naked capitalism

I am sticking my neck out in this post, so if any readers disagree, don’t hesitate to speak up.

We have seen the following over the last few weeks: concern about whether banks that have exposure to subprime can be trusted as counterparties; reports and rumors of losses at hedge funds (at a minimum, stat arb and “event driven” strategies); some less acute concern about banks’ LBO exposures (they will clearly take losses on their hung deals and commitments, and the more distress there is in the credit markets, the longer and probably more costly the resolution).

These conditions should have serious ramifications for the credit default swaps market. CDS are only as good as the credit-worthiness of the protection seller, yet because this is an OTC market with high transaction volume, no one knows how much in CDS any one protection seller has written (and how much might be offset by having purchased offsetting contracts).

The market is considered to have been tested by having survived major defaults, such as Enron and Swissair, although it has never faced a broad-scale credit contraction (the market was much smaller at the time of the Sept. 11 attacks and that period of distress was short-lived). Contract volume has grown explosively, so the market of today is different from that of a few years ago. The British Bankers Association estimated the global volume of CDS as of last September as $20,000 billion. In 2004, a survey by the same group reported outstandings of a mere $8,000 billion. A typical comment:

“The CDS market is huge and has grown tremendously in last few years,” says Han Altink, credit portfolio manager at F&C Asset Management in Amsterdam. “Ninety per cent use CDS rather than actual bonds. It is difficult to have an insight into what is happening in that market and how much leverage has gone with that. For us it’s a black box.”

Personally, I don’t understand how one can buy insurance if you aren’t certain of the creditworthiness of your counterparty (and I don’t mean credit rating, since I doubt the rating agencies pay much heed to how much in CDS a particular bank has outstanding). Moreover, hedge funds have become increasingly active as buyers and sellers of protection.

To the extent that the major hedge funds that have suffered losses were also protection-sellers, it would raise questions about the value of their CDS contracts. Ditto any banks that have credit exposure to structured investment vehicles. And if LBO worries grow, the credit concerns may extend to banks like Citigroup that were major LBO lenders (and oh, BTW, is a leading, if not the leading, CDS trader).

You get the picture. If enough financial players are distrusted as counterparties for routine transactions, one would think at a certain point those worries have to infect the CDS market. And the CDS market has become so central to bank and credit investor activities that an impairment there would have far reaching, perhaps even devastating, consequences.

Could this worry be the real reason the ECB was so fast to intervene?