Financial institutions are in a mad dash to raise capital in an effort to avoid the fate that befell Bear Stearns when it ran out of cash and nearly collapsed.  Many of them have had to issue new stock at bargain basement prices which has angered existing stockholders because it will dilute their earnings per share for years. 

While some of this capital is being hoarded in anticipation for more write downs from additional sub prime defaults. another area that has many of them concerned is their exposure to credit default swaps(CDS).  One of the many financial innovations that came about in the last decade, the notational value of the fast growing market is estimated at over $62 trillion.

CDS are basically insurance polices sold by financial institutions to protect purchasers of bonds against the risk of default.  Many parties use them as hedges against their positions but because the only money that changes hands initially are the premium payments, it’s also a very popular tool for speculation.  Reconciliation payments take place only when a certain credit event is triggered like a ratings downgrade or default.

CDS were very popular during a booming economy when the default risk was low because it was basically free money for  the sellers of these instruments.  Now with credit markets in shambles, CDS have become an albatross around the neck of many financial institutions.

Warren Buffet spoke out against CDS as early as 2002 saying that they were a disaster waiting to happen.  Since it was pretty much an unregulated market, much of the risk exposure to sellers of CDS was unfunded.  Some analysts believe that it would only take one large financial institution to default on a CDS to cause a catastrophic chain reaction in the entire credit market.

CDS spreads ballooned during the height of the sub prime write downs and although they have recently tightened somewhat, they are still nowhere near their normal levels.  Some believe this may be an indication that credit markets are starting to improve or that at least financial institutions are now less pessimistic than they were a couple of months ago.

Nonetheless any money that’s being hoarded isn’t being loaned out, which serves to exacerbate an already tight credit market.