Credit Default Swaps: Danger Passing?

The amount outstanding has fallen 25%. Exchanges are creating more transparent ways to trade them. Are we finally getting a handle on these derivatives?

Tick. Tick. Tick. That's the sound of the credit-default-swap time bomb counting down to financial Armageddon, if the critics of the now-famous financial derivatives are to be believed. Designed to insure bondholders against losses from issuer defaults, credit default swaps have been largely invisible, untraceable, and unchecked for nearly three decades. That opaqueness is adding to the uncertainty in the market, an environment that has banks hoarding cash and refusing to lend.

But as the world waits breathlessly for the blow-up, something strange is happening: Recent news reports and data on CDS seem to suggest that banks and securities dealers may be getting a handle on the situation.

For starters, the International Swaps & Derivatives Assn. (ISDA), an industry trade group, announced on Oct. 31 that $25 trillion in notional value—the face amount of the debt insured by the instruments—has been eliminated from the CDS market since the beginning of the year. That brings the total down to $46.95 trillion. (The number does not include new trades since July 1, 2008.) That's a 25% decline from the market's $62.2 trillion peak, meaning that CDS investors have fewer open contracts on the market.

Greater Transparency Ahead

At the same time, the Depository Trust & Clearing Corp., which collects credit-default-swap data, announced on Oct. 31 that it will begin releasing market information weekly, including trading volume.

While it's a far cry from the transparency we're used to in the equity markets, this kind of information has been sorely lacking in the CDS market. The resulting murkiness contributed to fears about companies' CDS exposure, especially after the government bailout of American International Group (AIG). The added info will give everyone, including the general public, a better understanding of what's happening in the market.

Another nettlesome feature of CDS is also being addressed: the lack of a centralized place to clear trades. Today, credit default swaps are simply contracts between two parties. If one party can't pay up, then the other is just out of luck. Regulators, however, continue to push for a central clearinghouse, which would provide money-back guarantees in case one party goes belly-up.

Reducing Counterparty Risk

When you conduct business with a clearinghouse acting as a counterparty, "you don't have to worry whether the person you're trading with goes bankrupt," says Joe Kinahan, chief derivatives strategist at online brokerage thinkorswim (SWIM). Proposals for clearinghouses from the Chicago Mercantile Exchange, the Intercontinental Exchange (ICE), Eurex, and NYSE Euronext (NYX) were to have been submitted to the U.S. Treasury Dept. on Oct. 31. These proposals, Treasury says, will ultimately make counterparty risk—the risk that the other side of the CDS contract will be unable to pay up—a thing of the past.

So, is it time to stop worrying and heed the advice of those who tell us the crisis is past? Not quite.

Let's start with that pesky notional number. At $46.95 trillion, it's enormous. And it's what everyone focuses on, partially because in the muddy informational waters of CDS, it's all we have. Beginning Nov. 4, the Depository Trust & Clearing Corp. will begin breaking down the notional amounts of CDS outstanding by index and company for the first time. This will give interested parties a better sense of what's actually happening in the marketplace.

Is Risk Exaggerated?

ISDA and others have long insisted, and continue to insist, that the notional amount, that $46.95 trillion, is not the amount that's actually at risk.

Said Robert Pickel, ISDA's chief executive officer, in an Oct. 31 press release: "Notional outstandings…tend to give an exaggerated impression of amounts at risk."

And most experts agree. "The changes in that number are interesting," says Robert Claasen, chair of the derivatives and structured products group at international law firm Paul Hastings. "But as a sign of risk, it's pretty meaningless."

That's why regulators and industry players are pushing for a central clearinghouse. But it's unclear whether all credit default swaps would make the move. One appeal of these deals is that the terms and conditions can be endlessly modified to protect against just about any risk. Stocks, bonds, and even exchange-traded options are far more generic, and contain fairly standard terms. Only plain-vanilla swaps that could be standardized in a similar manner to futures and options could be traded through a clearinghouse.

Outstanding Contracts May be Excluded

"You'll have a bifurcated market place going forward," says Andy Nybo, a senior strategist at the Tabb Group. "Anything that can be standardized and cleared through a central clearinghouse will gravitate to that. Once we get through this crisis, you'll see the over-the-counter market [for nonstandardized CDS] come back to life."

But even if new trades do migrate to a clearinghouse, it's unclear whether already outstanding CDS contracts will join them, and those may house the biggest risk. Three years ago, when credit was cheap, banks and hedge funds could sell the "insurance" promised by CDS and collect their premiums, for example, $100,000 for insurance on $10 million of Lehman Brothers debt. It seemed like easy money—most sellers of Lehman CDS assumed the Wall Street stalwart would never default and they'd never have to pay up.

Fast forward to the present. Lehman went belly-up and sellers of insurance on that particular CDS trade must hand over more than $9 million to the insured. That wouldn't be so bad if Lehman was the only company going bust, but in a recession, default rates can hit 18% of outstanding corporate bonds. That's a lot of insurance to pay, and most companies haven't put money aside to cover the cost.

Some estimate that companies could be on the hook for trillions in losses. "Unwinding the credit-default- swap market will suck all the liquidity out of the [financial] system," says Chris Whalen, a risk manager at Institutional Risk Analytics. "It dwarfs the bailout by comparison."

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