Thomas Tan is an Investment Director at vestopia.com.  A previous version of this article appeared on his blog at www.vestopia.com/thomast and this article is a follow-up to an earlier article, What Caused the Home Mortgage Market to Go Out of Control? He can be reached at thomast2@optonline.net.

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We have all heard about CDOs (collateralized debt obligations) and probably about the insurance of CDOs through CDSs (credit default swaps), which transfer the credit risks of CDOs between two parties (financial institutions).

The CDS is a bet between two parties on whether or not a company or a financial product will default. It is third party speculation on the outcome of the CDO. The CDS provides insurance to cover a fixed income product in case of its default. If a company declares bankruptcy or a debt is downgraded, a claim is triggered.

Currently, the outstanding notional amount of all credit default swaps is about $65 trillion, more than half of the entire asset base of the global banking system. Why are financial institutions are so interested in them? Why have they created so many of them to make this market so big and out of control?

There are many incentives, some of them are larger, and some smaller. I will discuss the three major reasons.

Transference of Risk

First, credit default swaps are not normal insurance policies; each side can trade them to make a quick profit (spread) if there is a willing counterparty. Commonly, after the original CDS contract is engaged, each of the original two parties will try to engage another party to further hedge their risk and earn a small spread. Pretty soon there are layers and layers of counterparties involved, with the total notional amount increasing several fold, until no one knows who they are really dealing with anymore.

You can't monitor this risk since you don't know your counterparty down the CDS chain, and whether they are able to pay in the event of a default. If you throw the counterparty risk out the window, you can always find a sucker to do the trade with you and earn a small spread.

This kind of entanglement has never been seen before in the usually highly-regulated insurance industry. This is why CDSs are traded on OTC (over the counter) derivative markets which bypass all government regulations.

This entanglement creates a chain reaction.  If something happens - even a downgrade but not a default - the claim will trigger a domino effect of many claims cascading down through various parties. It will break at the weakest joint (counterparty), probably a highly leveraged hedge fund, and will ripple through all parties involved and likely break the whole chain. It amplifies counterparty risk to the hilt, beyond the default risk of the CDO itself.

Let us use the analogy of new type of car insurance: Car insurance company A trades our car insurance policy costing us $1,000 per year (or $1,000 revenue for them) for another $1,100 similar policy from another company B, and pockets a $100 quick profit. Or we trade our $1,000 policy (company A) with $900 policy from another company C. If we find cheap auto insurance, we just simply cut A out and make a switch to C. Our relationship with the insurance company is always one on one.

However, imagine what happens if both parties trade the policy with a third party. If an accident occurs, company A will not want to pay us, since we engaged company C, and company C will not want to pay either, since it did not issue the original policy. And if company A pays us eventually, they will have to file a claim against company B, who will most likely deny such claim.

This is what happened to the insurance company AON in a story that surfaced last year from a lawsuit. In this real story, Bear Stearns loaned $10M to an entity in Philippines.  To hedge this default risk, Bear purchased a protection contract from AON for $0.4M. To hedge this risk, AON purchased protection from Societe Generale for $0.3M. AON thought they were geniuses, offsetting the risk and at the same time earning an easy quick $0.1M profit. Who says there is no free lunch on Wall Street? Think again!

You guessed it - the loan went bust as expected. Bear sued AON for $10M based on the first CDS contract.  AON lost the case and paid. Of course, AON sued Societe Generale. Due to some legal technicalities, a different court and judge had a different opinion.

The judgment was that the first and second CDS contracts were two separate contracts. Legally, the resolution of first CDS lawsuit did not automatically grant the similar status to the second CDS. The first judgment can't be referenced in the second lawsuit.  As a result, the risk can't automatically be transferred and offset each time.

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