Tuesday, January 29, 2008

Can Counterparty Exposure on Credit Default Swaps Sink the Economy?

I've been reading a lot about credit derivatives recently, and the potential economic impact of defaults in the credit derivative market. Specifically, there has been much discussion of "counterparty risk" (here's a 1/11/08 article by Saskia Scholtes and Gillian Tett of the FT).

According to the Bank for International Settlements' Quarterly Review of December 2007, at June 30, 2007 the notional value of all outstanding Credit Default Swaps (over-the-counter) was $42.58 trillion (see Table 19 on Page A 103). This consisted of $24.24 trillion of single-name instruments and $18.34 trillion of multi-name instruments. To put that in perspective, all assets of all BIS reporting banks totaled $33.71 trillion; US GDP is currently just under $14.0 trillion.

Bill Gross of Pimco speculated, in his January 2008 Investment Outlook, that there could be $250 billion of default payments to be made in relation to CDS transactions. The impact of such losses could create defaults on the swaps (I guess we could call that "defaults squared"), which would create further distress in the financial system (in addition to the potential for confusion related to the use of the term "default" in relation to "credit default swaps"). The repercussions would likely be felt in the economy through the reduced availability of credit (as bank capital might be expected to shrink).

The impact on the parties to the CDS transactions will be significantly less than these estimates. As Robert Pickel (the chief executive of the International Swaps and Derivatives Association) points out in an article in the 1/29/08 edition of the FT, the use of notional value is misleading. He refers to a recent Fitch Ratings Report (which I could not locate) that estimated $1 trillion of net exposure (after taking hedges and other factors into account).

He then calculates the net exposure as $15 billion and notes that losses on the swaps would remain in the financial system (the gains would match the losses).

His estimate seems a bit low to me.

The economy would suffer if the amount of capital available for funding businesses were significantly reduced by losses on these swaps. These losses could be due to unhedged exposures or counterparty defaults. If the net impact on the system were minimal, there would seem to be little risk to the overall economy.

Credit Default Swap products that are traded on exchanges are subject to net settlement on a regular basis (at least that's my understanding), so the counterparty risk would seem minimal on those securities. The over-the-counter market, however, is much less consistent in regular settlement. Any risk, therefore, is likely to come from that segment (remember, that's only $42.58 trillion of notional value!).

Two wild cards that have taken on more prominence in the last few months are Sovereign Wealth Funds and Private Equity Funds. These funds have come to the rescue of MBIA (at least Warburg tried), Citigroup, and Merrill Lynch.

There is still a tremendous amount of capital looking for higher yields than that available in the Treasury market (currently ranging from 1.77 percent on a Treasury Bill maturing in two weeks to 4.33 percent for the May 2037 Treasury Bond). Financial institutions seem to be attracting a high degree of interest as potentially cheap investments.

Please let me know what you think.

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