Credit Default Swaps are the Real Stress in Bank Tests

Stress tests to be revealed Thursday will likely show that while subprime, corporate and commercial real estate loans are doing their fair share of tearing apart bank balance sheets, the real gremlin in the banking engine is the credit default swap, or CDS.

Credit default swaps are private contracts where the buyer pays for protection against the default of an underlying instrument — making them ideal for “insuring” a bond issued by a shaky lender. And there are a lot of CDSes floating around out there — the Depository Trust & Clearing Corporation currently counts $27.5 trillion in outstanding CDS contracts.

As the Financial Times points out U.S. banks will need to take CDS exposure into account for the first time when conducting stress tests. Banks will need to determine how much capital would be lost if their “counterparty risk” increased under different scenarios.

In derivatives-speak, counterparty risk is the possibility of one side of a transaction defaulting. Once that occurs, the issuer of a CDS would be on the hook for the full value of the default immediately. No bankruptcy courts or loan work-outs: In a CDS, it’s pay up and move on.

Defaults on CDSes can take many forms, such as missing a loan payment, a credit downgrade or a straight  bankruptcy. And the default can be triggered by either the company an investor has “insured” or the issuer that sold CDSes in a swap.

For example, when Lehman Brothers declared bankruptcy, it triggered billions of dollars of credit default swaps since hedge funds had purchased credit protection on Lehman corporate debt — in some cases, for speculative purposes. AIG, by contrast, had sold billions in CDSes on all types of companies. The swaps were technically thrown into default once AIG’s credit rating sagged, even though the debt referenced in many of the swaps remained solid.

Stress testing CDS instruments may not be pretty, as commercial banks have actually increased their exposure to the potentially toxic sector over the course of the credit crisis. A report by the Office of the Comptroller of Currrency points out that the value of derivatives held by commercial banks increased 14 percent over 2008 as they absorbed the remains of crippled investment banking industry.

While a majority of derivatives are held in relatively benign (for now) interest rate instruments, commercial banks now hold $15.9 trillion in credit derivatives. And 98 percent of those contracts are credit default swaps. Holding credit default swaps may not be inherently bad for the nation’s largest banks, but they have been shown to make a bad situation worse in financial stressful times.

For example, after Lehman Brothers failed in September of last year, it took nearly a month to settle the estimated $600 billion in CDSes tied to the firm, which threw the financial system into a state of anxiety. That’s because there was no way to settle the transactions or even determine how much was owed on individual swaps. A commercial bank waiting to settle a large CDS default could find itself watching depositors flee and its share price plummet.

Lawmakers have jumped into the fray by proposing a series of regulations on the over-the-counter derivatives market, but that will be a little too late for Thursday’s stress test announcement. With a number of banks already sending out signals that the will need additonal money, it’s more than likely that credit default swaps will be the culprit eating away at bank capital.