When you buy insurance, you generally assume that the insurer has the means to payout in the event of a claim. Actually most people probably never even go so far as to consider the matter and if they did they may rely either on it being a regulated market or that they will only have a small claim against a financial colossus.
Bill Gross of Pimco*, who runs the world’s largest bond fund and one of the most successful by some measures, compared the CDS market with that of a pyramid scheme in his January investment note. Whilst technically a swap market, credit default swaps economically look like insurance and in essence he questioned whether the CDS market was capable of paying out potential claims to those down the insurance pyramid.
In his back-of-the-envelope calculation he projected that the losses from CDS caused by a rise in bankruptcies could be $250bn or more. His calculation assumes that the corporate insolvency rate would return to a normal level of 1.25 per cent (measured as the default rate of all investment grade and junk debt outstanding). As the entire CDS market is worth about $45,000bn, $500bn in CDS insurance would be triggered under this assumption. The protection sellers would probably be able to recover some of this, so the net loss would come to about half of that ie 250bn. On this scale, he suggest there will be sizeable defaults which will not only hit current protection buyers but also deter future buyers. “Pyramid schemes and chain letters collapse because there is no more credit to feed them.”
This would have enormous consequences for the whole financial system undermining confidence in instruments designed to disperse risk and curtailing banks ability to offer the same magnitude of credit since their ability to trade it on would be diminished.