Henry Paulson and Ben Bernanke may be escaping from the precipice of one horrific calamity, only to be breathing a sigh of relief just as an even worse catastrophe looms. The plan to buy distressed mortgage related assets and derivative products, referred to by some as TARP (the Troubled Asset Relief Program) and by others as MOAB (the Mother of All Bailouts), may provide some short term relief to the global financial markets, which perhaps will suffice to head off greater disaster. However, putting aside the concerns raised regarding the wisdom and efficacy of the proposal, the larger question remains as to how to mitigate the threat posed by the still-completely-unregulated $62 trillion credit default swap market.
As discussed in this space before, a credit default swap (CDS) is a swap agreement whereby the holder of debt may purchase protection from a third party against the debt issuer’s default. The seller thereby takes on the credit risk of the issuer, and the buyer replaces the credit risk with counterparty risk. As CDSs have evolved from hedging devices into speculative instruments (buyers making short bets without actually owning the underlying debt), the market has grown exponentially. The perils posed by such rapid growth in an unregulated over the counter market were fast becoming apparent last year. Several months ago, I wrote:
Given both the immense size of the CDS market and how poorly risk in other asset
classes was assessed and priced over the past several years, CDS counterparty
risk is accurately being called the “sword
of Damocles” hanging over the financial services industry. The term
“counterparty risk” will likely soon move alongside “subprime borrower” as a
disquieting addition to the financial lexicon.
Fear of exposure to the CDS market led to the Federal Reserve’s willingness to backstop in part the JP Morgan takeover of Bear Stearns and the rescue of AIG. Lehman Brothers was permitted to fail because its CDS exposure appeared to present less of a systemic threat.
CDS market participants and the International Swaps and Derivatives Association have been working for months to increase transparency and reduce counterparty risk. As of today, there are no standardized settlement procedures, and the market has never been forced to deal with a major default. The obvious need is for the creation of a central exchange. Unfortunately, the development of such a clearing system will probably not be in place until early 2009.
In the meantime, it is anyone’s guess where the major fault lines lie. The bailout of Fannie and Freddie triggered “credit events” under an unprecedented number of CDS contracts – as much as $1.4 trillion by some estimates. However, because the conservatorship effectively assures full payment of the underlying Fannie/Freddie debt, the settlement amounts on the trades (the difference between par and market value that the CDS seller owes to the CDS buyer) should be $0. Accordingly, there will be relatively little economic impact as the major market participants seek to sort this all out.
The financial markets may not be so lucky the next time a company whose debt is the subject of over $1 trillion in CDSs goes into default. If, for instance, one of the Big Three automakers were to seek bankruptcy protection, its bonds will almost certainly be worth substantially less than par, and the settlement amounts owed by CDS sellers to CDS buyers could be overwhelming. While most trades will net out, the failure of a financial institution or hedge fund to make good on its obligations as a protection seller could trigger another financial crisis equal in scope or greater to what has been faced over the past two weeks.
It also gives rise to the even more unsettling possibility that the government may be forced to step in and prevent such a major bankruptcy filing. The perils continue. TARP / MOAB may be just the beginning.