Toomre Capital Markets LLC ("TCM") has long been concerned about the opaqueness of the Credit Default Swap market. As this market sector has exploded in size in the past decade, TCM has feared that some losses from these credit derivative instruments may be hidden from investors, regulators and counterparties. Hence, the soundness of the global financial system might well be less sound than what international regulators, rating agencies and large financial institutions might think.

Others have been concerned too. The Australian has started off the 2008 New Year with a rather ominously entitled article Forget CDOs, Is is Time for CDSs. The article starts with "If 2007 was the year of the CDO, the latest acronym to loom dark and large on the financial markets' horizon for 2008 is the CDS. And the CDS (credit default swap) is shaping up to be far more noxious than its little derivative brother, the CDO - a spliced and diced bundle of mortgages known as a collateralized debt obligation that sent Wall Street into a tailspin last August when the market for low-grade US mortgages froze over. At least Warren Buffett seems to think so. After the world's top two bond insurers were scolded with [the threat of] a ratings downgrade last month and told to go and raise some capital, the visionary Buffett revealed last Friday that he was to set up a bond insurance business." [emphasis added]

The key point of this article is that "the murmur among the cognoscenti is that an implosion in the CDS market could do serious damage to the international banking system." They have slightly misquoted Warren Buffett who did say "We felt that, in many cases, the prices that people were charging were inappropriate." What Mr. Buffett was referring to was the cost of credit enhancement insurance to ensure that a municipality's debt was paid on a timely and ultimate basis that is part and parcel of a AAA/Aaa rating. He was not referring to the prices of CDS transactions. However, the article authors were correct that the crux of the problem is that there is not only price transparency but there also are problems about reserving and regulation.

The CDS market indeed "has ballooned from $US2 trillion to more than $US40 trillion (the notional amount of the underlying securities) in the past five years alone." Unlike a more traditional insurance product (like credit enhancement insurance primarily regulated by the New York State Department of Insurance), there is no market regulator to answer to or are there prudential reserving requirements to meet. As the article states, the current situation is "sort of like having a $US40 trillion insurance market with no funding set aside for losses." As the author also points out, "Indeed, the data on CDS is so scant that various commentators put the value of the market not at $US40 trillion, but between $US30 trillion and $US50 trillion."

The derivatives markets have long defied doomsayers for more than two decades. Financial risk has indeed been spread around the globe to mitigate so called "long-tail events" or big, once-in-a very-long-while disasters. However, the CDS market has developed and thrived on a landscape of generally easing interest rates and shrinking credit spreads, driven in large part for the demand for collateral to back CDOs. In short, this has been a perfect environment for debt-heavy speculation which in turn has enhanced the appetite for extra leverage in the global credit markets.

As Toomre Capital Markets LLC wrote in the AMD white paper Deriving Value in Credit Products, a vibrant CDS market has been net positive for the credit markets since they allow institutional investors to go "long" and (perhaps more importantly for the first time) "short" a specific credit without having to physically own the underlying reference credit instrument. This ability to go "long" or "short" has allowed for a much more efficient price discovery process and in an efficient market, a more effective allocation of capital. The trouble is that the introduction of CDS has also allowed for increased speculation on credits and no one is real sure how much there is or how off-sides the many institutional participants might be.

As the article also points out, "What cannot be gauged is the fallout from a slather of defaults or an increase in risk-aversion that dries up liquidity through the markets. In that event, derivatives could take a massive hit, perhaps diminishing the demand for and the price of the hard assets in the process." Corporate defaults are likely to increase from their historically low levels of the last two years. Also, given the massive hits that various investment banks and global banks have taken (and will continue to take) from the sub-prime mortgage mess, it is likely that there will be decreased liquidity in the coming months. Hence, there is a strong probability that the CDS market will be going through a period of stress in the months to come.

The key question will be just how much stress the CDS market will experience and how it affects something known as "counterparty risk". TCM suspects that CDS shakeout will be far worse than what the market consensus currently is. Thus, add the CDS market shakeout to further price declines in the CDO market, increasing defaults in the Alt-A and Prime mortgage sectors, the growing acceptance of "jingle mail", the on-going meltdown in the CMBS sector, the ticking time bomb known as Option ARMs and uncertainty about the leveraged loan market.

No doubt these are sobering thoughts to welcome in 2008 with… One thing is for certain. 2008 will witness periods of extreme volatility as liquidity decreases and the thin markets are buffeted by various news events. Liquidity certainly will be key. The interesting question each investor will need to decide is when and what cost is it appropriate to go illiquid – to invest in less liquid securities. Readers thoughts and comments are welcome.