"Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers ... The troubles of one could quickly infect the others ... In our view, however, derivatives are financial weapons of mass destruction ..."

-- Warren Buffett, 2002 Berkshire Hathaway shareholder letter

That passage adds to Warren Buffett's reputation as the Oracle of Omaha, but it’s of no comfort to investors who are now struggling to understand how credit derivatives -- once an arcane segment of the financial markets -- will impact them.

Yesterday was a test for this market as more than 350 participants hashed out the settlement price for up to half a trillion dollars of credit default swaps (CDSs) on nationalized mortgage giants Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). With the swaps settling at between 91.5 and 99.9 cents on the dollar, total payouts are capped at a very respectable $42.5 billion.

However, the market has yet to swallow losses on CDSs due to Lehman Brothers’ bankruptcy. With half a trillion dollars of notional amount in play and Lehman bonds worth approximately 10 cents on the dollar, total payouts could reach $360 billion! And that still leaves CDSs written on Washington Mutual and AIG (NYSE:AIG).

How do credit default swaps work?
Don’t let anyone tell you CDSs are too complex for you to understand – they’re not much different from the insurance you purchase on your home or your car, except it’s bonds that are being insured.

Say you are the nervous owner of $10 million in face value of Morgan Stanley (NYSE:MS) bonds and you fear the bank could go belly-up, putting the value of your bonds at risk. One solution is to purchase protection in the form of a credit default swap.

Last Thursday, credit default swaps on Morgan Stanley’s debt were trading at 975 bps. In plain terms, in order to insure $10 million in face value of bonds against the risk that Morgan Stanley won’t meet its obligations, credit default swap buyers were willing to pay an annual premium of:

($10,000,000) * (9.75%) = $975,000

This premium is on top of an up-front payment -- last Monday, that sum was a whopping 12% of the total face amount being insured. In return, the credit default swap seller guarantees the bonds’ payments or their value in the event of default or bankruptcy.

Over-the-counter, yet under the radar
Credit default swaps are traded on the over-the-counter market, unlike the products traded on the CME Group’s (NASDAQ:CME) exchange, which monitors the total contracts outstanding centrally. As such, the CDS market lacks transparency regarding the size and concentration of risks it contains. In other words, nobody knows who owns what or how much; in this market, that makes a lot of people very nervous.

Major dealers had committed to creating a central counterparty for CDSs; the Fed is meeting with dealers and exchanges today to discuss the status of this project.

But why should you care about the CDS market? For one, the CDS tail has begun wagging the bond-market dog, with bonds being priced off credit default swap spreads. Bond markets are already under duress, and a meltdown in the CDS market wouldn’t do anything to soothe them, making it yet more difficult for companies to obtain normal financing conditions.

That’s hardly surprising given that the total notional amount of outstanding credit derivatives exceeded global debt outstanding, at a staggering $62.3 trillion at year-end 2007. Ten years ago, that figure was only $170 billion, for an astonishing annualized growth rate of 80% since then.

Stock investors aren’t immune to contagion
Still closer to your preoccupations as an individual investor, institutional investors have started to look closely at the cost of insuring companies’ debt, searching for signals of impending distress and creating ripples in the stock market. Spikes in the credit default swap spreads of Bear Stearns and Lehman Brothers debt roiled shareholders, contributing to those companies’ death spirals.

So far, the credit default swap market seems to be riding out the turmoil rather well, particularly since we are in a credit crisis. Paradoxically, the CDS market appears more resilient than some simpler, more transparent markets, such as overnight bank lending, money market instruments, and commercial paper. But that could change quickly as the market tries to digest Fannie and Freddie’s nationalization, Lehman Brothers’ bankruptcy, and the rescues of AIG and Washington Mutual.

More regulation, or has the market learned its lesson?
State and national regulators, including SEC Chairman Christopher Cox, are now calling for increased oversight of the CDS market. In fact, the market may already have started to self-correct after years of runaway growth. The credit derivatives market shrank for the first time this year, with the notional outstanding volume down 12% between December and June.

As with many of their activities, banks including Morgan Stanley, Goldman Sachs (NYSE:GS), and JPMorgan Chase (NYSE:JPM) will surely need to reassess the role of credit default swaps and the means to create a sustainable business around them. Hopefully, it won’t take a meltdown to provide them with the proper motivation to do so thoroughly.

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