I've got news for those who think the financial crisis is over: Just wait until the derivatives market starts blowing up in earnest. When firms that believed they were hedged discover -- belatedly -- that they aren't. When myriad counterparties positioned on the wrong side of losing trades -- or even on the right side of those that seemed to be winners -- suddenly see gushers of red ink spurting from those paper promises. And, finally, when major players and innocent bystanders alike are bludgeoned into deer-in-the-headlights submission by chaotic conditions that give new meaning to the word "volatility."
It's Friday, March 14, and hedge fund adviser Tim Backshall is trying to stave off panic. Backshall sits in the Walnut Creek, California, office of his firm, Credit Derivatives Research LLC, at a U-shaped desk dominated by five computer monitors.
Bear Stearns Cos. shares have plunged 50 percent since trading began today, and his fund manager clients, some of whom have their cash and other accounts at Bear, worry that the bank is on the verge of bankruptcy. They're unsure whether they should protect their assets by purchasing credit-default swaps, a type of insurance that's supposed to pay them face value if Bear's debt goes under.
Backshall, 37, tells them there are two rubs: The price of the swaps is skyrocketing by the minute, and the banks selling the insurance are also at risk of collapsing. If Bear goes down, he tells them, it may take other banks with it.
"There's always the danger the bank selling you the protection on Bear will fail," Backshall says. If that were to happen, his clients could spend millions of dollars for worthless insurance.
Investors can't tell whether the people selling the swaps - - known as counterparties -- have the money to honor their promises, Backshall says between phone calls.
"It's clearly a combination of absolute fear and investors really not knowing," he says.
On this day, a CDS-market meltdown doesn't happen. In a frenzy of weekend activity, the Federal Reserve and JPMorgan Chase & Co. rescue Bear Stearns from bankruptcy -- removing the need for the sellers of credit-default protection to pay up on their contracts.
Chain Reaction
Backshall and his clients aren't the only ones spooked by the prospect of a CDS catastrophe. Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis.
CDSs, which were devised by J.P. Morgan & Co. bankers in the early 1990s to hedge their loan risks, now constitute a sprawling, rapidly growing market that includes contracts protecting $62 trillion in debt.
The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb.
"It is a Damocles sword waiting to fall," says Soros, 77, whose new book is called "The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means" (PublicAffairs).
"To allow a market of that size to develop without regulatory supervision is really unacceptable," Soros says.
'Lumpy Exposures'
The Fed bailout of Bear Stearns on March 17 was motivated, in part, by a desire to keep that sword from falling, says Joseph Mason, a former U.S. Treasury Department economist who's now chair of the banking department at Louisiana State University's E.J. Ourso College of Business.
The Fed was concerned that banks might not have the money to pay CDS counterparties if there were large debt defaults, Mason says.
"The Fed's fear was that they didn't adequately monitor counterparty risk in credit-default swaps -- so they had no idea of where to lend nor where significant lumpy exposures may lie," he says.
Those counterparties include none other than JPMorgan itself, the largest seller and buyer of CDSs known to the Office of the Comptroller of the Currency, or OCC.
The Fed negotiated the deal to bail out Bear Stearns by allowing JPMorgan to buy it for $10 a share. The Fed pledged $29 billion to JPMorgan to cover any Bear debts.
'Cast Doubt'
"The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets," Fed Chairman Ben S. Bernanke told Congress on April 2. "It could also have cast doubt on the financial positions of some of Bear Stearns's thousands of counterparties."
The Fed was worried about the biggest players in the CDS market, Mason says. "It was a JPMorgan bailout, not a bailout of Bear," he says.
JPMorgan spokesman Brian Marchiony declined to comment for this article.
Credit-default swaps are derivatives, meaning they're financial contracts that don't contain any actual assets. Their value is based on the worth of underlying loans and bonds. Swaps are similar to insurance policies -- with two key differences.
Unlike with traditional insurance, no agency monitors the seller of a swap contract to be certain it has the money to cover debt defaults. In addition, swap buyers don't need to actually own the asset they want to protect.
It's as if many investors could buy insurance on the same multimillion-dollar home they didn't own and then collect on its full value if the house burned down.
Bigger Than NYSE
When traders buy swap protection, they're speculating a loan or bond will fail; when they sell swaps, they're betting that a borrower's ability to pay will improve.
The market, which has doubled in size every year since 2000 and is larger in dollar value than the New York Stock Exchange, is controlled by banks like JPMorgan, which act as dealers for buyers and sellers. Swap prices and trade volume aren't publicly posted, so investors have to rely on bids and offers by banks.
Most of the traders are banks; hedge funds, which are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall; and insurance companies. Mutual and pension funds also buy and sell the swaps.
Proponents of CDSs say the devices have been successful because they allow banks to spread the risk of default and enable hedge funds to efficiently speculate on the creditworthiness of companies.
'Seeing the Logic'
The market has grown so large so fast because swaps are often based on an index that includes the debt of scores of companies, says Robert Pickel, chief executive officer of the International Swaps and Derivatives Association.
"Whether you're a hedge fund, bank or some other user, you're increasingly seeing the logic of using these instruments," Pickel says, adding he doesn't worry about counterparty risk because banks carefully monitor the strength of investors. "There have been a very limited number of disputes. The parties understand these products and know how to use them."
Banks are the largest buyers and sellers of CDSs. New York- based JPMorgan trades the most, with swaps betting on future credit quality of $7.9 trillion in debt, according to the OCC. Citigroup Inc., also in New York, is second, with $3.2 trillion in CDSs.
Goldman Sachs Group Inc. and Morgan Stanley, two New York- based firms whose swap trading isn't tracked by the OCC because they're not commercial banks, are the largest swap counterparties, according to New York-based Fitch Ratings, which doesn't provide dollar amounts.
Untested Until Now
The credit-default-swap market has been untested until now because there's been a steady decline in global default rates in high-yield debt since 2002. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody's Investors Service.
Since then, defaults globally have dropped to 1.5 percent, as of March. The rating companies say the tide is turning on defaults.
Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002. On May 7, Moody's wrote that as the economy weakened, high-yield-debt defaults by companies worldwide would increase fourfold in one year to 6.1 percent by April 2009.
The pressure is building. On May 5, for example, Tropicana Entertainment LLC filed for bankruptcy after the casino owner defaulted on $1.32 billion in debt.
'Complicate the Crisis'
A surge in corporate defaults may leave swap buyers scrambling, many unsuccessfully, to collect hundreds of billions of dollars from their counterparties, says Satyajit Das, a former Citigroup derivatives trader and author of "Credit Derivatives: CDOs & Structured Credit Products" (Wiley Finance, 2005).
