CDS spared ultimate test, but prove their worth

By Karen Brettell - Analysis

NEW YORK (Reuters) - Government intervention has saved the $62 trillion credit derivative market from facing the nightmare of counterparty failure during the credit crisis of the past year, though the securities have proven themselves to be relatively liquid while other financial markets froze.

The failure of U.S. investment bank, Bear Stearns, would likely have sparked a systemic meltdown in financial markets, given the size of Bear's role as a counterparty in the credit default swaps (CDS) market, if the U.S. Federal Reserve had not organized Bear Stearn's rescue in March this year.

"Since the credit derivatives market came into being, we really haven't had a major dealer or bank at risk of defaulting," said Doug Warren, head of North American credit trading at Barclays Capital in New York, who has traded the securities since 1997.

After the government backed rescue of Bear Stearns, the market views other major derivative counterparties as also "too big to fail," and this implicit support, together with efforts to clean up trade processing problems, means the credit derivatives market will likely be spared its ultimate test.

Credit derivative volumes were significantly smaller, at less than $3 trillion, during the last credit downturn in 2001-2002 which saw defaults by energy group, Enron Corp, and telecommunications giant.

Under the strain of global risk aversion and high market volatility, however, the CDS market has proven more resilient than many other markets.

"This is much worse than in 2001 and 2002," said Chase van der Rhoer, head of principal credit trading at HSBC Securities in New York, who has traded the securities since 1998.

"Back then a lot of companies were facing demise because they had corporate governance issues or couldn't access commercial paper markets," he said.

"Now we're in a market where not only that is happening, and probably to a much worse extent, but there's also an oil crisis, a housing crisis, a credit crisis, and an equity market that is just getting hammered. This is a perfect storm with a lot of bad things all happening simultaneously," van der Rhoer added.

Losses by financial institutions from risky U.S. residential mortgages have dried up the flow of capital, creating severe illiquidity in markets such as mortgage-backed securities, Collateralized Debt Obligations (CDOs), auction-rate securities, and preferred shares.

The corporate bond market hasn't performed much better.

"There have been concerns with liquidity although I would definitely say that liquidity in CDS has been much better than liquidity in corporate bonds," said Barclays' Warren.

Investors unable to sell corporate bonds have been buying protection with credit derivatives to offset their exposures.

"Without the credit derivative market, people would not be able to get in and out of risk the way they can now," said HSBC's van der Rhoer. "CDS crosses a lot of different product types which have basically failed to have a proper market themselves," he said.

"The fact that this relatively new derivative product maintained some semblance of liquidity is I think a very good thing," van der Rhoer added.

LIQUIDITY STRESSES

That's not to say that it's all been smooth sailing.

"Clients have complained about a lack of liquidity, and there are definitely dealers that are not as active in the market today as they may have been at one time," said Barclays' Warren.

"Across the market there's a wider bid/offer and the size is smaller, because dealers are less willing to take on principal risk," he said.

Trading in credit default swaps has also been largely dominated by five-year contracts, and as liquidity worsens securities with longer or shorter maturities than this have suffered most.

"Liquidity in 7-year and 10-year swaps has been extremely poor," Warren said.

Lags in processing trades, which has been a key concern of regulators, also worsened amid volatility.

"We saw some volume spikes that caused trade processing backlogs to increase a bit, but I think they've gone back down again as volumes right now are probably lower than they were a year ago," Warren said.

"But it definitely did create problems and that's why automation is really the key, as it will go a long way toward eliminating the backlogs," he said.

A LEADING INDICATOR?

In some cases credit default swaps have also weakened ahead of stock prices, providing important clues into areas of concern.

For example, Bear Stearns Cos' CDS spreads widened by 10 times from June 2007 to the end of July 2007, significantly underperforming its stock, said Gary Kelly, director of research at Tradition Asiel Securities in New York.

Two Bear Stearns hedge funds collapsed from bad mortgage bets in July 2007, one of the first casualties of the credit crunch.

"This credit market was much more aware of the risk in mortgages and credit in general," he said. "Consequently credit focused guys hedged their exposure in the CDS market, not the equity market. I think that's why the CDS market moved first."

(Reporting by Karen Brettell;)