Sunday, January 20, 2008

Downgrade will hurt CDO markets

The $450 trillion CDO market seems to include a lot of double-triple-quadruple counted numbers. $27 trillion is still a lot of money. If we're talking about this being the worst recession since the Great Depression, we're looking at defaults of at least 12.7% or $3.43 trillion?
Or will the swaps end up cancelling each other out?

This has grown to be a huge market: The total value of all CDS contracts is something like $450 trillion. Because buyers and sellers of insurance usually create multiple "policies" as they attempt to control risk, that number includes a lot of duplication. Real exposure, says the Bank for International Settlements, may be only 20% of that, or $90 trillion. Some studies have put the real credit risk at just 6% of the total, or about $27 trillion. That puts the CDS market at somewhere between two and six times the size of the U.S. economy.
The CDS market has been a good place to make money in the past few years because default rates in the junk-bond market have been historically low. The default rate for all junk bonds declined to 1.7% in 2006. That's the lowest rate since 1996. With defaults that low, sellers were paid insurance premiums but didn't have to cough up much in return.
But that default rate started to rise in 2007, climbing to 2.6%. And Standard & Poor's projects the rate will climb to 3.4% by October. At that rate, 56 bonds would go into default in 2008, compared with 14 in 2007.
That level of default isn't likely to inflict too much damage on the CDS market. The historical rate for defaults by corporate junk bonds has averaged 5% a year since 1980. But the default rate has run as high as 12.7% in previous recessions.
The next banking crisis on the way - MSN Money

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