Once Upon a Time in CDS Land

As one of the treasurers participating in our recent treasury round table put it, "Preservation of principal has become our first order of business."

As the financial health of banks has come under increased scrutiny, those corporate treasurers counted among our 2008 round table participants revealed their growing preference to partner with "high-quality, well-capitalized" banks who either by implication are too big to fail or which are so well capitalized that they can withstand some of the turbulence that the markets have been dishing out. Who can blame them?

However, how exactly do you determine whether a bank is too big to fail? Or what are the metrics that can be used to determine whether a bank meets such a criteria? Is it market capitalization? Is it credit default swaps? Is it share price? When a bank's share price is down 75 percent, should you dissolve your 5-year-plus partnership, even when they've been good partners? And on and on the questions came. While some queries found easy answers, most did not.

Clearly, pricing is no longer the top criterion. "I don't necessarily need the best price anymore -- that is, if I know that a bank is going to preserve my capital, or at least have confidence that you will," explained one treasurer.

All of our treasury participants agreed that the number of transactions involving the complicated financial instruments known as credit default swaps were among their most favorite metrics. A form of insurance against losses on loans and bonds, CDSs became wildly popular over the past ten years, growing to more than a $45 trillion market.

"The credit default swap became an excellent indicator to see who's under pressure," explained another participant.

Of course, as it turns out, the treasurer's metric-of-choice is also credited with helping to fuel the crisis itself. Government officials are now investigating to determine whether traders deliberately began buying swaps at high prices to spark fear about the stability of different banks.

Uncovering the facts will not be easy. The CDS market is not regulated, and thus contracts are traded from one investor to the next without any oversight to ensure that the buyer has the resources to cover the losses if a security defaults. Moreover, when it comes to the CDS market, there are no public price quotes and trading is done by phone or e-mail.

Back at the round table, opinions concerning possible solutions to the economic crisis emphasize collaborative approaches.

Said one participant: "I think that the first line of defense is the banks, and it's up to the banks to now realize that no bank can go under -- the counterparty risk is too high and the ice we all now stand on is too thin."

When thin ice becomes common ground, collaboration is never in short supply.