in Swaps Face Peril With Rising Junk Bond Defaults
By David Evans
May 20 (Bloomberg) -- 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
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.
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
``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
The Fed bailout of Bear Stearns on March 17 was
motivated, in part, by a desire to keep that sword from falling,
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,
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.
``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
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.
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
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
Citigroup Inc., also in
New York, is second, with $3.2 trillion in CDSs.
Goldman Sachs Group Inc.
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).
``This is going to complicate the financial
crisis,'' Das says. He expects numerous disputes and lawsuits, as
protection buyers battle sellers over the technical definition of
default - - this requires proving which bond or loan holders
weren't paid -- and the amount of payments due.
``It's going to become extremely messy,'' he
says. ``I'm really scared this is going to freeze up the financial
Andrea Cicione, a
London-based senior credit strategist at
BNP Paribas SA, has
researched counterparty risk and says it's only a matter of time
before the sword begins falling. He says the crisis will likely
start with hedge funds that will be unable to pay banks for
contracts tied to at least $35 billion in defaults.
$150 Billion Loss Estimate
``That's a very conservative estimate,'' he
says, adding that his study finds that losses resulting from hedge
funds that can't pay their counterparties for defaults could
exceed $150 billion.
Hedge funds have sold 31 percent of all CDS
protection, according to a February 2007 report by Charlotte,
Bank of America Corp.
Cicione says banks will try to pre-empt this
default disaster by demanding hedge funds put up more collateral
for potential losses. That may not work, he says. Many of the
funds won't have the cash to meet the banks' requests, he says.
Sellers of protection aren't required by law to
set aside reserves in the CDS market. While banks ask protection
sellers to put up some money when making the trade, there are no
industry standards, Cicione says.
JPMorgan, in its annual report released in
February, said it held $22 billion of credit swap counterparty
risk not protected by collateral as of Dec. 31.
`A Major Risk'
``I think there's a major risk of counterparty
default from hedge funds,'' Cicione says. ``It's inconceivable
that the Fed or any central bank will bail out the hedge funds. If
you have a systemic crisis in the hedge fund industry, then of
course their banks will take the hit.''
The Joint Forum of the Basel Committee on
Banking Supervision, an international group of banking, insurance
and securities regulators, wrote in April that the trillions of
dollars in swaps traded by hedge funds pose a threat to financial
markets around the world.
``It is difficult to develop a clear picture of
which institutions are the ultimate holders of some of the credit
risk transferred,'' the report said. ``It can be difficult even to
quantify the amount of risk that has been transferred.''
Counterparty risk can become complicated in a
hurry, Das says. In a typical CDS deal, a hedge fund will sell
protection to a bank, which will then resell the same protection
to another bank, and such dealing will continue, sometimes in a
circle, Das says.
`Daisy Chain Vortex'
The original purpose of swaps -- to spread a
bank's loan risk among a large group of companies -- may be
circumvented, he says.
``It creates a huge concentration of risk,'' Das
says. ``The risk keeps spinning around and around in this daisy
chain like a vortex. There are only six to 10 dealers who sit in
the middle of all this. I don't think the regulators have the
information that they need to work that out.''
And traders, even the banks that serve as
dealers, don't always know exactly what is covered by a
credit-default-swap contract. There are numerous types of CDSs,
some far more complex than others.
More than half of all CDSs cover indexes of
companies and debt securities, such as asset-backed securities,
the Basel committee says. The rest include coverage of a single
company's debt or collateralized debt obligations.
A CDO is an opaque bundle of debt that can be
filled with junk bonds, auto loans, credit card liabilities and
home mortgages, including subprime debt. Some swaps are made up of
even murkier bank inventions -- so-called synthetic CDOs, which
are packages of credit-default swaps.
AIG $9.1 Billion Writedown
On May 8,
American International Group Inc.
wrote down $9.1 billion on the value of its CDS holdings. The
world's largest insurer by assets sold credit protection on CDOs
that declined in value. In 2007, New York-based AIG reported $11.5
billion in writedowns on CDO credit default swaps.
director of trading and markets at the
Commodity Futures Trading Commission
from 1997 to 1999, says the Fed is fully aware of the risk banks
and the global economy face if CDS holders can't cover their
``Oh, absolutely, there's no doubt about it,''
says Greenberger, who's now a professor at the University of
Maryland School of Law in Baltimore. He says swaps were very much
on the Fed's mind when Bear Stearns started sliding toward
``People who were relying on Bear for their own
solvency would've started defaulting,'' he says. ``That would've
triggered a series of counterparty failures. It was a house of
It's concerns about that house of cards that
have kept Backshall, the California fund adviser, up at night. His
worries about a nightmare scenario started in early March. The
details of what happened are still fresh in his mind.
It's Monday, March 10, and the market is rife
with rumors that Bear Stearns will run out of cash. Some of
Backshall's clients have pulled their accounts from Bear; others
are considering leaving the bank. Backshall's clients are exposed
to Bear in multiple ways: They keep their cash and other accounts
at the firm, and they use the bank as their broker for trades.
Backshall advises them to spread their assets among various banks.
That same day, Bear CEO
Alan Schwartz says
publicly, ``There is absolutely no truth to the rumors of
Backshall's clients are suspicious. They see
other hedge funds pulling their accounts from Bear. In the
afternoon after Schwartz's remarks, the cost of protection soars
past 600 basis points from 450 before Schwartz's statement.
CEO Didn't Calm Fears
Swaps are priced in basis points, or hundredths
of a percentage point. At 600 basis points, a trader would pay
$6,000 a year to insure $100,000 of Bear Stearns bonds.
``I don't think his comments did anything to
calm fears,'' Backshall says.
The next day, March 11,
Securities and Exchange Commission
Christopher Cox says his
agency is monitoring Bear Stearns and other securities firms.
``We have a good deal of comfort about the
capital cushions at these firms at the moment,'' he says.
Cox's comments are overshadowed by rumors that
European financial firms had stopped doing fixed-income trades
with Bear, Backshall says.
``Nobody has a clue what's going on,'' he says.
Bear swap costs are gyrating between 540 and 665.
For most investors, just getting default-swap
prices is a chore. Unlike stock prices, which are readily
available because they trade on a public exchange, swap prices are
hard to find. Traders looking up prices on the Internet or on
private trading systems see information that is hours or days old.
Banks send hedge funds, insurance companies and
other institutional investors e-mails throughout the day with bid
and offer prices, Backshall says. For many investors, this system
is a headache.
To find the price of a swap on
Ford Motor Co. debt, for
example, even sophisticated investors might have to search through
all of their daily e-mails, he says.
``It's terribly primitive,'' Backshall says.
``The only way you and I could get a level of prices is searching
for Ford in our inbox. This is no joke.''
In the past three years, at least two companies
have developed software programs that automatically parse an
investor's incoming messages, yank out CDS prices and build them
into real-time price displays.
The charts show the highest bids and lowest
offering prices for hundreds of swaps. Backshall tracks prices he
gets from banks using the new software.
`It's Very Hard'
Backshall has been talking with hedge fund
managers in New York all week.
``We'd quite frankly been warning them and
giving them advice on how to hedge,'' he says of the Bear Stearns
crisis and banks overall. ``It's very hard to hedge the
counterparty risk. These institutions are thinly capitalized in
the best of times.''
The night of Thursday, March 13, Backshall can't
sleep. He lies awake worrying about Bear and counterparty risk.
The next morning, he arrives at work at 5 a.m., two and a half
hours before sunrise.
Through the window of his ninth-floor corner
office, he takes a moment to watch the distant flickers of light
in the rolling foothills of Mount Diablo. Across the street, he
sees the still-dark Walnut Creek train station, about 30 miles (48
kilometers) east of San Francisco.
Backshall, wearing jeans and a blue, button-down
shirt, sits at his desk, staring at a pair of the 27-inch (68.6-
centimeter) monitors that display swap costs. CDS prices jumped by
more than 10-fold in just a year. The numbers show rising fear, he
Until early in 2007, the typical price of a
credit-default swap tied to the debt of an investment bank like
Merrill Lynch & Co., Bear
Stearns or Morgan Stanley was 25 basis points.
`Unknowns Are Out There'
If a swap buyer wanted to protect $10 million of
assets in the event of a company default, the contract would cost
about 0.25 percent of $10 million, or $25,000 a year for a
five-year protection contract.
Backshall's screens tell him the cost of buying
protection on Bear Stearns debt in the past 24 hours has been
moving in a range between 680 and 755 basis points.
``The unknowns are out there,'' Backshall says.
He advises his clients not to buy CDS protection
on Bear because the price is too high and the time is wrong. It's
too late to buy swaps now, he says.
At 9:13 Friday morning in New York, JPMorgan
announces it will loan money to Bear using funds provided by the
Federal Reserve. The JPMorgan statement doesn't say how much it
will lend; it says it will ``provide secured funding to Bear
Stearns, as necessary.''
Bear CEO Schwartz says his firm's liquidity has
``significantly deteriorated'' during the past 24 hours.
Protection quotes drop immediately into the low 500s, as some
dealers think a rescue has begun.
That doesn't last long.
``Very quickly, the trading action is swinging
violently wider,'' Backshall says. Bear's swap cost jumps to 850
basis points that afternoon, his screen shows. ``When fear gets
hold, fundamental analysis goes out the window,'' he says.
In the calmest of times, making reasoned
decisions about swap prices is a challenge. Now, it's impossible.
Traders don't have access to any company data more recent than
Bear's February annual report. Sharp-eyed investors looking
through that filing might have spotted a paragraph that's
``As a result of the global credit crises and
the increasingly large numbers of credit defaults, there is a risk
that counterparties could fail, shut down, file for bankruptcy or
be unable to pay out contracts,'' Bear wrote.
`Material Adverse Effect'
``The failure of a significant number of
counterparties or a counterparty that holds a significant amount
of credit-default swaps could have a material adverse effect on
the broader financial markets,'' the bank wrote.
Even after JPMorgan's Friday morning
announcement, the market is alive with rumors. Backshall's clients
tell him they've heard some investment banks have stopped
accepting trades with Bear Stearns and some money market funds
have reduced their short-term holdings of Bear-issued debt.
On Sunday, March 16, the Federal Reserve
effectively lifts the sellers of Bear Stearns protection out of
their misery. JPMorgan agrees to buy Bear for $2 a share.
While that's devastating news for Bear
shareholders -- the stock had traded at $62.30 just a week earlier
-- it's the best news imaginable for owners of Bear debt. That's
because JPMorgan agreed to cover Bear's liabilities, with the Fed
pledging $29 billion to cover Bear's loan obligations.
Turned to Dust
For traders who sold protection on Bear's debt,
the bailout is a godsend. Faced with the prospect of having to
hand over untold millions to their counterparties just three days
earlier, they now have to pay out nothing.
For traders who bought protection swaps just a
few days earlier -- when prices were in the 600s to 800s -- the
Fed bailout is crushing. Their investments have turned to dust.
On Monday morning, the cost of default
protection on Bear plunges to 280. Backshall sits back in his
chair and for the first time in two weeks, he can breathe easier.
``No wonder I look so tired all the time,'' he
says, finally showing a bit of a smile.
When it bailed out Bear Stearns, the Federal
Reserve effectively deputized JPMorgan to monitor the
credit-default- swap market, says
Edward Kane, a finance
professor at Boston College. Because regulators don't know where
the risks lie, they're helpless, Kane says.
Default swaps shift the risk from a company's
credit to the possibility that a counterparty might fail, says
Kane, who's a senior fellow at the Federal Deposit Insurance
Corporation's Center for financial Research.
`Off Balance Sheet'
``You've really disguised traditional credit
risk, pushed it off balance sheet to its counterparties,'' Kane
says. ``And this is not visible to the regulators.''
BNP analyst Cicione says regulators will be
hard-pressed to prevent the next potential breakdown in the swaps
``Apart from JPMorgan, there aren't many other
banks out there capable of doing this,'' he says. ``That's what's
worrying us. If there were to be more Bear Stearnses, who would
step in and give a helping hand? You can't expect the Fed to run a
broker, so someone has to take on assets and obligations.''
Banks have a vested interest in keeping the
swaps market opaque, says Das, the former Citigroup banker. As
dealers, the banks see a high volume of transactions, giving them
an edge over other buyers and sellers.
``Dealers get higher profitability through lack
of transparency,'' Das says. ``Since customers don't necessarily
know where the market is, you can charge them much wider
Banks Try to Hedge
Banks try to balance the protection they've sold
with credit-default swaps they purchase from others, either on the
same companies or indexes. They can also create synthetic CDOs,
which are packages of credit-default swaps the banks sell to
investors to get themselves protection.
The idea for the banks is to make a profit on
each trade and avoid taking on the swap's risk.
``Dealers are just like bookies,'' Kane says.
``Bookies don't want to bet on games. Bookies just want to balance
their books. That's why they're called bookies.''
The banks played the role of dealers in the CDO
market as well, and the breakdown in that market holds lessons for
what could go wrong with CDSs. The CDO market zoomed to $500
billion in sales in 2006, up fivefold from 2001.
Banks found a hungry market for CDOs because
they offered returns that were sometimes 2-3 percentage points
higher than corporate bonds with the same credit rating.
CDO Market Dried Up
By the middle of 2007, mortgage defaults in the
U.S. began reaching record highs each month. Banks and other
companies realized they were holding hundreds of billions in toxic
debt. By August 2007, no one would buy CDOs. That newly devised
debt market dried up in a matter of months.
In the past year, banks have written off $323
billion from debt, mostly from investments they created.
Now, if corporate defaults increase, as Moody's
predicts, another market recently invented by banks --
credit-default swaps -- could come unstuck.
managing director of
R.W. Pressprich & Co., a
New York firm that trades derivatives, says he expects a rash of
counterparty failures resulting in losses and lawsuits.
``There's a high probability that many people
who bought swap protection will wind up in court trying to get
their payouts,'' he says. ``If things are collapsing left and
right, people will use any trick they can.''
Frank Partnoy, a former
derivatives trader and now a securities law professor at the
University of San Diego School of Law, says it's high time for the
market to let in some sunshine.
``There should be a centralized pricing service
for credit-default swaps,'' he says. Companies should disclose
their swaps holdings, he adds.
``For example, a bank might disclose the nature
of its lending exposure based on its use of credit-default swaps
as a hedge,'' he says.
Last year, the
Chicago Mercantile Exchange
set up a federally regulated, exchange-based market to trade CDSs.
So far, it hasn't worked. It's been boycotted by banks, which
prefer to continue their trading privately.
Leo Melamed, 76, chairman emeritus of Chicago
Mercantile Exchange Holdings Inc., says there aren't any easy
``Plus we're not sure the banks want us to be in
this business because they do make a good deal of money, and we
might narrow the spreads considerably,'' he says.
`Central Clearing House'
For now and for some time in the future, CDSs
will remain unregulated and their trades will be done in the
secrecy of Wall Street's biggest securities firms. That means
counterparty risk will stay out of the sight of the public and
``In order for us to get away from worries about
counterparty risk, in order for us to encourage more trading and
more transparency, there's got to be some way to bring all the
price data together with exchange trading or a central
clearinghouse,'' Backshall says.
Until that happens, the sword of Damocles will
remain poised to fall, as banks, hedge funds and insurance
companies can only guess whether their trillions of dollars in
swaps are covered by anything other than darkness.
To contact the reporter on this story:
David Evans in Los
Last Updated: May 20, 2008 08:55 EDT