Statement of

E. Gerald Corrigan

Managing Director

Goldman, Sachs & Co.

Before the

Committee on Agriculture

United States House of Representatives

December 8, 2008

Washington, DC

Chairman Peterson, Ranking Minority Member Goodlatte, and members of the
Committee, I appreciate the opportunity to appear before you this
afternoon in order to share with you my observations on the workings of
the marketplace for credit default swaps (CDS). My remarks emphasize the
further steps which I believe should be taken to enhance the efficiency,
resiliency and the stability of that marketplace.

Needless to say, the CDS market is widely cited as a significant
contributing factor to the volatility and uncertainty that has been at
the center of the financial market crisis that has gripped the U.S. and
the global financial system for the last 16 months. Having said that, I
want to emphasize at the outset that despite the events of the recent
past, a great deal of effort has, over the past three years, been
devoted to enhancing market practices in the CDS space on the part of
both the public and private sectors. Accordingly, I have attached to
this statement two appendices drawn from the July 27, 2005 and the
August 6, 2008 Reports of the Counterparty Risk Management Policy Group
(CRMPG) which contain valuable information on the subject of this
hearing including an imposing list of Recommendations from the 2008
Report for further strengthening the CDS and related markets.

A number of these Recommendations have been, or are in the process of
being, implemented. Indeed, I would respectfully suggest that had it not
been for the improvements in market practices over the past three years,
the events of recent months probably would have been even more damaging
as difficult as it is to imagine such an outcome. But, we should make no
mistake about the future reform agenda which remains formidable.

My written statement covers four subjects that are relevant to the
purpose of the hearing as follows:

Section I: The Nature of the Credit Default Swap Instrument

Section II: The Structure of the Credit Default Swap Market

Section III Risk Monitoring and Risk Management for CDS Users

Section IV Enhanced Official Oversight

[Section I: The Nature of the Credit Default Swap
Instrument]{.underline}[^1]

In essence, the CDS is a deceptively simple financial instrument in
which counterparty A (the seller of credit protection) receives a fee
from counterparty B (the buyer of credit protection) in exchange for
protecting counterparty B against a decline in credit worthiness or a
"credit event" of a so-called "reference entity." The reference entity
may be a credit claim (a loan or a bond) against a particular company or
country (a single name CDS) or it may be a basket of single names (an
index CDS). The reference entity may also be a specific asset-backed
security or a structured credit product such as a collateralized debt
obligation (CDO).

If the creditworthiness of the reference entity declines -- the buyer of
protection (counterparty B in the above example) -- gains and the seller
of protection (counterparty A above) -- loses. In the extreme case in
which the reference entity experiences a "credit event" (such as a
default), the buyer of protection (counterparty B) delivers the
defaulted instrument to the seller of protection (counterparty A) and
receives the par amount of the CDS contract. Needless to say, in a
volatile financial market environment in which credit quality is falling
and the risk of default is rising, the counterparty risk management
process in the CDS market becomes very challenging -- to put it mildly
(see Section III below).

[Section II: The Structure of the Credit Default Swap
Market]{.underline}

The CDS market is comprised largely of sophisticated financial
institutions. There are about 16 so-called "dealers" at the center of
the CDS market. These dealers -- all of which are owned and controlled
by major U.S. and foreign banking institutions -- play the vital role of
market makers in a wide array of financial instruments including CDS.
They also take proprietary positions in these instruments, in part, as a
natural extension of their market making activities. While precise
estimates of activity levels in the CDS market are not easy to compile,
most observers would suggest that something approximating 90 percent of
overall activity in the CDS market can be attributed to the dealer
community. Whatever the precise number, it necessarily follows that the
bilateral and multilateral counterparty risk exposures among the dealers
to each other are very large.

The balance of the CDS market is comprised of several other classes of
institutions including corporates, insurers (including mono-lines) and,
in particular, hedge funds. As described in Appendix A, the rationale as
to why individual institutions and classes of institutions choose to
participate in the CDS market varies considerably across classes of
institutions and over the credit cycle. At the risk of considerable
oversimplification, however, the motivation for participation centers
around a few key factors including (1) satisfying the needs of clients;
(2) an explicit decision to be either long or short credit risk; and (3)
an explicit decision to hedge credit risk.

Reflecting in part the huge structural changes in financial markets over
the past decade or so and the even larger changes in the macro-economic
and the macro-financial environment over the past five years, the growth
of the CDS market has been explosive -- and then some. Over roughly the
last decade, the CDS market also experienced a radical transformation
from a market that was, in large part, designed to mitigate relatively
infrequent events (defaults) to a market that is dominated by trading
activity in which very large trades with short durations are
commonplace.

It is these patterns of trading activity that produce the headline news
items about the \$60 trillion plus notional size of the CDS market even
as we all know that notional amounts tell us very little about risk
factors for the marketplace and its participants.

Unfortunately, the industry itself contributed to the focus on the gross
notional sizes of the CDS market. That is, until recently when new
trades were put in place to offset existing trades the existing trades
typically were not closed out, thus swelling the gross notional size of
the market. In recent weeks, and months, joint public/private efforts
aimed at "trade compression" have resulted in dramatic declines in the
gross notional amounts of CDS outstanding. For example, information
released recently indicates that trade compression efforts have
eliminated the notional value of CDS outstanding by \$27 trillion.
Further reductions are expected in the period ahead such that even with
new transactions growing rapidly, the notional amount of CDS will soon
fall below \$30 trillion and will trend still lower over time.

There is one other feature of the CDS market that should be highlighted;
namely, while in trade count terms a significant fraction of CDS trades
are straight-forward in design and structure, a [relatively small number
of high value trades are highly structured and highly
complex.]{.underline} These so-called "bespoke" trades are often
initiated by clients of financial intermediaries and require quite
complex and unique documentation. These bespoke trades are a very
important source of the value added provided by the CDS market. Thus,
efforts aimed at reform must not be so rigid and mechanical so as to
undercut the ability of the market to forge unique solutions to unique
problems.

[Section III. Risk Monitoring and Risk Management for CDS
Users]{.underline}

With the benefit of hindsight it is quite obvious that a number of large
and sophisticated financial institutions experienced shortcomings in
their risk monitoring and risk management activities before and during
the crisis and that some such shortcomings occurred in the CDS space.
The mere presence of a small number of highly concentrated CDS risk
exposures across the financial landscape tells us in unmistaken terms
that some market participants were quite slow in recognizing that these
exposures risked material write-downs and very sizeable collateral
calls. It is also true that the more complex the reference entity (e.g.,
CDO's), the more difficult it is to anticipate credit problems and the
more likely it is that collateral disputes between counterparties will
arise. Having said that, failures in risk monitoring and risk management
were by no means limited to the CDS space in a context in which hedging
opportunities made possible by the CDS surely did help many institutions
to mitigate credit exposures.

All of this raises the very difficult analytical question of whether, on
balance, the CDS tempered or amplified the credit crisis. While I
believe that we will gravitate toward an informed answer to that
question only with the passage of time, based on what we now know I see
the CDS as a net plus. In saying that, I must acknowledge that the CDS
and other segments of the financial markets have benefited greatly from
large scale central bank and governmental interventions. It is also true
that the CDS market has benefited from a handful of recently implemented
critical reforms as follows:

> \(1\) The prohibition against novation of trades without the consent
> of the initial counterparty;
>
> \(2\) huge reductions in unsigned trade confirmations;
>
> \(3\) major advances in automation covering all steps in the trade
> processing cycles;
>
> \(4\) the building of a consensus approach to cash settlement in the
> event of a
>
> reference entity default which proved extremely valuable in the credit
> events at the housing GSE's and Lehman;
>
> \(5\) the agreement among the dealers on the use of a common close out
> methodology which, fortunately, was put in place only weeks before the
> Lehman bankruptcy. Had this agreement not been in place the very
> challenging aftermath of the Lehman bankruptcy would been an even
> greater blow to market confidence; and
>
> \(6\) important strides have been made in increasing the transparency
> of the CDS market.

Turning to the subject of risk management more generally, Appendix A
explains, in straight-forward terms, the nature of the risks associated
with the CDS instrument. In examining the events leading up to and
including the crisis it is quite clear that the very large write-downs
and losses witnessed in the CDS space were importantly driven by either
or both "basis" risk and "counterparty" risk.

To a considerable degree the basis risk problem arose because efforts to
hedge risks did not always perform as expected due to sometimes very
large disparities in the absolute and relative movements in the prices
of position being hedged and the CDS designed to provide the hedge. In a
few cases even the algebraic sign of the hedge was wrong; that is the
price of the underlying asset and the hedging instrument actually moved
in the same direction!

With regard to counterparty risk, it has been widely recognized in the
press and elsewhere that highly concentrated positions at a relatively
small number of institutions -- particularly sellers of protection
involving complex reference entities -- resulted in massive collateral
calls which caused large write-downs and impaired the liquidity position
of the institutions in question. Even worse, there were situations in
which basis risk, counterparty risk, and the embedded leverage in
certain classes of structured credit products interacted with each other
in ways that amplified contagion and volatility, and multiplied the size
of margin calls and write-downs.

The legacy of these events in the CDS space will be with us for a long
time. However, as we seek to draw lessons from these events we must
proceed with care. Indeed, as discussed in the next section of this
statement, I believe that the agenda for further reform in the CDS space
is reasonably clear even if full implementation of the agenda will be
challenging and time consuming.

[Section IV: Enhanced Official Oversight]{.underline}

Given all that has occurred on the financial front over the past 16
months, it is only natural that this Committee, the Congress as a whole
and the public at large are focused on enhanced official oversight of
financial markets and institutions. Fortunately, the Memorandum of
Understanding entered into by the FED, the SEC and the CFTC on November
14, 2008 regarding "Central Counterparties for Credit Default Swaps"
provides something of an anchor for such focus as it applies to CDS and
OTC derivatives more generally.

As I see it, the approach to enhance official oversight should be based
on five guiding principles

and five suggestions, all of which are focused on financial stability,
as follows:

> **[Guiding Principles]{.underline}**
>
> [First]{.underline}; the financial industry, broadly defined, must
> recognize at the highest levels of management that a substantial
> further commitment of leadership and resources must be devoted to
> necessary enhancements in the efficiency, resiliency, stability and
> integrity of the OTC markets with specific emphasis on the CDS.
>
> [Second]{.underline}; in shaping the reform agenda, the regulators,
> legislators and market participants should exercise great care so as
> not to fall victim to the laws of unintended consequences. As an
> example, even the hint of an approach that would raise questions about
> the legal standing of existing contracts could materially worsen the
> already badly shaken confidence in financial markets and institutions.
>
> [Third]{.underline}; even in the face of substantial write-downs
> experienced by some institutions in the CDS space, we must recognize
> that such losses probably reflect flaws in risk management much more
> than they reflect flaws in the instrument.
>
> [Fourth]{.underline}; from the viewpoint of financial stability,
> whether or to what extent CDS trades occur on organized exchanges is
> not a matter of overriding concern so long as the details of all such
> trades are made available on trade date to the DTCC warehouse.
>
> [Finally]{.underline}; the prompt implementation of a CCP for credit
> default swaps will constitute a necessary, but not sufficient,
> condition to facilitate the orderly wind-down of seriously troubled
> and highly inter-connected financial institutions.

With those guiding principles in mind, I would offer the following
specific suggestions as to official initiatives that would further
strengthen the CDS and related OTC derivatives markets. These
suggestions are all focused on measures to further mitigate systemic
risk. As such they complement the CCP and bring us closer to the goals
of achieving the necessary and sufficient conditions of containing
systemic risk arising from these markets.

**[Suggestions to Mitigate Systemic Risk]{.underline}**

> [First]{.underline}; regardless of which CCP emerges as the industry
> standard, the authorities must satisfy themselves that the risk
> mitigation features of the CCP have virtually failsafe operational and
> financial integrity including the capacity to absorb the default of
> two of its largest members. Consistent with this philosophy, I also
> believe that there should be a single dedicated global CCP for CDS and
> that any approach that co-mingles CDS settlement funds with settlement
> funds for other financial instruments is unwise.
>
> [Second;]{.underline} building on the highly effective leadership of
> the New York Fed and the community of domestic and international
> supervisors, we must sustain and strengthen the public/private
> cooperative efforts to ensure that the necessary steps to strengthen
> the industry wide infrastructure surrounding the OTC markets are
> implemented in a timely fashion. These necessary initiatives are
> outlined in Appendix B.
>
> [Third]{.underline}; prudential supervisors should, as a part of their
> regular inspections and examinations, insure that individual
> institutions are doing their part to insure that such institutions'
> policies, practices, procedures and operating systems regarding the
> needed infrastructure improvements are in line with industry best
> practices.
>
> [Fourth]{.underline}; prudential supervisors should, on a case by case
> basis, make inquiries regarding highly concentrated positions and
> crowded trades and, where necessary, encourage or require individual
> institution to moderate the risks of such positions. On a voluntary
> basis, hedge funds and other unregulated financial institutions should
> be willing to respond to similar inquiries or face the prospects of
> greater direct regulation.
>
> [Finally]{.underline}; major market participants and their supervisors
> must ensure that risk monitoring, risk management and, of special
> importance, corporate governance practices are in line with best
> practices with particular emphasis on monitoring exposures and the
> application of rigorous valuation and price verification practices to
> complex transactions. Among other things, such best practices will
> play a constructive role in quickly resolving collateral disputes.

These five guiding principles and five suggestions to enhance official
oversight of the OTC derivatives markets are, I believe, very much
consistent with the spirit of the FED, SEC and CFTC Memorandum of
Understanding. More importantly, they are also consistent with the
broader objective of enhancing our shared vision of greater financial
stability while striking a constructive and modest re-balancing of the
role of marketplace and the role of public policy in fostering a more
disciplined approach to financial intermediation, which of course, is
essential to economic growth and rising standards of living.

\* \* \* \* \* \* \* \* \* \* \*

**Appendix A**

The following is an extract from the July 27, 2005 Report of the
Counterparty Risk Management Policy Group II entitled "Toward Greater
Financial Stability: A Private Sector Perspective."

The credit default swap (CDS) is the cornerstone of the credit
derivatives market. A credit default swap is an agreement between two
parties to exchange the credit risk of an issuer (reference entity). The
buyer of the credit default swap is said to buy protection. The buyer
usually pays a periodic fee and profits if the reference entity has a
credit event, or if the credit worsens while the swap is outstanding. A
credit event includes bankruptcy, failing to pay outstanding debt
obligations or, in some CDS contracts, a restructuring of a bond or
loan. Buying protection has a similar credit risk position to selling a
bond short, or "going short risk."

The seller of the credit default swap is said to sell protection. The
seller collects the periodic fee and profits if the credit of the
reference entity remains stable or improves while the swap is
outstanding. Selling protection has a similar credit risk position to
owning a bond or loan, or "going long risk."

Other noteworthy aspects of the credit default swap market include:

-   The most commonly traded and therefore the most liquid tenors for
    credit default swap contracts are five and ten years. Historically,
    volumes are concentrated in the five-year maturity. One large
    financial intermediary estimates that 70% of the CDS volume is in
    this tenor, with 20% in longer maturities and 10% in shorter
    maturities. Liquidity across the maturity curve continues to
    develop, however, demonstrated by CDX indices, which are quoted in
    the 1, 2, 3, 4, 5, 7, and 10 year tenors.

-   Standard trading sizes vary depending on the reference entity. For
    example, in the US, \$10 million -- \$20 million notional is typical
    for investment grade credits, and \$2 million -- \$5 million
    notional is typical for high yield credits. In Europe, €10 million
    notional is typical for investment grade credits, and €2 million --
    €5 million notional is typical for high yield credits.

Credit default swap indices provide investors with a single, liquid
vehicle through which to take diversified long or short exposure to a
specific credit market or market segment. The first index product was
the High Yield Debt Index (HYDI), created by JPMorgan in 2001. Like the
S&P 500 and other market benchmarks, the credit default indices reflect
the performance of a basket of credits, namely a basket of single-name
credit default swaps (credit default swaps on individual credits). CDS
indices exist for the US investment-grade and high-yield markets, the
European investment-grade and high-yield markets, the Asian markets and
global emerging markets.

Unlike a perpetual index like the S&P 500, CDS indices have a fixed
composition and fixed maturities. New indices with an updated basket of
underlying credits are launched periodically, at least twice a year. New
indices are launched in order to reflect changes in the credit market
and to give the index more consistent duration and liquidity. When a new
index is launched (dubbed the "on-the-run index"), the existing indices
continue to trade (as "off-the-run") and will continue to trade until
maturity. The on-the-run indices tend to be more liquid than the
off-the-run indices.

Probably the most important event in the CDS market in 2004 was the
establishment of one credit derivative index family. The establishment
of the Dow Jones CDX index family in the US and the Dow Jones iTraxx
index family in Europe and Asia in the second quarter has led to
increased liquidity in index products and the growth of other products
(volatility, correlation) that require a standard, liquid underlying
market. In DJ CDX Investment Grade and High Yield, bid/offer spreads
have halved due to the liquidity benefit of having one single index
family, and transaction volumes have increased.

### Forces Driving Market Activity 

Credit derivatives have been widely adopted by credit market
participants as a tool for managing exposure to, or investing in,
credit. The rapid growth of this market is largely attributable to the
following features of credit derivatives:

#### Credit derivatives allow the disaggregation of credit risk from other risks inherent in traditional credit instruments

A corporate bond represents a bundle of risks including interest rate,
currency (potentially) and credit risk (constituting both the risk of
default and the risk of volatility in credit spreads). Before the advent
of credit default swaps, the primary way for a bond investor to adjust
his credit risk position was to buy or sell that bond, consequently
affecting his positions across the entire bundle of risks. Credit
derivatives provide the ability to independently manage default risk.

#### Credit derivatives provide an efficient way to short a credit

While it can be difficult to borrow corporate bonds on a term basis or
enter into a short sale of a bank loan, a short position can be easily
achieved by purchasing credit protection. Consequently, risk managers
can short specific credits or a broad index of credits, either as a
hedge of existing exposures or to profit from a negative credit view.

#### Credit derivatives create a market for "pure" credit risk that allows the market to transfer credit risk to the most efficient holder of risk

Credit default swaps represent the cost to assume "pure" credit risk.
Bond, loan, equity and equity-linked market participants may transact in
the credit default swap market. Because of this central position, the
credit default swap market will often react faster than the bond or loan
markets to news affecting credit prices. For example, investors buying
newly issued convertible debt are exposed to the credit risk in the bond
component of the convertible instrument, and may seek to hedge this risk
using credit default swaps. As buyers of the convertible bond purchase
protection, spreads in the CDS market widen. This spread change may
occur before the pricing implications of the convertible debt are
reflected in bond market spreads. However, the change in CDS spreads may
cause bond spreads to widen as investors seek to maintain the value
relationship between bonds and CDS. Thus, the CDS market can serve as a
link between structurally separate markets. This has led to more
awareness of and participation from different types of investors.

#### Credit derivatives can provide additional liquidity in times of turbulence in the credit markets

The credit derivative market can provide additional liquidity during
periods of market distress (high default rates). Before the credit
default swap market, a holder of a distressed or defaulted bond often
had difficulty selling the bond, even at reduced prices. This is because
cash bond desks are typically long risk as they own an inventory of
bonds. As a result, they are often unwilling to purchase bonds and
assume more risk in times of market stress. In contrast, credit
derivative desks typically hold an inventory of protection (short risk),
having bought protection through credit default swaps. In distressed
markets, investors may be able to reduce long risk positions by
purchasing protection from credit derivative desks, which may be better
positioned to sell protection (long risk) and change their inventory
position from short risk to neutral. Furthermore, the CDS market creates
natural buyers of defaulted bonds, as protection holders (short risk)
buy bonds to deliver to the protection sellers (long risk). CDS markets,
therefore, have tended to increase liquidity across many credit market
segments.

As the chart below illustrates, CDS volumes as a percentage of cash
volumes increased steadily during the distressed spring and summer of
2002 in the face of credit-spread volatility and corporate defaults.

Credit derivatives provide ways to tailor credit investments and hedges

Credit derivatives provide users with various options to customize their
risk profiles. Through the CDS market, investors may assume exposure to
credits that do not actively trade in the cash market, customize tenor
or currency exposure or benefit from relative value transactions between
credit derivatives and other asset classes. With credit derivatives,
investors have access to a variety of structures, such as baskets and
tranches, that can be used to tailor investments to suit the investor's
desired risk/return profile. As an example, investors who purchase risk
through synthetic baskets of credits may attempt to hedge this risk by
purchasing single-name credit default swaps. This can be a significant
driver of single-name CDS volumes.

#### Credit derivative transactions are confidential

As with the trading of a bond in the secondary market, the reference
entity whose credit risk is being transferred is neither a party to a
credit derivative transaction nor is even aware of it. This
confidentiality enables risk managers to isolate and transfer credit
risk discreetly, without affecting business relationships. In contrast,
a loan assignment through the secondary loan market may require borrower
notification and may require the participating bank to assume as much
credit risk to the selling bank as to the borrower itself. Because the
reference entity is not a party to the negotiation, the terms of the
credit derivative transaction (tenor, seniority and compensation
structure) can be customized to meet the needs of the buyer and seller,
rather than the particular liquidity or term needs of a borrower.

### Long and Short Users 

The following is a brief summary of strategies employed by the key
players in the credit derivatives market:

#### Banks and loan portfolio managers

Banks were once the primary players in the credit derivatives market.
They developed the CDS market in order to reduce their risk exposure to
companies to whom they lent money, thereby reducing the amount of
capital needed to satisfy regulatory requirements. Banks continue to use
credit derivatives for hedging both single-name and broad market credit
exposure.

#### Market makers 

In the past, market markers in the credit markets were constrained in
their ability to provide liquidity because of limits on the amount of
credit exposure they could have on one company or sector. The use of
more efficient hedging strategies, including credit derivatives, has
helped market makers trade more efficiently while employing less
capital. Credit derivatives allow market makers to hold their inventory
of bonds during a downturn in the credit cycle while remaining neutral
in terms of credit risk. To this end, a number of dealers have
integrated their CDS trading and cash trading businesses.

#### Hedge funds 

Since their early participation in the credit derivatives market, hedge
funds have continued to increase their presence and have helped to
increase the variety of trading strategies in the market. While hedge
fund activity was once primarily driven by convertible bond arbitrage,
many funds now use credit default swaps as the most efficient method to
buy and sell credit risk. Additionally, hedge funds have been the
primary users of relative value trading opportunities and new products
that facilitate the trading of credit spread volatility, correlation and
recovery rates.

#### Asset managers

Asset managers have significantly increased their participation in the
credit derivatives market in recent years. Asset managers are typically
end users of risk that use the CDS market as a relative value tool, or
to provide a structural feature they cannot find in the bond market,
such as a particular maturity. Also, the ability to use the CDS market
to express a bearish view is an attractive proposition for many asset
managers. Prior to the availability of CDS, an asset manager would
generally be flat or underweight in a credit they did not like, as most
were unable to short bonds in their portfolios. Now, many asset managers
may also buy credit protection as a way to take a short-term neutral
stance on a credit while taking a bullish longer term view. For example,
an asset manager might purchase three-year protection to hedge a
ten-year bond position on an entity where the credit is under stress but
is expected to perform well if it survives the next three years.
Finally, the emergence of a liquid CDS index market has provided asset
managers with a vehicle to efficiently express macro views on the credit
markets.

#### Insurance companies 

The participation of insurance companies in the credit default swap
market can be separated into two distinct groups: (1) life insurance and
property & casualty (P&C) companies and (2) monolines and reinsurers.
Life insurance and P&C companies typically use credit default swaps to
sell protection to enhance the return on their asset portfolio either
through Replication (Synthetic Asset) Transactions (\"RSATs\" or the
regulatory framework that allows some insurance companies to enter into
credit default swaps) or credit-linked notes. Monolines and reinsurers
often sell protection as a source of additional premium and to diversify
their portfolios to include credit risk.

#### Corporations 

Corporations are recent entrants to the credit derivatives market and
promise to be an area of growth. Most corporations focus on the use of
credit derivatives for risk management purposes, though some invest in
CDS indices and structured credit products as a way to increase returns
on pension assets or balance sheet cash positions.

Recent default experiences have made corporate risk managers more aware
of the amount of credit exposure they have to third parties and have
caused many to explore alternatives for managing this risk. Many
corporate treasury and credit officers find the use of CDS appealing as
an alternative to credit insurance or factoring arrangements due to the
greater liquidity, transparency of pricing and structural flexibility
afforded by the CDS market. Corporations are also focused on managing
funding costs; to this end, many corporate treasurers monitor their own
CDS spreads as a benchmark for pricing new bank and bond deals and are
exploring how the CDS market can be used to hedge future issuance.

### Risk Management Issues

The risk profile of a credit default swap is essentially equivalent to
the credit risk profile of a bond or loan, with some additional risks,
namely counterparty risk, basis risk, legal risk and operational risk.

#### Counterparty risk 

Recall that in a credit event, the buyer of protection (short risk)
delivers bonds of the defaulted reference entity, or other eligible
assets, and receives par from the seller (long risk). Therefore, an
additional risk to the protection buyer is that the protection seller
may not be able to pay the full par amount upon default. This risk,
referred to as counterparty credit risk, is a maximum of par less the
recovery rate, in the event that both the reference entity and the
counterparty default. While the likelihood of suffering this loss is
remote, the magnitude of the loss given default can be material.
Counterparties typically mitigate this risk through the posting of
collateral (as defined in a credit support annex (CSA) to the ISDA
Master Agreement) rather than through the adjustment of the price of
protection.

#### Basis risk 

Basis refers to the difference, in basis points, between a credit
default swap spread and a bond's par equivalent CDS spread with the same
maturity dates. Basis is either zero, positive or negative.

If the basis is negative, then the credit default swap spread is lower
than the bond's spread. This occurs when there is excess protection
selling (investors looking to go long risk and receive periodic
payments), reducing the CDS coupon. Excess protection selling may come
from structured credit issuers (or CDO issuers), for example, who sell
protection in order to fund coupon payments to the buyers of structured
credit products. Protection selling may also come from investors who
lend at rates above Libor. For these investors, it may be more
economical to sell protection and invest at spreads above Libor rather
than borrow money and purchase a bond.

If the basis is positive, then the credit default spread is greater than
the bond's spread. Positive basis occurs for technical and fundamental
reasons. The technical reasons are primarily due to imperfections in the
repo market for borrowing bonds. Specifically, if cash bonds could be
borrowed for extended periods of time at fixed costs, then there would
not be a reason for bonds to trade "expensive" relative to credit
default swaps. If a positive basis situation arises, investors would
borrow the bonds and sell them short, eliminating the spread
discrepancy. In practice, there are significant costs and uncertainties
in borrowing bonds. Therefore, if the market becomes more bearish on a
credit, rather than selling bonds short, investors may buy default
protection. This may cause credit default swap spreads to widen compared
with bond spreads.

Another technical factor that causes positive basis is that there is, to
some degree, a segmented market between bonds and credit default swaps.
Regulatory, legal and other factors prevent some holders of bonds from
switching between the bond and credit default swap markets. These
investors are unable to sell a bond and then sell protection when the
credit default swap market offers better value. Along this vein of
segmented markets, sometimes there are market participants, particularly
coming from the convertible bond market, who wish to short a credit (buy
default swap protection) because it makes another transaction
profitable. These investors may pay more for the protection than
investors who are comparing the bonds and credit default swap markets.
This is another manifestation of the undeveloped repo market.

A fundamental factor that creates positive basis is the
cheapest-to-deliver option. A short CDS position (long risk) is short
the cheapest-to-deliver option. If there is a credit event, the
protection buyer (short risk) is contractually allowed to choose which
bond to deliver in exchange for the notional amount. This investor will
generally deliver the cheapest bond in the market. When there is a
credit event, bonds at the same level of the capital structure generally
trade at the same price (except for potential differences in accrued
interest) as they will be treated similarly in a restructuring. Still,
there is the potential for price disparity. Thus, protection sellers may
expect to receive additional spread compared to bonds for bearing this
risk. This would lead to CDS spreads trading wider than bond spreads and
therefore contribute to positive basis. Thus, when investors invest in
credit default swaps, they risk entering into a position that is
relatively expensive as compared to entering into a similar risk
position with bonds or loans.

#### Legal risk 

Credit default swaps investors may face legal risk if there is a credit
event and the legality of the CDS contract is challenged. Although not
without specific disputes, as previously stated, ISDA's standard
contract has generally proven effective in the face of significant
credit market stress. The large majority of contracts have tended to
settle without disputes or litigation. As discussed in Section IV of the
main CRMPG II Report, legal issues can and do arise in this market from
time to time. Most of these disputes have involved contractual claims
related to whether there was a credit event under the terms of the
contract, the identity of the reference entity, the timeliness of
notices delivered under the contract, the nature of the assets
deliverable into the contract and the timeliness of the delivery of
assets for settlement purposes.

#### Operational risk

With limited straight through processing, confirmation backlogs, and a
clearing service in relatively early stages of operation, back offices
have tended to feel the strain of handling a rapidly growing volume of
activity. The recent credit event in which gross positions in the
reference entity exceeded the available deliverable assets highlighted
the potential difficulty for market participants in settling
transactions in a timely and efficient manner. Section IV of the main
CRMPG II Report addresses these issues more fully.

Other risk considerations:

-   Credit default swaps are leveraged transactions. Unlike a
    transaction related to floating rate notes or corporate bonds with a
    similar amount of credit risk, principal amount is not exchanged
    upfront in a CDS. As noted above, large and/or sophisticated
    counterparties typically mitigate the risk of non-performance by the
    daily updating of collateral accounts reflecting gains or losses on
    positions.

-   Credit default swaps are over-the-counter transactions between two
    parties and it is difficult to estimate the amount of default swaps
    which are outstanding. While the net amount of all credit default
    swaps is zero, as the amount of long protection positions must be
    equal to the short protection position, there may be market
    participants who are very long or short exposure to specific
    credits.

-   In marking the value of an open credit default swap to market,
    investors must estimate a recovery rate. If investors deviate from
    industry standard recovery rates, they can calculate different
    values for their open contracts.

\* \* \* \* \* \* \* \* \* \* \* \* \* \*

> **Appendix B**

*CRMPGIII Recommendations*

The following is an extract from the August 6, 2008 Report of the
Counterparty Risk Management Policy Group III entitled "Containing
Systemic Risk: The Road to Reform."

[Recommendation]{.underline}

[Number]{.underline}

V-1. The Policy Group [recommends]{.underline} trade date (T+0) matching
for electronically eligible transactions.

> Goal: End 2009.

V-5. The Policy Group [recommends]{.underline} that market participants
should seek to streamline their methods for trade execution and
confirmation/affirmation, which should facilitate an end-to-end process
flow consistent with same-day matching and legal confirmation.

V-6. The Policy Group [recommends]{.underline} that senior leaders of
trading support functions should clearly articulate to senior management
the resource requirements necessary to achieve the same-day standards.
Recognizing the expense management imperatives driven by recent market
conditions, senior management should make every effort to help support
functions achieve these standards for the overarching benefit of
enhancing market resilience.

> Goal: Ongoing.

V-10. The Policy Group further [recommends]{.underline} frequent
portfolio reconciliations and mark-to-market comparisons, including on
collateralized instruments.

> Goal: Weekly end 2008, moving to daily for electronically eligible
> trades mid 2009.

V-11. ISDA Credit Support Annex documents spell out the bilateral terms
of the margin process. While the process is generally standardized, the
Policy Group [recommends]{.underline} that the industry needs to find an
effective means to resolve valuations disputes, particularly for
illiquid products. Doing so is likely to be a difficult and demanding
matter and therefore an industry-wide approach may have to be
considered.

> Goal: End of 2009.

V-12. The Policy Group [recommends]{.underline} that, as mark-to-market
disputes inevitably surface through the collateral portfolio
reconciliation process, the information should be passed to the
executing trading desks on a real-time basis to allow for research and
resolution. This should, of course, be done with appropriate anonymity
of the counterparty's identity, positions, and broader portfolio. A
close alignment of the collateral team with trading desks -- without
violating the fire walls and controls that are critically important to
the integrity of the financial system -- would facilitate such
information sharing. As necessary, significant and large value
collateral disputes should promptly be escalated to the appropriate
senior officers.

> Goal: Immediate.

V-14. The Policy Group [recommends]{.underline} that market participants
actively engage in single name and index CDS trade compression. ISDA has
agreed on a mechanism to facilitate single name trade compression with
Creditex and Mark-it Partners. Established vendor platforms exist for
termination of offsetting index trades, and we urge major market
participants to aggressively pursue their use.

V-15. Based on the considerations above, the Policy Group
[recommends]{.underline} that the industry, under the auspices of the
current ISDA Portfolio Compression Working Group, commit immediately and
with all due speed to achieve consistency of the current product,
including potentially:

1.  utilizing industry preferred Reference Obligations or elimination of
    Reference Obligations;

2.  eliminating Restructuring Basis distinctions, recognizing that this
    needs to be considered in a broader global perspective taking into
    account regional and national differences; and

3.  standardizing fee calculations based on a single, common model
    analytic.

V-16. The Policy Group [recommends]{.underline} that ISDA should update
its Credit Derivative Definitions to incorporate the auction mechanism
so that counterparties to new credit default swap trades commit to
utilize the auction mechanism in connection with future credit events.

V-18. The Policy Group [recommends]{.underline} that all large
integrated financial intermediaries (*e.g.*, the major dealers) should
promptly adopt the Close-out Amount approach for early termination upon
default in their counterparty relationships with each other. We note
that this can be agreed and suitably documented without making any other
changes to the ISDA Master. The Policy Group expects that these
arrangements will be in place in the very near term.

V-20. The Policy Group [recommends]{.underline} that all major market
participants should periodically conduct hypothetical simulations of
close-out situations, including a comprehensive review of key
documentation, identification of legal risks and issues, establishing
the speed and accuracy with which comprehensive counterparty exposure
data and net cash outflows can be compiled, and ascertaining the
sequencing of critical tasks and decision-making responsibilities
associated with events leading up to and including the execution of a
close-out event.

V-21. The Policy Group [recommends]{.underline} that all market
participants should both promptly and periodically review their existing
documentation covering counterparty terminations and ensure that they
have in place appropriate and current agreements including the
definition of events of default and the termination methodology that
will be used. Where such documents are not current, market participants
should take immediate steps to update them. Moreover, each market
participant should make explicit judgments about the risks of trading
with counterparties who are unwilling or unable to maintain appropriate
and current documentation and procedures.

V-22. The Policy Group [recommends]{.underline} that the industry should
consider the formation of a "default management group", composed of
senior business representatives of major market participants (from the
buy-side as well as the sell-side) to work with the regulatory
authorities on an ongoing basis to consider and anticipate issues likely
to arise in the event of a default of a major market counterparty.

V-23. Recognizing the benefits of a counterparty clearing arrangement
([CCP]{.underline}) as discussed above, the Policy Group strongly
[recommends]{.underline} that the industry develop a CCP for the credit
derivatives market to become operational as soon as possible and that
its operations adhere to the BIS Recommendations.

\* \* \* \* \* \* \* \* \* \*

[^1]: For a detailed description of the CDS see Appendix A