Credit default swap (CDS) market predicting widespread defaults

One reason most banks have not been panicking about the growth in sub-prime debt is that there's a new instrument for hedging against default by big-name creditors. But price signals currently being sent by the credit default swap (CDS) market are generally more pessimistic than those from equities, even in the same companies. And the rising price of CDSs has led to fears that big banks – and those lending to them - may have viewed this as an easy way to insure against default, leading to more reckless lending than if the insurance had not been available.
What it is
An agreement by a bondholder to make scheduled payments to another party, who pays out if the bond is subject to a rescheduling or default. Payment is linked to the fall in the bond's resale price after the adverse event, and is not made if the event does not occur. The swap, written (and resaleable) in the over-the-counter derivatives market, offers a form of insurance against default, transferring risk to a specialist writer of CDSs.
The market has grown rapidly, with CDSs issued against an estimated $45,000 billion worth of bonds in the six months to June, as banks use them to hedge their exposure, especially when lending to customers with credit ratings below the top investment grade.
The recent behaviour of CDSs suggests a misalignment between the expectations of equity and debt investors, and in pricing on their respective markets. That rings alarm bells, because such misalignments have tended to precede big stock market corrections – including the recently commemorated Crash of 87.
The price of CDSs has been rising, on both sides of the Atlantic. That means lenders are seeing a rising risk of default on the bonds they buy. It contrasts with the expectation of share buyers, who have been bidding share prices to near-record levels in New York, London and elsewhere, implying an expectation of rising profitability.
Demand for CDSs has risen because more bondholders and bank lenders want to insure themselves against repayment difficulties – and because speculators who expect more defaults have piled into the market, amplifying its upward movement. One reason some analysts fear that US banks’ bad news won’t be confined to Q3 2007, despite the big write-offs recently reported, is that some may successfully have disguised the extent of their sub-prime losses by buying instruments – including CDSs - that take default risk off the balance sheet.
As CDS investors tend to hold cash covering only the riskiest portion of a company’s debt, they can be forced to raise more capital at short notice if a fall in the debt price goes deeper and wider than anticipated. Credit research group Creditsights calculated last month that adverse debt market price movements "could cause market flows of up to $345bn of CDS protection buying should unwind provisions be triggered." Unwinding is a problem because the market for credit swaps has become substantially more liquid than that for many of the underlying bonds.
In an ironic piece of market feedback, CDSs can be subjected to the same sort of packaging as the collateralised debt obligations (CDOs) whose collapse in value started the present apprehension in the bond markets. Where large corporations issue senior debt with a very high credit rating and other debt with lower ratings, it is possible to sell a CDS in an AAA-rated corporation which actually covers lower-grade tranches with higher default risk.