Credit default swaps — an unregulated, over-the-counter market fed by banks, insurance companies, pension funds and hedge funds — have been the biggest force behind the leverage of Wall Street. Collectively, CDSs had a notional value of $54.6 trillion as of June 30, according to the International Swaps and Derivatives Association, based in New York. To lend context to that number, consider that the estimated U.S. gross domestic product for 2008 is $14.3 trillion and that the Bush administration proposed a federal budget of about $3 trillion for fiscal 2009. The collapse of the CDS market would make the subprime meltdown look like child’s play. Ergo, calls for regulation.
A CDS, in short, is an insurance policy against the potential of a default on a bond. Through the sale of a swap, a lender can transfer the risk on a loan. Whoever buys a swap does the same thing, and the risk is passed along, over and over again. As the distance between borrower and lender grows, all sense of proportion is lost. Easy credit and strong international growth fueled the explosive expansion of the CDS market, which was just $2.2 trillion in 2002. CDSs were profitable, and some companies fell all over themselves to collect the quarterly premiums. Notable underwriters included investment bank Bear Stearns Cos. and insurer American International Group.
Today, however, the CDS market is as frozen as the credit markets; fear of loan defaults has spread even to the debt of stalwart corporations like General Electric and Boeing. “We’ve gone from a situation where there was too much leverage to an extreme where there’s too little,” says Jeff Kushner, a London-based partner with $5 billion hedge fund firm BlueMountain Capital Management.
Liquidity has evaporated, stocks have tanked, and the value of almost everything seems in question — the supposed wealth in CDSs included. So much for insurance. “Cash,” Kushner says, “is king.”
