Meddling in credit swaps poses sizeable stability risks The costs of credit protection on the big US banks have come down from their peak levels five weeks ago, reflecting the belief that the probability of a European meltdown, with all the contagion that would imply, has diminished. That means concerns around the potential shocks that could come from the credit default swap market have also receded - at least temporarily. But the potential for future shocks is still there. Central bankers and analysts say they are convinced that there are no major financial institutions in the US that have sold massive amounts of protection on European sovereigns or on European banks with huge concentrated bets in the credit default swap market. In other words, they are convinced that there are no AIGs out there - institutions that have sold massive amounts of credit insurance without any offsetting positions or hedges on what was once highly rated debt. But the fact is that more than three years after the AIG debacle nobody knows for sure. Trading remains opaque, an indication of how little progress has been made in making the market more transparent. That is ironic because part of the debacle with AIG was that AIG had actually disclosed its exposure in its financial statements - it was just that nobody had ever bothered to look at them. Readers who bothered to do so would have learned, for example, that in the second quarter of 2008, AIG had sold about $450bn in credit insurance. Today, the best information on the CDS market comes from the Bank for International Settlements. That information, though stale, contains some interesting data points, nevertheless. For example, Wall Street risk officers fret that there may be hedge funds that have such exposures. Indeed, hedge funds have sold over three times as much protection on sovereign risk - $111bn - as they have bought, according to data from the BIS as of the end of June. Meanwhile American banks in aggregate have provided "guarantees" of over $500bn on all debts in the periphery countries of Greece, Portugal, Italy and Ireland, or three times their exposure, the BIS adds. Still, the fear of another AIG is not the only fear hanging over the CDS market today. Recently, European regulators decided that private sector creditor losses on Greek sovereign debt in any restructuring should be voluntary, meaning that even a loss of 50 cents on the dollar wouldn't trigger payments in the CDS market. That led some players to conclude that the rules of the game had changed in an effort to protect European banks or insurers that had sold protection and would lose money on that insurance. The fear that CDS protection may prove worthless is already leading to unintended consequences in the real world. Since this eurocrat ruling, the chief risk officer at one major Wall Street company says his organisation has concluded that the contracts are too risky and is either tearing them up or trying to trade out of them. But because the process is expensive and difficult to hedge this company is also shorting sovereign bond issues, driving down their value and contributing to eurozone jitters. And because those bonds are used as collateral in the interbank market, the ruling that CDS isn't triggered in a "voluntary" restructuring makes that collateral less valuable, which contributes in turn to pressures in the funding market and falling liquidity. Weeks before the Russian default in 1998, senior executives at the former Donaldson, Lufkin & Jenrette became concerned about their exposure to the debt of that country and bought credit insurance from a myriad of counterparties, mostly Russian banks in an effort to protect the Wall Street company (now part of Credit Suisse) from the possibility that the government would renege on its debt. It didn't work. The Russian government prohibited the Russian firms from honouring the claims of the foreign creditors and DLJ had to tear up the worthless insurance it held, nursing substantial losses. "The European central bank balance sheet may have to grow by another €1tn to support sovereigns and under-capitalised, under-reserved banks," noted JPMorgan's Michael Cembalest in his "Eye on the Markets" publication earlier this week, adding that it is possible that many private investors will use that to sell European exposure to "non-economic" buyers. After a grim start to December, which saw the iTraxx Europe index for financials widen more than 100 basis points in ten days, the ECB calmed the markets with its three year refinancing facility. But if regulators attempt to intervene with initiatives such as their proposal to make a Greek restructuring "voluntary," they will become a bigger risk to stability than the markets themselves this year.