Gathering Storm Clouds in CDS Losses

In my last blog post, I told you how once gridlocked credit markets have now returned to “normal.” Well, as “normal” as can be expected considering the highly leveraged and rather opaque nature of the modern financial system.

Libor rates, the barometer of the credit crunch, have declined significantly in recent weeks. Asset backed commercial paper rates have likewise fallen substantially, and companies have been net issuers of ABCP in recent weeks.

This indicates fair weather has returned to global capital markets. Mortgage loan rates too have fallen below 6%. Mortgage loan applications are surging again – up over 100% in the past two weeks alone – as homeowners struggle to refinance their way out of trouble before existing loan rates reset.

These are all hopeful signs that must be watched carefully in coming weeks and months, but if the trend continues, the worst of the credit crunch market shock may be over. Or is it?

New concerns were raised last week about the ability of financial firms to make good on their “derivative” obligations. Also, there’s growing concern about the solvency of firms that insured billions in subprime bonds amid rampant credit rating downgrades. Could this be the next shoe to drop? Yet another, deeper and darker chapter in the subprime market shock?

The latest issue to worry about is the market for credit default swaps (CDS). A recent article by bond fund manager Bill Gross highlighted the growing risk of a blowup in this derivative market. Credit-default swaps are a kind of insurance policy that financial firms trade (or swap) with each other to protect against the risk that a particular bond may end up defaulting. If the bond itself doesn’t pay principle and interest as an investor expects, the CDS pays off instead. At least that’s the theory.

Big institutional investors and hedge funds are big players in the CDS market, and the market for this particular type of derivative has grown to massive size.

In fact, the amount of CDS derivatives outstanding has doubled every year since 2004 – to a whopping $45.5 trillion today, according to the International Swaps and Derivatives Association. That’s up from just $632 billion in 2001 – a 70-fold increase in just six years.

The trouble is this: the global financial system has already suffered significant stress. Although credit market conditions are now substantially back to “normal” (as I described in my previous post), the damage has been done.

Banks and brokers have already owned-up to subprime losses and asset write-offs of nearly $150 billion since the third-quarter of 2007 (for a firm by firm “hit list” see table above).

There is already evidence that last year’s subprime debacle is spilling over into this year’s junk bond market, credit card and auto loans; and now into commercial real estate too. Yet, the global default rate on high-yield bonds finished 2007 at a 26-year low of just 0.9 percent.

According to forecasts by Moody’s, the default rate will jump more than fivefold to 4.8% by the end of 2008.  This growing default rate is sure to trigger massive losses in credit default swaps going forward.

Bond fund manager Bill Gross notes that, according to estimates from Goldman Sachs, "mortgage related losses of $200-$400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession."

Another dropping shoe that could go “thud” in the night!