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Are markets hurricane-proof?

• Robert Peston
• 6 Jul 07, 10:30 AM

Most of us would never give a moment's thought to strange financial products with names like credit default swaps or collateralised debt obligations.

But please stifle that yawn, because whether you know it or not you probably have a stake in these things – and they could have an effect on your wealth.

There are trillions and trillions of dollars of these investment products held by banks, insurance companies, pension funds and hedge funds all over the world.

And if there were suddenly a collapse in the market for them – and people who know think that's possible – well, that could be painful for all of us.

In fact there have already been over the past few weeks, which stemmed from difficulties experienced by providers of riskier mortgages – known as sub-prime loans – in the US.

A number of hedge funds have experience humungous losses on their holdings of collateralised debt obligations related to these sub-prime loans.

Now I know that will sound like Mandarin to many of you. But a credit default swap is really just an insurance contract.

They started life as a way for banks who'd lent money to a company to protect themselves against the risk of that company running into difficulties.

But over the past few years, this market has evolved away from its roots in insurance into a giant speculative market, in which investors with no loans to a company are speculating on the ability of that company to pay its debts.

What has really put rocket fuel into the CDS market has been the development of the related market in collateralised debt obligations, or CDOs.

So what on earth is a CDO? Well, they are often described as bonds, but they are not normal bonds, in that they are not direct borrowing by a government or a company.

The way to think of a CDO is as a specially prepared financial product created by chucking a load of other financial products into a melting pot.

So let's say you chuck the debt or even the credit default swaps of a bunch of companies into this cooking pot. Now out of that the master-chefs at the investment banks can prepare a variety of new financial products that match the tastes and needs of particular investors.

That might be an investment with a lower than average risk of the loan going bad. Or it might be one with a higher risk of default but a much more generous interest rate.

But here's the thing. Because they are a confection of lots of other financial products, they are fearfully difficult to analyse and to value.

And just imagine how difficult it is to put a price on the more complex CDOs, such as those manufactured purely out of other CDOs, which believe it or not are called CDOs squared.

There are also CDOs cubed and others to the power of N - just thinking about those makes me feel dizzy

Anyway, hundreds of billions of pounds worth of these things have been created and sold to professional investors.

Here's what worries central bankers and regulators, who are supposed to police the global financial markets to pre-empt a calamity.

First that the existence of the insurance contracts, the credit default swaps, is encouraging careless lending by banks, because they know that if the loans go bad someone else will pick up the tab.

Second that if there were a sudden collapse in investor confidence, for whatever reason, CDOs would be impossible to sell and their price would collapse in a dangerous way.

Third that losses incurred by investors in the event of such a price-collapse could bring down banks or other institutions vital to the smooth running of the financial system - on which we all depend.

How likely is such a market meltdown? Not huge, according to Thomas Huertas, a sort of lifeguard of the banking system at the City watchdog, the . He told me that the FSA is encouraging banks to simulate the effects of a massive markets shock – the financial equivalent, say, of a dirty bomb in London – to see whether they would survive.

While not being complacent, the FSA is confident that our major institutions are founded on strong foundations. It matters to all of us that he’s right.

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