'Culprit' returns for another bite

The collapse of Lehman Brothers triggered a freeze on lending. Photo / AP

A year after the bankruptcy of Lehman Brothers, credit-default swaps have lost their stigma for disaster and are contributing to the growing confidence in the credit markets.

While the US struggles with the slowest recovery since 1945, the market where investors protect themselves from default and speculate on corporate debt shows confidence is the highest since June 2008.

The insurance cost to protect against a failure by Goldman Sachs, Charlotte, Bank of America and 12 of the other biggest derivatives dealers has dropped 66 per cent in the past six months, according to an index of swaps compiled by Credit Derivatives Research.

Credit-default swaps are often identified as the culprit behind the financial crisis. The meltdown of Lehman and American International Group (AIG), two of the largest traders, caused a seizure in lending. Now, Wall St is accelerating reforms Treasury Secretary Timothy Geithner started in 2005 when he was president of the New York Federal Reserve to increase transparency in a market lawmakers plan to regulate.

Credit-default swaps pay the buyer a face value price in exchange for the underlying bonds or the cash equivalent should a company fail to meet its debt obligations. Prices rise when perceptions of creditworthiness deteriorate and fall when they improve.

Banks have had unparalleled access to money after Federal Reserve Chairman Ben Bernanke reduced the rates to near zero, from 5.25 per cent in 2007. The Fed and the Government spent, lent or committed US$12.8 trillion ($18 trillion) to revive the economy.

One result is that expectations another big financial institution will fail have receded. Credit Derivatives Research's Counterparty Risk Index, which measures default swaps on 14 firms, has dropped to 104 basis points, after peaking on March 9 at a record 305.6 basis points. The Libor-OIS spread, a gauge of banks' reluctance to lend, contracted to 0.11 percentage points this week from a peak of 3.64 percentage points last October. Former Fed Chairman Alan Greenspan said in June 2008 he would consider credit markets back to "normal" if the spread was 0.25 percentage points.

In addition to supporting banks by lowering rates and providing financing for troubled loans, Bernanke has succeeded in reducing the cost of credit for consumers.

Companies have issued a record US$2.6 trillion of debt this year in dollars, euros, pounds and yen, the fastest pace on record and up 21 per cent from 2008, according to data compiled by Bloomberg.

Credit markets seized up after Lehman collapsed and the Government bailed out AIG with a US$85 billion investment. That amount ballooned to US$182.5 billion.

AIG needed to be rescued after handing over more than US$18 billion in collateral tied to credit swaps sold to banks including Goldman Sachs and Societe General. The insurer had sold about US$400 billion of swaps protecting against losses on securities backed by US sub-prime mortgages and corporate loans.

The benchmark rate banks charged each other for three-month dollar loans, the London interbank offered rate (Libor), almost doubled in a month to 4.82 per cent. The Dow Jones Industrial Average fell 43 per cent over the next six months to the lowest level in six years.

New York Attorney General Andrew Cuomo began investigating whether credit-default swaps were manipulated to spread rumours about financial companies and drive down stock prices, a person in his office who asked not to be identified said at the time.

President Barack Obama has said that credit swaps and other derivatives "have threatened the entire financial system" and US Congresswoman Maxine Waters, a California Democrat, introduced a bill in July that tried to ban credit-default swaps.

But Wall St has responded to rising criticism in late 2008 by bringing more order to the market, which was developed more than a decade ago by traders at New York-based JPMorgan Chase as a way for banks to hedge against losses on corporate loans.

Contracts outstanding exploded from less than US$632 billion in the first half of 2001 to as much as US$62 trillion at the end of 2007, almost 10 times the amount of US government debt outstanding, according to surveys by the International Swaps and Derivatives Association.

The market grew so fast that dealers couldn't keep up with the administrative details. Former Fed Chairman Alan Greenspan said in 2006 that trades often were recorded on scraps of paper.

Banks want to show regulators the market doesn't need fixing from outsiders. Cancelling redundant trades cut the overall notional amount of credit-swap contracts almost in half to US$32 trillion as of last week, according to data by New York-based Depository Trust & Clearing.

This year more than 2100 institutions agreed to standard terms to make the privately negotiated contracts easier to trade. For the first time they're being processed through a clearing house, reducing the chance that one party will fail to make payments. About US$2.5 trillion of swaps have been cleared since March. None of the almost 50 auctions that have been held to settle swaps tied to borrowers who defaulted over the past year has failed.

"The only market that I know of that seems to have worked virtually every day has been the CDS market," said Eraj Shirvani, at Credit Suisse Group. But investment guru George Soros says the market is still unsafe. The 79-year-old billionaire investor said that credit-default swaps are "toxic" and "a very dangerous derivative" because it's easier and potentially more profitable for investors to bet against companies using them than through so-called short sales. The market "held up because it was effectively put on artificial life support" by government bailouts, said Soros, chairman of New York-based hedge fund Soros Fund Management. "It is a toxic instrument, and if people want to forget it, I think they'll regret it."

Lawmakers from Washington to Brussels are considering regulations to oversee the market.

In the US, the Justice Department said it's examining potentially anti-competitive practices related to clearing, trading and information services.

"We believe there are massive risks that have gone undetected by both market participants and regulators," said US Treasury spokesman Andrew Williams.

The Obama Administration sent Congress proposed legislation last month that would require the most active contracts in the US$592 trillion over-the-counter derivatives market to be backed by clearing houses and traded either on an exchange or on regulated systems.

Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather. Unlike exchanges, the business is unregulated and prices aren't public.

Dealers and investors in the US agreed in April to buy and sell swaps for fixed annual premiums and an upfront exchange of cash that fluctuates with market values, similar to how bonds trade in an effort to make the market more uniform. Europe followed in July.

US premiums are set at 100 or 500 basis points, meaning buyers pay an upfront fee and US$100,000 or US$500,000 annually to protect US$10 million of bonds from default for five years.

Fed officials now say that for all the concern about the fallout from Lehman's bankruptcy, the effect on the business of the derivatives market was negligible.

Unwinding derivatives trades including credit-default swaps that Lehman held "was operationally complex, but it wasn't a systemic problem", said Theo Lubke, the senior vice-president of the New York Fed.

CREDIT DEFAULT SWAPS

* Buyer pays a price in exchange for a set payout if a borrower fails to meet its debt obligations.

* Price of the default swap rises when perceptions of creditworthiness deteriorate and falls when they improve.

- BLOOMBERG