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Counterparty Risk Trumps Fiscal Stimulus


CDS trades are perpetuating the fear that bad subprime debt may rupture the $500 trillion market for financial derivatives.

Yesterday's market sell-off was indiscriminate, with all 30 Dow components falling and major indices blowing through all sorts of key support levels. While many were looking to Fed Chairman Bernanke's testimony on capital hill for an upside catalyst, an esoteric segment of the market for financial derivatives rattled the already beleaguered financial complex.

Credit rating agencies Moody's (MCO) and Standard and Poor's announced they were reviewing the two largest financial insurance companies, Ambac Financial (ABK) and MBIA (MBI) for possible ratings downgrades. Ambac and MBIA guarantee corporate, municipal and structured credit, relying on their AAA ratings to support insurance contracts sold to owners of debt.

Despite recent efforts by these so-called "mono-line insurers" to raise capital and strengthen their highly levered balance sheets, concerns have mounted over their ability to survive exposure to structured financial products tied to subprime mortgages. And while these firms may be small in comparison to the rest of the financial markets, the implications of Ambac and MBIA's potential collapse are significant.

Of the many ways financial firms hedge exposure to debt positions, one is through the use of Credit Default Swaps, or CDS. The WSJ estimates the CDS market to be around $45 trillion, or equivalent to the money on deposit in the world's banking system. CDS allow debt owners to offload part or all of the risk of default, whether by a corporation, state government, or subprime borrower.

Counterparty risk and the maze of paperwork required to unwind complex and poorly document CDS trades are perpetuating the fear on Wall Street that the relatively small nominal amount of bad subprime debt may rupture the $500 trillion market for financial derivatives.

The CDS market is largely unregulated, and as long as a firm can find a counter-party to take the other side of their position, a hastily thrown together contract is all that's required to write a contract. It's sort of like that guy in the office who will take the other side of any bet: you're not quite sure if he'll pay, but at least there's a chance you'll see your money on Monday. And therein lies the problem.

Wall Street firms like Merrill Lynch (MER) – who yesterday wrote down $3.1 billion on debt securities it had hedged through the now defunct bond insurance firm ACA Financial – are worried their counterparties in various hedging transactions may not show up to honor their side of the bet.

Market participants, even many wary of the longer-term expansion of our debt-laden economy, are looking for this morning's strong open to stick and provide a near-term rally. However, as mortgage delinquencies accelerate and recession fears increase the likelihood of increased corporate defaults, the market for CDS may be wise to settle in for a rough ride.
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