CDSs and the web we weave

Covering more that $62 trillion in debt, credit default swaps are a market larger than the value traded on the New York Stock Exchange, but little is known about them - even among those who invest, and worse yet, those who issue the derivative securities.

CDSs are derivatives; they are assets that are synthetically created and how's value is derived from underlying assets - the debt obligations their holders are attempting to protect against default. Unlike your home, which you do not expect to actually burn down and buy insurance against such a rare eventuality just in-case, CDSs are purchased on the worst debt securities - those rated below investment grade. Of course, these too are the very securities are most likely to default when times are bad and, if you hadn't yet noticed, times they are bad ...and getting worse.

It gets worse. The firms selling these insurance policies are not only unmonitored, but are not officially considered banks - including the likes of JPMorgan, Goldman Sachs and many hedge funds. With losses expected to be as high as $150 billion dollars on the first round of defaults, will these firms be able to survive? Moreover, as we saw with Bear Stearns, can the economy afford the collapse of even one such firm or would it spell disaster for the capital markets as a whole? Unlike Bear Stearns, however, the Fed is unlikely to bail-out a hedge fund.

It gets more complicated. To get a handle on the situation, the first step would need to be to properly value the risk that is actually assumed by these various counterparties, but even this first step is not easily accomplished. Firms resell these securities as they would others - if you're having a moment of CDO-inspired Deja Vu, you ain't alone.

Most fundamentally, the CDSs were created with a very useful purpose in mind: to distribute the risk of a default across many firms that could bear that risk. However, with so few firms actually acting as the counterparty in many of these transactions, the very opposite has happened - with much of the risk concentrated. Go figure!

CDSs & Counterparty Risk; What Every Investor Should Know

Credit Default Swaps (CDSs) are making headlines these days, and not for good reasons. CDSs are essentially insurance contracts on debts - investors buy them to protect their income streams and principal investments in debentures should the issuing party default on their obligations. Most notable of these almost-defaults, of course, has been Bear Stearns and CDSs have been in the headlines ever since.

Why do you care? Well, would you believet that CDSs are unregulated and that there's no public record of the sellers solvency should they actually have to deliver on the contracts they sell. As an investor, this should scare you to death. Think about it this way: imagine you paid into your insurance policy, for your car, your home or even  your life, and when the worst actually happened, the insurance company just disappeared; this is the situation that may very well still happen. Yes, still; we're not out of the woods by any extent.

George Soros has been one of the most outspoken investors on the subject of how "unacceptable" it is to have a market such as this develop in an unregulated fashion. Now representing as much as $62 trillion in contracts, the collapse of such a market could mean worldwide financial fallout. This is no joke folks.

How's this for a revelation. JPMorgan is not only the investor of these types of contracts, but is also one of its biggest issuing firms (i.e. counterparties). Unlike traditional insurance companies, there is no agency that monitors the sellers of swap contracts. What makes things even more interesting, you don't even have to own the asset that you want to protect when you buy the swaps. Yes, that's like buying a life insurance policy on someone else - could you imagine if that were possible and what sort of practices that would condone?