Shadows of the CDS Market
I have been writing about the Credit Default Swaps (CDS) ticking time bomb for a long time. In Who's Holding The Bag? I compared Warren Buffet's position to Greenspan's. Here is Greenspan's position: "Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth." Buffett's take is quite different of course.
Discussion of Credit Default Swaps is finally hitting mainstream press, including the New York Times. Before we take a look, let's recap exactly what a CDS is.
Credit Default Swaps (CDS)
A Credit Default Swap is a bet between two parties on whether or not a company will default on its bonds. A CDS investor is therefore making essentially the bet as the corporate bond investor. The difference being the counterparty is not a company issuing bonds but a third party willing to speculate on the outcome.
Credit Default Swaps are often used in lieu of corporate bonds when a fund manager can not find enough bonds of the right duration for a company in which they want to invest. In that case, if a hedge fund or other party wants to make a bet as to whether or not a particular company will default, all it has to do is find a suitable counterparty such as another hedge fund, a broker/dealer, or an insurance company, etc. to take the other side of the trade. In a typical CDS, the parties agree to swap cash flows so that one party gets a large payoff if the company defaults within a set period of time, while the counterparty gets periodic payments as long as the company does not default.
In theory, CDSs should trade in tandem with corporate bonds. Then again, there is theory and there is practice. One reason they may not trade in tandem is due to the fact that CDS trades are party-to-party deals that are by their very nature extremely illiquid. There is also a huge anomaly because these derivatives are not marked to market as a general rule. Book value can dramatically overstate open market value.
Credit Default Swap Tsunami
On February 11 2008 I mentioned the $45 Trillion CDS market in Credit Default Swap Tsunami Approaches. Inquiring minds may wish to take a look.
Today, the New York Times is writing Arcane Market Is Next to Face Big Credit Test.
Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.
Since 2000, [the market for CDS securities] has ballooned from $900 billion to more than $45.5 trillion -- roughly twice the size of the entire United States stock market.
No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.
An inkling of trouble emerged in a recent report from the Office of the Comptroller of the Currency, a federal banking regulator. It warned that a significant increase in trading in swaps during the third quarter of last year "put a strain on processing systems" used by banks to handle these trades and make sure they match up.
And last week, the American International Group said that it had incorrectly valued some of the swaps it had written and that sharp declines in some of these instruments had translated to $3.6 billion more in losses than the company had previously estimated. Its stock dropped 12 percent on the news but edged up in the days after.
My Comment: I talked about AIG at length in Credit Default Swap Tsunami Approaches
In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.
But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.
Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.
My Comment: No one knows who the ultimate guarantor of these contracts is. I have stated on many occasions that it just might be "Madame Merriweather's Mudhut Malaysia" or some obscure hedge fund that may not be in business tomorrow.
Credit default swaps were invented by major banks in the mid-1990s as a way to offset risk in their lending or bond portfolios. At the outset, each contract was different, volume in the market was small and participants knew whom they were dealing with.
Years of a healthy economy and few corporate defaults led many banks to write more credit insurance, finding it a low-risk way to earn income because failures were few.
My Comment: This is exactly what happened in the subprime market. Continually rising prices made it seem like there was no risk in the mortgage business. There were proclamations that housing was "A totally New Paradigm", from economists at major firms. See Housing Bottom Nowhere in Sight.
Just as housing became a one way bet, so did bets on corporate bonds. Things got totally insane when the credit markets allowed interest on bonds to be paid not with cash but with issuance of still more debt. Debt was paid back with more debt! See Toggle Bonds - Yet Another High Wire Act.
Everyone was partying without any worries because defaults on corporate bonds were low. There was a mad rush to write insurance. Ambac and MBIA wanted in on the act too. And by guaranteeing derivatives both now appear headed for bankruptcty.
Speculators have also flooded into the credit insurance market recently because these securities make it easier to bet on the health of a company than using corporate bonds.
Both factors have resulted in a market of credit swaps that now far exceeds the face value of corporate bonds underlying it. Commercial banks are among the biggest participants -- at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter.
JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.
In 2000, $900 billion of credit insurance contracts changed hands. Since then, the face value of the contracts outstanding has doubled every year as new contracts have been written. In the first six months of 2007, the figure rose 75 percent; the market now dwarfs the value of United States Treasuries outstanding.
The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks' books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank's losses would have to be reflected on its books.
My Comment: There is simply no way those derivatives are marked to market. AIG told investors in December that it estimated valuation losses on its credit default swaps for October and November at just over $1bn. AIG has scrapped the adjustment because market conditions mean it cannot "reliably quantify" the figure.
One of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against.
My Comment: There is approximately $1 trillion in swaps bet on the success or failure of GM when the entire market cap of GM is a mere $15 billion.
Typically, settling the agreements has required the delivery of defaulted bonds if the insurance buyer wants to be fully covered. If the insurance contracts exceed the bonds that are available for delivery, problems arise.
For example, when Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company's debt exceeded the value of underlying bonds tenfold. Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt.
As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in.
"The insurance business is very difficult to quantify risk in," said Mr. Farrell of Annaly Capital Management. "You have to really read the contract to make sure you are covered. That is going to be the test of the market this year. As defaults kick in and as these events unfold, you are going to find out who has managed this well."
And who hasn't.
$45 trillion bet on swaps with the entire treasury market is a mere $4 trillion is simply absurd. Compounding the problem is lack of knowledge abut who the guarantors are and lack of liquidity in much of the derivatives market. There's always plenty of liquidity when times are good. However, liquidity is a coward. It runs and hides at the first sign of trouble.
Things are so illiquid now that even the municipal bond market has locked up. Insurance guarantees made by Ambac and MBIA are at the heart of it. See No Underwriter Support For Failed Muni Auctions.
Credit Default Swaps on Ambac and MBIA are trading 7 or more levels below investment grade (deep into junk) and 12-14 levels below the AAA or AA ratings assigned by Moody's, Fitch, and the S&P. Clearly this calls into question the competency of the rating agencies.
Banks and brokerages are unwilling to commit capital and who can blame them?
- No one knows what anything is really worth because there is no market at all for some of these securities.
- Banks and brokerage houses are afraid of a downgrade of Ambac and MBIA because it might require as much as $200 Billion more in capital to be raised.
- Mark to fantasy models have too much stuff on the books at unrealistic prices.
- No one trusts the ratings put out by Moody's, Fitch, and the S&P.
- Fears of counterparty failures are in everyone's minds.
Credit default swaps are going to blow sky high. If 10% of credit default swaps blow up, it would wipe out $4.5 trillion in capital. A mere 1% hit would wipe out $450 billion. We don't know when, but we do know the fuse is lit.