Credit Default Swaps Lose Disaster Stigma as Confidence Returns

A year after the bankruptcy of Lehman Brothers Holdings Inc., credit-default swaps have lost their stigma for disaster and are contributing to the growing confidence in the credit markets.

The cost to protect against a failure by New York-based Goldman Sachs Group Inc., Charlotte, North Carolina-based Bank of America Corp., and 12 of the other biggest derivatives dealers dropped 66 percent in the past six months, according to an index of swaps compiled by Credit Derivatives Research LLC. While the U.S. struggles with the slowest recovery since 1945, the market where investors protect themselves from default and speculate on corporate debt shows confidence is the highest since June 2008.

Credit-default swaps worsened the biggest financial crisis since the 1930s as the meltdown of Lehman and American International Group Inc., two of the largest traders, caused a seizure in lending. Now, Wall Street is accelerating reforms Treasury Secretary Timothy Geithner started in 2005 when he was president of the New York Federal Reserve to increase transparency in a market lawmakers plan to regulate.

“A functioning credit-default swaps market contributes to more efficient extension of credit” by giving investors and lenders confidence that the industry won’t implode, said Alexander Yavorsky, a senior analyst at Moody’s Investors Service in New York. The consequences of Lehman’s failure “were astronomical, broadly speaking, but the CDS market worked well,” he said.

Receding Concerns

Credit-default swaps pay the buyer face value in exchange for the underlying bonds or the cash equivalent should a company fail to meet its debt obligations. Prices rise when perceptions of creditworthiness deteriorate and fall when they improve.

Banks have had unparalleled access to money after Federal Reserve Chairman Ben S. Bernanke reduced the target rate for overnight loans between banks to a range of zero to 0.25 percent from 5.25 percent in 2007. The Fed and the government spent, lent or committed $12.8 trillion to revive the economy.

One result is that expectations another big financial institution will fail have receded. Credit Derivatives Research’s Counterparty Risk Index, which measures default swaps on 14 firms, has dropped to 104 basis points, after peaking on March 9 at a record 305.6 basis points, or 3.056 percentage points. That means it costs an average of $104,000 a year for a credit-default swap protecting $10 million of debt.

The Libor-OIS spread, a gauge of banks’ reluctance to lend, contracted to 0.11 percentage point yesterday from a peak of 3.64 percentage points in October. Former Fed Chairman Alan Greenspan said in June 2008 he would consider credit markets back to “normal” if the spread was 0.25 percentage point.

Record Bond Sales

In addition to supporting banks by lowering rates and providing financing for troubled loans, Bernanke has succeede