Credit Default Swaps: Next Milestone is this fall
The fall in the market seems unrelenting these days, even a supposed good day today turned bad in the end. It seems to show a common trait of a classic bear market where like a bull market where no bad news can bring it down, no good news can bring it up.
So why am I mentioning more bad news? Because there is always a chance for it to happen. Like the sub-prime debacle, many seem unwilling to accept that such a scenario can happen until logic prevails, when the CDOs were reduced to worthless junk.
The Economist, seems dead on when they report this on Bond Insurers having a hard time maintaining their credit ratings. It looks like they are walking a tightrope on a cliff edge right now.
Bond insurers in effect “lend” their top-notch ratings to lower-quality debt, raising its value in the eyes of investors. Any cut in those ratings may make it impossible for the bond insurers to take on new business and would reduce the value of the securities they have already underwritten. Such cuts are now a distinct possibility because the insurers have underwritten billions of dollars of mortgage-backed securities, including those notorious collateralised-debt obligations (CDOs) that have now gone sour.
On Wednesday Ambac announced a $3.5 billion writedown—as well as the ousting of its chief executive—$1.1 billion of which was related to CDOs. The insurers’ exposure to these and other exotic products is a huge multiple of their flimsy capital bases—and the chances of them having to cover claims has soared as the economy has slowed. Small wonder, then, that their share prices plummeted this week—proving that the market has already decided they no longer deserve such lofty ratings and creating a vicious downwards spiral. Ambac’s falling share price has severely dented it chances of raising fresh capital.
As what Jim Jubak from MSN Money mentioned here:
This has grown to be a huge market: The total value of all CDS contracts is something like $450 trillion. Because buyers and sellers of insurance usually create multiple "policies" as they attempt to control risk, that number includes a lot of duplication. Real exposure, says the Bank for International Settlements, may be only 20% of that, or $90 trillion. Some studies have put the real credit risk at just 6% of the total, or about $27 trillion. That puts the CDS market at somewhere between two and six times the size of the U.S. economy.
The CDS market has been a good place to make money in the past few years because default rates in the junk-bond market have been historically low. The default rate for all junk bonds declined to 1.7% in 2006. That’s the lowest rate since 1996. With defaults that low, sellers were paid insurance premiums but didn’t have to cough up much in return.
But that default rate started to rise in 2007, climbing to 2.6%. And Standard & Poor’s projects the rate will climb to 3.4% by October. At that rate, 56 bonds would go into default in 2008, compared with 14 in 2007.
That level of default isn’t likely to inflict too much damage on the CDS market. The historical rate for defaults by corporate junk bonds has averaged 5% a year since 1980. But the default rate has run as high as 12.7% in previous recessions.
So whats likely to happen? The smart people will use sub-prime debacle as a guide. Not many in this sentiment driven market will think something of this magnitude is not likely to happen. Most likely, if you are holding on to junk bonds, although they are hedged with CDS, you wouldn’t want to stand around holding those bonds. Unfortunately, no one will buy it from you unless they really are out of their brains.
The writers of credit default swap seems to be in a worse situation. Should the underlying company such as General Motors starts having bad cashflow and no liquidity, it will start defaulting and this is when the CDS is activated. All those who bought these insurance would want the CDS writer to pay them the payout. The CDS writer, if it pays out for a few controlled ones within his capacity, will be alright. But when the majority or unanticipated amount starts doing that, then they will have a problem.
The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives, in this case, also amplify it considerably.
Related posts:
- What is a Credit Default Swap?
- Fwah Moment: What your Credit Card number tells you
- Understanding how Predatory Lending works and not fall for it
- GMO’s Jeremy Grantham sees prolonged credit crisis
- Being Addicted to credit cards? Join a support Group!
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