Complex Financial Trades Worry Economy Watchers

Rise of Bets Called Swaps Could Worsen Subprime Damage

Even as lawmakers agreed yesterday on a tax rebate to stimulate consumer spending, a new threat to the economy is emerging because of the complex way the financial system has recently tried to cover its losses.

The issue has come to a head as damage mounts from the subprime mortgage crisis. While early estimates put losses from those troublesome home loans at $250 billion, the total exposure could be five times greater, mortgage analysts and researchers say.

The explanation for that may seem, initially, unrelated to mortgages. Financiers have realized in recent years they could start gambling on things they didn't own. Many banks, hedge funds and institutions began making side bets on a host of other financial developments as varied as an earnings report at Sprint Nextel and the fate of North Korea's economy.

Like two gamblers betting on a football game they don't play in, investors all over the world made bets on the performance of securities backed by subprime mortgages. These bets were so profitable and generated such large fees on Wall Street that they eventually outgrew the total value of the mortgages themselves.

The market for all of the side bets, called credit default swaps, exploded from $6.4 trillion in 2004 to at least $43 trillion at the end of 2007, far surpassing the total value of the debt markets, according to the Bank for International Settlements.

Swaps originated as insurance for financial institutions that lent money. They sold these policies to other investors who, in turn, could trade them and speculate on whether the riskiness of a loan would rise or fall.

The astonishingly rapid evolution of swaps took place largely outside the view of regulators. Many Wall Street investors now say that these side bets may have magnified losses in the mortgage industry because they pulled in unrelated investors and financial institutions.

An example of this danger came to light when a little-known firm called ACA Financial Guaranty caused some of Wall Street's biggest banks to write down billions of dollars in holdings, restating their value on corporate balance sheets. ACA revealed last month that it had promised to cover $60 billion worth of mortgage and corporate debt, but had enough cash to cover only a fraction of that. Merrill Lynch, Citigroup and financial institutions in Canada and France, which had all sold swaps to ACA, set aside billions in case the firm collapsed.

ACA isn't the only firm that took on more swaps than it could handle. Two of its larger competitors, MBIA and Ambac Financial Group, had also promised to cover massive losses in subprime mortgages but now say they don't have enough cash to do so.

That shortfall is threatening MBIA and Ambac's $1 trillion business of providing insurance to companies and municipalities that issue bonds. The prospect of losses rippling across the bond markets has pushed banks and regulators in New York and Washington to craft a multibillion-dollar rescue package for the firms. It could involve a cash infusion of up to $15 billion.

With the possibility of a recession and the global financial system unsettled, federal officials say the swaps market has become a primary concern. Since swaps are traded privately, outside any exchange or clearinghouse, it is difficult for regulators to know how losses can spread and who is making the riskiest bets.

"Given the size of the market now and the lack of public information on who holds what . . . this market will be really tested for the first time if we do see a big round of defaults," said David Munves, head of capital markets research group at Moody's. "It's a risk factor no doubt."