Although this blog post is somewhat sensational (even more than me): CDS Phantom Menace It did have some pretty sweet pictures of how big the CDS market is getting.
For those who don’t know, basically a Credit Default Swap (CDS) is like an insurance contract. In principle, it lets someone who wants to own a company’s bonds but doesn’t want to risk the company defaulting buy insurance from someone else, who is willing to pay the buyer of CDS protection the face value of the bond if a default happens. In theory, these contracts are used for hedging purposes and are great for isolating the “default” risk of a credit instrument from other risks like the risk of interest rate changes.
In practice, as you can see from the below graphs, the CDS market has become an area where people can either hedge entire portfolios of securities by buying a portfolio-based CDS. Or it allows people to speculate on the implosion of other companies by basically “shorting” the bonds (i.e. if you buy CDS protection and the company goes kaput, you get paid much in the same way that if you short a company’s stock, you get paid if they go belly-up).
What makes the above graphs scariest for me is what is referred to as counter-party credit risk. Basically this concept is why people like to put their money in FDIC-insured banks – if you enter a trade with the bank (i.e. I give you my money, you give it back when I need it with maybe a little interest), you don’t want to worry about them renegging on the deal.
Well in the wild world of CDS-trading, not all counterparties are as credit worthy as the FDIC. In fact, according to a structured derivatives expert I spoke with yesterday, and as discussed in this oldie-but goodie article: Buyers and sellers of CDSs not all sellers are created equally. In other words, there is a chance that the person writing your insurance won’t be there if the fan really gets hit.
Given the current conditions of the market, such a scenario does not seem that far afield. Let’s just hope I am just being paranoid.
But if a recent blog post regarding CDS exposure in insurance cos is any indication, there are major cracks in this market already beginning to form.
Lawrence Summers, former Chief Economist of the World Bank Secretary of the Treasury and President of Harvard, wrote an OpEd this weekend in the Financial Times that echos much of what you have read on this blog. The full article is linked here: Wake Up to the Dangers of a Deepening Crisis
Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. Single family home construction may be down over the next year by as much as half from previous peak levels. There are forecasts implied by at least one property derivatives market indicating that nationwide house prices could fall from their previous peaks by as much as 25 per cent over the next several years.
Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. On even the most optimistic estimates, the rate of foreclosure will more than double over the next year as rates reset on subprime mortgages and home values fall. Estimates vary, but there is nearly universal agreement that – if all assets were marked to market valuations – total losses in the American financial sector would be several times the $50bn or so in write-downs that have already been announced by big financial institutions.
Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. The extent of the flight to quality and its expected persistence was powerfully demonstrated last week when the yield on the two-year Treasury bond dropped below 3 per cent for the first time in years. Banks and other financial intermediaries will inevitably curtail new lending as they are hit by a perfect storm of declining capital due to mark-to-market losses, involuntary balance sheet expansion as various backstop facilities are called, and greatly reduced confidence in the creditworthiness of traditional borrowers as the economy turns downwards and asset prices fall.
I am glad to be in school right now so that I don’t have to face the pragmatic consequences of the largest train wreck in history that we have been watching since June.
Another land mine was revealed recently when it Citi and others acknowledged that they basically wrote put options on CDO liquidity. For those who aren’t options savvy, in English this means they agreed to bail out up to $25B of CDO’s to the extent they run out of money.
This article discusses the details, but to me this is just one more in a chain of events suggesting that the full brunt of the credit unwinding that we are currently in the midst of will not be known for at least a year and maybe longer:
There are really a lot of good quotes in here for a one page article, but here is a good one from a research analyst discussing Zero Amortization Subprime loans:
“Despite these risks, there isn’t any performance information available on any of these products just yet because they are still very new to the subprime market. Due to the time lag associated with delinquencies and losses in RMBS pools, and the nature of these risks, it will be several years before the product performance is tested. It is anticipated that all risks associated with these loans have been adequately covered.”
Well…I guess they have been “tested” now. So much for adequate coverage.
Well it is official for anyone who ever had any doubt – the biggest distressed cycle in history is underway.
Remember the ABX charts I first posted in June? Take a look at them now. From high to low, these are BBB, A, AA and AAA (yes, TRIPLE A) Asset-backed security indices.
This is really insane and so much worse than the worst part of the summer it is scary:
What these mean in English is that even previously A rated securities are almost worthless. This surely has to be a technical factor – there is no “bid” for the massive glut of CDO-related junk that is being unloaded, and the SIV-fake bid apparatus is apparently too little too late.
Next steps – increasing defaults in completely “unrelated” asset classes like credit-card receivables, auto-loan receivables, corporate bonds and others. Things will unfortunately get much uglier before this is over.
My biggest hope is that it can be spread over a few years rather than a snowball at once. I can’t believe it but I am actually a bit supportive of the interventionist tendencies at this point.
Unfortunately, I am not sure even a fake bid will convince anyone that the house of cards is still standing.