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In Light of Crisis, Common Trading Practice Looks Risky

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.

That risk was on display when American International Group nearly collapsed last month. The insurance giant had provided tens of billions of insurance contracts in the form of credit-default swaps. The prospect of AIG defaulting on these obligations compelled the government to bail out the firm with a $85 billion loan.

There is no federal regulation of the credit-default swap market, but the Securities and Exchange Commission has asked Congress for that authority in what would be a sweeping extension of its responsibilities.

"This potential for unfettered naked shorting and the lack of regulation in this market are a cause for great concern," SEC chairman Christopher Cox said. Any change is not likely to happen until Congress returns in January.

In the meantime, regulators are searching for provisional ways to curb the market. The SEC announced that it would review credit-default trades as part of a broader investigation of possible market manipulation.

The State of New York said it would impose new rules Jan. 1 on some credit-default swaps under its existing authority to regulate insurance companies.

"We think there's a problem that the credit-default swap market is unregulated . . . and we were trying to make that point pretty strongly ," said David Neustadt, a spokesman for New York State Insurance Department. "When the price of credit-default swaps on some company's bonds gets way too high, people look at that and it affects the stock price, it affects their ability to borrow, it starts to affect their credit rating, and their rating affects the credit-default swap price in turn. It becomes a spiral."

For Sallie Mae, the annual cost of purchasing a credit-default swap insurance policy has roughly doubled in the past week to $1.6 million for every $10 million in bonds, according to Bloomberg. That price, according to Bloomberg, suggests a 74 percent chance that Sallie Mae will default on its debts within five years.

Yesterday Sallie Mae's chief executive Albert L. Lord sought to fight off the perception that his firm was on shaky ground. He said in a SEC filing that the firm is "liquid and well capitalized." He cited a new program put in place by the Education Department that not only guarantees the loans, but also directly funds them.

With the federal government behind the firm, Sallie Mae is reducing its reliance on private lenders to raise money to issue student loans.

Mark Kantrowitz, publisher of FinAid, a Web site that provides financial advice for students, said he did not understand why Sallie Mae's credit-default swaps soared this week. But the firm faces problems, he said.

The rising cost of borrowing because of the turmoil in the credit markets is squeezing its profits. If these rates continue to stay high, he said, Sallie Mae may struggle to pay its debts.

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