Increasing Counterparty Risk in CDS market

As reported in Financial News and the WSJ, people are starting to talk more about the potential counterparty risk problems with the credit default swap (CDS) market. It often gets reported how large the CDS market has become, from $180 million more than 10 years ago, to over $62 trillion now. Of course, the $62 trillion in notional value is somewhat misleading given that the CDS market is a "closed system" or zero-sum game such that the losses of one party are offset by the gains of another. When looked at like normal insurance, and protection against specific assets, the cost to replace contracts and provide protection is being reported by the WSJ to be more like $2 trillion.

The real issue is the counterparty risk from an investment bank not meeting their obligations. Beyond affecting just one specific type of corporate debt, failure of an investment bank could affect the entire CDS market and the underlying securities (i.e., corporate bonds) upon which the swaps are valued. This effect was seen last March at the height of the credit crisis as Bear Stearns was being bailed out (sorry, purchased), causing CDS cost to rise. A similar increase in cost is now occurring with Lehman Brothers and Merrill Lynch. It is yet to be seen if this is a short-term blip. Nonetheless, you can expect that the Federal Reserve is keeping an eye on this market and be ready to take future action to protect the bond and equity markets, and potential international market contagion.