Will Credit Default Swaps Be the Next Shoe to Drop?

The potential dangers of a crumbling CDS (credit default swaps) market are finally coming into the limelight. Frankly, I don't know why it took so long. It has been a perennial topic among analysts of the more bearish bent, even I wrote about it last September, albeit I was mostly copying somebody else. Now it's got prime billing in this week's Economist in an article titled "Stepping beyond subprime" (subscription), where JPMorgan (JPM) is mentioned as having serious exposure.

In addition to the article in The Economist, Bill Gross of Pimco specifically mentioned the contraction in the "shadow banking system" in the Barron's Roundtable (subscription) this week. Gross further fleshed out this idea in his most recent "Investment Outlook." It was the first time I saw anyone putting a number on the potential loss from CDS:

While the exact amount of reserves supporting the Bank of Shadows is undeterminable, let’s go back to the $45 trillion BIS estimate of outstanding CDS for more insight. If total investment grade and junk bond defaults approach historical norms of 1¼% in 2008 (Moody’s and S&P forecast something close) then $500 billion of these default contracts will be triggered resulting in losses of $250 billion or more to the "protection selling" party once recoveries are inserted into the equation. To put that number in perspective, many street estimates ascribe similar losses to subprime mortgages, a derivative category substantially distinct from CDS insurance.

So the loss from CDS will be comparable to that from subprime? Talk about a second shoe to drop. And what d'ya know, it's a matching pair!

Update

This Financial Times article comments on the same estimates from Bill Gross. As they correctly point out, credit default swaps are insurance, so in theory the gain/loss should cancel out, unlike the real losses in a mortgage crisis. However, the "counter party risk" in an already liquidity-constrained system is a cause for concern.

Comments

[helplessobs...:]

This is not a zero sum game if the hedge fund counterparty simply closes shop and files for bankruptcy leaving the holder with defaulted bonds. Market chaos will ensue if this market begins unraveling. Hedge funds are into these big time since it involves big upfront payments with liability, if any, far out in the future. Plenty of time to slip the noose.

2008 Jan 14 08:39 AM

[Nick Gogert:]

counterparty risk could be very real. buying a CDS is a short gamma trade. A lot of funds with high sharpe ratios >2.00 get them playing the short gamma game. It always end in tears. With $45trillion in notional outstanding and no centralized clearing system, expect todays liquidity issues to look irrelevant once the CDS call start happening. Those monolines that insured CDO's could fail, causing in some cases an event of default in the CDO and consequently the CDS to trigger. Anyone have any idea how many CDS's are wrap risked?

2008 Jan 15 02:41 PM

[Kunst:]

CDS will be a much greater fiasco than subprime. Those involved all assumed there was no real risk. Wrong!

2008 Jan 16 02:06 AM