Several Australian companies in trouble

So far in this downturn in the United States most of the defaults have been confined to households defaulting on their mortgages and losing their homes. Those defaults are at a record high and the general sense is that there will be more of them this year. That problem has led to a credit squeeze as banks are forced to rebuild their capital bases to cover the subprime mortgage losses. That is now affecting corporate borrowers who have to refinance their short term debt, and we are seeing several Australian companies in trouble because of that.
It was a piece about credit default swaps, and how it will be the next subprime-type debacle. The CDS market is getting the wobbles, it seems.
In Australia, for example, the spread on Macquarie Group CDSs has blown out from 60 basis points (0.6 per cent over bank bills) in December to 190 basis points today. The same thing is happening across the United States and last week American International Group shocked the market by confessing that its auditor had found a $US3.6 billion mistake in the valuing of its massive CDS portfolio.
A credit default swap is a contract under which two parties agree to isolate and trade the credit risk of at least one third-party. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a payment by the seller in the event of default in the reference entity.
When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).Basically credit default swaps are insurance policies, as they can be used by debt owners to hedge, or insure against default on a loan. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spreads. Anyway, towards the end of the NY Times article was the news that the market for CDSs now stands at about $US45 trillion, but that the corporate bonds against whose defaults the swaps were created to protect lenders total just $US15.7 trillion. What on earth does this mean? I was already having enough trouble getting my head around the shadowy, unregulated credit default swap market that is twice the New York stockmarket to begin with. But the idea that the derivatives were three times the value of the debt they are created against was too much.

It must mean that a lot of people have bought protection who don’t need it – they just did it as a bet that the company will fail.

It’s like short selling a company’s shares. Someone on the other side has bet with you that the company won’t default. It’s like betting on flies crawling up the wall, except without the form guide.

So, for example, when car parts maker Delphi went broke in 2005, the credit default swaps on the company’s debt exceeded the value of the underlying bonds tenfold. Those who had committed to deliver bonds in the event of default couldn’t do so, and an arrangement had to be struck that saw the buyers of protection get US$366.25 for every US$1000 they had bought. If the insurance was in their books at $1000, it had to be written down by $633.75.

Credit default swaps were invented with collateralised debt obligations in 1995 by Blythe Masters, a 34-year Cambridge graduate who was then the head of JP Morgan’s Global Credit Derivatives group.

The CDS market has now grown to be twice the size of the NY stock exchange and it is entirely unregulated. The contract is typically documented under nothing more than a confirmation that references a definition published by the International Swaps and Derivatives Association.

The prices are not reported to the public and trades are done in private – there is no CDS exchange.

They are valued by the institutions involved (that is, the bookies) using sophisticated computer models. The trade is not overseen by regulators and no one is checking whether anyone can meet their obligations.

About a third of swaps are held by banks, according to the banking regulator, the Comptroler of the Currency, some of it to insure against possible default losses among their loan clients and some of it simply to bet against, or for, other banks’ clients.

But of course the big explosion in the trade in default swaps and CDOs has come from hedge funds.

Only about a third of the credit default swaps were created against a specific corporate debt issuer. The rest are either written against indexes representing baskets of debt from a variety of issuers or against collateralised debt obligations (CDOs) which are pools of bonds that include subprime mortgages as well as corporate bonds.

Many CDOs, in fact, act like credit default swaps. The ones that have been sold to now-grumpy Australian municipal councils are created out of thin air and are based on an artificial list of companies, usually a grab-bag US companies that the issuing bank wants to buy insurance against.

If four or five of these companies default, then the buyer of the CDO loses its entire investment. It is simply another form of default insurance for banks, but they have been turned into a form of gambling for hedge funds and investors like municipal councils, who should know better.

Fear of the unknown is now stalking financial markets. Warren Buffett called all these derivatives “financial weapons of mass destruction” and his words are haunting ordinary investors who haven’t the faintest clue about this unseen “dark matter” that is filling the night sky.

During the credit market turmoil of last August, 14 per cent of the CDS trades were “unconfirmed”, which meant one of the counterparties in the resale transactions was unknown, and remained unknown for 30 days.

This means insurance has been bought from, or a bet has been made with, an unknown person. Whether that party can meet the obligation in the event of a default is unknown.

On second thoughts, it is a fear of the Very Well Known: that is, recession.

Recessions have come and gone throughout history, and with them always come some corporate defaults.