American credit market outlook

The credit derivative market, which has ballooned to over $62 trillion to dwarf the underlying debt market, has yet to experience the default of a significant issuer since its rapid growth.
Corporate defaults, however, are on the uptick and expected to accelerate, and the number of companies with credit default swaps trading at distressed levels are also on the rise, indicating the market may soon be tested. "I don't see a lot of risk around one big event. I think the market, particularly following the auto sector stresses in 2005, has prepared for such episodes," said Matthew Mish, high yield credit strategist at Barclays Capital in New York. "I'm more worried about an environment characterized by a high frequency of defaults among large issuers," he added. "The related settlement and back-office issues would be more complex and laborious. But I would not expect a breakdown in the market."
Some lags in processing credit derivative trades have made regulators and market participants nervous there could be confusion if a large borrower, or even worse a counterparty, failed. In many cases the amount of protection written on a borrower's debt also outstrips the amount of bonds outstanding, necessitating an auction to determine the cash value of the contracts.
Volumes in credit derivatives were significantly smaller, at less than $3 trillion, when the market last saw significant corporate defaults, capped by Enron Corp in 2001 and WorldCom in 2002.
Concerns earlier this month over the liquidity of General Motors Corp, one of the most actively traded issuers in the credit derivative market, however, raises questions over whether the market could absorb such a failure if it occurred. Though worries over the GM's near-term viability have eased, credit default swaps on its debt still imply a more than 70 percent chance of defaulting over the next five years.
Credit default swaps on Ford Motor Co, Tribune Co and Charter Communications Holdings are also trading at distressed levels. There are no reliable estimates on how much credit protection is written on GM's debt, though as an actively traded credit it is thought to be several times the $34 billion it has in outstanding bonds.