Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.
Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends — the insured and the insurer.
All of this makes it tough for banks to value the insurance contracts and the securities on their books. And it comes at a time when banks are already reeling from write-downs on mortgage-related securities. "These are the same institutions that themselves have either directly or through subsidiaries invested in the subprime market," said Andrea Pincus, partner at Reed Smith LLP. "They're suffering losses all over the place," and now they face potentially more losses from the CDS market.
Indeed, commercial banks are among the most active in this market, with the top 25 banks holding more than $13 trillion in credit default swaps — where they acted as either the insured or insurer — at the end of the third quarter of 2007, according to the Comptroller of the Currency, a federal banking regulator. JP Morgan Chase, Citibank, Bank of America and Wachovia were ranked among the top four most active, it said.
Credit default swaps were seen as easy money for banks when they were first launched more than a decade ago. Reason? The economy was booming and corporate defaults were few back then, making the swaps a low-risk way to collect premiums and earn extra cash. The swaps focused primarily on municipal bonds and corporate debt in the 1990s, not on structured finance securities. Investors flocked to the swaps in the belief that big corporations would seldom go bust in such flourishing economic times.
The CDS market then expanded into structured finance, such as CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. "They're betting on whether the investments will succeed or fail," said Pincus. "It's like betting on a sports event. The game is being played and you're not playing in the game, but people all over the country are betting on the outcome."
But as the economy soured and the subprime credit crunch began expanding into other credit areas over the past year, CDS investors became jittery. They wondered if the parties holding the CDS insurance after multiple trades would have the financial wherewithal to pay up in the event of mass defaults. "In the past six to eight months, there's been a deterioration in market liquidity and the ability to get willing buyers for structured finance securities," causing the values of the securities to fall, said Glenn Arden, a partner at Jones Day who heads up the firm's worldwide securitization practice and New York derivative.
The situation is already taking a toll on insurers, who have been forced to write down the value of their CDS portfolios. American International Group, the world's largest insurer, recently reported the biggest loss in the company's history largely due to an $11 billion writedown on its CDS holdings. Even Swiss Reinsurance Co., the industry's largest reinsurer, took CDS writedowns in the fourth quarter and warned of more to come in the first quarter of 2008.
Monoline bond insurance companies, such as MBIA and Ambac Financial Group Inc., have been hit the hardest as they scramble to raise capital to cover possible defaults and to stave off a downgrade from the ratings agencies. It was this group's foray out of its traditional municipal bonds and into mortgage-backed securities that caused the turmoil. A rating downgrade of the monoline companies could be devastating for banks and others who bought insurance protection from them to cover their corporate bond exposure.
The situation is exacerbated by the heavy trading volume of the instruments, the secrecy surrounding the trades, and — most importantly — the lack of regulation in this insurance contract business. "An original CDS can go through 15 or 20 trades," said Miller. "So when a default occurs, the so-called insured party or hedged party doesn't know who's responsible for making up the default and if that end player has the resources to cure the default."
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