US CREDIT-Large defaults could test CDS market

By Karen Brettell

NEW YORK, July 18 (Reuters) - The credit derivative market,
which has ballooned to over $62 trillion to dwarf the
underlying debt market, has yet to experience the default of a
significant issuer since its rapid growth.

Corporate defaults, however, are on the uptick and expected
to accelerate, and the number of companies with credit default
swaps trading at distressed levels are also on the rise,
indicating the market may soon be tested.

"I don't see a lot of risk around one big event. I think
the market, particularly following the auto sector stresses in
2005, has prepared for such episodes," said Matthew Mish, high
yield credit strategist at Barclays Capital in New York.

"I'm more worried about an environment characterized by a
high frequency of defaults among large issuers," he added. "The
related settlement and back-office issues would be more complex
and laborious. But I would not expect a breakdown in the
market."

Some lags in processing credit derivative trades have made
regulators and market participants nervous there could be
confusion if a large borrower, or even worse a counterparty,
failed.

In many cases the amount of protection written on a
borrower's debt also outstrips the amount of bonds outstanding,
necessitating an auction to determine the cash value of the
contracts.

Volumes in credit derivatives were significantly smaller,
at less than $3 trillion, when the market last saw significant
corporate defaults, capped by Enron Corp in 2001 and WorldCom
in 2002.

Concerns earlier this month over the liquidity of General
Motors Corp (GM.N), one of the most actively traded issuers in
the credit derivative market, however, raises questions over
whether the market could absorb such a failure if it occurred.

Though worries over the GM's near-term viability have
eased, credit default swaps on its debt still imply a more than
70 percent chance of defaulting over the next five years.

Credit default swaps on Ford Motor Co (F.N), Tribune Co and
Charter Communications Holdings CHTR.O are also trading at
distressed levels.

There are no reliable estimates on how much credit
protection is written on GM's debt, though as an actively
traded credit it is thought to be several times the $34 billion
it has in outstanding bonds.

"I'm sure that the number of outstanding notional of CDS on
GM is larger than any amount we've had before on a defaulted
entity," said Jeff Kushner, managing director at hedge fund
BlueMountain Capital Management.

"But I'm also certain that we've had a few runs at credit
events and people understand how the protocol works," he said.
"The market is becoming more and more operationally
sophisticated, and the issues around confirmations have been
greatly improved."

MEASURES TO AVOID BOND SQUEEZES

The bankruptcy of auto parts supplier Delphi Corp in 2005
led to the development of a protocol that market participants
say has taken much of the risk of settling trades out of the
market.

When Delphi defaulted, the amount of credit default swaps
written on the company greatly exceeded the number of bonds it
had outstanding, leading to a scramble to buy up the debt,
which was needed to settle the credit derivative contract.

To avoid future bond squeezes a settlement procedure was
developed whereby credit protection holders participate in an
auction to determine a cash value for the contracts. This
auction has already successfully been tested with a number of
smaller issuers.

Initiatives to create a central clearing house for credit
derivative trades and to compress trade volumes is also likely
to help the market absorb a large default, or series of
defaults, when it occurs.

"The move to swaps prime brokerage concentrates a lot of
the work in places that are equipped to handle that work," said
BlueMountain's Kushner. "The market has also tried to reduce
the amount of gross notional default swaps outstanding. All of
those things have the effect of reducing operational
complexity."

"I personally do not think that the autos (despite their
size) pose a significant risk to the CDS settlement process,"
said Brian Yelvington, analyst at independent research firm
CreditSights.

"They are relatively homogenous from an economic
perspective and the auction process would target a few, highly
liquid, deliverables that would set the settlement price," he
said.
(Editing by Leslie Adler)