Looming increasingly larger on the financial market horizon is the threat of credit default swap risk. Large global banks have become major players in the credit default swap market over the last few years and problematic exposure is beginning to unravel.
Banks releasing results are now provisioning for credit default swaps exposure, often linked to troubled bond insurers.
Credit default swaps are instruments used for loans and bonds, and effectively act as an insurance policy on corporate debt. The trades also allow investors to speculate on a company’s ability to repay the debt. Credit default swaps is an area where both counterparty risk is opaque and the insurance in some cases already impaired.
Bond insurers such as the troubled ACA, started insuring more complex products like credit default swaps and collateralised debt obligations, which have been hard hit by the falling value of those products.
Often a bank’s deal involves buying a credit default swap (CDS) and then selling it on to another bank for a small fee. The trade can come undone due to the downgrading of the bond insurer, which is the counterparty risk. Once the counterparty gets into difficulty, the bank faces a credit-risk event because it must now insure a big group of companies’ bond issues. It will usually only lose money if around 20 per cent of those companies fail to pay interest on the bond. Investment banks such as Merrill Lynch are now looking carefully at banks’ exposure to CDSs as they are relatively untested instruments through a cycle.
European bank credit default swaps, a good proxy for funding costs, are now trading in aggregate at higher spreads than the Continent’s blue-chip corporate borrowers, a complete reversal of historic norms. Many banks are now unable to obtain funding at rates that would allow them to profitably lend to their higher-quality clients. And while the European Central Bank’s willingness to provide banks short-term funding against loans they are stuck with has helped to avoid an out-and-out disaster, it too leaves banks with a currently unworkable business model and increasingly unwilling to extend new credits or take on risk.
The global market for CDSs has rocketed over the past four years. There are now $46 trillion of outstanding trades. CDSs have been widely used by the thinly capitalised off-balance sheet vehicles created by banks over the past few years, and so these could struggle to find the money required if the derivative contracts are triggered, creating so-called counterparty risk for those expecting to be paid.
So far, few CDS contracts have been triggered because corporate defaults have been rare. But debt agencies expect the worldwide default rate for junk-rated firms to jump this year from 0.9 per cent to just under 5 per cent – the historical average – as the economy weakens. The overall corporate-insolvency rate (encompassing investment-grade and junk debt) is set to return to a historically typical 1.25 per cent. That would trigger around $500 billion in default insurance.
The risk of Asia Pacific corporates and governments defaulting on their debt has risen recently on concern that a proposal to split US bond insurers may spark further credit losses, credit-default swaps show. Over the past couple of days, the Markit iTraxx Asia Index of 20 high-risk, high-yield borrowers increased by 19 basis points to 580 basis points. The Markit iTraxx Asia Index of 50 investment-grade borrowers increased by 3 basis points to 158.5 basis points. There are worries about the credit contagion from the US sub-prime and monocline insurance groups.
The credit-default swap indexes are benchmarks for protecting debt against default and traders use them to speculate on shifts in credit quality. A basis point, or 0.01 percentage point, is equivalent to $1,000 on a swap that protects $10 million of debt from default. The contracts were developed to protect bondholders by paying the buyer face value in exchange for the underlying securities should the borrower default.
Any turmoil in the credit default swap market could result in a greater financial crisis than that caused by the sub-prime crisis in late 2007.
The amount of outstanding trades. The global market for CDSs has rocketed over the past four years and they have been widely used by the thinly capitalised off-balance sheet vehicles created by banks
A basis point, or 0.01 percentage point, is equivalent to $1,000 on a swap that protects $10 million of debt from default. The contracts were developed to protect bondholders
The number of basis points the Markit iTraxx Asia Index of 20 high-risk, high-yield borrowers increased by over the past couple of days, to reach 580 basis points. There are worries about credit contagion
Credit default swap risk gathers momentum