Folks have regularly challenged my contention that the integration of capital markets, which was promoted in part as a political and economic force for stability, actually engenders perilous fragility. Here we have a striking example: and it’s our old friend the credit-default swap. These are the now infamous derivative securities designed to provide liquidity to bond markets by allowing investors to buy and sell “protection,” or what amounts to insurance, on various classes of debt. A CDS contract pays out in the event of the underlying debt’s default; and its own value fluctuates according to the expectation of that default, which is important because the sellers of these derivatives — those writing the insurance contracts, usually investment banks or funds of some kind — must post collateral against declines in the underlying security.
So in case before us, we have CDS on notes and bonds issued by BP and other oil firms entangled in the ghastly Gulf disaster. Just two months ago, these bonds were staid and stable instruments that few paid any attention to. The sellers of protection (i.e., the third-parties writing default swaps on those bonds) were taking in steady fees to insure the debt, and other parties were buying the CDS to hedge their exposure, and everyone was feeling hunky-dory.
Then there was the calamity on the Deepwater Horizon, the destruction of the underwater well, and the subsequent venting of massive quantities of crude oil into the Gulf of Mexico, an environmental disaster that continues to this day.
BP’s stock price has tanked; its debt rating has been downgraded; and it has lost tens of billions in equity capital. Similar woes have beset the other oil and gas firms with exposure to the lost platform. For these companies the possibility of default or even bankruptcy has gone from unthinkable to chillingly plausible in a matter of weeks. The cost of default protection has soared; the credit-default swaps are much more valuable.
In a word: if you were a net seller of CDS protection on bonds issued by these firms, you are in a world of hurt.
Now, keep in mind that chances are you never expected to have to post sizable collateral against these obligations. The default of BP was unthinkable as recently as April. It is still rather unlikely, but far from unthinkable. That unanticipated shift in the risk horizon has put a big hole in your capital base. CDS contracts mark-to-market regularly; the collateral calls can be swift and unforgiving. It was a rapid series of collateral calls, after all, that sunk AIG back in 2008.
The upshot of all this, from the Bloomberg report: “An indicator of corporate credit risk in the U.S. rose to the highest since July as the cost to protect BP Plc bonds against default rose to a record.” The risk contagion spreads; corporate credit fears broaden well beyond the one affected sector because of the tight integration of global capital. In the UK, where BP’s steady dividend payments are integral to many pension funds, a similar dynamic afflicts equity markets.
The pulverizing paradox is that the attempts of investors to protect, hedge, secure, and otherwise guarantee their holdings actually accomplishes the opposite, systemically. These derivative instruments can, of course, be used to speculate. (A speculator might get wind of another debt rating downgrade, say, and rush to purchase CDS protection, angling to make a quick profit on the subsequent collateral owed him in the downgrade.) But even the normal and legitimate effort of hedging exposure, undertaken by millions of actors around the world, produces this brittle structure of ever-shifting payments, abbreviated securities, and abstractions on property claims of extraordinary subtlety. The structure is not characterized by stability but rather the reverse.