"MBS" was the first three-letter acronym to become synonymous with bankruptcy and danger, but as the financial crisis has churned three new letters have risen to predict doom and gloom for investors and companies alike: CDS.
The dreaded credit default swap is the latest credit derivative product to be demonized, but before investors begin to scour the books of the major banks left standing for CDS risk, there are some important factors to consider.
The transfer of risk is a major goal of any financial institution, and these swaps allow for the protection against the default of underlying assets by transferring risk to another party. Perhaps no bank is better at this transfer of risk than JPMorgan Chase (NYSE:JPM). Investors catching wind of the looming threat of credit default swaps should take a moment to understand the proficiency of JPMorgan's position in the credit derivatives market. (For a detailed discussion, read Credit Default Swaps: An Introduction.)
JPMorgan bankers invented the credit default swap in the early '90s. The idea is as follows. Making a loan like a mortgage exposes the lender to the risk of a borrower defaulting. Banks have been able to enter into agreements with insurers like AIG (NYSE:AIG) for protection against borrower default. The bank makes a steady stream of payments to the insurer and in return, should the borrower default, the insurer would make the lender whole again.
As evidence of the popularity of this type of credit derivative, investors should note that in 2007 the Comptroller of the Currency Administrator of National Banks (a division of the U.S. Department of Treasury) reported that the notional amount of credit derivatives increased 16% from the prior quarter to $11.8 trillion in the second quarter. These were comprised mostly of CDS, which were the fastest growing product among global derivatives.
The Big Buyers and Sellers
During that time period JPMorgan was the most active and largest buyer and seller of CDS with transactions totaling more than $3 trillion on each side. In second place was Bank of America (NYSE:BAC) with more than $1 trillion in CDS bought followed by Citibank (NYSE:C) with over $1 trillion in transactions on both the buy and sell side.
At the end of the first quarter of 2008 the notional value of credit derivative contracts rose again to $16.4 trillion. The top three participants in CDS remained the same, but the amount of swaps bought and sold by each commercial bank increased. In the case of JPMorgan it bought more than $4 trillion in CDS and sold $3.97 trillion.
Not so Sweet
American Insurance Group was one of the major issuers of CDS. Once the value of the assets AIG was securing fell in value, the insurer was forced to write down billions for its expected losses and post collateral to buyers of the CDS.
The market for credit default swaps remains unregulated. While regulators may be pointing their finger at CDS next as the cause for the market's downward cycle, investors should note the correlation between the banks at the top of the credit default swap transaction tables and the banks that are doing the best in today's up and down market.