Tuesday, May 13, 2008

Barron's on Credit Default Swaps

Credit default swaps (CDS) have become an increasingly well-known financial instrument in recent years.

Originally developed for insuring against debt default and hedging against, or speculating on, changes in credit spreads between debt instruments, CDS have grown into a $62 trillion market and are now the most widely traded credit derivatives.

Barron's has put their focus on the CDS market in a recent piece entitled, "Credit-Default Swaps: Weapons of Mass Speculation". Here are some excerpts from that article.

"DON'T KNOW MUCH ABOUT derivatives called credit-default swaps, or CDS? There's no reason one should. Even today, CDS, which represent bets on the default risk of various debt issues, remain an obscure corner of the global-finance market, inhabited mostly by big banks and brokerages, hedge funds and other institutions. Denizens of the CDS market strike customized insurance deals covering all manner of debt, from corporate, sovereign and municipal bonds to asset-backed securitization paper. There's no formal clearing house for this over-the-counter market. Nor is there much public reporting of the pricing of the trades.

But don't be fooled by the low profile of the business. In the decade since credit- default swaps were invented, the market has exploded in size, to some $62 trillion of CDS deals outstanding from just $1 trillion in 2000, according to industry estimates. This dwarfs the size of the underlying bond issues.

Beyond concerns about its size, the CDS market seems to have become a weapon of mass speculation that is destabilizing international debt and even equity markets. That looks to be true in the subprime-debt-induced crisis of recent months that still has the credit markets in a deep-freeze. At the height of the crisis, in the first quarter, the price of credit-default insurance for key financial companies zoomed to once-unimaginable heights, signaling rightly or wrongly the imminent default of their debt issues."

I won't be able to properly judge the article until I've read it from start to finish (skimming through parts for now), but so far, it seems that Barron's' take on the subject is tailor-made to fit the retail investor's limited understanding of the subject.

You won't find me claiming to be an expert on any segment of the credit derivatives market, but I have to wonder whether this piece is an honest account of the market or an introductory set-up to attack short-sellers who have used the CDS market to profit in their short bets against financial companies (the article goes on to detail Bill Ackman's short campaign against Ambac and MBIA).

Glancing through this piece, it's not difficult to size up the author's slant on this subject. Take the Barron's "Bottom Line" article summation, for example:

"The $62 trillion CDS market has become a destabilizing influence in the bond and stock markets. Rumor-mongering by CDS holders helped drive down many financial shares."

So, as you might have guessed, this is not an "up" piece.

What are your thoughts on the CDS market and Barron's coverage of this topic?

Related articles and posts:

"Credit default swap" - Finance Trends Matter

"Credit default swaps and financial WMDs" - The Big Picture

"Bill Ackman and David Einhorn on CNBC" - Finance Trends Matter

"Watchdog wants credit derivative controls" - Financial Times