A bad market? You ain't seen nothin'

In other words, if you think it's hard to get your insurance company to pay off in the event of a car accident, just wait until you hear the screaming from CDS holders in the next couple of years. Here are a few ways insurance sellers will try to jump off the hook, according to derivatives expert Satyajit Das, who spoke to me this week from Pune, India:

• Documentation difficulties. Ever go into a store to try to return a piece of merchandise and forget your receipt? Or have you had clerks point out that the return period expired two weeks ago, or that the fine print says the warranty is not good if the package been opened or if the item was bought on a Tuesday, or that they're sorry, but Bob, the guy who wrote the receipt, doesn't work there anymore, and current management can't honor it? Das says CDS sellers' attorneys have innumerable ways of claiming your contract does not apply. The big problem is that the standard CDS contact is a trading instrument that is standardized for simplicity and may not match the risk in the way its owner expects, even if the owner is a sophisticated investor like Merrill. It cannot be tested except by a real default, and by then it may be too late.

• Weakness in the instrument. If you bought a CDS contract on the bonds of a company that has been bought by another firm, the new owners may not be obligated to pay up. This is particularly true if the original "reference obligor," as they say in the business, is based in one country and the new owner is based in another. Foreign courts might not enforce contracts. Ownership change can also change the credit risk of a derivative in unforeseen ways, preventing you from even having a seat at the table to protect your interests.

• Credit event definition. CDS contracts rely on a trigger to go into effect -- typically a sharp downgrade, failure to make a payment or bankruptcy. But CDS buyers may not be protected against all defaults in all currencies, particularly if a bondholder restructures rather than enter bankruptcy. CDS holders may thus have trouble proving a default has taken place. Additionally, CDS sellers may be in such dire straits that forcing them into bankruptcy may exacerbate losses.

• Settlement and collateral problems. The CDS holder must deliver a defaulted bond or loan, but today CDS sales are six to 10 times larger than all bonds outstanding due to the way they were resold and leveraged. In the case of car-parts maker Delphi (DPHIQ, news, msgs), protection buyers received an average of just $3.6 million per $10 million CDS contract, meaning they were not fully hedged and had no further legal recourse to recover.

• Counterparty risk. This is when you realize that CDS contracts don't eliminate credit risk -- they only transfer it. Instead of just worrying if a bond will pay off, now you have to worry about the health of the insurer. Transference of risk was the main reason to buy CDSs, but in an era of extreme leverage, the example of ACA Capital shows that no counterparty is safe, especially as many banks and funds have "daisy-chained" their risks together.

In September, Das told us he believed the unwinding of the great post-millennial credit bubble had barely begun. Now he thinks that the game is finally in the first inning, with much more pain and heartache to come. He points out that all of the new capital raised by UBS AG (UBS, news, msgs), Citigroup (C, news, msgs) and Merrill Lynch has only made up for the losses they have acknowledged so far in the fourth quarter of last year, and that if they continue to need to write off their credit default swaps and loans as customers sink under the weight of recession and default on loans, they will be taking equally large deductions against earnings in every quarter of this year and into 2009.

With at least $1.5 trillion in off-balance-sheet debt coming onto their books and tens of billions of dollars in CDS contracts potentially up in smoke, Das figures the banks will need $200 billion in new capital to shore up reserves at the same time they suffer $100 billion in real loan losses. If they need $300 billion -- and so far the sovereign wealth funds have, with some reluctance, put up only around $25 billion -- you start to see the potential size of the problem that lies ahead.

"The hole is bigger than they or their investors expected," Das said. "And they're still digging."

In short, though it appears the Federal Reserve has answered its wake-up call with an interest-rate cut of unprecedented size, I continue to recommend that you treat financial stocks with skepticism. Their Maginot Line has been breached, and reinforcements are bogged down.

Fine print

To learn more about bond insurer ACA Capital, visit its Web site. To learnmore about Merrill's ACA write-down, check out this Bloomberg story. . . . Satyajit Das occasionally publishes a blog on quantitative finance at his publisher's Web site. His latest book, "Traders, Guns and Money," is a very amusing and detailed look at the "knowns and unknowns" in the Wild West world of structured finance. It's the best book to help you understand the underpinnings of modern credit and currency markets. . . . The Economist published a good primer on credit derivatives last April. Read it here. . . .

Business is booming for professionals skilled in unwinding and auditing the credit-derivatives wagon trail. One pro on the case is Janet Tavakoli. Check out her Tavakoli Structured Finance site here. She calls the whole mess the "largest Ponzi network in financial history." . . . The leader in credit-derivatives indexes and trading is International Index Co. and its Markit brand. Visit its site here. . . . The business is fully international, as you can learn at Vinod Kothari's Credit Derivative Web site. To learn more about the "phony war" phase of World War II, click here. Learn about the Maginot Line here.

Meet Markman at The Money Show

MSN Money columnist Jon Markman will be among more than 120 investment experts sharing their strategies for 2008 at The World Money Show in Orlando, Fla., Feb. 6-9. Meet Markman in person at the MSN Money booth at 1 p.m. Thursday, Feb. 7; 3 p.m. Friday, Feb. 8; or 1 p.m. Saturday, Feb. 9. Spend four days planning and refining your portfolio as you choose from more than 320 workshops and panel presentations.

Admission is free for MSN Money users. To sign up, call 1-800-970-4355 and mention priority code No. 009553, or click here to register online.

At the time of publication, Jon Markman did not own or control shares of any companies mentioned in this column.

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