Risk Waits For No One

Back in September, one of the first posts to this blog focused on the systemic risk failure that led to the current financial crisis.  The systemic risk discussed was related to the use of derivative instruments such as credit default swaps ("CDS") to mitigate credit risk associated with corporate debt.  The rapid increase in use of these CDS instruments combined with the lack of regulatory oversight led to a dramatic increase in systemic risk that has not been well managed.  A recent article by Institutional Risk Analytics provides a great example.

The basic tension over CDS starts with the fact that these instruments actually increase overall systemic risk. 

Consider a real world example: When the auto parts make for General Motors, Delphi, filed bankruptcy in October 2005, there were between $20 and $30 billion in CDS outstanding and deliverable against the $2 billion in debt outstanding and another $2 billion in bank loans that were also deliverable against the CDS.  Whereas the maximum cash loss to investors in the Delphi default might have been limited to the $4 billion of extant debt without CDS, the existence of CDS actually multiplied the potential opportunities for gain and loss on the Delphi default nearly 10 fold. 

While proponents of the CDS market will and do argue that the “net” exposure from the Delphi default was quite small, the fact remains that the “innovation” of CDS actually created a multiplicity of new risks around the existing cash default of Delphi, risks whose sole benefits seem to be a) providing speculative opportunities for a certain class of market participants – I won’t call them investors, because often they are not -- and b) generating commission for CDS dealer banks.

A great deal of work must begin immediately to address this situation that is at the core of our economic meltdown.  While potential solutions have been discussed, no real steps have yet been taken by the public or private sector.  However, as we all know too well, risk waits for no one.