Default Swaps May Be Next In Credit Crisis

This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

The New York Sun

The biggest Wall Street story most Americans haven’t yet heard of is the $62 trillion unregulated credit default swaps market.

Here is one scenario: A hedge fund buys insurance in case a company defaults on its bonds — a so-called credit default swap — when the hedge fund doesn’t necessarily own the bonds. Then it immediately shorts the stock, driving down the company’s share price, leading to a downgrade, and eventually triggering a default. It is the ultimate moral hazard, like taking out fire insurance for a home you don’t own: There is an obvious motivation to set the house on fire and collect the insurance.

Meanwhile, that same hedge fund may also be issuing its own credit default swaps, where it promises to cover a company’s bonds if it defaults, in exchange for the buyer of the swap paying out a premium. The premium is paid out in regular intervals, much like an insurance premium, and is a simple means for the hedge fund to generate additional income. This is especially true because the hedge fund does not have to put aside any capital to cover the swaps it is writing. Riskier still, no bond has to actually be delivered to settle the swap in case of a default.


“The credit default swap market is the ultimate bubble, and it is about to collapse,” the managing director of Institutional Risk Analytics, Christopher Whalen, said. “It is a Ponzi scheme, and is basically the same method as a bookie uses.”

Hedge funds have been employing this strategy over the past several months as the financial sector caves in, some analysts and industry observers said. “If they had tried this any time in the last three years, they would have gotten torched; it is only very recently that something like this could work,” the chief strategist at Fusion IQ, Barry Ritholtz, said, adding that he had no first-hand knowledge of the strategy.

With defaults on the rise — Standard & Poor’s 12-month forward default rate forecast is 4.9%, although it said it could reach as high as 8.5%, compared to a 25-year low of 0.97% at the end of 2007 — more credit default swaps are being triggered.


In the past, if credit default swaps were triggered by a default, a hedge fund would just write more swaps to cover it. But now the credit default swap market is largely frozen following the collapse of Lehman Brothers Holdings, which was an important player in the market. Making matters worse, the hedge funds that wrote these swaps never put aside any capital to cover them, so they are unable to pay and are liquidating their positions and closing.

So far, many of the banks that bought the swaps from the hedge funds have quietly eaten the loss, market insiders with knowledge of the industry said. The banks and others in the markets do not want to arouse the attention of regulators or the bankruptcy court, which could issue adverse rulings that will constrict the lucrative market, people familiar with their strategy said.

“You don’t read about the fails because dealers come in and clean it up,” Mr. Whalen said. “The dealers are closing ranks, and don’t want anyone to hear about how they are taking back positions and absorbing the losses.”


Because hedge funds are private, and the swaps market is not traded on any central exchange, there is very little transparency and no real documentation. But the complex credit default swaps market may now be forced to come out of its shadow, as defaults mount and banks are unable to stomach the losses, leading contract disputes and bankruptcies to spill onto the front pages of newspapers and the court, analysts and investors said.

Still, much remains to be clarified. For example, it is still not clear whether credit default swaps are securities — and therefore under the jurisdiction of the Securities and Exchange Commission — or insurance tools that come under the umbrella of the New York State Insurance Department.

The Commissioner of the state’s Insurance Department, Eric Dinallo, has indicated that the instruments are a type of insurance, but has also said he is only likely to consider as valid those credit default swaps where the underlying bond against which a swap was issued is actually presented. This could pose difficulties for the billions of dollars in credit default swaps that were purchased without the underlying bond, people said.

The SEC has not taken any position in regards to the credit default swaps market, but on Friday the SEC said it would begin requiring some hedge fund managers to submit their trading activity, including credit default swaps, to the agency.

The trade group that represents the market — the International Swaps and Derivatives Association — has argued against any regulation from the SEC.

“Last week, as liquidity dried up, the derivatives market continued to serve as an outlet for managing risk,” the counsel and head of global public policy at ISDA, Greg Zerzan, said in a statement. “Over the counter derivatives continue to play a critical role in keeping the markets functioning.”

The New York Sun

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