Fear and Greed Blog

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.

Moody's recently published a report entitled Archaeology of the Crisis. I think it's definitely worth a read.

Given that Moody's is one of the agencies that many blame for, at least, part of the crisis, it is commendable that the report somewhat addresses the agencies' failures. Unfortunately, as is frequently the case, these failures are more obvious after the fact than they were prospectively.

Specifically highlighted is how loan originators, subprime loan borrowers, and market intermediaries were incentivized to provide limited information to other parties (including the rating agencies).

Also highlighted is the effect that differences in assumptions by market participants, particularly in relation to the definition of liquidity, had in the crisis. This disconnect was especially present in assumptions about how ratings do (or don't) reflect the market risk of a security (a "market-risk judgment") in addition to agencies' credit judgment (based on analyses of financial statements and the ability to pay).

The problem of how to consider the liquidity (defined, in this case, as a sufficient number of buyers and sellers), particularly over time, of securities (particularly unseasoned structured securities) is certainly significant.

The report also identifies the mark-to-market approach for valuation as one of the causes of the credit crisis. I have been concerned about the impact that financial reporting has been having on markets. It has been the financial equivalent of the "observer effect" where the measurement of the value of securities effects the value of those securities.

Accounting is supposed to provide information. It is designed to measure and report on asset values; not to impact those values.

The paper quotes from Raghuram G. Rajan's paper Has Financial Development Made the World Riskier and Claudio E. V. Borio's paper Change and constancy in the financial system: implications for financial distress and policy. Dr. Rajan is the Economic Counselor and Director of Research at the International Monetary Fund. Dr. Borio is the
Head of Research and Policy Analysis at the Bank for International
Settlements.

I recommend that readers peruse the Moody's report.

On August 17th, Rick Bookstaber posted an article that he wrote for Time Magazine. My comments to him, and a link to his article, are set out below:
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I really liked the Time piece.

You neglected, I assume for brevity’s sake, to mention the leverage inherent in derivatives, which is incalculable.

What is known is that notional value of OTC derivatives outstanding is more than $415 trillion at 12/31/06 (per Bank of International Settlements Quarterly Review, June 2007). This is a nearly four-fold increase from the $111 trillion at 12/31/01.

The vast majority of these positions are hedged against securities (or physical assets, as appropriate) or other derivatives, but some are speculative positions.

There are a great many players in these markets, each with their own proprietary positions and strategies (almost all of which are closely guarded secrets – although recent events indicate that, as you noted elsewhere, some appear to be highly correlated - as you wrote in your post of 8/16). I believe, therefore, that there are significant potential liquidity and counter-party risks (particularly given that there are still a number of problems in the recording and settlement of these positions per BIS).

Furthermore, the ability of hedge fund LPs to redeem their interests for cash on a somewhat regular basis (perhaps requiring the unexpected unwinding of illiquid positions), while technically not leverage, means that these funds are exposed to the risk of a run of redemptions (subject, of course, to the terms of the specific LP agreements).

All of this complexity, I believe makes any estimate of effective leverage almost, if not completely, incalculable.

As long as markets remain somewhat rational, there shouldn't be a problem. As you point out in your book, however, tail events DO happen and the impact would be potentially catastrophic. Hopefully I'm overstating the potential impact.