Basic 101: Derivatives and Credit-Default Swaps

I wanted to use this posting to explain the terms 'derivatives' and 'credit default swaps' (CDS) in the most easy to understand manner possible and connect them to what's going on in Greece so people can really understand what the terms mean and what's going on currently in the news.  But rather than write like a dry economics textbook  and put the reader to sleep, I will do my best to explain using real-world everyday examples.

Let's start with derivatives.  The best way to explain what they are is to take you with me on a magic trip to a casino, specifically the roulette table.  If you're not familiar with roulette and how you bet, etc, hopefully you can still follow along and understand.

The picture above shows what the roulette table looks like.  You can bet on anything- whether the ball on the roulette wheel will land on a specific number, odd or even, black or red and so forth..

Let us say for this example you take $50 in chips and place on the 'Even' box.  This means if the ball lands on an even number between 2-36, you win, if its Odd, you lose.. BUT..your odds are not 50-50.  There are two other numbers on the wheel, 0 and 00 and if the ball lands on either, you will lose your $50

So what do you do to prevent the possibility of the ball landing on 0 or 00 and losing your $50?  You 'hedge' your bet so as to minimize your potential losses.  If you were to place a $10 chip on the 0 and 00 boxes separately, you've just created two derivatives i.e. insurance bets.

Now you're still open to risk because the roulette wheel's spin can land on an Odd number and you lose everything, but the risk has been minimized.  Now usually those entities that engage in derivatives make sure they're protected as much as possible.

So using this example, say you placed a $10 chip on 'Odd' as well, then you have all scenarios covered- 'Even', 'Odd' and 0 & 00.  Your chance at a big payday is greatly minimized but if you were in roulette for the long term, and not just 3-4 spins, then its a safe way to bet and gradually make money.  

Banks and financial  entities are not in the investing game for the short term. They are constantly investing and as long as nothing puts them at risk of a Lehman Bros-type collapse, they will continue wheeling & dealing, and using derivatives as stopgaps against big losses.

Now that you understand what basically derivatives are, let's focus our attention on credit default swaps (CDS).

In this example, we have 4 people- Amy, Beth, Cindy and Dara.

Amy needs money badly so she borrows $500 from Beth at high interest.  Beth lent it to Amy because the profit potential at high interest was too great to pass up, but she really doesn't have a lot of faith she'll get her $$ back.  So Beth contacts Cindy.

Cindy says to Beth for a $25 fee she will insure the loan so that if Amy defaults, she will pay whatever portion of the $500 + interest wasn't repaid if Amy stops paying Beth.  So for the nominal fee, Beth feels secure she'll get all her money back no matter what and at this point it doesn't matter Who the money comes from.  Cindy is acting as an insurance agent.

Now Dara believes Amy will never repay so she wants to get in on the action.  She is a speculator.  Dara also pays Cindy $25 because if Amy defaults, Cindy will be now responsible to two people, Beth and Dara, to cover the portion of the original $500 loan + interest which Amy stops paying.

So here's where it gets tricky...

If Amy pays on time and Beth gets her money back, then Cindy profited $50 while Dara lost her $$ on a speculation bet.  BUT- if Amy stops paying after let's say $100, then Cindy is on the hook for $400 + interest to Beth and Dara EACH!

Oh yes- I forgot, Cindy only has $300 in her life savings so there's absolutely No way she will be able to make good on the insurance to both Beth and Dara.  She only offered the CDS as a means to get quick money and never imagined she'd have to cover the loan!

So Cindy is now forced to 'loan' Amy the $$ she needs to pay Beth even if Amy never repays her back, so as to not trigger the CDS making Cindy on the hook to repay both Beth And Dara, the speculator, which Cindy is in no position to do.
_____________

Now let's tie this all into what's currently going on in Greece.

Investors purchased Greek bonds or 'debt' at high interest rates because Greece's credit rating was so poor.  Because they felt a bit insecure as to what happens if Greece stops paying i.e. default, investors made hedge bets in the form of CDS to banks and financial institutions in Europe who received money at this point for doing nothing but giving assurances to insure the Greek debt so investors would not take a loss or 'haircut'

If Greece pays their debts, the banks keep the money with no losses.

If/when Greece defaults, it means the CDS trigger in... this means they have to pay back the difference of the billions in euros the Greeks defaulted on, not only to the investors, but also speculators who do not directly hold Greek debt but still got in on the action to bet on Greece's default.

Now the European financial institutions thought to themselves, "Maybe we've over-extended ourselves with all these CDS".  So they made insurance bets or sold derivatives to US banks and financials so that if Greece did default, it would somewhat minimize their losses because these US banks would have to pick up the difference.

This exposed US banks and financial institutions to risk from Greek default while keeping 100% of the money if Greece pays their debts.

So basically what's happened is this-  Greece is pretty much insolvent.  It needs more loans to keep making its payments to the investors who hold its debt.  The money is lent by the IMF and ECB not because they expect Greece to pay them back.  Its because its more financially beneficial to give Greece 100 billion euro, let's say, then to have to pay out trillions of euro in CDS to all the investors and speculators upon a default.

I hope this helps people understand what's going on with Greece, the Eurozone, the US and why everyone is so scared of Greece defaulting even though realistically the nation has no chance to survive on its own, and this everyone is in a great quandry.

Failed Korean Debt Sale

With tsunamis of sovereign debt being issued around the globe i think news like this will pop up on a regularly basis ( especially for those countries mentioned in So Begin The (Serious) Sovereign Downgrades…? ). This also raises the question what will happen to spreads on corporate bonds ( see Death of Corporate Bonds Is Worth Investigating from William Pesek/ Bloomberg ) .... It will be interesting to see if some countries will be forced to issue debt in foreign currencies if even higher yields are failing to attract enough investors.....And lets all hope that the central banks are resisting the call to be the buyer of last resort ( monetize the debt )..... This would almost definitely lead to trouble down the road......

Mit der nicht enden wollenden Flut an neuen Staatsschulden rund um den Globus dürften vergleichbare Meldungen bald öfter über die Ticker laufen ( verweise in diesem Zusammenhang auch besonders auf die Staaten die in dem folgenden Link angesprochen werden So Begin The (Serious) Sovereign Downgrades…? ). Desweitern muß man sich fragen was solche Ereignisse für Unternehmensanleihen bedeuten ( sieheDeath of Corporate Bonds Is Worth Investigating from William Pesek / Bloomberg ) ..... Entscheidend wird sein ob bestimmte Staaten gezwungen werden einen Teil Ihrer Verbindlichkeiten in Fremdwährungen zu begeben wenn selbst steigende Renditen nicht mehr ausreichen um genügend Investoren anzuziehen..... Bin gespannt ob auch dann die Notenbanken sich dem Druck widersetzen und nicht als Käufer auftreten ( sprich die Notenpresse anzuwerfen )......... Das dürfte eher früher als später zu großen Problemen führen.....

Korea Fails to Meet Target in Bond Sale for 2nd Month

South Korea failed to meet its target at an auction of 10-year bonds for a second consecutive month on concern that the nation will increase debt sales to fund stimulus spending.

The government raised 584 billion won ($415 million) at today’s sale, less than the 800 billion won targeted, after investors offered to buy 604 billion won, the finance ministry said on its Web site. The securities were sold at an average yield of 5.2 percent, higher than the 5.1 percent the market expected, said Kim Do Sung, a futures trader with PB Futures Co. in Seoul.

“The market has shown little interest in longer-dated debt,” Kim said. “The trend may continue for a while as concern about oversupply lingers.”

Investors including Pacific Investment Management Co., which runs the world’s biggest bond fund, and DBS Asset Management Ltd., are avoiding long-term securities as governments fund extra spending by increasing debt sales. Asian nations have pledged an additional $685 billion over the next five years to support growth after recessions in the U.S., Europe and Japan caused exports in the region to collapse.

In a Jan. 19 auction, the Korean government sold 426 billion won of similar-maturity debt, failing to raise a planned 800 billion won. Malaysia attracted bids for 1.46 times the 3.5 billion ringgit ($967 million) of five-year notes sold on Jan. 22, the weakest bid-to-cover ratio since May 2008. The Philippines rejected all bids from investors for 7 billion pesos ($148 million) of treasury bills at an auction on Feb. 9 in Manila.

Curve Steepens

The extra yield that investors are asking to hold 10-year Korean bonds over those maturing in three years widened to 1.63 percentage points last week, the most since November 2001. The spread was 81 basis points at the end of 2008.

Asian local-currency government bonds have handed investors a 4.3 percent loss this year, after rallying 9.7 percent in December, when interest-rate cuts by central banks drove down yields, according to indexes compiled by HSBC Holdings Plc.

Borrowing costs will climb in the region this month as policy makers increase spending to revive their economies, Mirae Asset Investment Management Co. and CIMB-Principal Asset Management said.

India, the Philippines, Thailand, Korea and Malaysia were scheduled to sell at least $3.8 billion of local-currency bonds maturing in 10 to 30 years in February.

“The deeper the recession, the more the stimulus and the more the bond supply,” Kim Sung Jin, head of debt investment at Mirae, South Korea’s biggest asset manager with the equivalent of $43 billion under management, said last week. “The long-end maturities are the most vulnerable.”

Yields Rise
South Korea has already allocated 51 trillion won in tax cuts and infrastructure projects to shore up the economy, and the government needs to increase its budget spending to revive growth, Deputy Finance Minister Noh Dae Lae said on Feb. 12.

The yield on Korea’s 10-year government debt rose one basis point, or 0.01 percentage point, to 5.20 percent today compared with 4.22 percent on Dec. 31, according to Korea Securities Dealers Association. The rate averaged 5.15 percent over the past five years, according to data compiled by Bloomberg.

“Asian local-currency yield curves have bear-steepened so far this year on supply concerns, but more steepening lies ahead as 10-year yields remain below their long-term averages,” said Jens Lauschke, a fixed-income strategist at DBS Group Holdings Ltd. in Singapore.

So Begin The (Serious) Sovereign Downgrades…?

A possible downgrade of Spain.......Shocking..... But i doubt we will see some serious action to under AA- ( besides minor countries ) on this front ( just watch the table with regulatory risk weitghtings & the impact on bank´s balance sheets) UPDATE: S&P lowers Greece rating to A- & an excellent Interactive graphic: Europe on credit alert ...... Why numerous countries are still able to get away with an AAA rating is beyond me. Main reason in my mind is the political pressure ( especially when it comes to the US )..... Too bad that countries like Greece, Italy and Spain cannot stimulate their economy with a weak currency like in the past before they joined the €.... It´s a safe bet that the Euro in the current form won´t last ( see also from the FT Could the eurozone actually split up? )? No wonder Gold in € is hitting new highs almost on a daily basis ( see Daily gold price in a range of currencies since January 2000 ) ?



Ein mögliches Downgrade von Spanien.....Schockierend.....Aber ich denke das wir von dieser Seite nichts richtig drastisches auf unter AA- ( abgesehen von einigen unbedeutenden Ländern ) sehen werden ( man braucht dazu nur einen Blick auf die Übersicht mit den risikowichteten Bilanzpositionen zu werfen um zu erkennen welch desaströse Auswirkungen das auf Bankbilanzen hätte ) UPDATE : S&P lowers Greece rating to A- & sowie eine erstklassige Karte der FT Interactive graphic: Europe on credit alert ..... Man muß sich ernsthaft fragen ob die Ratingagenturen überhaupt was aus dem kollosalen Versagen während des Kreditbonanzas gelernt haben..... Wie anders ist es zu erklären das noch etliche Staaten mit AAA bewertet werden? Schon bald peinlich wie noch immer behauptet wird das Ihre "Bewertungen" jenseits von politischen Einflüssen erfolgen ( ist besonders auf die Boni der USA gemünzt )..... Habe noch gut das Hohelied der "Unabhängigkeit" bei den Bewertungspraktiken der implodierten strukturierten Produkten in den Ohren ...... Für Staaten wie Griechenland, Italien, Irland und Spanien ist es natürlich nicht gerade hifreich das Sie sich nicht wie in der Vergangenheit über die Währung etwas Linderung verschaffen können. Ich denke die Aussage das dem € noch turbulente Zeiten ins Haus stehen dürfte untertrieben sein ( siehe auch aus der FT Could the eurozone actually split up? )...... Sicher kein Zufall das Gold in € momentan nahe der historischen Hochs notiert ( siehe Daily gold price in a range of currencies since January 2000 ) .

So begin the (serious) sovereign downgrades…? FT Alphaville

Not just developing world sovereigns either. From S&P today (emphasis ours):



Jan 12 - Standard & Poor’s Ratings Services today said it had placed its ‘AAA’ long-term foreign and local currency sovereign credit ratings on the Kingdom of Spain on CreditWatch with negative implications. A CreditWatch listing signals a potential but not inevitable change in a rating over the short term.



The ‘A-1+’ short-term ratings were affirmed.



“The CreditWatch placement reflects our view of the significant challenges facing the Spanish economy as it traverses a period of very weak growth, and a sustained period of deleveraging, which we expect to lead to a rebalancing toward traded sectors requiring real exchange rate depreciation,” Standard & Poor’s credit analyst Trevor Cullinan said.



In our opinion, the credit-driven nature of Spain’s strong growth performance in recent years has led to a build-up in imbalances, as evidenced by the sizeable current account deficit (around 10% of GDP in 2008).



> For more insights read Why Spain’s Economic Crisis Is Something More Than A “Housing Slump” from A Fistful Of Euros / Edward Hugh. Cleary worth a AAA rating.......



> Deutlich mehr Details bitte Why Spain’s Economic Crisis Is Something More Than A “Housing Slump” von A Fistful Of Euros / Edward Hugh lesen. Klarer AAA Kandidat.......

Due to the need for the private sector to restructure and deleverage balance sheets, we believe that the unwinding of the deficit increases the probability of a protracted economic slowdown… Despite a relatively strong starting position, we expect the Kingdom’s public finances to deteriorate markedly, with the general government deficit rising well above 3% of GDP until 2011, and peaking above 6% in 2009.



Now this is only a ratings watch action. No downgrade is necessarily forthcoming. It’s just a distinct possibility.



The spectre of which might go some way as to suggesting why CDS on a triple-A-rated sovereign should be a possibility. Something which has been discussed on FT Alphaville before.



Downgraded securities carry more onerous regulatory risk weightings under the Basel II ratings-based approach:

… unless you have a hedge in place. Such as a sovereign CDS.



That might go some way towards explaining why CDS contracts on Spain are some of the most heavily traded - and have the highest net notional levels - $13,489,091,873 according to the latest DTCC data.

Also up there with Spain: Italy. $158,198,385,126bn gross, $18,283,028,951 net.



If there are downgrades in the Eurozone, there could be some other rather nasty effects.

Country Default Risk Rises Across the Board Bespoke

Ireland, Austria, Greece, and the UK have seen default risk rise the most over the last month. All have risen close to or more than 100%. US default risk has risen the 8th most at 68%.

> Compare the table above from November 2008 with the latest news from last Friday and it looks like the "market" is once more way ahead of the agencies.....

> Vergleicht man die obrige Tabelle für den November 2008 mit der aktuellen Meldung von letztem Freitag sieht es ganz so aus als wenn die Märkte einen deutlich besseren Indikator als die Ratingagenturen abgeben..... Mal abwarten wann auch hier das Shorting verboten wird........:-)

FT Alphaville

On Friday, Greece and Ireland were also warned by the agency that their ratings could be downgraded as economic conditions worsen

> More evidence example that the market has lost total confidence in the rating agencies....

> Hier ein weiterer Beleg das der Markt zum Glück einiges an Vertrauen in die Methodik der ratingagneturen verloren hat

Credit-Default Swaps on Ireland, Spain Surge on Ratings Threat Bloomberg

Yields on the bonds of smaller European economies, such as Spain, Italy and Greece, have risen to the highest relative to German bunds since before the ECB was established a decade ago. Spanish 10-year notes yield 99 basis points more than bunds, up from 17 basis points one year ago. For Italian notes, the gap almost quadrupled to 141 basis points from 36 basis points.

> Needless to say that the US is of course a rock solid AAA..... For more AAA facts & charts read Deficits, Debt and Looming Disaster: Reform of Entitlement Programs May Be the Only Hope from the St. Louis Fed. I´m with Bill Gross ( see Ponzi meets treasuries bubble ) but am not willing to bet against bonds yet . Here is another very good summary on this topic ( On return-free risk and the bond bubble )It will be fascinating to see what happend to the bondmarket & the $ if the foreigners are finally waking up ( see Who Will Be Left To Buy US Treasuries...... ) I´m still fascinated how the US has manage to finance this ponzi game for years ( NO SARCASM!)....... UPDATE: Another must read via The Mess That Greenspan Made A deflationary spiral?? Not likely in the U.S

> Wie man bei den nachfolgenden Aussichten längerfristig ein AAA der USA rechtfertigen will wissen wohl nur die Ratingagenturen...... Für mehr AAA würdige Fakten und Charts bitte Deficits, Debt and Looming Disaster: Reform of Entitlement Programs May Be the Only Hope der St. Louis Fed lesen. Bin hier klar der Meinung von Bill Gross ( siehe Ponzi meets treasuries bubble ) traue mich aber noch nicht schon jetzt gegen die Bonds zu setzen. Hier kommt eine weiter sehr gute Zusammenfassung zum "Sratus" der US Staatsanleihen (On return-free risk and the bond bubble ) Ein Katalysator für den Shorteinstieg könnte sein wenn die Ausländer die ja den Großteil finanzieren sich aus den Auktionen zurückziehen oder was ja anscheinend keiner auch nur auf dem Radar hat aktiv anfangen Positionen zuverkaufen.Denke dann werden alle von einem "Black Swan" sprechen.( siehe Who Will Be Left To Buy US Treasuries.......) Bis dahin muß man den USA ehrlich Respekt dafür zollen das Sie es bisher geschafft haben Ihre Defizite zu diesen fast beispiellos günstigen Konditionen zu finanzieren. Das meine ich ausnahmsweise mal nicht sarkastisch. UPDATE: Hier noch ein echtes Sahnestück via The Mess That Greenspan Made A deflationary spiral?? Not likely in the U.S

Quote of the Day: S&P is Cool with U.S. Debt HT Infectious Greed

Quote of the day goes to S&P credit analysts for this comment while keeping U.S. credit at a “AAA” rating:

The rating (for the U.S.) was affirmed despite our judgment that fiscal risk has noticeably increased as we expect that the fiscal deterioration will be temporary.

Words to remember

Update / Hat Tip Credit Writedowns

New Zealand’s AA+ Credit Rating May Be Cut, S&P Says -

Bloomberg.com (The article sys “nations that have been downgraded from AAA previously include Japan, Sweden, Finland and Denmark. The rating company today affirmed Australia’s AAA rating.”)

Chart Of The Day "Junk Yields"

Despite the rollercoaster ride in stocks the action in the bond & debtmarket is even more fascinating....... The main driver of equities for the next few years will be the quality of the balance sheet ( especially after goodwill....) and the timetable for the refinancing of the maturing debt/bonds..... Earnings will be a second-tier issue..... Bondholders will be in the driver seat........ No more attempts to "return value to shareholders" like shown from Daimler ( see How Daimler Wasted € 7 Billion On Buybacks In Just 15 Months...... )..... Needless to say they are also now begging for some kind of bailout.......

Trotz des tagtäglichen Wahnsinns an den Aktienmärkten spielt sich noch sagenhafteres an den Kredit & Anleihemärkten ab. Denke das in den nächten Jahren wie bereits mehrfach erwähnt vorrangig die Bilanzqualität ( vor allem nach den kommenden Goodwillabschreibungen, da versteckt sich noch so manche Bombe....siehe Die nächste Bilanzbombe tickt FTD, besonders interessant wenn mal wieder auf die niedrige Buchwertbewertung der DAXtitel hingewiesen wird .... Got Gold......) sowie die Zeitachse der kommenden Refinanzierungen der ausstehen Anleihen/Kredite die erste Geige für die Aktienkursentwicklung spielen wird. Die Gewinne ( oder besser ausgedrückt Verluste ) rücken da eindeutig in den Hintergrund. Die Bondholder werden zukünftig das sagen haben..... Immerhin bleibt uns dann der Wahnsinn der schuldenfinanzierten Aktienrückkäufe erspart ( das passiert wenn der Vorstand sich mit Haut und Haaren dem kurzfristigen "shareholder value" & seinen Aktienoptionen verschrieben hat.....Betonung liegt hier auf kurzfristig ... Fragt mal bei Daimler nach... siehe How Daimler Wasted € 7 Billion On Buybacks In Just 15 Months...... )


WSJ

Unrelenting declines in corporate "junk" bonds have pushed yields on these riskier securities to over 20% on average, a record

Bespoke

Based on data from Merrill Lynch, high yield bonds are yielding nearly 1,800 basis points more than comparable Treasuries. In the last month alone, spreads have risen by more than 200 basis points, and since bottoming in the Summer of 2007 at 241 basis points, they are up 645%. To put this in perspective, with the 10-Year US Treasury now yielding 3.4%, a high-yield borrower would need to pay roughly 21.4% per year to take out a ten-year loan. With terms like these, who needs loan sharks?

Much more insight via Naked Cpitalism Junk Bond Yields Up Sharply. On top of this visit FT Alphaville for an even more "impressive" chart on CDS ( see iTraxx Europe at all time high ). Combine all this with this chart and is not difficult to imagine that the worst is still to come.....

Mehr Details mal wieder von Naked Capitalism Junk Bond Yields Up Sharply . Einen noch beeindruckenderen Chart der CDS bietet FT Alphaville ( siehe iTraxx Europe at all time high ). Wenn man nun das Drama mit diesem Chart kombiniert ist unschwer zu erkennen das uns "ruppige" Zeiten ins Haus stehen......

Chart Of The Day " CDS On 10yr US Treasuries

There is no free lunch..... Looks like some are questioning the AAA rating of the US..... :-) And with future liabilities from roughly $ 40 to 50 trillion ( growing $ 3-4 trillion p.a. - see If we are Rome, Wall Street's our Coliseum ) only the rating agencies and their bullet proof models are able to justify/create this rating ..... Got GOLD?

Ist das nicht herrlich.... Die Kreditabsicherung gegen einen möglichen Zahlungsausfall von US Staatspapieren ist im Zuge der ganzen täglichen Balioutaktionen geradezu explodiert. Sieht so aus als wenn einige Marktteilnehmer das AAA Rating der USA ernsthaft in Frage stellen... :-) Bei knapp 40 - 50 Billionen $ an zukünftigen Zahlungsverpflichtungen die zudem jährlich momentan ohne all die Bailouts mit ca. 3-4 Billion $ anwachsen ( siehe If we are Rome, Wall Street's our Coliseum ) ist die Sorge eigentlich kaum verständlich. Immerhin haben die Ratingagentuen in einem Ihrer unfehlbaren Modelle die AAA Einschätzung trotz dieser Daten etliche Male bestätigt . Hoffe man hat meinen Sarkasmus heraushören können..... Got GOLD?

Actual numbers: cost of protecting US government debt up 2 basis points to 22bp at close Tuesday, exceeding March all-time-high of 20bp. “In normal times, the spread [full stop] is less than 2bp.”

Hat tip HT Alea: & FT Alphaville

UPDATE: Here is more on this topic from Michael Panzner

The Beginning of the End for America's AAA Rating?

There is no doubt that talk of a bailout of Fannie Mae and Freddie Mac has spurred what could be a short-lived spike. Still, it makes you wonder if the market is starting to price in what many say is inevitable after years of profligacy and failed policies: a credit downgrade for the United States.

This is not merely a subprime crisis / Münchau on Credit Default Swaps

I´m back from my 3 week vacation and it looks like i missed a lot of fun..... Thanks for all the mails during the past weeks. I´ll answer them this week.

It looks like more and more dominoes are falling at an accelerating pace. No wonder more and more people are waking up an are finally discovering Gold ..... Wolfgang Münchau from the FT has some good thoughts on one of the next shoes to drop

Melde mich nach einem dreiwöchigen Urlaub zurück und muß feststellen das ich wohl eine Menge Spaß verpaßt habe...... Dank an alle die gemailt haben. Ich werde diese im Laufe der Woche beantworten.

Es sieht so aus als wenn unübersehbar immer mehr Dominosteine kippen. So verwundert es wenig das endlich immer mehr Leute Gold für sich entdecken.....Wolfgang Münchau from The FT hat sich Gedanken zum nächsten drohenden "Unheil" gemacht.

This is not merely a subprime crisis

If this had been a mere subprime crisis, it would now be over. But it is not, and nor will it be over soon. The reason is that several other pockets of the credit market are also vulnerable. Credit cards are one such segment, similar in size to the subprime market. Another is credit default swaps, relatively modern financial instruments that allow bondholders to insure against default. Those who such sell such protection receive a quarterly premium, based on a percentage of the amount insured.

The CDS market is worth about $45,000bn (€30,500bn, £23,000bn). This is not an easy figure to imagine. It is more than three times the annual gross domestic product of the US. Economically, credit default swaps are insurance. But legally, they are not, which is why this market is largely unregulated.

Technically, they are swaps: two parties swap payments streams – one pays a regular premium for protection, the other pays up in case of default. At a time of low insolvency rates, many investors used to consider the selling of protection as a fairly risk-free way of generating a steady stream of income. But as insolvency rates go up, so will be the payment obligations under the CDS contracts. If insolvencies reach a certain level, one would expect some protection sellers to default on their obligations.

So the general health of this market crucially depends on the rate of insolvencies. This in turn depends on the economy. The US and Europe are the two largest CDS markets in the world. It is now widely recognised, including by the Federal Reserve, that the US economy is heading for a sharp downturn, possibly a recession. The eurozone, too, is heading for a downturn, but possibly not quite as sharp. ....

Today, the really important question is not whether the US can avoid a sharp downturn. It probably cannot. Far more important is the question of how long such a downturn or recession will last. An optimistic scenario would be a short and shallow downturn. A second-best scenario would be for a sharp, but still short, recession. .....

So what then would be the effects of these scenarios on the CDS market? Bill Gross of Pimco*, who runs the world’s largest bond fund, last week produced an interesting back-of-the-envelope calculation that received widespread publicity. He projected ( see his latest Investment Outlook ) that the losses from credit default swaps caused by a rise in bankruptcies could be $250bn or more – which would be similar to the expected total loss as a result of subprime.

This is how he arrived at this estimate. His calculation assumes that the corporate insolvency rate would return to a normal level of 1.25 per cent (measured as the default rate of all investment grade and junk debt outstanding). As the entire CDS market is worth about $45,000bn, $500bn in CDS insurance would be triggered under this assumption. The protection sellers would probably be able to recover some of this, so the net loss would come to about half of that. This estimate is very rough, of course. Most important, it is based on the assumption that the hypothetical US recession would not turn into a prolonged slump. In that case, one would expect corporate default rates not merely to return to trend, but to overshoot in the other direction.

So one could take that calculation as a starting point. A downturn lasting two years could easily trigger payments streams of a multiple of $250bn.

At this point we might be tempted to conclude that this all is irrelevant, since this is only insurance, which is a zero-sum financial game. The money is still there, only somebody else has got it. But in the light of the current liquidity conditions in financial markets, that would be a complacent view to take.

If protection sellers were to default en masse, so too could some protection buyers who erroneously assume that they are protected. Given that the CDS market is largely unregulated there is no guarantee of sufficient liquidity behind each contract.

It is not difficult at all to see how the CDS market has the potential to cause serious financial contagion. The subprime crisis came fairly close to destabilising the global financial system. A CDS crisis, under a pessimistic scenario, could produce a global financial meltdown.

This is not a prediction of what will happen, merely a contingent scenario. But it is contingent on an event – a nasty and long recession – that is not entirely improbable.