How the CDS Market Can Support the Bond Market

I'm glad that Equity Private quoted herself yesterday, because I missed this the first time round:

Are we surprised when people point fingers at Bear and suggest, for instance, that they are buying up the underlying assets and loosening credit terms on the debtors to avoid a default, a mark to market problem and, to boot, to avoid paying, for instance, on credit default swaps- for which their liability is much greater than taking a complete loss on the debt itself would be?

She adds, in her latest post:

The key distinction that makes it wildly worth it to attempt such a thing if you are on the wrong side of a credit default swap is the fact that 10:1 to 100:1 leverage is often being applied such that the derivative liabilities floating above the assets may vastly outweigh the value of the underlying instruments. Pretty cheap to just stick your hand in the black box of "mark to market" and prevent a write-down that way, nay?

I have no idea how many firms have written, on a net basis and on a certain credit, more credit protection than there is debt outstanding. But clearly, insofar as there are such firms, it makes sense for them to take on full responsibility for that debt and ensure that all payments get made in full and on time.

What's more, if it makes sense for one firm to do this, it makes sense for a consortium of credit insurers to do it as well, if the consortium has a large contingent CDS liability. So long as the coupon payments get made, they get their insurance premiums; if there's ever an event of default, however, they stand to lose a lot of money. (Although, looking at what happened with Delphi, perhaps they'll lose much less than full par value.)

Could the existence of the CDS market therefore help to prop up the bond market, and minimize the number of defaults that occur? It's possible. Frankly I'm skeptical that there are many institutions with such enormous positions in CDS: I'd expect banks, for one, to be much more hedged than that. When Equity Private talks about people pointing fingers at Bear, I think she's talking about John Paulson, way back in June. Since then, I haven't heard any more talk along these lines, and I don't think the Paulson allegations went anywhere in the end. But still, it's an intriguing possibility.

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