CDS market adds to risks that banks will fail

By Jane Baird - Analysis

LONDON (Reuters) - The $45 trillion credit derivatives market, created as a way for banks to hedge their lending, is now also contributing to the risks that banks will fail.

The rise of the market over the past 15 years, however, also makes it crucial that a big bank not be allowed to go down.

"Because of derivatives, it gets more probable that a big bank is going to get into trouble, but then there would be intervention to make sure it doesn't fail," said Willem Sels, head of credit strategy for Dresdner Kleinwort.

About two dozen big banks are major broker-dealers in the CDS market, which means they take one side of nearly every contract. The failure of a dealer such as Bear Stearns would threaten the entire CDS market and other derivatives markets.

Credit default swaps (CDS) are bets on whether a company will default on its debts.

A bank that has made a loan to a company can buy protection to ensure it is paid even if the company defaults. The seller of protection receives an annual fee for promising to cover losses in the event of a default.

With the introduction of major indexes in 2004, the bulk of CDS trading shifted from hedging to making speculative bets on the direction of credit spreads and the economy.

Volumes of outstanding CDS on many of the roughly 3,400 corporate names, particularly those in the indexes, are now greater than companies' underlying debts. That means in a default, overall losses are larger and spread to more players.

Yet while the corporate default rate remains low, the CDS market is already magnifying risks in the credit crisis as indexes hit record wide levels.

The CDS market is more liquid than the underlying corporate bond market and has led the slump in the credit markets.

The derivatives market can amplify fears or rumors as people rush to buy protection on a name such as Bear Stearns BSC.N and drive its spreads wider in a vicious spiral, increasing the risks a bank could suffer a liquidity crunch.

Such a scenario is more threatening to a bank, which survives on constant borrowing and lending, than to an industrial company, which can put off going to the debt market.

COUNTERPARTY RISK

If a fund or investor goes under, banks must deal with another type of risk inherent in derivatives contracts.

A CDS contract is only as good as the financial strength of the counterparty on the other side of the bet.