As Bear Stearns careened toward its eventual fire sale to JPMorgan Chase
last weekend, the cost of protecting its debt, through an instrument called
a credit default swap, began to rise rapidly as investors feared that Bear
would not be good for the money it promised on its bonds. Not familiar with
credit default swaps? Well, we didn’t know much about collateralized debt
obligations either — until they began to undermine the economy. Credit default swaps, once an obscure financial instrument for banks and bondholders, could soon become the eye of the credit hurricane. Fun, huh?
The CDS market exploded over the past decade to more than $45 trillion in
mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market and far exceeds the $7.1 trillion mortgage market
and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior
partner at Weil, Gotshal & Manges. “It could be another — I hate to use the
expression — nail in the coffin,” said Miller, when referring to how this
troubled CDS market could impact the country’s credit crisis.
Credit default swaps are insurance-like contracts that promise to cover
losses on certain securities in the event of a default. They typically apply
to municipal bonds, corporate debt and mortgage securities and are sold by
banks, hedge funds and others. The buyer of the credit default insurance
pays premiums 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.
Except that it doesn’t. Banks and insurance companies are regulated; the
credit swaps market is not. As a result, 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
defaults. The instruments can be bought and sold from both ends — the
insured and the insurer.
All of this makes it tough for banks to value the insurance contracts and
the securities on their books. And it comes at a time when banks are already reeling from write-downs on mortgage-related securities. “These are the same institutions that themselves have either directly or through subsidiaries invested in the subprime market,” said Andrea Pincus, partner at Reed Smith LLP. “They’re suffering losses all over the place,” and now they face potentially more losses from the CDS market.
Indeed, commercial banks are among the most active in this market, with the top 25 banks holding more than $13 trillion in credit default swaps — 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.
Credit default swaps were seen as easy money for banks when they were first
launched more than a decade ago. Reason? The economy was booming and
corporate defaults were few back then, making the swaps a low-risk way to
collect premiums and earn extra cash. The swaps focused primarily on
municipal bonds and corporate debt in the 1990s, not on structured finance
securities. Investors flocked to the swaps in the belief that big
corporations would seldom go bust in such flourishing economic times.
The CDS market then expanded into structured finance, such as CDOs, that
contained pools of mortgages. It also exploded into the secondary market,
where speculative investors, hedge funds and others would buy and sell CDS
instruments from the sidelines without having any direct relationship with
the underlying investment. “They’re betting on whether the investments will
succeed or fail,” said Pincus. “It’s like betting on a sports event. The
game is being played and you’re not playing in the game, but people all over
the country are betting on the outcome.”
But as the economy soured and the subprime credit crunch began expanding
into other credit areas over the past year, CDS investors became jittery.
They wondered if the parties holding the CDS insurance after multiple trades
would have the financial wherewithal to pay up in the event of mass
defaults. “In the past six to eight months, there’s been a deterioration in
market liquidity and the ability to get willing buyers for structured
finance securities,” causing the values of the securities to fall, said Glenn Arden, a partner at Jones Day who heads up the firm’s worldwide securitization practice and New York derivative.
The situation is already taking a toll on insurers, who have been forced to
write down the value of their CDS portfolios. American International Group,
the world’s largest insurer, recently reported the biggest loss in the
company’s history largely due to an $11 billion writedown on its CDS
holdings. Even Swiss Reinsurance Co., the industry’s largest reinsurer,
took CDS writedowns in the fourth quarter and warned of more to come in the
first quarter of 2008.
Monoline bond insurance companies, such as MBIA and Ambac Financial Group
Inc., have been hit the hardest as they scramble to raise capital to cover
possible defaults and to stave off a downgrade from the ratings agencies.
It was this group’s foray out of its traditional municipal bonds and into
mortgage-backed securities that caused the turmoil. A rating downgrade of
the monoline companies could be devastating for banks and others who bought
insurance protection from them to cover their corporate bond exposure.
The situation is exacerbated by the heavy trading volume of the instruments,
the secrecy surrounding the trades, and — most importantly — the lack of
regulation in this insurance contract business. “An original CDS can go through 15 or 20 trades,” said Miller. “So when a default occurs, the so-called insured party or hedged party doesn’t know who’s responsible for making up the default and if that end player has the resources to cure the default.”
Prakash Shimpi, managing principal at Towers Perrin, downplays this risk,
noting that contractual law requires both parties to inform and get approval
from the other before selling the CDS policy to someone else. “These
transactions don’t take place on a handshake,” he said.
Still, being unregulated, there is no standard contract, no standard capital
requirements, and no standard way of valuating securities in these
transactions. As a result, Pincus said she wouldn’t be surprised to see a surge in litigation as defaults start happening. “There’s a
lot of outcry right now for more regulation and more transparency,” said
Pincus.
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. “We’re seeing
players in all of those spaces being more circumspect about whose credit
they’re going to guarantee and what exactly the credit obligation is,” said
Ellen Marshall, partner at Manatt, Phelps & Phillips LLP.
Shimpi admits a meltdown or even a slowdown in the CDS market would affect
the amount and cost of liquidity in the market. However, he dismisses
concerns that municipalities and others seeking capital could be left in the
dust. “Even if the U.S. takes
a hit, there are other markets in the world that have different dynamics, and
capital flows are international,” he said.
Still, most agree the potential repercussions are far-reaching. “It’s the
ripple effects, the domino effects” that are worrisome, said Pincus. “I
think it’s [going to be] one of the next shoes to fall” in the credit
crisis.
Miller said the subprime debacle, rising unemployment, record-high oil
prices, and now CDS market troubles “have all the makings of the perfect
storm…. There are some economists who say this could be another 1929 — but
I don’t believe it,” he said. “We have a lot of safeguards built into the
system that did not exist in 1929 and 1930.” None of them, though, are
directly targeted at CDS.
On Wall Street, innovators are always ahead of regulators. And that can
sometimes have a very steep price.
