Spot Banks Before They Go Bust!

Do you have savings with HBOS? Kaupthing? Or any other UK based bank? We measure the risk that your bank might go bust.

It's been a rollercoaster ride in the markets recently. As the credit crisis continues to unfold, everyone's waiting to see which bank will be the next to fold, where the next bail-out will be and which superhero government, if any will come and save the day.

But how can you tell if your bank is in danger of going bust?

There are many ways to measure how robust a company is, with trading announcements and share prices both good indicators of how a company is faring.

However, there is also one other measure you can use to see how safe a company is. These are called credit default swaps (CDSs).

JP Morgan pioneered the idea of CDSs during the mid 90s. By mid-2007, it had grown into a $45 trillion (£26 trillion) market. But what are they?

CDSs explained

In the simplest terms, a CDS is essentially insurance on debt, and guarantees a holder's money will be covered in the event that a company goes under.

So, for example, if you owned corporate bonds in a company and were worried that it might go bust, you could buy a CDS from a third party. This quasi-insurance policy would then pay up if the company defaulted on its payments, ensuring you'd get all your money back.

CDS contracts are mainly bought on bonds, corporate debt and mortgage securities. Its cost is priced as a percentage of the debt, and is measured in basis points (one-hundredth of a percentage point). The higher the CDS, the riskier the debt.

And, like insurance, the riskier a bank is perceived to be by the markets, the more expensive it is to insure the debts.

Of course this, like other measures of risk, is not a sure-fire indicator of how likely a bank is going to go bust. The market may think that a bank is about to go bust, but the market could be wrong.

To put it another way, just because you live in an area where burglary rates are high and have to pay higher home insurance premiums, that doesn't necessarily mean your house will be burgled - in the same way a bank won't definitely go bust if its CDS price is high.

But overall, I think CDSs do provide a  good barometer for measuring the financial health of a company, because like the stockmarket, CDSs react quickly to what's going on in the real world.

For example, the price of a five-year CDS in HBOS shot up amid rumours that the bank was in trouble, at one stage rising by 185 basis points in just one day. As Lloyds TSB announced its takeover of the bank in mid-September, CDSs in HBOS immediately came down.

An Icy Warning

So, now you know what CDSs are, here's a list of the three riskiest banks in Europe in terms of senior five-year debt:

Source: Bloomberg on the morning of Monday, October 6th

Alarmingly, all three of the riskiest banks in Europe originate from Iceland. CDSs in Landsbanki, which owns UK company Icesave were priced at 3,000 basis points on Monday.

This means that in order to insure, say £10 million worth of debt, investors would have to pay an additional £3 million on top of their existing payments. Now I don't know about you, but that sounds very expensive, and very risky to me.

So it's not surprising that trading in Landsbanki and Kaupthing shares was suspended yesterday. And today Landsbanki has been nationalised by the Icelandic government.

If you would like to read more about what this means for you and your savings, Ed Bowsher gives a full update of the current situation here.

Domestic doom? Or not all gloom?

So that was the lowdown on the riskiest banks. But what about banks based in the UK? Here's how risky UK banks are deemed to be, plus a few others that are significant players in the UK market.

Source: Bloomberg on the morning of Monday, October 6th

As you can see from the table, HBOS is judged to be the riskiest, with RBS a close second and HSBC viewed as the least risky. In any case, when you look at the numbers above, they are much smaller than those for the Icelandic banks. So the market thinks the risk of bankruptcy is much lower.

Interestingly, both Dutch bank ING and Spanish usurper Santander are deemed safer than four of the big five banks, and may be a safer bet for your cash if you're looking to move your money.

The Irish banks have also been deemed less risky since the Irish government announced it was backing 100% of all deposits, with CDSs in the Bank of Ireland now at 161.7, after trading at nearly 400 basis points previously.

However, the axiom that you shouldn't put all your eggs in one basket rings true in this case. HBOS, Britain's largest mortgage lender, is paying the price during this credit crisis, while HSBC has softened the blow of its sub-prime losses through its diversified assets.

Warning bells

On a separate note, the CDS industry itself could be about to collapse. This is because, unlike the banking sector, the CDS market is unregulated.
This means that contracts can be traded from investor to investor without anyone making sure that the holder has the assets to pay up if the company defaults. What started off as a way to make a quick buck when the economy was booming is quickly becoming a financial quagmire.

Most recently, crippled insurance giant American International Group wrote down a record $11 billion on its CDS holdings, the biggest loss in the company's history.

With multiple CDS trades taking place, it is increasingly clear that nobody knows who should cough up in the event of a default and, scarily, if the insurer even has enough money to do so.

These concerns have been a major factor behind the financial crisis. And things could get worse. If bond insurance disappears or becomes too costly, lenders will become even more cautious about lending money, with the effects being felt by everyone from big banks to ordinary customers trying to get a mortgage.

Unfortunately, unless you have a Bloomberg terminal sitting in your room, there's no easy way to find current CDS data. If any canny Fools know where to get this on the internet or otherwise, please share your knowledge in the comment box below.

But for now, I have a feeling there's a lot more unraveling to be done in the coming months.

More: I Never Thought It Would Get This Bad | Credit Market Carnage