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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory
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To: redfrecknj who wrote (67653)8/8/2006 2:04:49 PM
From: YanivBA  Read Replies (1) of 110194
 
``Investors are thinking twice about buying credit-default swaps because they're wary'' of companies eliminating debt or not having enough bonds to meet the needs of the contracts, said Christian Evans, who helps manage 1.3 billion euros of debt and derivatives at Credaris Portfolio Management in London.

This is becoming a well known problem. Again, to claim the protection a credit-default swaps provides the insured party must hand over the underling bond. This is because a CDS is really a conditional put, giving the insured party the right to sell the bond at par value even if the company defaulted.

However, if there are more credit-default swaps than bonds, upon default some of the CDS holders can not obtain the underlying bond. Without the bond the value of the CDS is zero. The result will be that the price of the CDS will drop fast and even bond holders that do not have CDS protection would be able to get it for practically nothing.

I believe news like the above are indicative CDS investors are starting to realize this. As they start selling their contracts seemingly it narrows the spread on the underlying bonds but at the end the scandal will hit top news and someone will end up with a very big loss on his books (the scale of the aggregate loss would be in proportion to the size of the CDS market).

This development no longer seems far. The reaction is also predictable. Once the rumors of the losses would start spreading through the markets all participants would fear compulsory liquidation of unrelated assets and would respond by liquidating first. A large scale credit event would spread through and from the CDS market killing hedge fund after hedge fund.

YanivBA.
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