Hedging Risk

I am reading the Sunday Times a day late. On the "arcane market" of credit default swaps:

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion—roughly twice the size of the entire United States stock market.

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.

A credit default swap (CDS) is a financial instrument backed by a contract in which one party agrees to pay a contingent payment to a second party upon a default by a third. In exchange, the second party pays a periodic fee to the first party. Acting as the first party in a CDS is similar to functioning as a reinsurer, taking on risk in exchange for cash. The second party in a CDS is looking to hedge existing risk, transferring risk off the books along with some cash. Because the parties do not have to actually hold the debt in question, trading CDS obligations also allows traders to speculate on the pricing of risk.

The problem: As CDS contracts are not collateralized or otherwise guaranteed, their real value depends on the creditworthiness of the involved parties. Unfortunately, their traded value does not reflect this creditworthiness—in fact, "an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim." The CDS contracts are being marked to market as sizable profit, but if a series of defaults hit, can the reinsuring parties pay the hedgers? Or do we have another contagion stinking up corporate books? This suggests that the market needs better pricing of creditworthiness, along with some contractual standard thereof, into the CDS obligation.

A good book on derivatives and risk and recent meltdowns, including credit swaps, is A Demon of Our Own Design. For an older but classic look at hedge funds, see When Genius Failed—although LTCM ate it over fixed income arbitrage, not credit swaps.