It looks like there will be trouble in the Credit Default Swap market.
Credit Default Swaps are used to transfer credit exposure of fixed income instruments, such as mortgages and bonds, between parties, to spread risk. It works in the following way. One party buys protection on a debt instrument from another party, the seller, who guarantees the credit worthiness of the debt instrument. If the instrument, let's say a corporate bond, defaults in its interest payments, for example if the company that issued the bond goes out of business, the seller of the credit default swap is supposed to reimburse the buyer. Basically, Credit Default Swaps are insurance on fixed income securities that holders buy to limit their risk. We can call Credit Default Swap sellers insurers.
The combined value of all Credit Default Swaps is somewhere around $450 trillion, but this includes lots of reselling. That is, the same default swaps have been sold multiple times. The actual value of the Credit Default swap market is in the range of $27 to $90 trillion. For perspective, note that the size of the US economy was around $12 trillion, as of July, 2007.
So what's the problem, and what does it have to do with stocks?
In the Credit Default Swap market, it's really difficult to determine who owns what. As defaults rise, and Standard & Poors estimates the default rate will go up to 3.4% by the fourth quarter of this year (up from the current 2.6%), and it turns out that some sellers cannot reimburse the buyers, a panic may ensue. The market may freeze up because no one really knows who holds what.
Why would swap sellers be unable to reimburse buyers if buyers' bonds default? Because some (maybe most) sellers have sold much more insurance than they have in assets. Imagine a seller with $500 million in assets selling $5 billion worth of insurance. Should those bonds default, the seller can't possibly pay for all of them. It will go out of business, leaving the buyer in a bind.
As one example, this is just happened with Merrill Lynch (MER) recently. Of the $11.5 billion in bad debt that the investment bank wrote down in its last quarterly report, around $3 billion was credit default swaps Merrill Lynch bought from ACA Capital (which was AAA-rated, but sold $60 billion in insurance while its assets were only $500 million!). So, Merrill Lynch wasted its money buying insurance because it was left unprotected. Lehman Brothers (LEH) and Canadian Imperial Bank of Commerce (CM) have experienced a similar problem. All indications point to it happening again with other buyers of Credit Default Swaps. The upshot is that the Credit Default Swap market could dry up, for why should buyers pay for something that could be essentially worthless? Keep in mind that the Credit Default Swap market is a lot bigger than sub-prime mortgages.
Another thing to note is that in addition to being buyers of Credit Default Swaps, banks and hedge funds are also sellers. That is, they are also insurers. No one but them knows how much they have sold. Default rates, until recently, have been at historic lows. It's entirely possible that banks could have sold much more insurance than they have in assets.
Bill Gross of PIMCO has said not too long ago that the typical default rate during recessions is 1.25%. This is around $250 billion dollars. (Note that S&P's figure, mentioned above, is much higher.) Insurers will be driven into bankruptcy and/or buyers of Credit Default Swaps will be left unprotected, also possibly driven into bankruptcy. Either way, someone will lose a lot of money, and this could trigger a chain of defaults that might not stop until the over leverage (e.g. what ACA Capital did) is worked out of the system. There will be lots of fear, and stocks should head lower.
Of course, no one really knows what stocks will do. Another large Fed rate cut could send stocks much higher (this would be an excellent time to buy an inverse ETF, in my opinion) or it could spook investors into selling everything, potentially making some bargains in unrelated industries, like my favorite, tobacco.
Just an example of how near term market activity can be premature/irrational: UBS had reported huge sub-prime related losses before the market opened at the end of October, 2007. If I had enough money and was brave enough, I would have shorted it. The next day, when the market opened, I was surprised to see that the stock was going up. The explanation was that with its losses revealed, all the bank's problems were behind it. How fortunate, I thought then, that I didn't short it. UBS was trading in the low to mid $50s then. As of last market close, it was $41.62, about 20% lower.
If the markets go up in the near term, it will be on unfounded optimism. I am firmly convinced, as I was last October, that the debt crisis is far from over. Nothing has been resolved with the sub-prime mortgages. Home prices are still falling around the country, and are just now starting to fall in NY. The inventory of new homes is large enough to have home prices fall some more. As collateralized debt obligation holders find that their sub-prime mortgages continue to default, and as the recession progresses and corporations begin defaulting on their bonds, the Credit Default Swap market, which is over leveraged, will have problems of its own. I'm not a near term trader, nor do I make buy and sell recommendations (or at least I try not to) but I would ask you to consider selling during market rallies, or at least not buying during them, until hope is finally squashed and the market is less volatile.