Complex Financial Trades Worry Economy Watchers

As ACA demonstrated, when one firm in the chain of swaps contracts has a shortfall, it can affect many financial firms and banks around the world, said Greg Medcraft, chairman of the American Securitization Forum, an association of investors.

"There was a chain effect," he said. "That's the great concern at the moment. It gets to the common theme of trust and confidence. Banks rely on trust and confidence, and if that trust and confidence is impaired, if people start getting panicky about financial credit quality of a counter-party, you'll have a further tightening of credit availability."

Since becoming a major financial player, the swaps market has not been tested when default rates were high. In the past few years, as swaps grew, the rate has remained at historic lows -- below 1 percent of all corporations. But both Moody's Investor Services and Standard & Poor's estimate that defaults will reach 4 to 5 percent this year. S&P reported yesterday that the amount of corporate debt issued by companies in distress has increased to its highest level in four years.

Bill Gross, managing director of PIMCO, one of the largest bond funds in the world, calculates that losses on swaps contracts could reach $250 billion this year if default rates return to historic norms. If a recession were to occur, the default rate and the resulting losses among swaps likely would be much higher and far more widely felt.

Swaps have made the global financial system a much smaller place since they became common in the 1990s.

Corporate bond holders enter into swaps contracts to try to minimize their losses in case the company issuing the bond runs out of cash or cannot make payments on its loans. The bond holder does this by paying a financial firm to cover any losses. That financial firm, in turn, typically creates and sells swaps to cover its own risky positions.

This process continues, forming a chain of swap contracts and linking the fortunes of banks, hedge funds and financial firms around the world. As a result, many parties end up sharing the risk of a single investment. Advocates of this financial instrument often say swaps spread risk a mile wide and an inch deep.

Over the past few years, bond holders discovered that swaps contracts, when traded, act like corporate bonds, only better. Bond holders are limited in how much they can invest by the total amount of available debt, while swaps traders can create an unlimited number of bets.

Two parties are needed for a swap to work -- one who believes a firm's fortunes are going down and another who believes they are rising. To bring the parties together, some of Wall Street's biggest banks served as brokers, usually charging 0.1 percent for a $10 million swap contract.

Derek Smith, head of U.S. flow credit trading at Deutsche Bank, said his firm was brokering 100 swap trades a day five years ago. Now it does 1,000. The whole industry does about $50 billion daily, he said. "It's definitely a mainstream instrument now," Smith said.

Kent Wosepka, managing director at Standish, which manages $210 billion in investments, says swaps have become bigger and more important to most financiers than the bond markets that created them.

"The bond markets are no longer the dog," he said. "They have become the tail. Credit default swaps are the dog now."

But swaps come with a major hazard: You have to know whether the counter-party who has agreed to your contract has the money to cover the loss in the event of a default.

Some noted investors such as Warren Buffett have called them "ticking time bombs."

In a letter published in Investment Outlook, Gross, the PIMCO managing director, warned that the swaps market represents a "bank of shadows" largely because it operates without anyone watching.

"Credit default swaps are perhaps the most egregious offenders" of all derivatives, Gross wrote. "Throw in an embarrassed regulatory network consisting of the Fed and Congressional watchdogs asleep at their post, and you have a recipe for credit contraction -- a run on the shadow banking system."