in these policies by selling them, swapping or trading them for money or other securities, great. EXCEPT, nobody was checking to see if the people now holding these credit default swap contracts actually had the money to pay in case of a real default.

Now, fast forward to 2007 /2008 / 2009, where mortgages are going bad, the economy is in the crapper and the possibility of corporate defaults are real. So what is happening. People are looking at their credit default contracts and are realizing they might actually have to come up with the money to pay if these companies or mortgages go under. But we do not know if they have that money or not since these contracts have been traded sometimes 15 to 20 times!

Sooo...
#1 the value of the credit default swap drops because nobody wants to trade them anymore, now banks and others holding this product need to take hits on their balance sheets and write off their value
#2 the people who thought they were insured realize they might not be and are very nervous
#3 people do not want to buy bonds anymore because they cannot get insurance to hedge anymore, so lending slows and when lending slows, growth slows, the economy slows, jobs disappear and on and on...

So how big is this problem? It is Enormous. Check out the numbers below that I got off the internet:

Commercial banks are among the most active in this market, with the top 25 banks holding more than $13 trillion in credit default swaps in the U.S. alone— where they acted as either the insured or insurer — at the end of the third quarter of 2007, according to the Comptroller of the Currency, a federal banking regulator. JP Morgan Chase, Citibank, Bank of America and Wachovia were ranked among the top four most active, it said. The Bank for International Settlements reported the notional amount on outstanding OTC credit default swaps to be $42.6 trillion in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). By the end of 2007 there were an estimated $45 trillion to $62.2 trillion worth of credit default swap contracts outstanding worldwide. Can you believe these numbers?

On September 23, 2008, Christopher Cox, Chairman of the U.S. Securities and Exchange Commission, placed the worldwide Credit Default Swap market at $58 trillion, and stated it was "completely lacking in transparency and completely unregulated." The U.S. Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from reporting banks to be $16.4 trillion at the end of March 2008. (For reference and perspective, the U.S. GDP for 2007 was $13.8 trillion, while the world's GDP for 2007 was estimated at $54.3 trillion).

Warren Buffet, considered America's smartest investor described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire's annual report to shareholders in 2002, he said, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. 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 (or sometimes, so it seems, madmen)."

The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name is vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and there may be $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion.It acts like 'insurance' but isn't. "It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap'.

Unfortunately, although defaults are rare they tend to occur at the same time and are usually highest during recessions. In order to ensure that a hedge fund or other company had sufficient funds to meet payouts, in the past they would need to put aside sufficient funds to cover an average of at least 2.6% defaults per year. A more conservative investor might put aside enough to cover defaults of 5%. However the more capital a fund puts aside to cover losses, the lower the potential returns because they cant use their money to invest and get higher returns. This encourages funds to use as little capital as possible. However in recessions defaults can climb much higher than 5%. With insufficient provisioning many financial institutions could fail.

According to Moodys, defaults could exceed 10% in 2009 in the event of a US recession. Now we all know that a recession is here already so if companies have not adequately provisioned for much higher defaults, then many such financial firms will fail. As the credit default swap market is not regulated, there is no offical body ensuring that sufficient capital is being put aside to cover potential losses. This increases the possibility of a failure of a large market counterparty and causing a systemic failure that can potenially bring down the whole US and even global economy. Am I sounding alarmist? I hope so because this is a real live problem that is out there. This 800 pound gorilla needs to be deal this NOW because if the CDS market starts to unravel, combined with the already severe Sub prime crisis we are facing, we would be in for a "perfect Storm" the like of which we have not seen since the Great Depression.

A meltdown in the CDS market has potentially even wider ramifications nationwide than the subprime crisis. If bond insurance disappears or becomes too costly, lenders will become even more cautious about making loans, and this could impact everyone from mortgage-seekers to municipalities that need money to fix roads and build schools.

Go online and enter Credit Default Swaps and read about this totally over leveraged, unregulated powder keg that is just sitting out there. There is a ton of discussion on the Sub Prime issues and how to deal with them, but in my view, this needs to be put front and center and a solution needs to be found asap before this unravelled and spirals out of our control.

I welcome your comments as always,

Addendum: Funny how I finished this article last night and today, Reuters wrote a story about how the NY State Attorney General's office is launching a probe into the illegality of Credit Default Swaps; see link below:

http://www.reuters.com/article/topNews/idUSTRE49J1GC20081020?feedType=RSS&feedName=topNews

OSO

Note: Information for this post was taken from:
Wikipedia
Investopedia
Time.com
Some of the above was paraphrased and posted directly from those sites.