Posted by: Tobias | October 8, 2008

CDS, an unexploded bomb

This crisis seems to be far from over. Richard Baldwin, over at the Economist’s Free Exchange blog, summarizes the danger that credit default swaps may yet pose for the financial system:

Fact one—there are several dozen trillion dollars of these things out there—an amount that makes Paulson’s $700 billion look like a rounding error.

Fact two—they are basically insurance policies on bond defaults that are written without regulation, so the usual insurance-industry practice of setting aside reserves does not apply. Oh, and while the premia enter as bank income the pay-out obligations are not on their balance sheets.

Fact three—the large banks think they are hedged since they have "insurance policies" on both sides of the default events. Hedged? In normal times, perhaps. But imagine if one big issuer of these insurance policies went broke at roughly the same time that one of the insured bonds went bad—say, for instance, Ford bonds and a major Wall Street bank headquartered in Europe.

The Ford bond default would trigger a call for a huge payout by many banks, but the disappearance of one of the major issuers would wipe out the hedge that many other banks thought they had. This would leave banks liable for a huge payout for which they would have no reserves. This could trigger a wave of failures that would be very hard to stop given the size of the market.

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