Report on swapping credit, default hides truth on risk

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 study by the Depository Trust and Clearing Corp fails to 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 mortgage securities, according to Andrea Cicione at BNP Paribas SA in London.

New York-based DTCC's report, released on its Web site November 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 study may have missed as much as 40 per cent of the trades outstanding in the market, Cicione said.

The data are “likely to underestimate the amount of net CDS exposure,” he said in an interview. “A broadening of the coverage to the entire market is what investors really need.”

‘Increased Transparency’: Cicione, who correctly forecast in January that the cost of protecting European companies would rise, said increased transparency in the CDS market is “definitely a welcome development.”

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 in part 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.

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 reached 240 basis points on October 27. The index closed at 187 basis points in New York on Wednesday, according to Deutsche Bank AG.

The Markit iTraxx Europe rose to 195 basis points from as low as 20 in June 2007. It was 138.5 basis points, according to JPMorgan Chase & Co prices at 10:35 am in London.

$440 Billion: 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 a deterioration in the perception of credit quality; a decline signals the opposite.