Flowchart of the Goldman Sachs trade, that got them in trouble with the SEC and created a dip in the market Friday.


Approaching the CLOSE, I’m looking at buying LONG @ circa $103.00 to $102.75 and exiting tomorrow circa $104.00


From The Economist.

THEY are, says a former securities regulator, a “Ponzi scheme” that no self-respecting firm should touch. Eric Dinallo, the insurance superintendent of New York state, calls them a “catastrophic enabler” of the dark forces that have swept through financial markets. Alan Greenspan, who used to be a cheerleader, has disowned them in “shocked disbelief”. They have even been ridiculed on “Saturday Night Live”, an American television show.

Until last year credit-default swaps (CDSs) were hailed as a wonder of modern finance. These derivatives allow sellers to take on new credit exposure and buyers to insure against companies or governments failing to honour their debts. The notional value of outstanding CDSs exploded from almost nil a decade ago to $62 trillion at the end of 2007—though it slipped to $55 trillion in the first half of this year and has since continued to fall. Traded privately, or “over the counter”, by banks, they seemed to prove that large, newfangled markets could function perfectly well with minimal regulation.

That view now looks quaint. Since September a wave of large defaults and near-misses, involving tottering banks, brokers, insurers and America’s giant mortgage agencies, Fannie Mae and Freddie Mac, has sent the CDS market reeling. Concern that CDSs are partly to blame for wild swings in financial shares has frayed nerves further.

The failure in mid-September of Lehman Brothers showed that the main systemic risk posed by CDSs came not from widespread losses on underlying debts but from the demise of a big dealer. The aftershock spread well beyond derivatives. Almost as traumatic was the rescue of American International Group (AIG), a huge insurer that had sold credit protection on some $440 billion of elaborate structures packed with mortgages and corporate debt, known as collateralised-debt obligations (CDOs). Had AIG been allowed to go bust, the swaps market might well have unravelled. Similar fears had led to the forced sale of Bear Stearns in March.

Foul-ups with derivatives are hardly uncommon, but CDSs have been causing particular consternation. One reason is the broad threat of “counterparty risk”—the possibility that a seller or buyer cannot meet its obligations. Another is the rickety state of back-office plumbing, which was neglected as the market boomed. A third is that swaps can be used to hide credit risk from markets, since positions do not have to be accounted for on balance-sheets. They make it beguilingly easy to concentrate risk. AIG could have taken the same gamble in other ways, for instance by borrowing heavily to buy mortgages. But the CDS route was quicker and less visible.

If counterparties pay up, CDSs are a zero-sum game: what the seller loses, the buyer gains. Counterparty risk upsets the symmetry. It is tempting to write lots of swaps in good times, when pay-outs seem improbable, without putting aside enough cash to cover the potential losses. Being AAA-rated, AIG was able to post modest margin requirements—the deposit it had to pay against the risk of the contract being triggered. When its credit rating was cut, a lot more margin was suddenly demanded and it had to turn to the public purse.

“We sent out a signal that the stronger you were, the crazier you could be,” says Mr Dinallo: highly rated companies were allowed to write reckless volumes of swaps. Originally conceived as a means for banks to reduce their credit exposure to large corporate clients, CDSs quickly became instruments of speculation for pension funds, insurers, companies and (especially) hedge funds. And with no fixed supply of raw material, unlike stocks or bonds, bets could be almost limitless.

The industry is scrambling to limit the damage. Robert Pickel, head of the International Swaps and Derivatives Association (ISDA), says he is determined to combat “misconceptions” about CDSs. The true amount at risk, after cancelling out offsetting exposures, is only about 3% of their notional value (that is $1.6 trillion, even so). Opaque as CDSs may be, they are less complex than CDOs. In essence, they unbundle the interest on a debt from the risk that it is not paid back. Selling credit protection is similar to writing certain kinds of common options on shares.

The root cause of the crisis, Mr Pickel argues, is bad mortgage lending, not derivatives: swaps on subprime mortgages grew unstable because the loans themselves were dodgy. Last month JPMorgan’s Blythe Masters, one of the market’s founders, urged regulators to distinguish between tools and their users: “Tools that transfer risk can also increase systemic risk if major counterparties fail to manage their exposures properly.”

That will not reassure everyone. Still, there has been “more fear than facts” around the CDS market, says Brian Yelvington of CreditSights, a research firm. Essentially, it provides fixed-income investors with “a liquid way to do what equity and futures participants have been doing for years: to take a negative as well as constructive view on credit.”

Furthermore, the market has held up better than many expected. The process for settling claims after Lehman’s default and the government’s seizure of Fannie Mae and Freddie Mac “performed as designed”, says Darrell Duffie of Stanford University. Only $6 billion had to change hands in the Lehman auction, overseen by ISDA, because most payments had already been made as swap-sellers marked their positions to market; in all, $21 billion had been theoretically at risk. Margin payments are widely thought to cover two-thirds of total CDS exposure.

The CDS market has remained fairly liquid throughout the crisis, even as cash markets dried up. At the moment, derivatives spreads reflect fundamental values more accurately than those in corporate-bond markets, reckons Tim Backshall of Credit Derivatives Research (CDR). Swap spreads have become a key barometer of financial health. They provided an early indicator of trouble at investment banks, although they became distorted as more and more firms scrambled to hedge or speculate.

But if credit swaps were not a primary cause of the past year’s conflagrations, they were, in certain respects, an accelerant. Financial eggheads used them as building blocks in “synthetic” CDO-type structures, which are based on CDSs rather than actual bonds. The market value of some tranches has slumped to less than ten cents on the dollar. And CDSs share some problems with securitisation. A paper last year by economists at the Federal Reserve Bank of New York concluded that they “give banks an opaque means to sever links to their borrowers, thus reducing lender incentives to screen and monitor.”

Some fear that worse may be yet to come. The failure of another big actor in the market would send dealers and other counterparties scurrying to replace trades, almost certainly at a higher cost. Replacing those struck with Lehman, as spreads widened after its bankruptcy filing, is thought to have cost some dealers upwards of $200m each.

That risk remains, judging by CDR’s counterparty-risk index, which measures the health of CDS dealers (see chart 1). The next shock could be the failure of a hedge fund with a big swap book, given the spike in redemptions and margin calls many funds face, thinks Pierre Pourquery of the Boston Consulting Group. Hedge funds wrote almost a third of all credit protection last year (see chart 2).



Sellers of protection will be watching nervously for a wave of corporate defaults as big economies slip into recession. Standard & Poor’s expects the default rate on junk-grade debt to leap to 23% by 2010. Sovereign debt is looking wobbly too, especially but not exclusively in emerging markets. The cost of insuring against a default by the United States has quadrupled since January.

As rising defaults trigger CDS payments, the effect on other markets is likely to grow. Credit insurers are increasingly having to find money to pay claims that once seemed merely notional. Christopher Whalen of Institutional Risk Analytics, a consultancy, calls these commitments a “liquidity black hole”. Because banks lack the liquidity to cover these positions, they must raise it in interbank markets. This may be keeping the rate at which big banks borrow from each other higher than it would otherwise be, thinks Mr Whalen (though it has fallen from its peak last month). It may also be causing rushed sales in equity and bond markets.

Concern about the damage that the failure of a big swap-seller might yet do has created pressure for the CDS market to be regulated. New York has charitably offered to oversee “covered” swaps—those where the protection buyer holds the underlying bonds; Mr Dinallo labels uncovered CDS trades as “naked”, likening them to abusive short-selling of shares. Federal regulators, who passed up several opportunities to police the market during the credit boom, are circling too.

Dealers are hoping to head them off with a series of initiatives, which have been stepped up recently at the prompting of the Federal Reserve. Chief among them is the creation of a central clearing house for credit derivatives. Several groups, including a dealer-backed venture led by Intercontinental Exchange and a tie-up between CME Group, another exchange operator, and Citadel, a hedge fund, are vying for licences. One or more is likely to be awarded in the next few weeks.

The biggest benefit would be less counterparty risk, since each member firm would face only the clearing house, not lots of partners. Standardised collateral arrangements would reduce the sort of payment disputes that have flared up this year, including those between AIG and buyers of its insurance. This set-up has worked well for trading of energy swaps.

Although it would ease one problem, it may create another by concentrating risk in the clearer—“like the military putting all its artillery shells in a single dump,” says a banker. Any clearer will need to have “tremendous creditworthiness” and iron-clad risk controls, says Craig Donohue, chief executive of CME, which is planning to back its venture with its $7 billion guarantee fund and $115 billion in collateral.

Besides a clearing house, the market could do with more transparency. A lack of disclosure on CDS exposures has frequently led the market to overestimate risks: had it been realised that settlement payments on Lehman swaps would be only $6 billion, rather than the hundreds of billions feared, much of the turmoil in debt markets could have been avoided. To provide more clarity, the Depository Trust & Clearing Corporation, which runs the central registry for swaps, has just begun publishing weekly data on the largest (but not broken down by counterparty).

A streamlining of back offices, which were swamped as trading surged, is also necessary. Only now is the industry discovering the joys of “compression”, which allows offsetting swaps to be torn up. A staggering $25 trillion-worth, almost half of the total, has been binned in recent months. Though this does little to cut the amount at risk, it reduces operational costs and strips away a layer of complexity that has obscured trading exposures. There are plans to extend this tidying-up exercise to other derivatives, including interest-rate swaps, whose gross value, $393 trillion at the end of 2007, dwarfs that of CDSs.

All this will strengthen market infrastructure. But it will also eat into the profits of big dealers, such as Goldman Sachs and JPMorgan, at a time when every dollar is precious. Estimates of their total revenue related to CDSs run as high as $30 billion a year. This will fall as central clearing brings more price transparency, and drop even further if the swaps end up being traded on exchanges. The dealers have long argued that bespoke swaps do not belong on bourses. But contracts, especially those tied to indices rather than single names, are steadily becoming more standardised. Most CDSs, thinks a bank regulator, will move to exchanges “within a few years”.

These quasi-voluntary efforts may or may not reassure those calling for more dramatic intervention. Buyers and sellers of swaps will probably be required to disclose more information. They will certainly have to stump up more capital to trade, making the market less attractive. Indeed, since September the typical margin demanded by dealers has more than doubled. Once reshaped, the CDS market will be a bit duller and a lot less lucrative. But it will also be much safer.

For “sierrawater”

Regulators to Approve Derivatives Clearinghouse
Friday October 31, 2:27 pm ET

Regulators are expected to approve a clearing house for credit derivative swaps in the next several weeks, CNBC has learned.

Regulators and industry participants have voiced concern that the private nature of the $55 trillion market for credit default swaps poses systemic risks because no one knows the size of a counterparty’s derivative portfolio, and the failure of a large counterparty can create massive losses globally.

Creating a clearing house would remove the risk posed by a counterparty failure, provide price transparency and offer simpler, more standardized settlement of contracts when an issuer defaults, proponents argue.

Calls for regulation and centralized clearing of credit default swap trades has gathered steam in the wake of Lehman Brothers’ failure last month.

The New York Federal Reserve Bank Friday said it “welcomes” progress in clearing credit default swaps and urged “broader action.”

The Chicago Mercantile Exchange, or CME Group, and Citadel Investment Group unveiled plans earlier this month for an electronic exchange for credit default swaps, which they said would be integrated with a central clearinghouse.

Clearing operations will be in place for CDS indexes in November and for single-name CDS in January. Depository Trust & Clearing Corp. will begin releasing total stock and trade data on Nov. 4.

About $24 trillion has recently been netted of the gross exposure in the CDS market, almost a third of the total.

—Reuters contributed to this report

The Tail risk of CDS contracts related to MBS seems due to their lack of transparency, has it seems been grossly overestimated by analysts. That is good news. It means that the variety of extraordinary measures implemented by the Federal Reserve and Treasury in partnership with Central Banks around the world, can in all likelihood [assuming accuracy of the numbers] contain the further potential deterioration to Balance Sheets.

Reported estimates of the size of the credit default swap market have so far been based on surveys. These surveys tend to overstate the size of the market due to each party to a trade separately reporting its own side. Thus, when two parties to a single $10 million dollar trade each report their “side” of the trade, the amount reported is $20 million, which overstates the actual size by a factor of two since both reports relate to a single $10 million contract. When examining the outstanding amount of actual contracts registered in the Warehouse (not separately reported “sides”) as of October 9, 2008, credit default swap contracts registered in the Warehouse totaled approximately $34.8 trillion (in US Dollar equivalents). This is down significantly from the approximately $44 trillion that were registered in the Warehouse at the end of April this year.

Still a substantial figure. However, for the problem child, CDS on MBS;

Less than 1% of credit default swap contracts currently registered in the Warehouse relate to particular residential mortgage-backed securities. Mortgage-related index products also have some components relating to residential mortgages and, as a whole, also constitute a relatively small fraction of total credit default swaps registered in the Warehouse.

Settlements, importantly can be made in cash. In other words, the physical Bonds need not be purchased or owned for settlement to occur.

One of the many central servicing functions of the Trade Information Warehouse is to caculate payments due on registered contracts, including cash payments due upon the occurrence of the insolvency of any company on which the contracts are written. Calculated amounts are netted on a bilateral basis, and then, for firms electing to use the service, transmitted to CLS Bank (the world’s central settlement bank for foreign exchange) where they are combined with foreign exchange settlement obligations and settled on a multi-lateral net basis. Currently, all major global credit default swap dealers use CLS Bank to settle obligations under credit default swaps. It is expected that all major institutional players in the credit default swap market will use the same process for settlement by the end of 2009.

In summary, the truly frightening risk of a total derivative meltdown, “seem” to have been overstated due to the lack of transparency in the market. As this problem is resolved via a central exchange in the future, this risk will at least be transparent in the market.

Officials at the Federal Reserve plan to meet with top executives from two commodities exchanges in an effort to create a new marketplace for credit default swaps, one of the most important, controversial and opaque securities traded on the Wall Street, CNBC has learned.

The meeting, scheduled to be held as early as Tuesday of this week at the headquarters of the New York Fed, is expected to clear the way for the creation of a new clearing house, or exchange, where CDSs can be traded with more transparency and with a degree of government oversight.

At the moment CDSs are traded in the over-the-counter market, where traders buy and sell the securities among themselves.

The effort by the Fed is designed to create a centralized market place where CDSs can be traded.

People close to the talks say that the new exchange could be up and running in a matter of weeks.

Easy enough, and would have alleviated some of the problems that numerous banks etc have encountered in this cycle. Counterparty risk has been a major feature of the unwillingness of banks to part with cash in any shape or form over any period.

The derivative overhang is the Sword of Damocles that is threatening not only the financial markets but the world economy. BIS had the notional value of derivatives [CDS] at $63 Trillion. Notional means that this is the total exposure. Much of the total exposure was hedged. With each failure of a large financial institution, one side of the hedge becomes unhedged thus, the now unhedged exposure is required to be marked-to-market, which, due to the figures involved simply overwhelms the capital that the institution has, instant insolvancy.

It is simply a game of dominos, one failure knocks over the next domino, until nothing remains. The bailout attempts to take the triggers for the CDS contracts out of the equation. By removing the toxic MBS from Balance Sheets, there is no further increase/decrease in CDS values.

Credit requires confidence to create. Debt, needs to be rolled over. If the actual debt has to be paid in cash, then many firms will simply go under. Their cashflows were designed to service debt levels via interest payments, while depreciation on capital investment [in theory] amortised debt.

If the Banks implode, the generators and distributors of credit cease to exist, thus, the real economy could quite possibly follow behind into the debt abyss.

Credit, or confidence, is the sine qua non of banking. The word “credit,” after all, comes from the Latin verb credere, “to believe.” Without belief, or faith, or forbearance, there is no credit.

Credit, is after all, simply money of the mind.

In a low return world, investors seek yield. This would imply the higher the yield sought, the higher the potential risks involved. Two major recipients of the world’s cashflow, China, selling the world cheap nasty trash and the Oil producing nations required investment opportunities.

Investments were purchased all over the world, and the riskier investments were insured via Credit Default Swaps [CDS] by counterparties. These counterparties in essence became insurance companies. The counterparties were the companies that formed the financial system, the Banks, Insurance companies themselves and all manner of Hedge Funds.

To limit risk on a written CDS contract, a Bank might purchase reinsurance from a third party. So Lehmans, selling a CDS contract to Aramco might purchase reinsurance [an offsetting CDS] from Bear Stearns, who, to manage their risk might purchase retrocession from Citibank.

In theory, there is no limit to how far this process can go. In reality, the spread that you earn on each transaction becomes smaller and smaller, until it stops. Who ever it does finally stop with becomes the ultimate counterparty. They may have only taken a % exposure, a certain amount of exposure remaining in each link of the chain.

The problem with insurance is that in a competitive market, risk is systemically underpriced. Purchasers should, but rarely, purchase insurance on counterparty risk, rather they purchase on price, which, if a risk materialises, wipes out any profitability that the insurance contract may have generated. More importantly however, the insured party may well not get paid. With the leverage inherent in CDS derivatives, the insurer is bankrupted in the process.

The notional totals currently run at circa $63 Trillion dollars. Lehman was a party to hundreds of billions in one-off derivatives that covered risks of default, interest rates, equity moves and moves in commodity prices. AIG was an even bigger player. Its near bankruptcy and then its $85 billion government buyout led the London Stock Exchange to suspend trading in 113 exchange-traded commodity funds run by ETF Securities. All had been backed on matching derivatives from AIG.

Investors are faced with taking a hit if they want to buy the same insurance, because prices are higher, if they can find a counterparty at all now that the derivatives market is shrinking.

Problems in the derivatives market don’t stay confined to that market. In the short run, we’ve already seen the effects at work in the commodities market. AIG was a counterparty to a good part of the $30 billion invested in the Dow Jones AIG Commodity Index, the second-most-popular benchmark for commodity investors. AIG, was counterparty to $422 billion in derivatives. That’s just a tad below the low-end estimate for the government buy-up plan as a whole. For a single company.

With volatility running close to or below all time lows in the 2005 to early 2007 period, risk models that incorporate volatility as a measure of risk, underpriced risk even further. Add to that the abandonment of any concept of credit risk, and the long tailed risks were building very quickly.

With the Federal Reserve raising interest rates steadily from the Greenspan era of 1% very quickly to the 5.5% of the Bernanke era, the credit risk in the market was exposed and blew-up. This was the sub-prime market.

This led to a endless stream of losses and writedowns within the financial sector, that rather than slowing seemed to be picking up speed, huge capitalization firms failing in weeks and days. This seems to be primarily due to their leverage. Levarage is a hallmark of derivatives.

Thus we arrive at the Treasury proposing that the taxpayer assume the role of the retrorecessionay agent of last resort. The problem of course is that as huge as the US economy is, some $15 Trillion, it is dwarfed by the derivatives market, notionally valued at $455 Trillion.

No-one really knows were the links are. Is the market at risk, primarily the $63 Trillion notional market only? Or, have the counterparty risks been offset somehow into other markets, expanding to the scary total of $455 Trillion?

Derivatives are hard to understand. The reforms needed to fix the market are even tougher to grasp. One big problem, for example, are that most derivative contacts aren’t traded on any exchange. They are unique, one-off contracts between an individual buyer and seller. Without a market to act as a clearinghouse, there’s no way to know how many contracts any individual seller has written. Which, of course, turns out to be crucial to figuring out which sellers can stand behind which deals. And without a market, there’s really no way to price these contracts.

The accounting rules that require mark-to-market in a deliciously ironic twist, triggered the snowball at the top of the hill to start rolling. Time is a crucial factor in the insurance model. The longer the timeframe that passes without risks being claimed, the larger the allocated potential losses that can be allowed for and set aside. Additionally, bad loans can be restructured, refinanced, or liquidated in an orderly manner. With mark-to-market accounting, the dirty laundry comes due every quarter, this triggers all manner of problems as capital has become unavailable at almost any price currently

This then is the climate that has the market absolutely psychotic currently.

Fast rewind to October 1987 and the market crash. Options traders kept track of their trades on cards, later reporting their trades to the clearing houses.

Some traders losing their shirts in the panic, basically went all in with the clearing houses” capital. As markets dropped further and further, some of these traders simply dropped their trades on the floor, never to report them and caught cabs to O’Hare airport, thus the term “airport trade.”

After the crash, new regulatory measures were introduced, electronic reporting of trades, so that the system would not be exposed to these weaknesses again. Banks, had to fund with capital the clearing houses that would otherwise have gone under.

CDS contracts, notional values running into tens of trillions of dollars, are an unregulated market. No-one quite knows, in the event of a bankruptcy, what happens. Looks like we might find out. Almost certainly the days of monster fees for originating Investment Banks etc are long gone. Regulations are already being discussed for this market to have central clearing and be traded on an exchange.

Should Lehmans travails, cause dislocations due to counterparty failures, that day will be hastened. It remains to be seen as the rest of the week plays out how much CDS was hedged, how much is a liability and to whom.

Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults

By David Evans

May 20 (Bloomberg) — It’s Friday, March 14, and hedge fund adviser Tim Backshall is trying to stave off panic. Backshall sits in the Walnut Creek, California, office of his firm, Credit Derivatives Research LLC, at a U-shaped desk dominated by five computer monitors.

Bear Stearns Cos. shares have plunged 50 percent since trading began today, and his fund manager clients, some of whom have their cash and other accounts at Bear, worry that the bank is on the verge of bankruptcy. They’re unsure whether they should protect their assets by purchasing credit-default swaps, a type of insurance that’s supposed to pay them face value if Bear’s debt goes under.

Backshall, 37, tells them there are two rubs: The price of the swaps is skyrocketing by the minute, and the banks selling the insurance are also at risk of collapsing. If Bear goes down, he tells them, it may take other banks with it.

“There’s always the danger the bank selling you the protection on Bear will fail,” Backshall says. If that were to happen, his clients could spend millions of dollars for worthless insurance.

Investors can’t tell whether the people selling the swaps – – known as counterparties — have the money to honor their promises, Backshall says between phone calls.

“It’s clearly a combination of absolute fear and investors really not knowing,” he says.

On this day, a CDS-market meltdown doesn’t happen. In a frenzy of weekend activity, the Federal Reserve and JPMorgan Chase & Co. rescue Bear Stearns from bankruptcy — removing the need for the sellers of credit-default protection to pay up on their contracts.

Chain Reaction

Backshall and his clients aren’t the only ones spooked by the prospect of a CDS catastrophe. Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis.

CDSs, which were devised by J.P. Morgan & Co. bankers in the early 1990s to hedge their loan risks, now constitute a sprawling, rapidly growing market that includes contracts protecting $62 trillion in debt.

The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb.

“It is a Damocles sword waiting to fall,” says Soros, 77, whose new book is called “The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means” (PublicAffairs).

“To allow a market of that size to develop without regulatory supervision is really unacceptable,” Soros says.

`Lumpy Exposures’

The Fed bailout of Bear Stearns on March 17 was motivated, in part, by a desire to keep that sword from falling, says Joseph Mason, a former U.S. Treasury Department economist who’s now chair of the banking department at Louisiana State University’s E.J. Ourso College of Business.

The Fed was concerned that banks might not have the money to pay CDS counterparties if there were large debt defaults, Mason says.

“The Fed’s fear was that they didn’t adequately monitor counterparty risk in credit-default swaps — so they had no idea of where to lend nor where significant lumpy exposures may lie,” he says.

Those counterparties include none other than JPMorgan itself, the largest seller and buyer of CDSs known to the Office of the Comptroller of the Currency, or OCC.

The Fed negotiated the deal to bail out Bear Stearns by allowing JPMorgan to buy it for $10 a share. The Fed pledged $29 billion to JPMorgan to cover any Bear debts.

`Cast Doubt’

“The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets,” Fed Chairman Ben S. Bernanke told Congress on April 2. “It could also have cast doubt on the financial positions of some of Bear Stearns’s thousands of counterparties.”

The Fed was worried about the biggest players in the CDS market, Mason says. “It was a JPMorgan bailout, not a bailout of Bear,” he says.

JPMorgan spokesman Brian Marchiony declined to comment for this article.

Credit-default swaps are derivatives, meaning they’re financial contracts that don’t contain any actual assets. Their value is based on the worth of underlying loans and bonds. Swaps are similar to insurance policies — with two key differences.

Unlike with traditional insurance, no agency monitors the seller of a swap contract to be certain it has the money to cover debt defaults. In addition, swap buyers don’t need to actually own the asset they want to protect.

It’s as if many investors could buy insurance on the same multimillion-dollar home they didn’t own and then collect on its full value if the house burned down.

Bigger Than NYSE

When traders buy swap protection, they’re speculating a loan or bond will fail; when they sell swaps, they’re betting that a borrower’s ability to pay will improve.

The market, which has doubled in size every year since 2000 and is larger in dollar value than the New York Stock Exchange, is controlled by banks like JPMorgan, which act as dealers for buyers and sellers. Swap prices and trade volume aren’t publicly posted, so investors have to rely on bids and offers by banks.

Most of the traders are banks; hedge funds, which are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall; and insurance companies. Mutual and pension funds also buy and sell the swaps.

Proponents of CDSs say the devices have been successful because they allow banks to spread the risk of default and enable hedge funds to efficiently speculate on the creditworthiness of companies.

`Seeing the Logic’

The market has grown so large so fast because swaps are often based on an index that includes the debt of scores of companies, says Robert Pickel, chief executive officer of the International Swaps and Derivatives Association.

“Whether you’re a hedge fund, bank or some other user, you’re increasingly seeing the logic of using these instruments,” Pickel says, adding he doesn’t worry about counterparty risk because banks carefully monitor the strength of investors. “There have been a very limited number of disputes. The parties understand these products and know how to use them.”

Banks are the largest buyers and sellers of CDSs. New York- based JPMorgan trades the most, with swaps betting on future credit quality of $7.9 trillion in debt, according to the OCC. Citigroup Inc., also in New York, is second, with $3.2 trillion in CDSs.

Goldman Sachs Group Inc. and Morgan Stanley, two New York- based firms whose swap trading isn’t tracked by the OCC because they’re not commercial banks, are the largest swap counterparties, according to New York-based Fitch Ratings, which doesn’t provide dollar amounts.

Untested Until Now

The credit-default-swap market has been untested until now because there’s been a steady decline in global default rates in high-yield debt since 2002. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody’s Investors Service.

Since then, defaults globally have dropped to 1.5 percent, as of March. The rating companies say the tide is turning on defaults.

Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002. On May 7, Moody’s wrote that as the economy weakened, high-yield-debt defaults by companies worldwide would increase fourfold in one year to 6.1 percent by April 2009.

The pressure is building. On May 5, for example, Tropicana Entertainment LLC filed for bankruptcy after the casino owner defaulted on $1.32 billion in debt.

`Complicate the Crisis’

A surge in corporate defaults may leave swap buyers scrambling, many unsuccessfully, to collect hundreds of billions of dollars from their counterparties, says Satyajit Das, a former Citigroup derivatives trader and author of “Credit Derivatives: CDOs & Structured Credit Products” (Wiley Finance, 2005).

“This is going to complicate the financial crisis,” Das says. He expects numerous disputes and lawsuits, as protection buyers battle sellers over the technical definition of default – – this requires proving which bond or loan holders weren’t paid — and the amount of payments due.

“It’s going to become extremely messy,” he says. “I’m really scared this is going to freeze up the financial system.”

Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, has researched counterparty risk and says it’s only a matter of time before the sword begins falling. He says the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $35 billion in defaults.

$150 Billion Loss Estimate

“That’s a very conservative estimate,” he says, adding that his study finds that losses resulting from hedge funds that can’t pay their counterparties for defaults could exceed $150 billion.

Hedge funds have sold 31 percent of all CDS protection, according to a February 2007 report by Charlotte, North Carolina-based Bank of America Corp.

Cicione says banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That may not work, he says. Many of the funds won’t have the cash to meet the banks’ requests, he says.

Sellers of protection aren’t required by law to set aside reserves in the CDS market. While banks ask protection sellers to put up some money when making the trade, there are no industry standards, Cicione says.

JPMorgan, in its annual report released in February, said it held $22 billion of credit swap counterparty risk not protected by collateral as of Dec. 31.

`A Major Risk’

“I think there’s a major risk of counterparty default from hedge funds,” Cicione says. “It’s inconceivable that the Fed or any central bank will bail out the hedge funds. If you have a systemic crisis in the hedge fund industry, then of course their banks will take the hit.”

The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.

“It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred,” the report said. “It can be difficult even to quantify the amount of risk that has been transferred.”

Counterparty risk can become complicated in a hurry, Das says. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle, Das says.

`Daisy Chain Vortex’

The original purpose of swaps — to spread a bank’s loan risk among a large group of companies — may be circumvented, he says.

“It creates a huge concentration of risk,” Das says. “The risk keeps spinning around and around in this daisy chain like a vortex. There are only six to 10 dealers who sit in the middle of all this. I don’t think the regulators have the information that they need to work that out.”

And traders, even the banks that serve as dealers, don’t always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDSs, some far more complex than others.

More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company’s debt or collateralized debt obligations.

A CDO is an opaque bundle of debt that can be filled with junk bonds, auto loans, credit card liabilities and home mortgages, including subprime debt. Some swaps are made up of even murkier bank inventions — so-called synthetic CDOs, which are packages of credit-default swaps.

AIG $9.1 Billion Writedown

On May 8, American International Group Inc. wrote down $9.1 billion on the value of its CDS holdings. The world’s largest insurer by assets sold credit protection on CDOs that declined in value. In 2007, New York-based AIG reported $11.5 billion in writedowns on CDO credit default swaps.

Michael Greenberger, director of trading and markets at the Commodity Futures Trading Commission from 1997 to 1999, says the Fed is fully aware of the risk banks and the global economy face if CDS holders can’t cover their losses.

“Oh, absolutely, there’s no doubt about it,” says Greenberger, who’s now a professor at the University of Maryland School of Law in Baltimore. He says swaps were very much on the Fed’s mind when Bear Stearns started sliding toward bankruptcy.

“People who were relying on Bear for their own solvency would’ve started defaulting,” he says. “That would’ve triggered a series of counterparty failures. It was a house of cards.”

Risk Nightmare

It’s concerns about that house of cards that have kept Backshall, the California fund adviser, up at night. His worries about a nightmare scenario started in early March. The details of what happened are still fresh in his mind.

It’s Monday, March 10, and the market is rife with rumors that Bear Stearns will run out of cash. Some of Backshall’s clients have pulled their accounts from Bear; others are considering leaving the bank. Backshall’s clients are exposed to Bear in multiple ways: They keep their cash and other accounts at the firm, and they use the bank as their broker for trades. Backshall advises them to spread their assets among various banks.

That same day, Bear CEO Alan Schwartz says publicly, “There is absolutely no truth to the rumors of liquidity problems.”

Backshall’s clients are suspicious. They see other hedge funds pulling their accounts from Bear. In the afternoon after Schwartz’s remarks, the cost of protection soars past 600 basis points from 450 before Schwartz’s statement.

CEO Didn’t Calm Fears

Swaps are priced in basis points, or hundredths of a percentage point. At 600 basis points, a trader would pay $6,000 a year to insure $100,000 of Bear Stearns bonds.

“I don’t think his comments did anything to calm fears,” Backshall says.

The next day, March 11, Securities and Exchange Commission Chairman Christopher Cox says his agency is monitoring Bear Stearns and other securities firms.

“We have a good deal of comfort about the capital cushions at these firms at the moment,” he says.

Cox’s comments are overshadowed by rumors that European financial firms had stopped doing fixed-income trades with Bear, Backshall says.

“Nobody has a clue what’s going on,” he says. Bear swap costs are gyrating between 540 and 665.

For most investors, just getting default-swap prices is a chore. Unlike stock prices, which are readily available because they trade on a public exchange, swap prices are hard to find. Traders looking up prices on the Internet or on private trading systems see information that is hours or days old.

`Terribly Primitive’

Banks send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, Backshall says. For many investors, this system is a headache.

To find the price of a swap on Ford Motor Co. debt, for example, even sophisticated investors might have to search through all of their daily e-mails, he says.

“It’s terribly primitive,” Backshall says. “The only way you and I could get a level of prices is searching for Ford in our inbox. This is no joke.”

In the past three years, at least two companies have developed software programs that automatically parse an investor’s incoming messages, yank out CDS prices and build them into real-time price displays.

The charts show the highest bids and lowest offering prices for hundreds of swaps. Backshall tracks prices he gets from banks using the new software.

`It’s Very Hard’

Backshall has been talking with hedge fund managers in New York all week.

“We’d quite frankly been warning them and giving them advice on how to hedge,” he says of the Bear Stearns crisis and banks overall. “It’s very hard to hedge the counterparty risk. These institutions are thinly capitalized in the best of times.”

The night of Thursday, March 13, Backshall can’t sleep. He lies awake worrying about Bear and counterparty risk. The next morning, he arrives at work at 5 a.m., two and a half hours before sunrise.

Through the window of his ninth-floor corner office, he takes a moment to watch the distant flickers of light in the rolling foothills of Mount Diablo. Across the street, he sees the still-dark Walnut Creek train station, about 30 miles (48 kilometers) east of San Francisco.

Backshall, wearing jeans and a blue, button-down shirt, sits at his desk, staring at a pair of the 27-inch (68.6- centimeter) monitors that display swap costs. CDS prices jumped by more than 10-fold in just a year. The numbers show rising fear, he says.

Until early in 2007, the typical price of a credit-default swap tied to the debt of an investment bank like Merrill Lynch & Co., Bear Stearns or Morgan Stanley was 25 basis points.

`Unknowns Are Out There’

If a swap buyer wanted to protect $10 million of assets in the event of a company default, the contract would cost about 0.25 percent of $10 million, or $25,000 a year for a five-year protection contract.

Backshall’s screens tell him the cost of buying protection on Bear Stearns debt in the past 24 hours has been moving in a range between 680 and 755 basis points.

“The unknowns are out there,” Backshall says.

He advises his clients not to buy CDS protection on Bear because the price is too high and the time is wrong. It’s too late to buy swaps now, he says.

At 9:13 Friday morning in New York, JPMorgan announces it will loan money to Bear using funds provided by the Federal Reserve. The JPMorgan statement doesn’t say how much it will lend; it says it will “provide secured funding to Bear Stearns, as necessary.”

`Significantly Deteriorated’

Bear CEO Schwartz says his firm’s liquidity has “significantly deteriorated” during the past 24 hours. Protection quotes drop immediately into the low 500s, as some dealers think a rescue has begun.

That doesn’t last long.

“Very quickly, the trading action is swinging violently wider,” Backshall says. Bear’s swap cost jumps to 850 basis points that afternoon, his screen shows. “When fear gets hold, fundamental analysis goes out the window,” he says.

In the calmest of times, making reasoned decisions about swap prices is a challenge. Now, it’s impossible. Traders don’t have access to any company data more recent than Bear’s February annual report. Sharp-eyed investors looking through that filing might have spotted a paragraph that’s strangely prescient.

“As a result of the global credit crises and the increasingly large numbers of credit defaults, there is a risk that counterparties could fail, shut down, file for bankruptcy or be unable to pay out contracts,” Bear wrote.

`Material Adverse Effect’

“The failure of a significant number of counterparties or a counterparty that holds a significant amount of credit-default swaps could have a material adverse effect on the broader financial markets,” the bank wrote.

Even after JPMorgan’s Friday morning announcement, the market is alive with rumors. Backshall’s clients tell him they’ve heard some investment banks have stopped accepting trades with Bear Stearns and some money market funds have reduced their short-term holdings of Bear-issued debt.

On Sunday, March 16, the Federal Reserve effectively lifts the sellers of Bear Stearns protection out of their misery. JPMorgan agrees to buy Bear for $2 a share.

While that’s devastating news for Bear shareholders — the stock had traded at $62.30 just a week earlier — it’s the best news imaginable for owners of Bear debt. That’s because JPMorgan agreed to cover Bear’s liabilities, with the Fed pledging $29 billion to cover Bear’s loan obligations.

Turned to Dust

For traders who sold protection on Bear’s debt, the bailout is a godsend. Faced with the prospect of having to hand over untold millions to their counterparties just three days earlier, they now have to pay out nothing.

For traders who bought protection swaps just a few days earlier — when prices were in the 600s to 800s — the Fed bailout is crushing. Their investments have turned to dust.

On Monday morning, the cost of default protection on Bear plunges to 280. Backshall sits back in his chair and for the first time in two weeks, he can breathe easier.

“No wonder I look so tired all the time,” he says, finally showing a bit of a smile.

When it bailed out Bear Stearns, the Federal Reserve effectively deputized JPMorgan to monitor the credit-default- swap market, says Edward Kane, a finance professor at Boston College. Because regulators don’t know where the risks lie, they’re helpless, Kane says.

Default swaps shift the risk from a company’s credit to the possibility that a counterparty might fail, says Kane, who’s a senior fellow at the Federal Deposit Insurance Corporation’s Center for financial Research.

`Off Balance Sheet’

“You’ve really disguised traditional credit risk, pushed it off balance sheet to its counterparties,” Kane says. “And this is not visible to the regulators.”

BNP analyst Cicione says regulators will be hard-pressed to prevent the next potential breakdown in the swaps market.

“Apart from JPMorgan, there aren’t many other banks out there capable of doing this,” he says. “That’s what’s worrying us. If there were to be more Bear Stearnses, who would step in and give a helping hand? You can’t expect the Fed to run a broker, so someone has to take on assets and obligations.”

Banks have a vested interest in keeping the swaps market opaque, says Das, the former Citigroup banker. As dealers, the banks see a high volume of transactions, giving them an edge over other buyers and sellers.

“Dealers get higher profitability through lack of transparency,” Das says. “Since customers don’t necessarily know where the market is, you can charge them much wider margins.”

Banks Try to Hedge

Banks try to balance the protection they’ve sold with credit-default swaps they purchase from others, either on the same companies or indexes. They can also create synthetic CDOs, which are packages of credit-default swaps the banks sell to investors to get themselves protection.

The idea for the banks is to make a profit on each trade and avoid taking on the swap’s risk.

“Dealers are just like bookies,” Kane says. “Bookies don’t want to bet on games. Bookies just want to balance their books. That’s why they’re called bookies.”

The banks played the role of dealers in the CDO market as well, and the breakdown in that market holds lessons for what could go wrong with CDSs. The CDO market zoomed to $500 billion in sales in 2006, up fivefold from 2001.

Banks found a hungry market for CDOs because they offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating.

CDO Market Dried Up

By the middle of 2007, mortgage defaults in the U.S. began reaching record highs each month. Banks and other companies realized they were holding hundreds of billions in toxic debt. By August 2007, no one would buy CDOs. That newly devised debt market dried up in a matter of months.

In the past year, banks have written off $323 billion from debt, mostly from investments they created.

Now, if corporate defaults increase, as Moody’s predicts, another market recently invented by banks — credit-default swaps — could come unstuck. Arturo Cifuentes, managing director of R.W. Pressprich & Co., a New York firm that trades derivatives, says he expects a rash of counterparty failures resulting in losses and lawsuits.

“There’s a high probability that many people who bought swap protection will wind up in court trying to get their payouts,” he says. “If things are collapsing left and right, people will use any trick they can.”

Frank Partnoy, a former derivatives trader and now a securities law professor at the University of San Diego School of Law, says it’s high time for the market to let in some sunshine.

Centralized Pricing

“There should be a centralized pricing service for credit-default swaps,” he says. Companies should disclose their swaps holdings, he adds.

“For example, a bank might disclose the nature of its lending exposure based on its use of credit-default swaps as a hedge,” he says.

Last year, the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn’t worked. It’s been boycotted by banks, which prefer to continue their trading privately.

Leo Melamed, 76, chairman emeritus of Chicago Mercantile Exchange Holdings Inc., says there aren’t any easy solutions.

“Plus we’re not sure the banks want us to be in this business because they do make a good deal of money, and we might narrow the spreads considerably,” he says.

`Central Clearing House’

For now and for some time in the future, CDSs will remain unregulated and their trades will be done in the secrecy of Wall Street’s biggest securities firms. That means counterparty risk will stay out of the sight of the public and regulators.

“In order for us to get away from worries about counterparty risk, in order for us to encourage more trading and more transparency, there’s got to be some way to bring all the price data together with exchange trading or a central clearinghouse,” Backshall says.

Until that happens, the sword of Damocles will remain poised to fall, as banks, hedge funds and insurance companies can only guess whether their trillions of dollars in swaps are covered by anything other than darkness.

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