Credit Default Swaps: Underestimated Risk

by: Financial Rx

FinancialRx submits: "Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another." - Warren Buffet

Mike Panzner has an eye-popping chart comparing the notional value of Credit Default Swaps outstanding to various other recent bubbles.

Conveniently enough, the online Journal's MORNING BRIEF provides a primer on the subject (excerpted):

Senior officials at the Federal Reserve, the Securities and Exchange Commission and its British counterpart today issued an unusual joint warning that the financial risks of an increasingly global and mushrooming derivatives market are too big for any one country to oversee.

But first, a look at just how big that market is getting: Last week the International Swaps and Derivatives Association said that at the end of June, the outstanding nominal value of swaps and derivatives was $283.2 trillion... vastly superior to the combined gross domestic products of the U.S., European Union, Canada and China -- a paltry $34 trillion -- or the value of all U.S. homes, which is about the same amount.

Today, New York Fed chief Timothy Geithner, SEC Commissioner Annette Nazareth and Sir Callum McCarthy, chairman of the U.K.'s Financial Services Authority, write in the Financial Times that the financial innovation fueling the creation of derivatives transactions often drives the market faster than the pace of improvement in market infrastructure. "In a more integrated global market, we will increasingly find ourselves compelled to pursue borderless solutions," they argue. "In the case of derivatives, a local or national solution would have been insufficient to protect domestic financial markets from the risks posed by market practices..."

But with hedge funds among the biggest traders of derivatives, the potential cross-border vulnerability to market problems has increased. Earlier this month, the U.S. hedge fund Amaranth's big loss in the American gas markets set off a massive sale of its loans in London.