Friday, February 1, 2008

CDS Risk: The Economist Magazine's Analysis

As I pointed out earlier this week, one undefined risk to the health of the financial markets is the potential impact of credit default swaps. These securities are used by banks, hedge funds, and other large institutions to hedge, and speculate on, the potential for default by one or more companies.

There are two specific risks:

  1. The number and value of actual defaults that are insured with the product could lead to significant losses to the insuring parties, reducing their capital and, consequently, their ability to fund economic activity (thus slowing the economy); and
  2. The potential for defaults by insuring parties and the impact of these defaults on the insured parties (who may have used the swaps to hedge the risk of default, and who would then have an unexpected exposure).

Both of these risks are difficult to quantify given the opacity of the CDS markets. The bigger risk to the overall financial system is, I believe, the potential for defaults by insuring parties (counterparty risk).

Counterparty risk is, for many products, limited through the use of daily settlements. Most of the CDS market is, however, traded over-the-counter in private transactions. Regular settlement for private transactions is limited.

It would be very difficult to resolve a significant number of counterparty defaults, should they occur. When Long Term Capital Management failed, the Federal Reserve had to step in to help sort out the situation. In that case there was one large defaulting party. Should there be significant defaults in the CDS markets, it is unlikely that the risks would be contained in one or two entities. The complexity of cleaning up multi-party defaults would likely provide a much greater challenge than that posed by the CDO/sub-prime mess.

There is the potential, if there are a significant number of counterparty defaults, that there could be a cascade of failures by banks, hedge funds, and other large institutions.

The Economist provides an interesting analysis of the situation in this article.

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