Credit Default Swaps Adding Rather Than Mitigating Risk?
Credit default swaps, coupled with the continuing problems of monoline bond insurers, are causing increasing uncertainty, the opposite of what risk-management tools are supposed to do.
Jim Kaplan of Audit Integrity regards the current state of the CDS market as “a catastrophe in the making.” In his latest “Chairman’s Corner” letter, Kaplan notes that the CDS industry has grown in size from $3.8 trillion in 2003 to $62 trillion at the end of 2007, far in excess of the estimated $5-plus trillion in actual debt outstanding.
“With $60-plus trillion in swaps outstanding, it is fair to assume that a large number of sellers (underwriters) are not financially able to make the necessary payment when required. This condition is most readily observed in the Hedge Fund market where it is estimated that Hedge Funds are sellers (underwriters) of CDS, insuring exposure of over $14.0 trillion. Recent estimates put the net asset value of all Hedge Funds under management at just over $2 trillion. Fourteen trillion dollars’ worth of exposure will not all melt down simultaneously, but the $2-plus trillion in assets is completely inadequate to cover the risk exposure.”
In effect, the CDS market has morphed into a highly speculative, unregulated arena where fortunes are made and can be quickly lost — quite the opposite of its original intent, which was to create a vehicle for mitigating risk.
“This perversion has substantially increased the risk for the vast majority of major financial players to the point of potential catastrophe, ” Kaplan writes. Large Commercial banks dominate the CDS market, followed by Hedge Funds. However, Investment Banks and Insurance Companies have substantial exposure. Kaplan provides a list of major players, along with their rating on Audit Integrity’s accounting and governance risk rating.
The list includes monoline bond insurers such as MBIA (NYSE: MBI), whose CDS exposure is a major cause of concern for New York State insurance commissioner Eric Dinalla in his efforts to deal with the monolines’ problems, according the New York Times.
“MBIA has written $137 billion in swaps, which are privately traded insurance contracts that let people bet on companies’ financial health. Most of these contracts stipulate that if MBIA’s bond insurance unit becomes insolvent or is taken over by state regulators, buyers can demand payment immediately,” the Times reports. “But if that were to happen, MBIA would have far less money to pay policyholders and owners of municipal bonds backed by the company.”
So the swaps give MBIA significant leverage over Eric R. Dinallo, the commissioner of the New York State insurance department, who wanted the company to bolster its insurance unit with the $900 million in cash.
Last week, the company noted that “the landscape has changed,” and said it instead wanted to use the $900 million to start a new insurance subsidiary, letting the existing unit wind down its operations, according tot he Times. “The company said it had changed its thinking because S.& P. and Moody’s Investors Service, another rating firm, recently have indicated that a $900 million injection into its existing insurance subsidiary might not be enough for the unit to maintain its current high ratings.”
Felix Salmon at Portfolio.com agrees that there’s an issue, but thinks the concerns are overblown.
For one thing, there’s a world of difference between losing your triple-A rating, on the one hand, and being forced into receivership, on the other. MBIA is a double-A rated corporation, which puts it on the same level of creditworthiness as the world’s strongest banks.
CreditSights looks at worries about how the CDS of monoline insurers, who cannot qualify for bankruptcy protection under the US Bankruptcy Code, might be handled if one of them were to fail. In a timely report Credit Default Swaps: Will They Change the Course of Bankruptcy?, CreditSights notes that bankruptcy lawyers are uncertain how CDS would be treated in state bankruptcy proceedings of a failed monoline, for example. “This would mean that the market would be in totally uncharted waters, with a local judge faced with all kinds of situations that he or she has no familiarity with.”
More broadly, CreditSights notes that the existence of CDS may actually encourage bankuptcy filings in some situations.
Some bankruptcy practitioners think the existence of CDS makes some creditors indifferent to, or even in favor of, a bankruptcy filing.
Update: MBIA disputes the New York Times story. FT Alphaville and Felix Salmon dig deeper on the topic..
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June 20th, 2008 at 1:14 pm
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June 30th, 2008 at 4:37 pm
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