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Defaults Threaten CDS


Counterparty risk could force more writedowns.

Credit Default Swap contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. If the seller of protection is unable to perform, the buyer obtains no protection.

Currently, a significant proportion of protection sellers is financial guarantors - monoline insurers like MBIA (MBI) and Ambac (ABK) - and hedge funds. Concerns about the credit standing of monolines are well documented. Recently, a number of banks took charges against counterparty risk on hedges with financial guarantors including Merrill Lynch (MER) at $3.1 billion, Canadian Imperial Bank of Commerce (CM) at $2 billion and Calyon with $1.7 billion.

For hedge funds, the CDS is marked-to-market daily and any gain or loss is covered by collateral (cash or high quality securities) to minimize performance risk. If there is a failure to meet a margin call, the position must be closed out and the collateral applied against the loss. In practice, banks may not be willing or able to close out positions where collateral isn't posted.

ACA Financial Guaranty sold protection totaling $69 billion while having capital resources of around $425 million. When ACA was downgraded below "A" credit rating, it was required to post collateral of around $ 1.7 billion. ACA was unable to meet this requirement. The banks have agreed to a "forbearance agreement" whereby the buyer of protection waived the right to collateral temporarily. ACA subsequently has been downgraded to "CCC," reducing the value of the CDS contract and the protection offered. The problems at ACA are not unique.

A critical element is the level of over-collateralization. The buyer of protection will want an initial margin to cover the risk of a change in the value of the contract and the failure by the seller of protection to meet a margin call. The seller of protection wants to increase leverage by reducing the amount of cash it must post as initial margin. It is possible that the level of initial collateral may prove be too low. Collateral models use historical volatility and correlation that may underestimate the risk. The entire process also assumes liquidity in the underlying CDS market that may be absent in a crisis.

CDS contracts entail significant operational risks. Delays in documenting CDS contracts forced regulators to step in requiring banks to confirm trades more promptly. Where collateral is used, there are additional challenges of the accuracy of mark-to-market of CDS and monitoring of collateral.

If the CDS contracts fail then "hedged" banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between $33 billion and $158 billion [Andrea Cicione "Counterparty Risk: A Growing Cause of Concern" (25 January 2008) Credit Portfolio Strategy - BNP Paribas Corporate & Investment Banking.] This compares to the around $110 billion that banks have written off to date. While it may be unlikely that the CDS market will fail entirely it is possible that losses on the hedges will add to the losses that the banks have already incurred.

The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of Lloyds. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance since premiums are received up front. In both cases the risks are both potentially significant and "long tail" – they do not emerge immediately and may take some time to be fully quantified. As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Defaults may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.

Over the last year, securitization and the CDO (collateralised debt obligation) markets have become dysfunctional. As the credit crisis deepens, the risk of actual defaults becomes real. Analysts expect the level of defaults to increase. The CDS market is about to be tested. While there have been a few defaults, the market has not had to cope with a large number of defaults at the same time. CDS contracts may experience problems and may be found wanting.

CDS contracts may not actually improve the overall stability and security of the financial system but create additional risks. As John Kenneth Galbraith's noted of the 1929 stock market crash: "The singular feature… was that the worst continued to worsen".
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