The next credit tidal wave

Credit default swaps (CDSs) are the latest financial instruments to be hit by market turmoil. By Sean Farrell

The rocketing cost of protecting corporate bonds has shone a light on another arcane corner of the financial world – the $45trn (£23trn) market for credit default swaps (CDS).

The cost of insuring the debt of US and European companies against default surged to all-time highs so that buyers of protection in the market were paying €126,500 (£95,500) a year to insure €10m of debt over five years.

The markets eased a little yesterday but Wednesday's surge to an all-time high was triggered by a panic that market experts are struggling to explain.

Credit-default swaps are financial instruments linked to bonds and loans that are used to bet on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower does not honour its debt. A rise in the cost of the instruments indicates greater fears about credit quality.

The troublesome part of the market is constant proportion debt obligations (CPDOs) – products that package indexes of credit-default swaps. The trouble is caused partly by fears about the corporate debt that underpins the products.

But "fundamentals" do not necessarily have to get worse to cause a widening of spreads – the difference in the cost of insuring a security compared with risk-free debt. Structured products have been set up with triggers to stop investors losing more than they put in, and it can take only a small fall in the value of the securities to hit these triggers which force the structured products to start to unwind.

This causes further nervousness so that spreads widen still more. A similar thing has happened to structured investment vehicles (SIVs), which are having to be bailed out by the banks that manage them.

What is going on in the CDS market is, analysts say, an example of the vicious cycles that have been a feature of the credit crunch. Analysts say structured products based on corporate debt may be tarred with the same brush as those backed by US sub-prime mortgages as investors flee the exotic debt instrumentse constructed in recent years.

Willem Sels, head of credit strategy at Dresdner Kleinwort, says: "Given that the market has seen a big fall over past weeks, losses in the derivatives and levered loan markets are so high that certain structured products hit contractual triggers where managers are forced to sell the portfolio. By doing so, they exacerbate the widening in the market, which in turn causes trigger levels with other investors to go off."

Some believe the market is "front-running" a jump in corporate debt default. The problems are made worse because the market has become illiquid.

"It is messy at the moment because people want to hedge their portfolios because they believe risk is imminent and few people want to go the other way," an analyst said.

CDOs package assets such as mortgage bonds and use the income from the debt to pay investors. CDOs made up of credit default swaps are known as synthetic because they do not contain the original bonds. Their value falls as the cost of credit-default swaps rises.

CPDOs are based on the US CDX and European iTraxx indices, which track the cost of default insurance. Some CPDOs are linked to banks and other financial institutions whose losses from the credit crunch have rocked investors' confidence.

"People are definitely concerned about counterparty failure and all the unknowns in the system. They are concerned about a major counterparty failure such as the monolines, a dealer or a big bank," one analyst said.

The problems in the CDS market are probably exacerbated by fear about the future of the monoline bond insurers whose credit ratings are under pressure. Investors are concerned that a monoline collapse could cause major damage to a big bank exposed to the securities they insure.

Critics of the market are emerging. John Moulton, managing partner of the private equity firm Alchemy Partners, said this week that he expected the CDS market to be the next blow-up in the credit crunch.

Bill Gross, managing director at PIMCO, the fixed-income manager, estimated that if total investment grade and junk bond defaults approached historical norms of 1.25 per cent in 2008 then $500bn of default contracts will be triggered, causing losses of at least $250bn for the parties who sold the protection.

"As capital gains and capital losses slosh from one side of the shadow system's boat to the other, casualties and shipwrecks are the inevitable consequence," said Mr Gross last month. "Goldman Sachs wins? Fine, but the losers in many cases will not be back for a return match."

Mr Sels said: "The ultimate risk is often held by investors without a very solid capital base and who use leverage, such as hedge funds. In fact, they are very often taking directional bets that are not really 'hedged'.

"Therefore, their capital can easily be wiped out or investors in the hedge fund can pull out their money, which will likely bring some of them under. They would not be the only ones to suffer though: banks would as well, as they are the counterparty on many of the derivatives transactions that hedge funds undertake."