Credit default swaps: are we seeing a black swan?

We noted a quote from Bill Gross in the course of our January 2008 discussion of the dangerous $45 trillion in Credit Default Sawps outstanding (more like $55-60 trillion today). He referred to something we had never heard of, Black Swan Theory, the idea that something unimaginable actually could happen:

Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant “black swan” run that might break them.

One of our readers has speculated that the a cause of the continuing and unprecedented sell-offs in the market (a mere 679 points today on the Dow) is the unwinding of $400 billion in these Wild West credit contracts at bankrupt Lehman Brothers, contracts that exist in a shadow market without reserve requirements or regulations. Thus, perhaps the Treasury’s allowing Lehman Brothers to fail precipitated the “black swan run” that Bill Gross warned us about. FT:

The failure of Lehman Brothers has exposed new fault lines in the credit default swap market, with the bank’s absence putting pressure on its counterparties to buy more credit insurance just as confidence in the market is waning. “It is a cannibalistic frenzy,” says one lawyer representing some of the Lehman counterparties in disputes with the failed investment bank. “The credit default swap market has taken on a life of its own. There are huge exposures out there.”…

“Many investors had long and short CDS positions with Lehman which are terminated post Lehman’s default,” said a recent report from JPMorgan Securities. “This leaves investors suddenly long or short on credit risk. Investors need to reset these positions with other counterparties, sometimes at a loss.”…participants can’t just extinguish credit derivatives contracts with Lehman, they can only offset them. That, in turn, puts pressure on some participants to buy more credit insurance and the cost of such contracts is rising…

Theoretically, claims against Lehman should be offset by claims on Lehman’s part. But those who believe Lehman owes them money are pressing their claims, and those who owe money to Lehman “basically say come and get me”…

As we said the other day, normally the events of the last few weeks would get us thinking that the market was perhaps bottoming. But it is certainly conceivable that the current market turmoil is much more about the unimaginable amount and danger of Credit Default Swaps than it is about the mortgage market, bad as that is. If that is the case, we are in uncharted territory, and it’s anyone’s guess where the bottom might be — though it also implies that no more large institutions (in any country?) with significant exposure to the CDS market should be allowed to fail; rather, they should be merged into other, healthier financial institutions so that chaos is avoided among the various counterparties to the failed entity. “Should” is the key word in that last sentence.

One Response to “Credit default swaps: are we seeing a black swan?”

  1. canucklehead Says:

    Yesterday, the Canadian banking industry reset their respective mortgage rates. The coordinated central bank rate drop of 0.50% was not passed on to consumers. In actual fact, many mortgage rates were increased significantly. I suspect mortgage requirements have been greatly tightened. Don’t expect another central bank rate drop to start consumer spending. Is the banking industry preparing to batten down the hatches or they are preparing for “asset inflation” via helicopter delivery methods?

    Where do we go from here? Who knows. That alone should say we are near a bottom. I suspect in 6 months we should have navigated to somewhat better times.

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