The extended credit crisis and March's collapse of Bear Stearns Cos. have led institutional investors to take a hard look at whom they are doing business with in the $2 trillion credit default swaps market.
“We are playing with very large dominoes here, so the domino effect could be very large as well,” David Klein, manager for credit indexes at Credit Derivatives Research LLC, Walnut Creek, Calif., said in an interview.
About 20 financial firms worldwide are the counterparties of asset managers in more than 90% of the CDS market, which exploded in 2007 to a record $2 trillion in market value — more than four times the $470 billion in 2006 and eight times the $243 billion in 2006. Its notional value also doubled to $57.8 trillion from $20.3 trillion in 2006.
Most of these firms have reported balance sheet problems or other woes tied to their huge exposure to various credit markets.
“The credit market has not seen a high level of defaults so, as yet, CDS counterparties have not truly been tested,” said Mr. Klein, whose firm on June 17 launched the CRI index, the first to track the risk of banks and brokers that are the main counterparties in the $516 trillion over-the-counter credit derivatives market, .
CDS contracts are a form of insurance against default on a debt where the buyer of insurance makes periodic payments the seller, who assumes the risk of default. The main concern for investors who are buyers of that insurance is whether, in the event of a default, the seller of insurance will be able to make good on its obligations.
And there's growing concern about the mounting level of defaults.
“Defaults are on the rise, with the 12-month speculative-grade default rate at 1.92%, up from 0.97% at the end of 2007. Spreads remain elevated and volatile, with our investment-grade index at 267 basis points on Aug. 8, up 65 basis points from the end of 2007. The speculative-grade index is at 757 basis points, up 196 basis points since the end of 2007,” Diane Vazza, managing director at Standard & Poor's in New York, wrote in an Aug. 14 report.
According to a CDS market participant who declined to be named, the effect of the weaker economy already is obvious in certain industries, such as homebuilders, where CDS trading is close to a standstill.
In recent discussions with institutional clients, Mr. Klein noticed rising concern about counterparty risk at a time when a weaker economy is boosting the odds of default.
“We've encountered a fair amount of interest from market participants who are considering trading the CRI as a way to hedge counterparty risk. I view this as a sign that investors are concerned about the health of credit derivatives dealers,” added Mr. Klein.