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Friday, January 04, 2008


corporate defaults to rise more than tenfold, potentially crushing CDS markets

via calculated risk:

With credit flowing to practically any company in need of cash in recent years, the rate of defaults for U.S. high-yield companies fell to just 0.34% in December, according to a J.P. Morgan Chase analysis. The J.P. Morgan analyst, Peter Acciavatti, predicts that is about to rise drastically, to 4% by the end of 2009 ... Citigroup expects the default rate to surge to 5.5% ...

and the difficulty about that is, rightly noted by bill gross, its effect on the distended credit default swap market.

Credit-default swaps, used to help protect against the risk a company won't pay its debt, may cause losses of $250 billion this year, helping send the U.S. economy into a recession as corporate defaults rise, Pacific Investment Management Co.'s Bill Gross said.

``Credit-default swaps are perhaps the most egregious offenders'' in today's banking system, Gross wrote on the company's Web site today. ``Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.''

Goldman Sachs Group Inc. ``estimates that mortgage related losses of $200-$400 billion alone might lead to a pullback of $2 trillion of aggregate lending,'' Gross said. ``Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.''

``Of course, `buyers of protection' will be on the other `winning' side, but the point is that as capital gains and capital losses slosh from one side of the shadow system's boat to the other, casualties and shipwrecks are the inevitable consequence,'' Gross said. ``Goldman Sachs wins? Fine, but the losers in many cases will not be back for a return match.''

this is another avenue of deflation, with potentially huge ramifications for the shadow banking system that funded not only the housing inflation through RMBS but weaker corporate borrowers as well. many hedge funds have been writing CDS on the premise of picking up nickels in front of steamrollers with high leverage -- and have hence now fallen afoul of a black swan.

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