The credit swap credibility gap

The first domino in the great derivatives crash of 2008: A bond insurer gets a bad rating

Published December 19, 2007 7:19PM (EST)

2007 has been a big year for shocking news from the financial markets, but when all the dust settles, we may look back at Wednesday's decision by Standard & Poor's to downgrade its credit rating for the bond insurer ACA Financial Guaranty Corp. from Aaa to CCC "junk" status as the biggest blow of all.

As explained on Monday, the ripple effects of a credit rating downgrade for a bond insurer are likely to spread far and wide. All the myriad securities for which ACA sold insurance are now in danger of losing their own gilt-edged credit ratings. This will likely result in a plunge in the market value of those securities.

As the New York Times reported on Wednesday, ACA's troubles may result in the first big test for everybody's favorite credit derivative, the credit default swap. A credit default swap is essentially a way to bet on the likelihood of a bond defaulting. ACA was a huge player in the business of selling such swaps -- according to the Times, as of Sept. 30 it had outstanding contracts on $70 billion worth of bonds.

Back when Wall Street types were still bold enough to talk about how the proliferation of derivatives had made the world a safer place, the phenomenon they were describing was in large part the incredible growth of credit swaps. But now we're about to find out just how well these innovations work, because bonds are beginning to default, and the institutions that sold the protection are going to have to start paying up.

Which is why Standard & Poor's downgraded ACA; because, in its words, there is "significant doubt that the company could possibly access sufficient hard capital resources" to make good on its potential obligations.

But that's only the beginning. Remember, ACA is a monoline bond insurer -- its business specialty is evaluating the riskiness of bonds. Theoretically, it should have a reasonably good idea of how to go about such a task. But bond insurers aren't the only entities selling credit default swaps. Hedge funds also love to play this game.

In a gloomy look forward at the delights that 2008 might have to offer, Christopher Whalen, a managing director at Institutional Risk Analytics, notes that "among the tricks of the hedge fund trade in recent years was to write credit default protection on everything from corporate default swaps to subprime CDOs. As long as their was no apparent risk, the premium income seemed as free money, just like banks thought that lending was a zero cost activity. But hedge funds are not insurance companies and have neither permanent capital nor reserves, preferring instead to treat premiums on selling derivative put options as regular income." (Italics mine.)

Even worse, the hedge funds were selling protection to investment banks that were their own sources of credit. In other words, they were borrowing money from the same banks that they were insuring against bond default. So if the default occurred, they'd have to make good their own lender. Snakes generally have a far easier time swallowing their own tails.

Now, if specialized bond insurers are about to start going belly-up, what's going to happen to the hedge funds?

As 2007 limps to a close, the scariest realization of all is that this whole mess may only just be getting started.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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