(B) Earlier this year, Bill Gross from PIMCO identified in his January 2008 Investment Outlook, the emerging risks to the financial system caused by the $45 trillion credit default swaps (CDS). This week George Soros interviewed by Maria Bartiromo on CNBC and Law Professor Michael Greenberger interviewed on Fresh Air on NPR were discussing again the growing risks of those credit derivatives.

Widely hold by commercial banks, CDS are the most utilized derivative instruments in the credit market. They exploded to more than $45 trillion in 2007 according to the International Swaps and Derivatives Association and, far exceed the $7 trillion mortgage market (the total present worldwide market for derivatives is $500 trillion, while the present US stock market is (only!) $22 trillion).

CDS are insurance-like contract that promise to cover losses of the lender on the underlying asset in the event of a default by the borrower. But as with any other derivative products, they can be used both to hedge (risk avoiding) and to speculate (risk seeking). When used to hedge, investing in CDS protects the asset value of the credit. When used to speculate, investing in CDS is a “bet” in the change of the quality of the credit. If you bet that the owner of the mortgage will repay its loan or the company will improve its business (and so the rating of its debt), you are making more money through a CDS than having lend money to the home owner or to that company. Pretty simple, isn’t it, like any other derivative!

As in “structured finance”, the risk that mitigates CDS can be transfer from one investor to another one without the transfer of the underlying asset. So CDS are commonly “swapped” between investors who bet on the various directions of those underlying assets (bonds, mortgages).

CDS are over-the-counter (OTC) derivatives (that is privately negotiated and not traded over an exchange) and so not regulated. This lack of regulation has contributed to their morphism and their growth.

CDS are traded without any “regulated visibility requirement” to insure that the buyer of the security has the financial resources to cover the losses in case the borrower defaults. So as Mr. Gross pointed out, with humor, who knows what are the reserves of the “Bank of Shadows”?

But before any regulation of the CDS market happens, if it happens, if some of those transactions start to massively default, the effects on the financial system might lead to further turmoil ahead.

Or as better said by Mr. Soros, the credit default swaps might be the Sword of Damocles hanging over the present financial market. Who knows who is doing what in the Bank of Shadows?

Note: To better understand credit derivatives, two books: Credit Derivatives & Synthetic Structures and Collateralized Debt Obligations & Structured Finance from Ms. Janet Tavakoli from Tavakoli Structured Finance both published at John Wiley & Sons. 

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