Tuesday 14th October 2008
by Bob Bardsley
Know Your Money Editor
While Credit Default Swaps (CDSs) might have been overlooked in many headlines, they remain a multi-trillion dollar liability for global economies. The products relate to the risk put forward by a loan, with investors guaranteeing to cover any losses should the borrower default on their repayments.
Thanks to a lack of regulation surrounding them, CDSs in the US markets have come to be worth twice the entire combined value of the US stock exchange, according to the New York Times. So how much of a risk do the derivatives pose in the UK and Europe? And how is that risk likely to be spread across the financial sector during the credit crunch?
The birth of the CDS
CDSs have been around since the early 1990s and are an unregulated area of the financial services industry. News resource NPR explains that they are effectively a means by which an investor offers security to a bank that a loan it has provided to a third party will be paid back. If the borrowing is repaid as expected, the investor retains their fee for having provided the assurance. However, should the borrower default on their repayment of the loan, the investor becomes liable to cover the loss at the agreed rate, according to NPR. The publication explains that the profit comes from gambling that, of all the CDS contracts entered into, most will succeed without a hitch, meaning any liability suffered will be outweighed by the earnings from successful contracts. This need to hedge by entering into a large number of different CDS agreements could be one reason why the industry has grown to a value cited by NPR of around $70 trillion (£40 trillion).
The credit crunch
The credit crunch has been blamed on a host of different factors, ranging from ten years of growth under a Labour government to the sub-prime lending crisis in the US. But CDSs are also on the list of usual suspects economists have compiled when trying to work out where the planet's communal finances went wrong. Both Lehman Brothers and AIG - two of the credit crunch's headline-grabbers - have been linked with losses associated with CDS trading, while other areas of financial turbulence have been indicated as arising from the two institutions' own illiquidity.
In the case of Lehman Brothers, Will Hutton recently wrote for the Observer that the organisation's lack of funds left it unable to meet $440 billion of CDS contracts. When they were subsequently auctioned, the sale price averaged $0.08 per dollar of contract value - a loss of $414 billion overall. Mr Hutton suggests that the surplus must be met from elsewhere in the market, while the failure of institutions in Iceland has left a further $200 billion hole which must be plugged. Whether these losses are borne by the financial services industry or passed on to consumers remains to be seen.
AIG, meanwhile, has been earmarked as the culprit behind much of the European banking industry's exposure to CDS losses. Business Week reports that many firms on the continent entered into CDS contracts with AIG, leaving the European markets as a whole liable for around $426 billion over the past year. By outsourcing their risk in such a way, the publication notes that banks were left with more money to pass to consumers in the form of loans, as they were not required to retain capital to cover the CDS contracts as they might be with other forms of risk. While this may have benefited consumers during the boom time, they could be left counting the cost during an economic downturn.
What happens next?
So what lies ahead for CDSs - and for taxpayers the world over? The New York Times makes some observations that could have investors and consumers alike worried, as it notes that the CDS market in the US weighs in at around twice the value of the entire stock market. As such, a question mark may be raised over where the funds could come from to bail out investment houses or other financial institutions should they lose significant sums on CDS failures. New York Times columnist Gretchen Morgenson also points out that the CDS sector has been unregulated until now, meaning financial organisations have been able to place their own valuations on the products.
With world economies continuing to feel the effects of CDS losses and other shocks to the markets, perhaps unregulated areas of the industry are to become an area of focus for authorities in the coming months as they seek to get the global financial industry back on track. Certainly there have already been failings in the sector, Ms Morgenson notes, with high levels of CDS trading in the third quarter of 2007 - the time at which the credit crunch reared its head - putting financial institutions' computer systems under strain and resulting in many of the products being valued at significantly more than they were worth.
Consumers might expect that any losses made by the banks will be passed on in the form of tightened lending criteria or reduced interest payouts. But unless issues such as CDSs are brought under the jurisdiction of regulators - with the associated potential for the markets and individuals to be protected from knock-on effects should a CDS loss arise - the future may yet hold more turbulence as organisations continue to gamble on areas of financial risk.
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