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Announcement:

Moody's publishes report on risks of credit default swaps

28 May 2008
Moody's publishes report on risks of credit default swaps

New York, May 28, 2008 -- The most significant systemic risk posed by credit default swaps (CDS) is the effect the failure of a major CDS counterparty, such as a large universal bank or securities firm, would have on the operational integrity and pricing in the markets for CDS and, potentially, the underlying securities, such as corporate bonds, Moody's Investors Service reports.

In a report designed to dispel some common misperceptions about the CDS market and to examine its true risks, the rating agency concludes that the sheer size of the market in notional terms and its exposure to "credit events" among underlying securities do not, in and of themselves, pose undue concern.

Credit default swaps are derivative contracts intended to create credit exposures (long or short) to an underlying reference obligation (such as a bond, an ABS security, or an index of bonds or ABS securities). In a typical transaction, an insured party buys protection against a default in payments on the underlying instrument from a protection seller, who insures against this default risk in exchange for regular payments. If the reference entity defaults, the protection seller pays the insured party the difference between the par value of the reference obligation and its recovery value.

"The notion that credit default swaps represent this $62 trillion long credit exposure is not an accurate depiction of the market nor particularly helpful to investors in determining where the true risks lie," says Moody's AVP/Analyst Alexander Yavorsky, one of the authors of the report, referring to the oft-cited figure for the notional amount of CDS contracts outstanding.

He explains that unlike the cash bond market, in which credit losses result in a permanent loss of value, the CDS market, in its entirety, is a "closed system." Absent the failure of a major counterparty, the losses of one party ultimately equal the gains of another. For individual firms, losses on sold protection are also usually offset by gains on acquired protection, and vice versa, provided they run "net flat" books and have in place proper risk management techniques including concentration limits, margining, hedging, and conservative provisioning.

Yavorsky says a more useful number when looking at the CDS market is the gross replacement value, of outstanding contracts, which at just over $2 trillion is under 3.5% of the notional amount. This replacement value functions similar to a loan loss reserve for firms with derivative payables, which at current levels could accommodate losses in line with those experienced in 2001, when corporate defaults spiked, the US experienced a recession, and the major global equities markets underwent a correction. Practically speaking, however, any substantial increase in credit losses would almost inevitably lead to a further widening of credit spreads, which is usually one of the most severe stress tests for a typical investment bank or securities firm.

More concerning to Moody's than an increase in underlying credit losses is the potential for market disruption through the failure of a major bank or broker-dealer.

If a large CDS counterparty failed, this would very likely have a substantial market-wide re-pricing effect on the cost of CDS protection, and, by extension, the underlying cash bonds. The effect of this would be especially problematic for firms needing to replace the CDS trades they had with the failed counterparty. Until the trades were replaced -- an operationally challenging and unprecedented undertaking -- the firms that lost protection would be left with unhedged exposures amid what is likely to be a very volatile market environment.

"A great deal of uncertainty exists about what operational, market liquidity and pricing issues such a spike in demand for protection might introduce," Yavorsky says, adding that the untested nature of the market in such a scenario is itself a risk.

Moody's also notes, however, that the systemic importance of the largest CDS dealers provides powerful incentives to regulators to prevent their disorderly failure, as demonstrated by the recent case of Bear Stearns. The more important the role played by an institution the more likely regulators will consider it to be too systemically important to fail.

Moody's report also provides a general overview of risk management practices employed by securities firms in managing both CDS and other exposures. Moody's expects to comment on the individual firms in greater detail in the near term.

The report is titled " Credit Default Swaps: Market, Systemic, and Individual Firm Risks in Perspective." Additionally, Moody's said that it will host a teleconference for subscribers on Friday, May 30, 2008 to discuss this report. Please visit www.moodys.com/events to register.

New York
Alexander Yavorsky
Asst Vice President - Analyst
Financial Institutions Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Robert Young
Managing Director
Financial Institutions Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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