Upside Turns to Downside

The many cheerleaders of new age finance have often suggested that two developments only made the financial system stronger.

The first stems from the introduction over the past decade of a vast array of Wall Street-engineered financial products, including incredibly complex derivatives, which allow risk to be sliced and diced and shifted anywhere and everywhere.

The second has to do with what some might call the "democratization of risk." That is, the idea that all sorts of institutions could now play in a game that was once the exclusive purview of financial behemoths like money center banks and bulge bracket broker-dealers.

However, as FT Alphaville notes (with links to must-read Financial Times articles) in "Counterparty Risk, ‘08 Edition," there is also a frightening downside risk associated with the changes of recent years.

As complex, structured deals falter, new systemic risks are emerging and threatening to continue financial instability well into 2008.

Credit default swaps, say Gillian Tett and Saskia Scholtes in Friday’s FT, are a $45,000bn market - bigger than the US government bond and housing markets combined. Until now, that huge market has been regarded with a relatively benign eye - largely because its scope and complexity beggars generalisation.

But as more and more troubled, esoteric, off-balance sheet vehicles creep into the limelight, it’s becoming clear that counterparty risk to these deals - through CDS contracts - should be a cause for concern:

In recent years credit derivatives had been heavily used by the so-called shadow banking system - or the assortment of thinly capitalised, off balance sheet vehicles that have been created by banks this decade. These entities might struggle to meet their obligations if derivative contracts are triggered, creating so-called counterparty risk for those expecting to be paid.

To flesh that point out, CDS contracts are used in virtually every structured financial product created - from the lowly securitisation right through to CDO squared. Not only are CDS contracts used to hedge risk, but also to “synthetically” transfer it. Most of the $1,350bn CDO market, for example, uses “synthetic” technology and CDS contracts as a basis for the CDO asset portfolio. And in particular, it’s complex deals like synthetic CDOs, or Leveraged Super Senior Conduits that should have people worried.

Pimco’s Bill Gross tells Tett and Scholtes:

“The conduits that hold CDS contracts are, in effect, non-regulated banks,” says Mr Gross. “[There are] no requirements to hold reserves against a significant ‘black swan’ run that might break them.”

And that’s the rub: the CDS world is opaque - frighteningly so - and fragile.

Mr Gross himself calculates that, if total investment grade and junk bond defaults approach historical norms of 1.25 per cent, $500bn of the total $45,000bn of credit derivative contracts could be triggered, “resulting in losses of $250bn or more to the protection selling party once recoveries are inserted into the equation”.

The point is, that the process of the unwind - due to the shock of it, and the complexity of it - could be very violent: even though trouble in the CDS market should be a zero-sum game, it’s the way that game is played-out that is cause for concern.

Take for example, SCC, a Dublin-based CDS specialist that went bust last month. The FT writes,

SCC’s collapse raises important questions about how a company with no credit ratings and just $200m in capital was able to write default protection on $5bn worth of credit risk for the banks involved.

[SCC] …was designed to be similar to the handful of ventures known as Credit Derivative Product Companies. These exist to be end-of-the-line insurers of credit risk in the derivatives markets. But whereas CDPCs, such as Primus and Athilon, spend years building up their systems and capital bases to win the safest AAA credit ratings, SCC began writing credit protection far more quickly - and without the lower AA-rating it intended to apply for, but never actually achieved.

In the event, SCC was unable to post collateral against its CDS contracts, and that’s why it went bust.

Even though the losses to those tied up with SCC were small - around £250m - counterparties still got their fingers burned. Apart from the direct cost of SCCs collapse, counterparties were suddenly left exposed with unhedged risk.

It’s that sudden, unexpected exposure - and how institutions will react to it, that carries a systemic threat.

Comments

[D.N.R.]

For example, this is what the Morgan Stanley economist Richard Berner wrote in September 2006:

"[...] Second, securitization and innovation have broadly diffused the transmission of risks in financial markets. The ability to sell assets into securitized pools has enabled lenders to lay off the credit and interest-rate risks they want to avoid into the hands of investors more willing to hold them, such as hedge funds. The growth of ever-more sophisticated tools to separate risk into its component parts has enabled investors and issuers alike to discover the prices of those risk components, to trade them and to use them as risk-management tools. This dispersion of credit and other risks likely has made lenders more willing and able to extend credit. Thus, it has probably made the economy more flexible and resilient to financial shocks such as a sharp reduction in liquidity. "

Yeah, probably. *Much* more flexible and resilient to financial shocks.

As a Seinfeld fan, I recall the line by Kramer who was trying to hook Jerry up with a Romanian gymnast: "Think about all the flexibility, Jerry. you stand on the threshold to the magical world of sensual delights that most men dare not dream of!"

* * *

On a more general note, I am amazed how these *experts* are able to retain even a shred of credibility

[D.N.R.]

“By far the most significant event of finance during the past decade has been the extraordinary development and expansion of financial derivatives….. As we approach the twenty-first century, both banks and non-banks will continually reassess whether their own risk management practices have kept pace with their own evolving activities and with changes in financial market dynamics and readjust accordingly. Should they succeed I am quite confident that market participants will continue to increase their reliance on derivatives to unbundle risks and thereby enhance the process of wealth creation.”

Remarks at the Futures Industry Association, Boca Raton, Florida (19 March 1999). Thus spake Greenspan.