CDS market losses could reach $1.4 trln -analyst
LONDON, Jan 11 (Reuters) - Losses this year in the credit default swaps (CDS) market could reach notional amounts of as much as $1.4 trillion, and counterparties could fail to pay up to $150 billion in contracts, one credit strategist estimated.
These estimates by Andrea Cicione, of BNP Paribas, represent the worst possible scenario for the more than $45 trillion credit derivatives market.
They are even more severe than a recent forecast by Bill Gross, chief investment officer of Pacific Investment Management Co. (PIMCO) who is known for bearish views.
Gross, in an investment outlook this month, estimated that corporate defaults would trigger $500 billion in CDS contracts this year and result in $250 billion in losses.
To come up with those numbers, he assumed the combined investment grade and junk bond default rate would approach the historical norm of 1-1/4 percent and a recovery rate of 50 percent after default.
Cicione assumed a worst-case default rate of 4 percent and a 25 percent recovery rate. "These are aggressive estimates, the worst that can happen," he added.
Other analysts cautioned that estimates based on total amounts of CDS contracts triggered by defaults would not be representative of investors' actual losses.
A big bank, for example, may have sold protection in $120 million of contracts on a company and bought another $100 million in protection on the same company, leaving it with a much smaller net loss of $20 million.
But if a counterparty fails to pay on some contracts, Cicione said, then those contract losses are no longer just notional but add to an investor's net losses.
He looked at types of counterparties in the CDS market, based on the only available figures from the International Swaps and Derivatives Association, dating to 2003.
Hedge funds were sellers of protection on 15 percent of CDS contracts, and the "other" category including entities such as bond insurers, structured investment vehicles (SIVs) and credit derivative products companies amounted to 11 percent, while banks, security firms and insurers accounted for the rest.
Adding up the 15 percent, the 11 percent and half of the more traditional players, Cicione came up with an estimate that about half of protection sellers are risky. He estimated that about half of that group could default on contracts.
Some of those counterparties are collateralized, and some not, he said, and he assumed a recovery rate of 50 percent, which left a counterparty loss of about $150 billion. That's the worst case, and he cited a figure of $60 billion based on less severe estimates.
As risks rise, Cicione cautioned, then risk aversion alone can push leveraged players in the market under.
"With counterparty risk, you don't really need to have realized losses to have a problem," he said. "A hedge fund can go down because it is being asked for more collateral for a margin call, even though it has not had any defaults."
