Riskiest 40% of Credit Default Swaps Still Hidden

A few weeks ago, apologists for derivatives loudly trumpeted the claim that the Lehman credit default swap pay off was really only $5.2 billion, "proving" that the risk from CDS was overblown.

The Depository Trust and Clearing Corporation (DTCC) has made a big show of publicly releasing some data on CDS, leading people to believe that everything is out in the open.

But an article today in Bloomberg paints a different story:

The most comprehensive report on unregulated credit-default swaps didn't disclose bets in the section of the more than $47 trillion market that helped destroy American International Group Inc., once the world's biggest insurer.

A report by the Depository Trust and Clearing Corp. doesn't include privately negotiated credit-default swaps that insurers such as AIG, MBIA Inc. and Ambac Financial Group Inc. sold to guarantee securities known as collateralized debt obligations. It includes only a "small fraction'' of contracts linked to mortgage securities, according to Andrea Cicione at BNP Paribas SA in London.

New York-based DTCC's data, released on its Web site Nov. 4, showed a total $33.6 trillion of transactions on governments, companies and asset-backed securities worldwide, based on gross numbers. While designed to ease concerns about the amount of risk banks and investors amassed on borrowers from companies to homeowners, the report may have missed as much as 40 percent of the trades outstanding in the market, Cicione said.

The data are "likely to underestimate the amount of net CDS exposure,'' Cicione, who correctly forecast in January that the cost of protecting European companies from default would rise, said in an interview. "A broadening of the coverage to the entire market is what investors really need.''

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Investors hedging against losses on CDOs helped push the cost of default protection to a record last week.

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AIG first disclosed to investors in August 2007 that it held more than $440 billion of credit-swap trades linked to CDOs. The New York-based company was brought to the edge of bankruptcy in September after the value of the transactions plunged.

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A market survey this year by the New York-based International Swaps and Derivatives Association, which includes credit swaps on CDOs and other contracts that may not be captured by DTCC's Trade Information Warehouse, estimates more than $47 trillion in gross contracts are outstanding.

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"There appear to be gaps,'' said Henry Yu, a law professor at the University of Texas in Austin who has pressed for the creation of a data warehouse encompassing all privately negotiated derivative trades to offer a better understanding of their risks.

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Because the DTCC registry captures only commonly traded contracts that can be confirmed over electronic systems, not every swap trade is in the company's report, spokeswoman Judy Inosanto said. Among those not included are credit-default swaps on CDOs, she said.

Indeed, since CDOs are so risky, I would argue that the CDSs which aren't being publicly reported are the riskiest ones. This argument is supported by the fact that the two biggest bond insurers are getting hammered due to their CDO-related CDSs.