Counterparty credit risk surged to new record

September 18, 2008

CDR Counterparty Risk Index
Counterparty credit risk or risk of failure among large Wall Street dealers, measured by CDR Counterparty Risk Index, in the derivatives market surged to a new record Wednesday on concern the bailout of insurance giant American International Group hasn't eased market turmoil.

The CDR Counterparty Risk Index, which tracks averages of credit default swap (CDS) spreads of major credit derivative dealers, jumped more than 50 basis points to a record 430.8. A basis point is one hundredth of a percentage point. The index has more than doubled since last week. The CDR Counterparty Risk Index peaked at around 250 basis points during the Bear crisis.

CDS spreads on Goldman Sachs widened by more than 180 basis points to more than 600, while spreads on Morgan Stanley CDS also widened and now trade 16% "upfront”, CDR said.

In March, spreads on CDS tied to Bear Stearns surged to over 750 basis points, or more than $750,000 annually to insure against a default in $10 million of Bear debt over five years. At the time, many firms that had outstanding trades with Bear purchased credit protection on Bear itself because they were nervous about the firm’s ability to meet its trading obligations.

Credit Default Swap spreads
When CDS contracts trade upfront, that means investors seeking protection against a default by the thrift must pay fees immediately. These contracts usually require only annual payments. Upfront spreads on CDS of 16% mean that investors seeking protection on $100 million of debt would need to pay $16 million upfront and $5 million a year. But when concerns reach extreme levels, sellers of protection demand money upfront too.

Spreads on AIG traded 30% upfront, down from more than 50% upfront late Tuesday before the Federal Reserve took control of the giant insurer and agreed to lend it up to $85 billion to help meet short-term obligations.

Credit default swaps are a common type of derivative contract that pay out in the event of default. In a CDS, one party buys protection on a specific bond from another party, which in turn agrees to compensate it if the bond defaults. If more investors want to buy protection, they are willing to pay more, which in turn causes CDS “spreads” rise. Spread is the difference between rates on these contracts and rates on U.S. Treasury bonds.

The CDR index, compiled by New York-based Credit Derivatives Research, focuses on the 15 major financial institutions that control most of the trading in the credit default swap market. Credit Derivatives Research estimates that these companies are counterparties on roughly 90% of all CDS trading.