Credit Default Swap Counterparty Risk

The enormous amount of counterparty risk that is associated with the $45 trillion market in credit default swaps seems to be finally hitting the radar screens of mainstream news outlets. Unfortunately this reporting interest is way behind the curve, as the said counterparty risk is being triggered in a big way in the problems of the ACA Financial Guaranty Corp.

The Wall Street Journal published a front-page article titled "Default Fears Unnerve Markets" by Susan Pulliam and Serena Ng. It is an excellent overview of the troubled CDS market.

Today, a struggling bond insurer, ACA Financial Guaranty Corp., will ask its trading partners for more time as it scrambles to unwind more than $60 billion of insurance contracts it sold to financial firms but can't fully pay off, according to people familiar with the matter. The contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own.

The problem is that the insurer itself is teetering -- with repercussions across the financial world. Some of its trading partners, called counterparties, already are writing off billions of dollars because of its inability to pay.

This is the reason why some deals that looked like "free lunches" in February 2007 are not so free after all.

With many bond values falling and defaults rising, especially in the mortgage arena, some institutions involved in these trades are weakened. This has investors and regulators worried that, through such swaps, some market players could spread their own problems to the wider financial system.

"You are essentially counting on the reliability of strangers" to pay up on their contracts, notes Warren Buffett, the Omaha billionaire. In some cases, he says, market players can't determine whether their trading partners have the ability to pay in times of severe market stress.

What the article omits, though, goes even further. It doesn't mention that a very big part of these CDS contracts are written by synthetic CDOs that are by definition not prepared for major payments at all. If they were, they would not have been closed in the first place.

The current problems are all derived from the proliferation of belief in the efficient market hypothesis. This theory, which posits that market valuations carry meaningful information about the real world, is basically self-defeating.

A high proportion of credit market participants look at prices, believing that those prices actually represent expectations of future defaults, which they do, initially. Then those market participants start to make investment decisions based on the price level, resulting in even smaller risk premiums. These same investors now think that the reduction in risk premiums is a signal of lower risk, even though the price reduction was caused by their very own uninformed investment decisions.

This is just like Winnie the Pooh following his own tracks in the snow, round and round again, until a moment of truth arrives. The music stops, and some of the players are left without seats.