Page 1 of 2 Next up - the credit default swap crisis
By F William Engdahl
While attention has been focussed on the relatively tiny US subprime home
mortgage default crisis as the center of the current financial and credit
crisis impacting the Anglo-Saxon banking world, a far larger problem is now
coming into focus.
Subprime, or high-risk collateralized mortgage obligations (CMOs), are only the
tip of a colossal iceberg of dodgy credits that are beginning to go sour. The
next crisis is already beginning in the US$62 trillion market for credit
default swaps (CDS).
The credit default swap was invented a few years ago by a young Cambridge
University mathematics graduate, Blythe Masters, hired by JP Morgan Chase Bank
in New York and who, fresh from
university, convinced her new bosses to develop the revolutionary new risk
A CDS is a credit derivative or agreement between two counterparties in which
one makes periodic payments to the other and gets a promise of a payoff if a
third party defaults. The first party gets credit protection, a kind of
insurance, and is called the "buyer". The second party gives credit protection
and is called the "seller". The third party, the one that might go bankrupt or
default, is known as the "reference entity". CDSs became staggeringly popular
as credit risks exploded during the past seven years in the United States.
Banks argued that with CDS they could spread risk around the globe.
Credit default swaps resemble an insurance policy as they can be used by debt
owners to hedge, or insure against, a default on a debt. However, because there
is no requirement to actually hold any asset or suffer a loss, credit default
swaps can also be used for speculative purposes.
Warren Buffett once described derivatives bought speculatively as "financial
weapons of mass destruction". In his Berkshire Hathaway annual report to
shareholders he said:
Unless derivatives contracts are collateralized
or guaranteed, their ultimate value depends on the creditworthiness of the
counterparties. 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).
A typical CDO is for a
five-year term. Like many exotic financial products that are extremely complex
and profitable in times of easy credit, when markets reverse, as has been the
case since August 2007, in addition to spreading risk, credit derivatives, in
this case, also amplify risk considerably.
Now the other shoe is about to drop in the $62 trillion CDS market due to
rising junk bond defaults by US corporations as the recession deepens. That
market has long been a disaster in the making. An estimated $1.2 trillion could
be at risk of the nominal $62 trillion in CDOs outstanding, making it far
larger than the subprime market.
A chain reaction of failures in the CDS market could trigger the next global
financial crisis. The market is entirely unregulated, and there are no public
records showing whether sellers have the assets to pay out if a bond defaults.
This so-called counterparty risk is a ticking time bomb. The US Federal Reserve
under the former ultra-permissive chairman, Alan Greenspan, and the US
government's financial regulators allowed the CDS market to develop entirely
without supervision. Greenspan repeatedly testified to skeptical congressmen
that banks are better risk regulators than government bureaucrats.
The Fed bailout of Bear Stearns on March 17 this year was motivated, in part,
by a desire to keep the unknown risks of that bank's credit default swaps from
setting off a global chain reaction that might have brought the financial
system down. The Fed's fear was that because it didn't adequately monitor
counterparty risk in credit-default swaps, it had no idea what might happen.
Thank Greenspan for that. Those counterparties include JPMorgan Chase, the
largest seller and buyer of CDSs.
The Fed does not have supervision to regulate the CDS exposure of investment
banks or hedge funds, both of which are significant CDS issuers. Hedge funds,
for instance, are estimated to have written 31% in CDS protection.
The credit-default-swap market has been mainly untested until now. The default
rate in January 2002, when the swap market was valued at $1.5 trillion, was
10.7%, according to Moody's Investors Service. But Fitch Ratings reported in
July 2007 that 40% of CDS protection sold worldwide was on companies or
securities that are rated below investment grade, up from 8% in 2002.
A surge in corporate defaults will now leave swap buyers trying to collect
hundreds of billions of dollars from their counterparties. This will serve to
complicate the financial crisis, triggering numerous disputes and lawsuits, as
buyers battle sellers over the