Credit squeeze will get worse in 2008

Financial institutions face plenty more write-offs this year. However, the big theme of 2008 could well be the triggering of credit default swaps. We look at what the CDS market is - and why it could cause serious contagion.

Consider this, says David Rosenberg of Merrill Lynch: the first 7% down leg in US house prices triggered a 65% year-on-year surge in foreclosures, a 20% plunge in financial stocks and nearly $100bn of writedowns in the banking sector.

So what might another 20%-30% fall do? Prices still look hugely overvalued, inventory has risen, and 1.1 million prime borrowers are in arrears. So financial institutions face plenty more write-offs on mortgage-related securities, with Jan Hatzius of Goldman Sachs recently estimating that US losses could reach $400bn.

Meanwhile, other parts of the credit market student, car and credit-card loans look vulnerable. These were also parcelled up into "complex products with the same questionable credit ratings", says The Economist.

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But the major theme of 2008 may be credit default swaps (CDSs). These contracts provide insurance against corporate default. The seller of protection agrees, in return for a premium, to pay the face value of the underlying debt should the borrower default. The principle also applies to parts of complex instruments where debt of various kinds is bundled together collateralised debt obligations (CDOs) or to the CDOs as a whole; there are CDSs on mortgage-backed securities, for instance.

The global market for CDSs has rocketed: there are now $45trn of outstanding trades. Bill Gross of Pimco warns that CDSs have been widely used by the thinly capitalised off-balance-sheet vehicles (defined on page 40) created by banks over the past few years, and so these could struggle to find the money required if these derivative contracts are triggered, creating so-called counterparty risk for those expecting to be paid, says Gillian Tett in the FT.

So far, few CDS contracts have been triggered because corporate defaults have been rare. But debt agency Moody's expects the worldwide default rate for junk-rated firms to jump this year from 0.9% to just under 5% the historical average as the economy weakens. Gross assumes that the overall corporate-insolvency rate (encompassing investment-grade and junk debt) is set to return to a historically typical 1.25%. That would trigger around $500bn in default insurance; with protection sellers likely to be able to recover half of this, their losses would be around $250bn, reckons Gross.

But what if a US recession turns into a prolonged slump? asks Wolfgang Munchau in the FT. A two-year downturn, with default rates jumping, could "easily trigger payment streams of a multiple of $250bn". As more firms default, so might insurers and the insured, says The Daily Reckoning. You can see how the CDS market could cause "serious financial contagion", adds Munchau.

A major worry is that bond, or monoline, insurers are big players in CDS markets. Having guaranteed dodgy subprime-backed bonds they are currently at risk of being downgraded by ratings agencies, which would also lower the quality of bonds they insure; cue forced sales by institutions allowed to hold only top-notch debt and more bank write-downs. Monolines' balance sheets are shaky and if their guarantees are removed, global losses in CDS markets and the underlying credits they insure could ultimately be $365bn-$425bn, reckons Independent Strategy's David Roche.

Hatzius said in November that mortgage losses of $200bn-$400bn could reduce overall lending by leveraged financial institutions by $2trn, as Gross notes. Add the $250bn estimate of losses in CDSs, along with prospective losses on commercial real estate and credit cards, and credit will contract further, dealing growth an additional blow. Economies and markets, says Alan Abelson in Barron's, will be suffering from "the great credit squeeze for a long, long while".