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In Light of Crisis, Common Trading Practice Looks Risky

Albert L. Lord says Sallie Mae is
Albert L. Lord says Sallie Mae is "liquid and well capitalized." (Michael Nagle - Bloomberg News)
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By Binyamin Appelbaum and David Cho
Washington Post Staff Writers
Friday, October 3, 2008

Regulators and Wall Street's scarred survivors increasingly are zeroing in on a massive risk to the stability of the financial system posed by rampant, unregulated trading in credit-default swaps.

A key linchpin in global securities trading, swaps are basically insurance policies bought by investors to protect against an investment such as a corporate bond losing all value if the company falls apart. Over time, the broader market has come to view the price of that insurance, which fluctuates, as a leading indicator of a company's health.

Concerns about the growing and unchecked influence of credit-default swaps on the broader market have come to the fore recently as the soaring price of some swap contracts have raised questions about the viability of major financial institutions.

The price of swap contracts on Sallie Mae, the nation's largest student lender, doubled in recent days, apparently signaling that swap traders think the firm is more likely to collapse. Stock traders responded by driving down the firm's share price by 36 percent for the week, prompting the company to strongly defend its financial health.

Similar price spikes in the swap market sent the shares of some of the nation's leading insurance companies plummeting yesterday, including Hartford Financial Services, Prudential Financial and MetLife.

The movements have raised alarm over whether investors are manipulating the swap market to falsely suggest that companies are in trouble. Companies that have been punished by the swap market say that a recent ban on the short-selling of financial stocks, intended to protect companies from this kind of speculation, has pushed predatory investors into credit-default swaps.

Regulators also are worried that a collapse of a major financial firm could unleash chaos across the financial system. Widely used by banks, hedge funds and other investors, credit-default swaps' total outstanding value likely exceeds $58 trillion. But because the markets are unregulated, there is no guarantee that sellers of swaps would pay their obligations.

The turbulence in the credit default market may indicate that the financial markets' problems will not be resolved by the Bush administration's $700 billion plan to purchase troubled mortgage assets. Even though many in the markets expect Congress to pass the rescue effort today, the credit-default swap markets continue to indicate turmoil ahead for financial firms.

Credit-default swap is a complicated name for a simple concept.

It is a legal contract in which an investor who buys, say, $10 million worth of bonds could pay from tens of thousands of dollars to more than a million dollars for the insurance, depending on how credit analysts view the safety of the mortgages underlying the security. The insurance contracts enabled banks and other investors to buy securities and hold them as if they were top-grade assets, because even if the security defaulted, the credit-default swap would kick in and make the investor or bank whole.

One big problem: Anybody could write a credit-default swap.

Many in the market now worry that people who wrote the contracts may not have enough cash to honor them, which could leave institutions without safety nets they were counting on to limit their losses.

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