Who sells credit default swaps?

[ExHermit]

I keep seeing stories like this from Bloomberg

"Prices for credit-default swaps that pay investors if MBIA can't meet its debt obligations imply a 71 percent chance it will default in the next five years, according to a JPMorgan Chase & Co. valuation model. Contacts on Ambac imply 72 percent odds."

Or this from The Australian:

"Premiums on credit default swaps have been rising, adding fresh pressure to funding costs. At Bear Stearns, for example, credit default swaps have risen from about 20 basis points in the middle of last year to 230 basis points. At Citigroup, they have gone from about 7 basis points to 90 basis points."

Who is selling these credit default swaps? If Citygroup, the largest bank in the country, goes belly up, the financial system is obviously in major trouble. Who could you trust to guarantee payment of Citygroup's bonds?

How big is the credit default market? Are we likely to see cascading defaults caused by closed loops (or more complex closed webs) where Company A insures the bonds of Company B who insures the bonds of Company C who insures the bonds of Company A?

ExHermit

 

[danm]

Swaps are sold by institutional guys in limited partnerships. As to the exact size, nobody knows. You know - over the counter - unregulated? Faint idea. Wasn't until a few years ago that they even got organized into keeping track of who sold what to whom - under pressure.

"How big is the credit default market?"

Derivative market is about 500 trillion, swaps are a large portion of that (probably larger than our economy in monetary terms)

"Are we likely to see cascading defaults caused by closed loops (or more complex closed webs) where Company A insures the bonds of Company B who insures the bonds of Company C who insures the bonds of Company A?"

Yes, the bond insurers are next.

This is a huge deflationary event, the near money created in the derivatives market is quickly vaporizing. Deflation is impossible? Other than some trillions in housing wealth, some trillions in global stock wealth, and many more trillions in false credit all vaporizing, no, I'd say deflation is impossible. Right.

 

[clifp]

"How big is the credit default market?"

Derivative market is about 500 trillion, swaps are a large portion of that (probably larger than our economy in monetary terms)

"Are we likely to see cascading defaults caused by closed loops (or more complex closed webs) where Company A insures the bonds of Company B who insures the bonds of Company C who insures the bonds of Company A?"

Yes, the bond insurers are next.

This is a huge deflationary event, the near money created in the derivatives market is quickly vaporizing. Deflation is impossible? Other than some trillions in housing wealth, some trillions in global stock wealth, and many more trillions in false credit all vaporizing, no, I'd say deflation is impossible. Right.

Listening to the talking heads on CNBC on pretty informative special I was struck by a couple of points.

First, the potential for a financial disaster is certainly huge as DanM points out. 500 Trillion dollars in credit swaps is 30x the US GDP.

On the other hand the actual need to pay out insurance on these deals is very small. One of the CNBC guys said that corporate bond defaults in Nov. were at a record LOW. Assuming that everybody involved in the process can keep their heads and not panic we should be able to get through this mess. I also figure that people who have the most to lose are bankers and Wall St types and hence have a strong incentive to make the system work.

Not surprisingly Warren Buffett has been warning that financial derivative were weapons of mass destruction for the last few shareholder letters

 

[ExHermit]

Bloomberg column on this topic

This commentary published today by Jonathan Weil, a Bloomberg News columnist, addresses the topic of this thread.

Bloomberg.com: Opinion

In my original post, I speculated about the possibility of closed loops, where a small group of institutions claim to insure each other. Actually I was imaging too complex a structure. It seems that one institution can insure its own capital.

"At Sept. 30, MBIA said it had a $37.7 billion investment portfolio, including $24.5 billion of holdings rated AAA. Yet $5.1 billion of those investments were rated AAA only because they were insured by MBIA."

ExHermit

 

[haha]

"At Sept. 30, MBIA said it had a $37.7 billion investment portfolio, including $24.5 billion of holdings rated AAA. Yet $5.1 billion of those investments were rated AAA only because they were insured by MBIA."ExHermit

I love it! You couldn't make this stuff up.

Ha

 

[clifp]

I love it! You couldn't make this stuff up.

Ha

Actually it is even worse than this. Bill Ackman is a long time bear on MBIA and AMBAC and has been screaming about there abuses for a while. He has a long held short position on both companies and evidently will make $500 if the go belly up (he said he will donate the profits to charity!!)

This an excerpt from a recent open letter he wrote to credit rating [-]liars [/-]agencies. The whole letter is long but interesting.

Your ratings of the bond insurers are based on the bond insurers’ net credit exposures. That is, you reduce their credit exposure by those exposures that have been reinsured. This is best understood by example.

As of September 30, 2007, MBIA has re-insured approximately $80 billion of par value
of its exposures. More than $42 billion of this reinsurance was purchased from Channel Re, a Bermuda- based reinsurer whose only customer is MBIA. The two most senior officers of Channel Re are former executives of MBIA. MBIA owns 17% of the company and has two representatives on Channel Re’s board of directors.

On recent conference calls, Moody’s and S&P have stated that they have not yet updated their ratings of the monoline reinsurers including Channel Re. Earlier this week, on January 16th, Partner Re and Renaissance Re, the majority equity owners of Channel Re, wrote off the entire value of their investments in Channel Re due to losses it has recently incurred that substantially exceed Channel Re’s capital, an impairment that Channel Re’s two majority owners have concluded is “other than temporary.”

Despite the fact that Channel Re has negative book equity and $42 billion of MBIA’s credit exposure – $21.5 billion of which is CDOs of ABS or CLO/CBOs – Moody’s and S&P continue to rate the company Triple A with a stable outlook. Fitch does not rate Channel Re and apparently relies on S&P’s and Moody’s stale Triple A ratings in its
analysis of MBIA’s capital adequacy.

Shades of Enron.

 

[TickTock]

Jon Markman's take on the CDS mess.

ACA guaranteed $60 billion on a capital base of $500 million?!?!

I said sometime ago that my worst fear is that, when the whole mess is unravelled, each $1 of real house worth is collateral for $12 of loans. Maybe I was wrong; maybe it's $120 of loans per 'real' dollar!

 

[Maurice]

Outstanding notional of CDS is nowhere near 500T, the previous poster's sources were probably confusing CDS with interest rate swaps (which form the lion's share of derivatives contracts by notional value). I'd put total CDS notional at more like 50T.

These are mostly sold by top-tier investment banks. JPMorgan is the leader in the market. The big banks have lots of positions in these, but tend to manage the risk pretty flat - i.e. they'll be long default risk with one counterparty and short default risk with another, more or less netting out.

That's not to say there isn't any systemic risk in this market, I think there could be.

Another interesting issue arises from the fact that these contracts are usually physically settled - meaning if I sell you a CDS on reference entity X and X goes under, I owe you the notional value of the contract and you owe me that same (face) value of bonds. (since the bonds almost always have some value even in bankruptcy).

What happens if there are more CDS outstanding on a given name than bonds? It could be physically impossible for all the CDS buyers to obtain bonds in the market, thus many will be unable to meet their obligations under their existing contracts.