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Credit Default Swaps: The Next Subprime?

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Today's must-read story is Bloomberg's David Evans on counterparty risk in the credit default swap market. The credit default swap market is the focal point for a lot of fear these days. It's lightly regulated, non-transparent and there's thought to be lots of trading on inside information in the market. Rising defaults, particularly in riskier so-called "high yield" debt (also known as "junk bonds"), now has many people worried that credit default swap market could be worse than subprime. Yves Smith describes it as "a disaster in the making."

The credit-default-swap market has been untested until now because there's been a steady decline in global default rates in high-yield debt since 2002. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody's Investors Service.

Since then, defaults globally have dropped to 1.5 percent, as of March. The rating companies say the tide is turning on defaults.

Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002.

Many large institutional investors and banks have bought credit default swaps from counter-parties, often hedge funds, without adequate knowledge of financial position of the seller. Many sellers might be unable to pay, particularly if defaults cascade, with many coming at once. When defaults ramp up and those investors try to collect on the insurance policies they bought, they are likely to discover that many investors cannot afford to pay.
Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, estimates that hedge funds that will be unable to pay banks for credit default swaps tied to at least $35 billion in defaults. That's his conservative estimate. He also says the uncollectables could go as high as $150 billion.
That's pretty scary, we'll agree. Of course, there has been a lot of fear and loathing about credit default swaps for quite some time. Not too long ago the complaint was that the lack of transparency was creating opportunities for insider trading. Evans' story is admirable because it ties the risks of the CDS with the media's favorite financial villain, hedge funds. With all the losses coming from Wall Street titans like Bear and Citi, it's been hard to blame the hedge funds for creating "systemic risk." But it looks like that trade is back on.
Also, we can't talk about credit default swaps without remembering our favorite version of the old "you have two cows" joke.

Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults