[OPE] The risks in swaps

From: Jurriaan Bendien (adsl675281@tiscali.nl)
Date: Sun Feb 17 2008 - 08:08:46 EST

When business is booming, risk-taking is regarded as the very essence of entrepreneurialism, the proof of the superiority and dynamism of the capitalist system. Anybody unwilling to take a risk is viewed as a loser, after all, the odds are in the risk-taker's favour. But when business is sagging, doubts set in, and the ideology changes; what was previously the entrepreneurial ideal becomes viewed as an irresponsible gamble. 
The interesting thing is, that the insurance taken out against risk (contrary to the rhetoric of risktaking) does not in fact appear to be riskfree either. In which case, the "challenge to take a risk" is transformed into an inescapable confrontation with risk. To be precise, as a result of the enormous effort to insure against investment risk, nobody truly knows what the risks are anymore. Here's a clip:

Obscure, large and arcane, credit default swaps face a big test

By Gretchen Morgenson 

IHT Feb 17, 2008 http://www.iht.com/articles/2008/02/17/business/17swap.php?page=1

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term. Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies' finances. Like a homeowner's policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts. The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion - roughly twice the size of the entire United States stock market. 

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity. It is entirely possible that this market can withstand a big jump in corporate defaults, if it comes. But an inkling of trouble emerged in a recent report from the Office of the Comptroller of the Currency, a U.S. banking regulator. It warned that a significant increase in trading in swaps during the third quarter of last year "put a strain on processing systems" used by banks to handle these trades and make sure they match up. (...) In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured. (...) 

Commercial banks are among the biggest participants - at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter. JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively. But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation's bond and going into the market to borrow it to supply to the buyer.(...)  

In 2000, $900 billion of credit insurance contracts changed hands. Since then, the face value of the contracts outstanding has doubled every year as new contracts have been written. In the first six months of 2007, the figure rose 75 percent; the market now dwarfs the value of U. S. Treasuries outstanding. Roughly one-third of the credit default swaps provided insurance against a default by a specific corporate debt issuer in 2006, according to the British Bankers' Association. Around 30 percent of the contracts were written against indexes representing baskets of debt from numerous issuers. But 16 percent were created to protect holders of collateralized debt obligations, complex pools of bonds that have recently experienced problems because of mortgage holdings. 

There is no exchange where these insurance contracts trade, and their prices are not reported to the public. Because of this, institutions typically value them based on computer models rather than prices set by the market. Neither are the participants overseen by regulators verifying that the parties to the transactions can meet their obligations. The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks' books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank's losses would have to be reflected on its books. Investors are already reeling from the recognition that major banks inaccurately estimated losses from the mortgage debacle. If further write-downs emerge as a result of hedges that did not work, investor confidence could take another dive. (...) 

To be sure, the $45 trillion in credit default swaps is not an exact reflection of what would be lost or won if all the underlying securities defaulted. That figure is impossible to pinpoint since the amounts that are recovered in default situations vary. But one of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against. (...) As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in. "The insurance business is very difficult to quantify risk in," said Farrell of Annaly Capital Management. "You have to really read the contract to make sure you are covered. That is going to be the test of the market this year. As defaults kick in and as these events unfold, you are going to find out who has managed this well."

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