Credit-Default Swaps May Produce Another Bear Stearns
Back on January 16, 2008, I wrote a post about an article I had read earlier that day by the Washington Post’s Steven Pearlstein. In “Caught in a Downdraft and Starting to Panic,” the 2008 Pulitzer Prize winner talked about the danger from credit-default swaps. He wrote:
Despite the brave exhortations from the CNBC Squawk Box, we are nowhere near the end of the financial unraveling that is necessary for an economic bottom to be reached…
Looking ahead, the final phase of this unraveling is likely to implicate the giant market in credit-default swaps. Those swaps are essentially contracts that allow sophisticated investors to bet on whether a company, a government entity, or even a securitized package of loans will default on its debt obligations. And they can place these bets whether they own the underlying security or not.
Because these contracts trade on unregulated derivatives markets, nobody knows who holds the losing side of the bets. But it’s a good guess that if defaults rise even to historically normal levels, a big hit will be taken by highly leveraged hedge funds, some of which may be unable to pay off on their bets and simply collapse. That, in turn, would trigger even further losses by banks and other investors that, unlike pure speculators, rely on those instruments to insure against default.
The credit-default swap has become so central to modern global finance that its size — the amount insured, in effect — is estimated at $43 trillion. If the losing side is unable to make good on even a fraction of a percent of those contracts, it could set in motion a financial chain reaction that could easily rival the subprime debacle.
Recently, I’ve noticed increased chatter about credit-default swaps in my research. Just today, I came across the following piece by the Wall Street Journal’s Donna Kardos in the MarketBeat Blog. Kardos wrote:
A growing proportion of U.S. firms are seeing credit-default-swap counterparty risk as a serious threat to global markets, and think another major financial company will go under due amid the global-markets crisis, according to a study by research firm Greenwich Associates.
The study’s results, which say the proportion seeing CDS counterparty risk as a serious threat is approaching 85%, highlight the perceived concern of another financial firm going down. Only 27% of the institutions surveyed think there won’t be another casualty along the lines of Bear Stearns, Greenwich consultant Frank Feenstra said in a statement.
The research firm said of the 146 U.S. and European banks, hedge funds and investors it surveyed, most “believe another major financial-services firm will fail as a result of the ongoing crisis in global markets — and they expect it to happen sooner rather than later.”
Almost 60% of the respondents expect another big financial firm will collapse within the next six months, while another 15% see it happening in six to 12 months.
Source:
“Who’s on the Other Side of That Trade, Anyway?”
Donna Kardos
Wall Street Journal (MarketBeat Blog), August 12, 2008
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