Credit-Default Swaps

To those of you foolish enough to believe that the economy has any chance of near term recovery, I wish to introduce Credit-Default Swaps. They are unregulated insurance derivatives totaling as much as the subprime mess and the rates are starting to skyrocket, meaning the holders have to pay up.

From the WSJ:

This isn't like life insurance or homeowners' insurance, which states regulate closely. It consists of financial contracts called credit-default swaps, in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast: about $45 trillion, a number comparable to all of the deposits in banks around the world...

This market poses challenges for would-be regulators. It isn't clear, for instance, how securities laws on fraud and insider trading would apply to credit-default swaps, because it's not clear in what way they are even securities; they are private contracts...

The market for swaps has grown fivefold just since 2004. It has no publicly posted prices; the contracts are sold privately among dealers. The market began 12 years ago with insurance against defaults on corporate bonds, expanding in 2005 to mortgage securities...

As long as ACA kept its single-A rating, the banks didn't require ACA to post collateral even if the securities it insured slipped in value. It's different if a hedge fund, which doesn't have a credit rating, is selling the insurance. In that case, each time the security insured falls in value, the hedge fund may be asked to put up more collateral...

A tiny hedge fund sold a swap to a unit of Wachovia Corp. this spring and faced repeated demands for more collateral as the subprime market slid. The fund, CDO Plus Master Fund Ltd., says in a suit in New York federal court that it insured a $10 million security, but Wachovia eventually demanded more than $10 million of collateral -- even as the security's value dwindled. Wachovia called the suit "without merit..."

Bill Gross, chief investment officer at Allianz SE's Pacific Investment Management Co, or Pimco, recently told investors that if defaults in investment-grade and junk corporate bonds this year approach historical norms of 1.25% (versus a mere 0.5% in 2007), sellers of default insurance on such bonds could face losses of $250 billion on the contracts. That, he said, would equal the losses some expect in the subprime-mortgage arena.

From Bloomberg:

It still costs more to take out insurance against default for one year even after New York-based Citigroup Inc., the largest U.S. bank, obtained $14.5 billion yesterday to shore up depleted capital. Lenders hold more than $200 billion of bonds and loans used to finance leveraged buyouts that they can't sell and are falling in value, based on data compiled by JPMorgan Chase & Co...

The market for credit-default swaps is the fastest growing among derivatives. It expanded to cover $45.5 trillion in debt at the end of June, up from $632 billion six years earlier, according to the International Swaps and Derivatives Association in New York.

From Bloomberg:

Without new money, New York-based Ambac risks losing the top ranking it depends on to sell bond insurance. Ambac, the second- largest financial guarantor, may have to stop writing insurance or sell itself, said Robert Haines, an analyst at CreditSights Inc., a bond research firm in New York...

Prices for credit-default swaps that pay investors if Armonk, New York-based MBIA or Ambac can't meet their debt obligations imply a 73 percent chance the companies will default in the next five years, according to a JPMorgan Chase & Co. valuation model.

From Steven Pearlstein at WaPo:

Now we're entering a new stage: Panic. Hedge funds scrambling to actually hedge their positions. Central banks throwing money at money-center banks. Huge financial institutions raising capital from foreign investors on concessionary terms. Gold prices heading toward $1,000 an ounce, with record lows on the dollar.

The most eye-popping figuring in this week's report from Citigroup wasn't the $18-billion in write-downs on its subprime mortgage investments, but the $5.2-billion reserve it was setting aside for losses on its vanilla-variety home equity loans, auto loans and credit card loans.

And just as with the subprime, companies will begin to sheeplishly show their participation and begin the write downs.

This reminds me that a group of my customers - insurance companies - were meeting at the beach. A Wachovia rep gave a presentation and assured the group that the bank was free of exposure. Before the rascal could arrive back home, Wachovia made him a liar.

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