Seeking Alpha
What is your profession? ×
Profile| Send Message|
( followers)

The evaporation of the collateralized loan obligation market may be the other shoe dropping. The risks posed by credit default swaps (CDSs) may be not just the other shoe, but the neutron bomb. The rating cut by S&P of ACA Financial Guaranty Corporation (ACA) (from A to CCC), discussed in this article in yesterday's NY Times, may portend deep trouble.

Credit default swaps originated as a form of credit protection that the holder of a credit risk could purchase as a hedge against a borrower's default. A holder of General Motors (NYSE:GM) bonds, for example, can effectively insure against a default by GM by purchasing protection in the form of a CDS from a willing counterparty. Many holders of collateralized debt obligations that have recently plummeted in value had hedged their positions through CDSs, and ACA Financial has been a major seller of such protection. An accompanying article in the Times describes possible efforts by some of ACA's insureds, including Merrill Lynch (MER), CIBC and Bear Stearns (NYSE:BSC), to help bail out ACA in order to avoid a write-down of billions of dollars of insured securities.

As with so many other types of innovative financial products, CDSs have exploded in the past few years. They have become a simple way for investors to take long or short positions on particular companies or industries without having to buy or sell the actual underlying bank debt or securities. The notional amount of underlying obligations covered by CDSs now exceeds $40 trillion, up from less than $2 trillion in 2002.

In a low default environment, selling default protection through CDSs presented huge revenue opportunities. ACA more than doubled its CDS business over the past 12 months, and others have undoubtedly done likewise. However, if the events of the past several months have proven one thing, it is that investors have done a very poor job recently of accurately assessing and pricing risk. It is more likely than not that many CDS sellers have not properly gauged their exposure, or set aside sufficient reserves against it.

The potential ramifications are difficult to overstate. S&P contends that ACA is facing close to $3 billion of losses on its CDS exposures, for which it has only $650 million of reserved capital. There is no way to tell right now how many other banks, funds, and other insurers are similarly exposed. Of equal concern are the exposures of the CDS purchasers who believe themselves to be properly hedged against losses, but who may instead find their protection to be worthless because of their counterparty's inability to pay.

Disclosure: none