Those of us who have an eye for trouble have been nattering about the credit default swaps market from time to time. This $46 trillion unregulated market has suddenly captured the imagination after AIG reported in an 8-K filing that it had certain weaknesses in its internal controls and that the value of its credit defaults swaps had fallen in October and November by $4.88 billion, and oh, by the way, they still haven't figured out December. Their previously reported loss estimate on CDS was a mere $1 billion.
Now AIG has a big balance sheet, so even though this is painful and embarrassing, they'll be able to absorb the damage (unless December turns out to have been a black hole). But if a company heretofore regarded as savvy could get it that wrong, who else might be in trouble?
This article by Gretchen Morgenson in the New York Times, "Arcane Market Is Next to Face Big Credit Test," gives a reasonably good overview of the credit default swaps market, although we quibble with some of its emphasis and views.
One assumption that undergirds the piece is that the event that will test this market is increased corporate defaults. We disagree. Counterparty risk will emerge as a problem long before we see a rise in companies in financial extremis.
CDS are only as good as the party the wrote the guarantee. Monoline insurers, followed by hedge funds, were the big protection writers. Yet the role of the bond insurers is not mentioned once in this article (the article cited data on the activity of banks, who are only one of many types of participants in this market). Merrill Lynch has already taken $3.1 billion in writedowns due to financial guarantor counterparty risk on CDS.
Now what makes this situation really hairy is that the amount of CDS outstanding is a very big multiple of the underlying credits on which they are written (I've seen estimates as high as 12 times; the Morgenson article suggests a level more like 8 times). Aside from speculation, one of the reasons the CDS volume is so high is that some of the CDS are entered into to hedge other CDS positions.
Now follow the bouncing ball: a financial player that has written guarantees gets into serious trouble. Suddenly everyone realized any CDS written by that institution are probably not worth much. That means positions they thought were hedged aren't.
That will lead to a cascading series of events...
Now AIG has a big balance sheet, so even though this is painful and embarrassing, they'll be able to absorb the damage (unless December turns out to have been a black hole). But if a company heretofore regarded as savvy could get it that wrong, who else might be in trouble?
This article by Gretchen Morgenson in the New York Times, "Arcane Market Is Next to Face Big Credit Test," gives a reasonably good overview of the credit default swaps market, although we quibble with some of its emphasis and views.
One assumption that undergirds the piece is that the event that will test this market is increased corporate defaults. We disagree. Counterparty risk will emerge as a problem long before we see a rise in companies in financial extremis.
CDS are only as good as the party the wrote the guarantee. Monoline insurers, followed by hedge funds, were the big protection writers. Yet the role of the bond insurers is not mentioned once in this article (the article cited data on the activity of banks, who are only one of many types of participants in this market). Merrill Lynch has already taken $3.1 billion in writedowns due to financial guarantor counterparty risk on CDS.
Now what makes this situation really hairy is that the amount of CDS outstanding is a very big multiple of the underlying credits on which they are written (I've seen estimates as high as 12 times; the Morgenson article suggests a level more like 8 times). Aside from speculation, one of the reasons the CDS volume is so high is that some of the CDS are entered into to hedge other CDS positions.
Now follow the bouncing ball: a financial player that has written guarantees gets into serious trouble. Suddenly everyone realized any CDS written by that institution are probably not worth much. That means positions they thought were hedged aren't.
That will lead to a cascading series of events...
2 comments:
I personally do not see that the problem is that huge.
The outstanding CDS market is I understand about $45t.
The underlying CDS value is about (say) $4.5t. The
companies issuing the securities are only committed to the
value of $4.5t, not $45t. The Delphi case illustrated
what may happen in the event of a default. The value
of the underlying security rises in value as holders
of CDS paper attempt to obtain ownership. The people
at risk are the counterparty for the shortfall in the
debt, and the debtor for payment of the debt. Unless
large organisations have a huge exposure as
counterparties to the CDS market I cannot see how the
financial system faces a major risk.
Please enlighten me.
Check out:
http://www.ft.com/cms/s/0/f75c80e4-d3fd-11dc-a8c6-0000779fd2ac.html
As well as:
http://www.nakedcapitalism.com/2007/11/counterparty-risk-problems-with-credit.html
And, finally:
http://www.fxstreet.com/futures/market-review/outside-the-box/2008-02-12.html
'The Twelve Steps to Financial Disaster'
...Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD - or recovery given default - rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen.
While on average the US and European corporations are in better shape - in terms of profitability and debt burden - than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection - possibly large institutions such as monolines, some hedge funds or a large broker dealer - may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.
Ninth, the "shadow banking system" (as defined by the PIMCO folks) or more precisely the "shadow financial system" (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that - like banks - borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don't have direct or indirect access to the central bank's lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system - stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.
Tenth, stock markets in the US and abroad will start pricing a severe US recession - rather than a mild recession - and a sharp global economic slowdown. The fall in stock markets - after the late January 2008 rally fizzles out - will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.
Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates - TED spreads, BOR-OIS spreads, BOT - Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors' risk aversion - will massively widen again. Even the easing of the liquidity crunch after massive central banks' actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.
Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.
Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds - about $80 billion so far - will be unable to stop this credit disintermediation - (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe.
A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties - driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities - will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch.
In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.
Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question - to be detailed in a follow-up article - is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response - monetary, fiscal, regulatory, financial and otherwise - is coherent, timely and credible. I will argue - in my next article - that one should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis...
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