Last Updated Nov 25, 2009 7:32 AM EST
Credit default swaps, once all the rage among investors in the days when multi-billion dollar investment banks such as Morgan Stanley (MS) and Goldman Sachs (GS) faced bankruptcy a little over a year ago, have slowed in appeal this year as global markets have made a big push towards risk.
Now however, the credit derivatives are making something of a comeback: this time in the case of entire developed countries.
Credit default swaps (CDS) are essentially insurance contracts that pay out in the event of the bankruptcy of a particular institution or entity. As the likelihood of bankruptcy or of loan default of the entity rises, so does the value of the swaps.
The London paper the Financial Times pointed out this week that trading volumes for CDS contracts has spiked recently in the case of the United States, the United Kingdom and Japan, while in Italy, they are the highest for any country in the world. On a related note, the cost of insuring against the risk of credit default for Greece leaped nearly 7 percent in New York trading Tuesday.
Curiously, much of this CDS activity has yet to spread to individual companies. Despite concerns over further writedowns for Freddie Mac and Fannie Mae, warnings of continued defaults by British banks, and a possible downgrade of 775 global debt securities by Moody's, a ratings agency, CDS volumes remain relatively weak in Europe right now.
The point is all the more prescient given that this morning, the International Monetary Fund (IMF) said that it had received access to a credit line of $600 billion, created as a result of participating countries pooling credit contributions together. Meanwhile, IMF chief Dominique Strauss-Kahn commented yesterday that up to half of all banks' losses may be going undetected as a result of being hidden deep within their balance sheets.
The reason the bearish sentiment over the creditworthiness of individual countries is especially significant for financial services firms in the U.S. and Europe right now is that they are almost wholly dependent on their nations' ability to keep funding their growth out of recession. If credit default spreads are widening in the case of individual country debt, then they should be commensurately following suit for individual banks, too. The fact that they are not seems to imply a gross disconnect in the thinking about the true health of the western banking system as a whole; that is also why Strauss-Kahn's comments are particularly unnerving at this stage.
To make matters worse, as institutions bet bigger on the lack of creditworthiness of countries, the risk of those countries defaulting on the huge debt they have used to finance their way out recession becomes higher. That is because of the inverse relationship (called the "negative convexity" in financial parlance) between CDS and collateralized debt obligations (CDOs), derivatives which help finance the borrower's ability to keep borrowing. (There is quite a good explanation of that relationship here.)
In the worst case scenario, the situation may result in another wave of financial institution bankruptcies. As history has shown, because of the domino effect of such a scenario, it can often happen much faster -- and much more aggressively -- than we all at first thought was reasonably possible.