Is Credit Default Indigestion Coming?

Even as the summer solstice approaches, shadows are lengthening in the credit derivatives market. Credit derivatives are contracts that are akin to default insurance for bonds and other indebtedness. Holders of debt buy credit derivatives (usually in the form of credit default swaps) from counterparties willing to take the risk of a default. If the debtor defaults, the holder of the debt then turns to the counterparty to cover losses. The notional amount of credit derivatives more than doubled from $17.1 trillion as of Dec. 31, 2005 to $34.4 trillion as of Dec. 31, 2006, and then almost doubled again to $62.2 trillion as of Dec. 31, 2007. With the economy slowing and the credit crunch persisting, it would be fair to think that this trend has continued in 2008.

Notional amount is similar to the face amount of the debt, and is not necessarily or even likely to be a measure of the potential loss. But, with the economic downturn, continued housing market problems, persistent credit crunch, escalating energy prices and general economic malaise, it's easy to contemplate the possibility of hundreds of billions of dollars of losses and maybe more. The rapid growth of this market--at a rate of 100% a year--tells us that holders of debt certainly perceive the potential for lots of defaults, or they wouldn't have paid for credit derivative protection.

Regulators and the financial services industry are moving to make the credit derivatives market more transparent and to strengthen its clearing processes by creating a central clearing facility that would ensure contracts are paid. These are steps in the right direction. But what about the large and rapidly increasing quantity of credit derivatives that today are still traded in the old-fashioned over-the-counter manner? These contracts are often done over the phone, and then are followed up with written confirmation. The paperwork has sometimes lagged behind the trades, and the only significant assurance that a counterparty would fulfill the contract in the event of default is the counterparty's word. If the counterparty stiffs you, you'd have to go to court and ask a judge to give the matter some thought.

Only the larger financial services companies and firms can play in the credit derivatives sandbox. The amounts of debt involved are so great that only well-capitalized companies can credibly serve as counterparties. One must wonder whether these firms have enough wherewithal to cover the liabilities that will arise, because there surely will be liabilities. If there are widespread defaults on credit derivatives, the financial storm that would follow would make last summer's mortgage crisis and credit crunch will feel like a gentle summer breeze.

The regulators hopefully are looking into the risks of the credit default market. They should be finding out who's got how much exposure to whom, and when it might materialize. Then, they should take steps to shore up weak points and have a game plan for dealing with the fallout of a flurry of defaults. Last spring, there were warning signals that the mortgage crisis was coming. Nevertheless, the regulators were, to be generous, caught absolutely flatfooted. A year later, they've managed to arrest a couple of former mid-level Bear Stearns executives. But wouldn't it have been much better if they had acted to prevent some of the bad things from happening? Would it do much good if, a year from now, a couple of mid-level credit derivatives executives are arrested?