Investors grow fearful of credit swap defaults

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.

The Bear Stearns scare alarmed many money managers, as highlighted in a recent survey by Stamford, Conn.-based Greenwich Associates. The survey was based on interviews with 146 institutional investors, including 32 hedge funds, in North America and Europe.

Conducted not long after the mid-March collapse of Bear Stearns, it found that, among the U.S. institutions, nearly 85% of the respondents considered CDS counterparty risk a serious threat to global markets and that 62% of respondents who are into fixed-income investments have limited their use of CDS.

“People are nervous because they think there'll be another collapse of the Bear magnitude, but so far, that has not been the case. When we conducted the interviews, the markets were choppier than they are today,” said Timothy Sangston, fixed-income consultant at Greenwich Associates.

“The concern is that it's not an agency trade, it's a principal trade for the dealer who stands on the other side of the CDS contract. So, investors are reducing the number of trades they do with the counterparties that are in trouble. People are more selective in what they do,” Mr. Sangston added.

James Kauffmann, head of fixed income at ING Investment Management, Atlanta, said investment banks themselves are less eager than in the past to be counterparties in CDS trades. The firm has $234 billion in assets under management in its Americas division.

“I do not think the CDS market is in particularly good shape. It has narrowed considerably. We trade a lot of individual names and standardized indexes, but the liquidity is nowhere near what it used to be. It's reflected in the volume and the number of names that these brokers are willing to make markets in,” Mr. Kauffmann said. “Margin requirements went from zero to 3% or 5%. In some cases, depending on volatility, some of the margin requirements can be up to 30%.”

He added that ING now works with fewer counterparties because of the smaller field of active participants.

However, the CDS market, which serves an important hedging purpose in the corporate debt market, has proven resilient compared with more exotic OTC markets since the subprime mortgage crisis started roiling global markets a year ago.

“In August of last year, you could not trade anything,” Mr. Kauffmann said. “Today, you can trade by appointment. The dealers are a bit more on the side, acting as agents now, not as liquidity providers.”

Regulators also are concerned about counterparty risk in the CDS market.

The Federal Reserve Bank of New York is backing efforts to create a central clearinghouse for credit default swaps by year end that will provide additional transparency for these contracts and will be designed to curtail systemic risk. Seventeen broker-dealers and three major industry groups also are involved in the project.

“The question is, "Is there a systemic risk in the CDS and other over-the-counter derivatives markets?'” said Jay Gladieux, portfolio manager at Smith Breeden Associates Inc. in Chapel Hill, N.C., with $27 billion in assets under management.

“Yes, there is a systemic risk (from CDS and other instruments), as we have learned from Bear Stearns. But the Fed's "put' has substantially mitigated that risk by stepping in for an institution too big to fail. The concept is very much in place for the largest players,” said Mr. Gladieux, who viewed the Fed's new lending programs, including allowing investment banks to borrow from the central bank, as having curbed fears of counterparty risk problems.

“As a result, the CDS market remains active, although participants are careful about counterparty exposure. We are moving toward central clearing for the CDS market and this will be helpful, although what contracts would be included or what standard format and legal structure would be used for the contracts still needs to be defined,” he added.

The choice of a clearinghouse and procedures for the $2 trillion market raises a series of technical problems the dealers must sort out, as regulators do not want to force any particular solution upon the industry.

Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, New York, cautioned that, at least at first, the clearinghouse will only be used for interdealer transactions and only for index CDS, meaning this will offer no special protection for asset managers. But he also stressed that knowing with whom you do business is the soundest risk-management practice.

“In good times and in bad times, it is always important to understand who your counterparty is and what their creditworthiness is,” Mr. Pickel said. “Actually, the CDS market has been functioning far more effectively than others. But anybody entering in an OTC derivatives transaction would want to carefully scrutinize the quality of their counterparty risk.“

Contact Isabelle Clary at [email protected]