World Economic News

Credit Risk Threatens a New LTCM-Like Systemic Crisis

So warns Benedikt Fehr in a prominent article in the economic section of the Frankfurter Allgemeine Zeitung June 28. Headlined "Risky Transfer of Risk," the article reports that, from the end of 2005, the volume of credit default swaps contracts rose from $1 trillion to $17 trillion. How does the CDS mechanism work? It all goes fine, explains Fehr, if the conjuncture is good, and there are no bankruptcies. But "what happens if the conjuncture cools down and credit defaults begin to add up? Nobody knows." Also, "CDSs are the kernel of an entire family of financial instruments, which have a so-far-unknown complexity, and which hide possible risks of so-far-unimaginable dimensions." The problem is, that most "institutional investors," such as pension funds and hedge funds, have massively traded in CDSs. More than that, "you can insure yourself against credit insolvency by buying CDSs, even if you have extended no credit," writes the FAZ, describing how the derivative market on CDSs works, and many CDS-buyers in reality speculate on firms going bankruptcies, so that the prices of CDSs go up, and they can make a gain by selling their contracts on the secondary market. In order to help this industry, negative rumors about firms are circulated on purpose. It is believed, for instance, that Commerzbank was a victim of such an attack in September 2001.

In case of insolvency of a few insurers, "given the interconnections of the financial markets, a crisis could quickly develop, similar to 1998, as the near bankruptcy of LTCM led the financial system to the brink of a collapse."