All of those Bear Stearns CDS buyers must have thought they were really sitting pretty as Bear Stearns plummeted into the almost certain financial abyss. Then The Fed and JP Morgan stepped in, and in one fell swoop saved the CDS sellers from impending doom and fucked the buyers. That's one way to get screwed. Then there's the risk that your counterparty fails. There have been several articles in the last few months (especially after the Bear Stearns unraveling) on the perils of credit default swap market. Bloomberg has another excellent one.....
A surge in corporate defaults may leave swap buyers scrambling, many unsuccessfully, to collect hundreds of billions of dollars from their counterparties, says Satyajit Das, a former Citigroup derivatives trader and author of ``Credit Derivatives: CDOs & Structured Credit Products'' (Wiley Finance, 2005).
``This is going to complicate the financial crisis,'' Das says. He expects numerous disputes and lawsuits, as protection buyers battle sellers over the technical definition of default - - this requires proving which bond or loan holders weren't paid -- and the amount of payments due.
``It's going to become extremely messy,'' he says. ``I'm really scared this is going to freeze up the financial system.''
Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, has researched counterparty risk and says it's only a matter of time before the sword begins falling. He says the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $35 billion in defaults.
``That's a very conservative estimate,'' he says, adding that his study finds that losses resulting from hedge funds that can't pay their counterparties for defaults could exceed $150 billion.
Hedge funds have sold 31 percent of all CDS protection, according to a February 2007 report by Charlotte, North Carolina-based Bank of America Corp.
Cicione says banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That may not work, he says. Many of the funds won't have the cash to meet the banks' requests, he says.
Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults - Bloomberg
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