If you need something else to worry about this morning, consider the fact that the six big Canadian banks have $823-billion of notional exposure to a credit default swap market that faces chaos if AIG fails.
AIG is on one side of a great many bets in the credit default swaps (CDS), which banks use to hedge the risks of losses on their loans. A report Tuesday from Royal Bank of Canada's investment dealer arm pegs AIG's net exposure to credit default swaps at $441-billion (U.S.) Those swaps serve as insurance on the bank's loans and credit portfolios, known as collateralized debt obligations, or CDOs.
“The health of AIG as a counter-party is a key risk to monitor for Canadian (and other) banks,” said the report from RBC Capital Markets. The analysts said they “do not know how AIG's situation will turn out, but if banks suddenly found themselves exposed to future price movements on a notional $441-billion in CDOs, trading losses would very likely follow and risk weighted assets would jump, as finding a counter-party to take on exposure to CDOs at this time would be much more difficult than it would be for interest rate/fixed income hedges.”
While the Canadian banks would face mark-to-market losses on upheaval in credit derivative markets, they should have the capital and the regulatory support needed to weather the storm. Domestic insurers such as Sun Life, Manulife and Great-west Life would also have counter-party exposure to AIG, as they also buy credit insurance.
If AIG does fail, and the CDS market unravels, the next leg down in the credit crisis will come as poorly capitalized U.S. and European banks scramble to rebuild their balance sheet in the wake of what the RBC Capital markets team described that “jump in risk-weighted assets.” The prospect of such a crisis underlies central bank moves to inject liquidity into the system, and loosen rules on what counts as capital at financial institutions.
