I am sticking my neck out in this post, so if any readers disagree, don’t hesitate to speak up.
We have seen the following over the last few weeks: concern about whether banks that have exposure to subprime can be trusted as counterparties; reports and rumors of losses at hedge funds (at a minimum, stat arb and “event driven” strategies); some less acute concern about banks’ LBO exposures (they will clearly take losses on their hung deals and commitments, and the more distress there is in the credit markets, the longer and probably more costly the resolution).
These conditions should have serious ramifications for the credit default swaps market. CDS are only as good as the credit-worthiness of the protection seller, yet because this is an OTC market with high transaction volume, no one knows how much in CDS any one protection seller has written (and how much might be offset by having purchased offsetting contracts).
The market is considered to have been tested by having survived major defaults, such as Enron and Swissair, although it has never faced a broad-scale credit contraction (the market was much smaller at the time of the Sept. 11 attacks and that period of distress was short-lived). Contract volume has grown explosively, so the market of today is different from that of a few years ago. The British Bankers Association estimated the global volume of CDS as of last September as $20,000 billion. In 2004, a survey by the same group reported outstandings of a mere $8,000 billion. A typical comment:
“The CDS market is huge and has grown tremendously in last few years,” says Han Altink, credit portfolio manager at F&C Asset Management in Amsterdam. “Ninety per cent use CDS rather than actual bonds. It is difficult to have an insight into what is happening in that market and how much leverage has gone with that. For us it’s a black box.”
Personally, I don’t understand how one can buy insurance if you aren’t certain of the creditworthiness of your counterparty (and I don’t mean credit rating, since I doubt the rating agencies pay much heed to how much in CDS a particular bank has outstanding). Moreover, hedge funds have become increasingly active as buyers and sellers of protection.
To the extent that the major hedge funds that have suffered losses were also protection-sellers, it would raise questions about the value of their CDS contracts. Ditto any banks that have credit exposure to structured investment vehicles. And if LBO worries grow, the credit concerns may extend to banks like Citigroup that were major LBO lenders (and oh, BTW, is a leading, if not the leading, CDS trader).
You get the picture. If enough financial players are distrusted as counterparties for routine transactions, one would think at a certain point those worries have to infect the CDS market. And the CDS market has become so central to bank and credit investor activities that an impairment there would have far reaching, perhaps even devastating, consequences.
Could this worry be the real reason the ECB was so fast to intervene?
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Hi Yves,
I’m a big fan of your blog. I recently started a financial blog myself, but am an admitted amateur. I think you’re right about CDS and I’ve been blabbering about that for a while now. You’d probably find it laughable, but I wrote a bit about my thoughts here:
More on CDS, implied corporate leverage, and default rates
Here’s an excerpt:
“A logical next step following reduced easy credit is going to be increased default rates. This I think is going to severely test the CDS market (again nothing to do with subprime), especially when a default occurs on a company whose outstanding CDS protection exceeds the outstanding cash debt by factors of 10 or more. Even if the CDS is not settled physically, the cash needs to come from somewhere. Where will that be? What happens when the person you bought protection from defaults?”
Best wishes and thanks again for such an awesome blog.
In case you missed it, here is a recent Barrons article on ACS.
http://online.barrons.com/article/SB118619260136587979.html?mod=rss_barrons_features
The Barrons piece appears to suggest that some Wall Street firms are using CDS issued by ACS (and I assume others) to offset their subprime liabilities. The implication is that if the CDS issuers were to fail, these liabilities would reappear on their books. Its an oblique reference, so its hard to tell. My understanding is these are settled regularly (nightly?) so this risk may be overblown.
FWIW – the WSJ had a recent article on AIG stating that they had written $465 bln in CDS since 1998.
The lack of clarity here is remarkable. Same is true for CDOs, anything related to subprime, hedge fund investments, etc. Its hard to come up with a historical precedent other than the period before disclosure was the norm.
henny sender of the wsj had an article in last monday’s journal that touched on a similar theme — she noted that the failure of counterparties in indonesia and russia to honor commitments that the big money was using as hedges (why anyone thought the lcoal banks would be able to honor their commitments in a real crisis is another story) played a big role back then, and she noted that it is easy to sell protection now to pick up yield (lots of implicit leverage in such a position), and if the abiltiy of folks to actually honor their commitments ever became an issue, there could be problems.
bsetser
Thanks for these good comments and the links.
Eric, while the CDS market has been tested with a default in which the principal amount of the outstanding was 10 times the principal amount of the company’s cash bonds (Delphi), that was before the current credit fear.
Note that subprime-related paper has been marked down in advance of any/many failures to pay on the actual CDO tranches themselves. I similarly expect any CDS problems will be triggered not by a corporate default, but by the growing recognition that in many cases, the protection writer doesn’t have the wherewithall to make good on its commitments.
Scurvon,
Due to my absence, plus the fact that there is more to read than I can keep up with, I had missed the ACS story. I must confess I don’t get Barrons (heresy!) but I just checked out the related article on Reuters.
I’d be a bit surprised if ACS settled its own contracts frequently, since they are writing OTC agreements (or maybe that reference is to assure readers that they are current on the new CDS they are booking, unlike Citigroup, which has a backlog). Or alternatively, perhaps they are hedging with exchange traded contracts? Those are cash settled daily.
Brad,
Also missed that WSJ story. Thanks for pointing it out. My understanding is that, similarly, hedge funds have been protection writers to boost returns. And since this could be presented as a funding strategy (as a way to get further leverage) rather than an investment strategy, it’s quite possible that it is being done by funds whose strategies one would think are removed from CDS, like equity long/short.
Excellent thoughts. Non-US investors were fed so called AAA and took out insurance; who holds this bag?
Taking it from the volumes the core of the rat is in Europe and so far it is only far-flung speculation why Sarkozy wants to bring the ECB under the EU umbrella, making them a receiver of orders – just in case a Eurozone economy blows and/or its banks blow up.
Added you to my blogroll.
“I similarly expect any CDS problems will be triggered not by a corporate default, but by the growing recognition that in many cases, the protection writer doesn’t have the wherewithall to make good on its commitments.”
Maybe it will be BOTH corporate defaults AND a lack of commitments :)
I also wonder about credit card ABS. I think the days of rolling credit card debt over to 12 months 0% could also be coming to an end. Payment shock when mortgages reset is in the headlines, but what about credit card payment shock when the finance charges double?