Sunday, February 17, 2008

Could a world credit meltdown be brewing?

Analysts have talked about these kinds of things for years ... complex securities that used to manage risk but end up actually increasing risk, falling like dominos should the underlying market start to come apart. Read on as the New York Times' GRETCHEN MORGENSON explains the risks and potential perils that may be ahead for consumers, investors and financial institutions.:

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term. Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances.

Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debt.

The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.

It is entirely possible that this market can withstand a big jump in corporate defaults, if it comes. But an inkling of trouble emerged in a recent report from the Office of the Comptroller of the Currency, a federal banking regulator. It warned that a significant increase in trading in swaps during the third quarter of last year “put a strain on processing systems” used by banks to handle these trades and make sure they match up

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