Credit Crunch..Will the same credit risk failings in the sub-prime debacle hit CDS?

2008-07-04 00:15:46 - The recent downgrades of monoline insurers have highlighted the potential problems in the credit default swap market. The sheer size of the market means that any credit risk failings have the potential to dwarf the sub-prime crisis, with dramatic consequences for all markets. The $62 trillion credit default swap (CDS) market has the potential to repeat, on an even grander scale, the credit risk failings that caused the collapse of the sub-prime market to turn into a wider credit crisis.

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The recent downgrades of monoline insurers have highlighted the potential problems in the credit default swap market. The sheer size of the market means that any credit risk failings have the potential to dwarf the sub-prime crisis, with dramatic consequences for all markets.

The $62 trillion credit default swap (CDS) market has the potential to repeat, on an even grander scale, the credit risk failings that caused the collapse of the sub-prime market to turn into a wider credit crisis. Despite large scale investment in credit risk solutions, the sub-prime crisis spread largely due to an over reliance on models, and a breakdown of the credit monitoring responsibilities of the originators. In essence, the inability to identify the risks and therefore value mortgage-backed securities accurately was at the core of the sub-prime debacle. The same potential exists for the CDS market due to its unregulated and fragmented nature. In much the same way, the rogue trader at Societe Generale showed that applications are not enough on their own to stave off disaster. They must be supported by wider processes and an understanding of the nature of the market and risks being taken on.

The current credit crisis has underlined the fragility of this market, as the recent downgrade of the monoline insurers MBIA and Ambac have brought significant governmental and regulatory attention to bear. The good news is that this attention has prompted significant moves into the area of centralizing and standardizing the exchange of CDS.

Recently we have seen Intercontinental Exchange (ICE) purchase Creditex, an electronic CDS trading platform. This in turn was quickly followed by the announcement that a group headed by Goldman Sachs, Morgan Stanley and 14 other banks will be competing for this business through their subsidiary Clearing Corp. This group alone counts for 90% of the market, so exchanges will have a tough fight on their hands to reach critical mass. There will be a concerted effort to bring the majority of trades onto a common exchange and clearing mechanism, as well as standardizing settlements.

The battle between banks and exchanges will be over the $34 billion in fees the CDS market generates. What had been an unregulated OTC market, albeit growing exponentially, was primarily a bespoke market with little standardization of contract or capital requirements. Credit Default Swaps started as a relatively safe means of offloading counterparty risk, in that they functioned as insurance against the risk of a default. The purchaser pays a premium over a period of time for such coverage. The problem arose from the unregulated nature of the market, as these derivatives could then be traded an unlimited number of times. Once away from the original transactors, the ability to track the credit worthiness of the holder at any particular time is difficult at best.

Additionally there are largely untested processes and procedures for recovery in the event of default. The rapid growth in the market has outstripped middle and back office capacity and prompted attention from the Federal Reserve dating from 2005, due to a backlog of unconfirmed trades. The backlog in processing and the lack of standardization in contracts thus far in the market, despite the best efforts of ISDA, has posed challenges in terms of risk management terms of capturing both the market and credit risk inherent in such a product.

In order to assist banks in minimizing risk, technology vendors must ensure that their credit risk solutions maintain flexibility in terms of interoperability. At present there are a range processing systems in the market, making it costly for buy-side firms to configure their systems. Bear Stearns and its large scale exposure to CDSs, as the party writing the protection, provides the best example of the risks involved. The move to a centralized counterparty is therefore long overdue and the implications should be significant for market data vendors and trading firms alike.

Related Market Research Report: UK Sub-prime Mortgages 2007 - Segment Report:

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