ULI: Watch Out for Monolines, Credit Default Swaps

The Urban Land Institute's latest Capital Markets Update makes a case that the next red flags to look out for in the developing credit crunch are credit default swaps and monoline insurers.

That makes a lot of sense. Both the Financial Times and Wall St. Journal have had reams of coverage on both of these areas. Credit default swaps are derivatives that act like insurance for bonds. Basically, investors that bought subprime paper could go out and buy credit default swaps--in many cases from monoline insurers--that promised to pay the value of the bond if the bond itself defaulted. For that protection, investors would pay a monthly fee--usually a small percentage of the overall bond amount. In practice it sounds like a great idea. In reality, the monolines got overexposed to bad debt and there are doubts they'll be able to pay out the swaps if defaults continue to play out and especially if they continue to spread to other kinds of bonds.

Anyway, the ULI piece has lots of good data in it and is very good at describing the contours of the problem. Here's a taste:

There are an estimated $46 trillion—not billion—trillion in “notional amount” of Credit Default Swaps outstanding. Notional amount is the term used to describe the principal amount of the contract in the same way that an insurance policy has a face amount. Premium is the amount paid for the insurance. As in an insurance policy, no money changes hands in a CDS, except the premium, unless there is a credit default.

The easiest way to “visualize” a CDS is to think of it as a life insurance policy, assuming for this example a death benefit of $100,000. The $100,000 is the notional amount—a placeholder to remind us of what we will receive in the future when and if we make a claim (and our effective benefit for paying our annual premium all those years). In a CDS, instead of a benefit paid upon death, the notional amount is paid to the owner of the CDS if the “insured”—normally a corporation, government, or Sovereign credit—defaults on its obligations to a specific financial instrument, such as a bond, or files for protection in bankruptcy. A Credit Default Swap is normally utilized to hedge an existing risk—in the case of a CDS, the existing risk is ownership of the credit of the borrower (or debtor) underlying a financial instrument such as a bond. In the commodity markets, a farmer hedges himself against future price fluctuation by selling a contract which obligates him to deliver a certain amount of the commodity at a previously agreed upon price. If the value of the commodity increases, the farmer does not benefit as he has pre-sold his crop at a price negotiated today. If the price of the commodity decreases, the farmer profits as he receives the higher, negotiated contract price rather than the lower, market price. In a Credit Default Swap, an investor hedges himself by purchasing a CDS which protects him from a negative event such as a bankruptcy. However, his return is reduced by the amount of the annual premium charged by the counter-party in the CDS for the credit insurance provided. Alternatively, the investor suffers no loss in principal in the event of a bankruptcy as the CDS counter-party is responsible for paying him the notional amount.

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