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Credit swap inventory was grossly incomplete

Section: Daily Dispatches

Credit Swap Disclosure Obscures True Financial Risk

By Shannon D. Harrington and Abigail Moses
Bloomberg News
Thursday, November 6, 2008

NEW YORK -- The most comprehensive report on unregulated credit-default swaps didn't disclose bets in the section of the more than $47 trillion market that helped destroy American International Group Inc., once the world's biggest insurer.

A report by the Depository Trust and Clearing Corp. doesn't include privately negotiated credit-default swaps that insurers such as AIG, MBIA Inc., and Ambac Financial Group Inc. sold to guarantee securities known as collateralized debt obligations. It includes only a "small fraction" of contracts linked to mortgage securities, according to Andrea Cicione at BNP Paribas SA in London.

New York-based DTCC's data, released on its Web site Nov. 4, showed a total $33.6 trillion of transactions on governments, companies and asset-backed securities worldwide, based on gross numbers. While designed to ease concerns about the amount of risk banks and investors amassed on borrowers from companies to homeowners, the report may have missed as much as 40 percent of the trades outstanding in the market, Cicione said.

The data are "likely to underestimate the amount of net CDS exposure," Cicione, who correctly forecast in January that the cost of protecting European companies from default would rise, said in an interview. "A broadening of the coverage to the entire market is what investors really need."

... 'Increased Transparency'

DTCC released the data as dealers and investors in the market seek to counter criticism that the market has amplified the financial crisis. The Nov. 4 report showed, for example, that $15.4 trillion of contracts linked to individual companies, governments and other borrowers were created. After canceling out contracts that offset one another, though, sellers of that protection would have to pay $1.76 trillion if all underlying borrowers defaulted and debt holders recovered nothing.

The data is "definitely a welcome development," Cicione said.

Trading of credit derivatives soared 100-fold the past decade as banks, hedge funds, insurance companies and other investors used the contracts to protect against losses or speculate on debt they didn't own. The growth was driven partly by CDOs, securities that parcel bonds, loans and credit-default swaps, slicing them into varying layers of risk.

Banks worldwide have taken $693 billion in writedowns and losses on loans, CDOs and other investments since the start of 2007, according to data compiled by Bloomberg.

... CDX Indexes

Investors hedging against losses on CDOs helped push the cost of default protection to a record last week. The benchmark Markit CDX North America Investment Grade Index, linked to the bonds of 125 companies in the U.S. and Canada, reached 240 basis points on Oct. 27. The index rose 5 basis points to 192 basis points as of 8:48 a.m. in New York, according to broker Phoenix Partners Group.

The Markit iTraxx Europe rose to as high as 195 basis points from as low as 20 in June 2007. It was quoted at 139.5 basis points today, according to JPMorgan Chase & Co. A basis point on a credit-default swap protecting $10 million of debt from default for five years costs $1,000 a year.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. An increase indicates deterioration in the perception of credit quality; a decline signals the opposite.

... $440 Billion

AIG first disclosed to investors in August 2007 that it held more than $440 billion of credit-swap trades linked to CDOs. The New York-based company was brought to the edge of bankruptcy in September after the value of the transactions plunged. The insurer was forced to come up with more than $10 billion in collateral to back the contracts after its debt rankings were cut. It accepted an $85 billion government loan in exchange for ceding control to the U.S.

MBIA and Ambac, previously the world's two biggest bond insurers, lost their top AAA ratings earlier this year because of potential losses on credit swaps sold to guarantee CDOs backed by home loans. Moody's Investors Service cut New York-based Ambac's bond insurance rating four levels yesterday to Baa1, three steps above junk, because of potential losses on the derivatives.

A market survey this year by the New York-based International Swaps and Derivatives Association, which includes credit swaps on CDOs and other contracts that may not be captured by DTCC's Trade Information Warehouse, estimates more than $47 trillion in gross contracts are outstanding.

... 'Gaps'

The Federal Reserve Bank of New York, which urged dealers to curb risks and improve transparency in the credit swaps market over the past three years, said regulators will continue to push for more disclosure. Among the information the Fed wants to see are prices at which the derivatives trade, according to a New York Fed spokesman.

"There appear to be gaps," said Henry Hu, a law professor at the University of Texas in Austin who has pressed for the creation of a data warehouse encompassing all privately negotiated derivative trades to offer a better understanding of their risks.

"Hopefully, regulators are getting more information," he said.

Because the DTCC registry captures only commonly traded contracts that can be confirmed over electronic systems, not every swap trade is in the company's report, spokeswoman Judy Inosanto said. Among those not included are credit-default swaps on CDOs, she said.

MBIA, the Armonk, New York-based insurer crippled by ratings downgrades earlier this year following losses from such contracts, has said it sold $126.3 billion in guarantees on slices of CDOs backed by corporate bonds, mortgages and other debt. Ambac sold $60.7 billion in guarantees on these so-called tranches, mostly through credit swaps, the company said.

... CDO Losses

Insurers including AIG, MBIA, and Ambac typically sold protection on the highest-ranking slices of such deals, meaning they'd be required to make good on payments only after a substantial part of the underlying debt defaults.

The failures of Lehman Brothers Holdings Inc., Washington Mutual Inc., and three Icelandic banks that were widely held in CDOs linked to corporate debt caused no losses on tranches MBIA guaranteed, Mitchell Sonkin, the company's head of insured portfolio management, said in a conference call yesterday.

New York-based Lehman and WaMu, based in Seattle, filed for bankruptcy. Iceland's government took over its three biggest lenders last month after they were unable to raise short-term funding, triggering pay-outs on credit-default swaps.

Some investors holding the riskier slices of CDOs that weren't guaranteed lost more than 90 percent because of the bank failures.

"The worry is that these bespoke tranches are being eaten away, and who knows if and when these losses will get realized?," Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California, wrote in a note to clients yesterday.

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