The Next Shoe to Drop

Let me give you a few numbers: $9.40 trillion, $13.79 trillion, $45 trillion. What do these hefty figures represent?

  • $9.4 trillion is amount of outstanding public debt in the United States.
  • $13.79 trillion is the size of the U.S. economy, in terms of 2007 GDP.
  • $45 trillion ... drumroll, please ... is the notional amount of credit default swap contracts swimming around financial markets.

Credit default who?
Credit default swaps, or CDSs, are derivatives designed to insure the risk of default on debt. Those who buy CDSs do it as a safety net: If a particular piece of debt should happen to meet its demise, something will cushion the CDS owner's fall. They pay a premium to avoid the risk of holding worthless stock, similar to how you pay a premium to insure your ability to repair your car or house after an accident. It's risk management at its finest.

But if you ask billionaire investor George Soros, the possibility of defaults on CDSs hangs like "a sword of Damocles that is bound to fall," and could be a financial calamity in the making. Gulp.

Who's watchin' the shop?
Most markets are regulated, making so-called counterparty risk trivial. When you make a trade, you don't have to worry about whether the party to whom you're selling has enough cash to make good on their word. CDSs, on the other hand, don't trade in a regulated market -- it's more of a flea market. The contracts can be traded to investors and organizations that may or may not have even a dime to cover the losses they've promised to insure.

That can create quite a stir. When Judgment Day comes and debt defaults, those holding credit "insurance" via a CDS might not get the last laugh. As Warren Buffett stated in 2003, "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. ... The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)."

Imagine diligently paying your car insurance every month, and when you have an accident you find out your insurance company doesn't have enough money to pay for your fender bender. You'd be ticked, I know. Now let's assume you drive blindfolded with your feet shackled, making an accident all but certain (please don't try this). That's the situation facing a massive amount of money: Defaults are inevitable, yet nobody has a clue whether all CDSs will hold their worth.

I thought I smelled something fishy
Soros said he thinks the instability of CDSs played a role in the Federal Reserve's eleventh-hour decision to ensure that Bear Stearns didn't fully croak. Had Bear gone completely under, debt would have defaulted, and the market would have perhaps received its first true test of the ability of credit default swaps to fulfill their promise. Get JPMorgan Chase (NYSE: JPM  ) to step up to the plate, however, and the suspense is averted.

What are the ramifications of this pile of financial wagers? Nobody has the foggiest idea, and that's most of the problem. Any more uncertainty making its way into financial markets is bound to turn jittery investors into thumb-sucking crybabies. Case in point: Many think Bear Stearns' collapse was likely caused by a "run on the bank" provoked by fear, rather than actual credit-related losses.

While we've yet to experience full-fledged fallout, some companies have begun taking it on the chin over CDS exposure. Insurance giant AIG's (NYSE: AIG  ) most recent quarter included a $9.11 billion unrealized loss on CDS contracts gone haywire, and bond insurer MBIA (NYSE: MBI  ) has been slaughtered amid CDS writedowns, but who knows what's left to come? 

According to Comptroller of the Currency John C. Dugan, JPMorgan, Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and Wachovia (NYSE: WB  ) were some of the top players in the CDS market as of the third quarter of 2007, although it's not clear whether they acted as the insured or the insurer.

Vegas has nothing on these guys
Some people, of course, have used credit default swaps to exploit the credit crunch in grand fashion. Hedge fund manager John Paulson made a killing in 2007 betting against credit products, in part by using CDSs. Goldman Sachs (NYSE: GS  ) bought CDSs, knowing full well the debt market was overheated. While its neighbors floundered, Goldman scored a windfall profit betting against debt products.

What's the solution to this CDS bender? Thankfully, a few people have answers. Soros said that establishing a clearinghouse or exchange where the CDSs could be regulated would provide stability. Former Treasury Secretary Robert Rubin has also proposed regulating CDSs in a similar manner to stocks and bonds.

Will it work? By golly, let's hope so.

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Fool contributor Morgan Housel doesn't own shares in any companies mentioned in this article. He appreciates your questions, comments, and complaints. The Fool's disclosure policy is ready for Judgment Day.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 06, 2008, at 3:50 PM, gural wrote:

    This article is frightening. It raises a number of questions. One, how can you protect yourself? And what area of your investments will have the greatest impact? CDs held by banks? Would the FDIC be able to absorb as many failures as may happen? Would it be better to put your money into mutual savings banks as opposed to commercial savings banks? What are some alternative invesetments you can use to protect your money in case of a severe reaction to the failure of the CDS market?

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