The notional amount outstanding of credit default swaps (CDS) grew 37 percent to $62.2 trillion in the second half of 2007 from $45.5 trillion at mid-year. CDS notional growth for the whole of 2007 was 81 percent from $34.5 trillion at year-end 2006. The survey monitors credit default swaps on single names and obligations, baskets and portfolios of credits and index trades.
Up until now, I’ve been relatively sanguine about counterparty risk in the CDS market. Since most players are reasonably sophisticated and very hedged, net exposure is a tiny fraction of gross exposure. But at this point, even a tiny fraction of gross exposure is a mind-boggling sum. If there’s one bad apple in the barrel of players in the CDS market, the whole thing could go supercritical very, very quickly.
Even ignoring the systemic risk associated with the magnitude of the CDS market, however, the $62 trillion number means that bankruptcies and workouts during the upcoming slowdown are going to be very different to what most practitioners are used to. Many if not most major credits are now in the Delphi position, where the amount of protection written is vastly larger than the amount of debt issued. So far, that’s served to prop up distressed bond prices, which is probably not a bad thing. But it could serve to massively complicate bankruptcy proceedings as well, which would not be helpful.