Here comes the big one

by John Quiggin on February 17, 2008

My column in last week’s Australian Financial Review was about the spreading crisis in financial markets. In the same week, we saw the first indication* that the crisis was spreading to the market for credit derivatives. The possibility of a full-scale financial crisis arising from these markets, which financial market bears have been talking about for years. Whereas the losses from sub-prime loans and related derivatives markets are likely to be in the hundreds of billions, the nominal volume of outstanding contracts in the credit derivatives markets is in the tens of trillions, and interest rate swaps are in hundreds of trillions.

Such amounts cannot possibly be repaid by anybody, so a breakdown in these markets would imply either wholesale bankruptcy or a government rescue involving the abrogation of existing contracts on a scale unprecedented in history. Either way, as noted in the article, large classes of financial assets, and the associated financial markets, may simply disappear. Hundreds of trillions of dollars in derivative contracts may be unwound, reversing the explosion of asset and transaction volumes over the three decades since the Bretton Woods system of financial controls broke down in the 1970s.

The latest news from the US suggests that a recession in 2008 is highly likely, if indeed it has not already begun. Employment is falling, consumer confidence is slumping, and indexes of activity in the service sector, which accounts for the bulk of economic activity, have declined sharply. The housing sector is at the centre of the decline, as a wave of defaults on subprime and other nonstandard loans has produced the first nationwide decline in home prices since the Great Depression.

At this stage, it is impossible to forecast the length and severity of any recession. It is, however, safe enough to predict that the US economy will return to positive growth in due course. Within a few years at the most, income will surpass its pre-recession peak. If the recession brings about an unwinding of the massive imbalances in trade and capital flows that have built up over the past decade, it may even yield some long-term gains.

The picture is much less clear for the financial sector, the excesses of which have brought about the current crisis. The crisis has effectively killed the subprime loan market, and produced a drastic contraction in the associated market for mortgage-backed securities, and derivatives of those securities such as collateralized debt obligations (CDOs).

With residential mortgage-based CDOs now almost unsalable, concern has now focused on other credit derivatives. Delinquencies are already rising on CDOs backed by commercial real estate loans, and new issues of such CDOs have ground to a halt. The panic is now spreading to student loans, leveraged commercial loans and a range of collateralized loan obligations.

The cycle of default, downgrade and debt deflation has not stopped there. During the boom, so-called ‘monoline’ insurers which were supposed to confine their business to a single activity, the provision of guarantees for municipal debt, extended themselves to insuring the AAA status of mortgage-backed CDOs, many now worthless. As a result, the main insurers Ambac and MBIA seem certain to lose their own AAA ratings and therefore their capacity to write new business.

A new competitor established by Warren Buffett of Berkshire Hathaway may partially replace the existing firms, at least for municipal bonds. But, the capacity to turn risky debt into AAA-rated assets through insurance is unlikely to return any time soon.

The problems are even worse for the rating agencies that issue the AAA (and lower) ratings on debt. The value of agency ratings was cast into doubt in the stock market bubble of the late 1990s when they gave investment-grade ratings to shonky enterprises like Enron and Worldcom, providing no warning to hapless bondholders until it was to late to escape from the inevitable collapse.

In the epidemic of unsound and outright fraudulent lending that generated the current crisis, the availability of AAA ratings for dubious credit derivatives played a crucial role. Thousands of these assets have already been downgraded, and large-scale defaults appear certain.

The failure of ratings agencies has some implications for Australia. During the 1980s, the good opinion of the ratings agencies was taken as a critical indicator of national economic health. Even today, the economically dubious decision of the NSW government to sell its electricity asset has been sold on the basis of the supposed need to maintain the state’s AAA rating.

Given this massive demonstration of incompetence, the idea that US rating agencies should sit in judgement on Australian governments, none of which has ever defaulted on obligations to foreign creditors, is simply laughable.

With so many pillars of the financial system displaying weak foundations, it is natural to wonder how the problems will be resolved. The general assumption is that, as with the real economy, the financial sector may contract briefly during the coming year, but will then resume its rapid expansion.

But the scale of the problems now becoming apparent suggests that the financialisation of the economy has exceeded the capacity of financial markets to manage risk. If so, large classes of financial assets, and the associated financial markets, may simply disappear. Hundreds of trillions of dollars in derivative contracts may be unwound, reversing the explosion of asset and transaction volumes over the three decades since the Bretton Woods system of financial controls broke down in the 1970s.

Such a development would have some bad effects, in reducing the range of options available to households and businesses to manage risk. But it would also reduce the danger of dubious financial innovations undermining the stability of the financial system as a whole.

{ 57 comments }

1

Bush pilot 02.17.08 at 2:50 am

Well, I for one won’t mind the passing of the sub-prime mortgage market. Giving money to people with dodgy credit on the hope that asset prices forever increase doesn’t seem to be a sound business practice. Sorta like giving lots of equity capital to 23 year old internet entrepreneurs on the hope that they build something useful that customers will pay for before blowing through the money on video games and caffine.

As for Moody’s & S&P, their methodology was always out there for anyone to read … it appears that investment bankers, german industrial banks, and Japanese commercial banks didn’t read the report. Heck, a year ago Moody’s upgraded all three icelandic banks to AAA on the basis that the implied gov’t guarantee made them AAA. At the time, I believe that was more than the number of US AAA banks. Buyer beware, especially if the buyers were supposed to be professionals with a duty to due an ounce of due diligence.

2

Rich Puchalsky 02.17.08 at 3:04 am

Let’s see if I can predict wingnut thinking on this.

Of course, I have it, the same solution they have for everything: let’s start another war! All of these financial assets probably have an “in case of major war, contract no longer applies” reset button clause somewhere, right? Well then all it takes is a few nukes and everyone can start out with a clean slate and start selling again. Not to mention that with so much housing stock destroyed (and some judicious evacuations first to preserve consumers), the housing market will pick up. It’s win-win!

3

"Q" the Enchanter 02.17.08 at 3:12 am

Just cut taxes. That’ll fix it for sure.

4

DB 02.17.08 at 3:48 am

bush pilot, I for one wonder how many of the sub prime borrowers were speculators, for whom the crazy features of the subprime loans were attractive features rather than poorly understood bugs. They too made their decisions by betting on the come, represented by a hope for continued home price appreciation that would allow the property to be flipped at a considerable profit (rather than to be refinanced at a fixed rate with a comfortable margin of equity, which would be the hope of the dodgy high risk borrower). I’m not saying that there are not lots of people who are being hurt by loans that weren’t adequately thought through, but that’s not the entire story.

5

albertchampion 02.17.08 at 5:53 am

i urge you to tune into these sites…

lemetropolecafe.com

read antal fekete’s THE CRASH OF THE BANK OF THE UNITED STATES

bill buckler’s the-privateer.com

his latest, #597

these are subscription sites, but have so much more to offer than freelancing.

6

Tim Worstall 02.17.08 at 10:53 am

“Such amounts cannot possibly be repaid by anybody, so a breakdown in these markets would imply either wholesale bankruptcy or a government rescue involving the abrogation of existing contracts on a scale unprecedented in history.”

I’m a little confused here. These markets are zero sum games, aren’t they? Whatever is lost by one participant is gained by another? For example, the Soc Gen derivatives on European equities. Yes, Soc Gen lost € 7 billion, but other participants in the same markets made the same sum (minus market fees etc).

What is it that I’m missing here?

7

John Quiggin 02.17.08 at 11:17 am

In general, the process of defaulting on a debt or pursuing a defaulted debt involves some pretty substantial costs. For a simple illustration, look at the subprime housing fiasco. To be sure, some of the losses being incurred by lenders are gains to borrowers, and some lenders have charged margins high enough to be able to foreclose and still make a profit. But most foreclosures leave both borrower and lender worse off than if the transaction had not taken place.

With amounts as large as those in question here, it’s a much bigger deal. Suppose Bank A owes a trillion dollars to bank B which in turn owes a trillion to C which in turn owes a trillion to D which owes a trillion to A. Now suppose that A gets into liquidity trouble and can’t pay. Then B is similarly in trouble and so in turn are C and D. If D could cancel the debt to A and forgive C who would in turn forgive B and so on to A, all would be well. But in the normal course of business you can’t do that. The fact that its zero sum doesn’t help. You need either wholesale resor to bankruptcy or outside intervention.

8

GreatZamfir 02.17.08 at 11:35 am

Tim, I think your mostly right, and the ‘hundreds of trillions’ is mostly a result of double counting. But there might be some ways how problems here can spread to the ‘real’ economy. The most important one is probably simply that misjudgement of the value of these contracts somehow leads to real capital flowing to the wrong places, just as the whole mortgage CDO mess lead to sound capital being used to build houses people couldn’t really afford. But if the derivative market has lead to similar large-scale misinvestments, than I suppose the damage is already done, and a crisis would merely bring this to light.

But a crisis can have real effects if the result is a stop to financial trading when all trust in a class of contracts is lost, as the mortgage crisis already is producing. This might well hurt the good transactions just as hard as the unhealthy ones, meaning that people who need capital can’t get it.

9

GreatZamfir 02.17.08 at 11:54 am

John Quiggin:If D could cancel the debt to A and forgive C who would in turn forgive B and so on to A, all would be well.

Perhaps I am wrong, but I thought this is pretty much exactly what banks do everyday, at least under normal circumstances? Clearing and settlement of the debts between them?

10

John Quiggin 02.17.08 at 12:04 pm

The key phrase being “under normal circumstances”. Under normal circumstances, CDOs are liquid assets, and the process of matching and clearing is straightforward. But once holders start worrying about counterparty risk (the danger that the party on the other side of the deal won’t be able to meet their obligations) all this changes. Or rather, it’s all likely to change in unpredictable ways, since we’ve never seen a situation of this kind in markets of this scale.

11

John Cleary 02.17.08 at 12:07 pm

Tim Worstal,
No, unfortunately these are NOT a zero sum game.
For example certain types of contracts enabled BOTH PARTIES to recognise a “profit” on the transaction on signature.

How can that be?
It’s the Wild West of unregulated markets.

12

GreatZamfir 02.17.08 at 12:53 pm

So, it’s not the hundreds of trillions themselves that are the toruble, because in theory these would basically cancel out, but the frictions associated with a untidy cancelling process that are the real danger?

I suppose the ‘hundreds of trilions’ is to some extend a measure for the potential damage, but what order of damage corresponds to a given amount of outstanding contracts is unclear to me. It’s probably not linear, as in ‘a market with hundreds of trillions can do 1000 times the damage of a market with hundreds of billions’.

13

james 02.17.08 at 1:48 pm

Seems like the totality of CDS and monoline insurance is 0 sum in one sense. But the critical systemic risk must be the deviant distribution of the sum across individual positions. The biggest exposures would seem to be those with large net liability positions (mostly the monolines) and those with large gross asset positions (i.e. ‘book runners’ like hedge funds and banks who have hedged their CDS sales with purchases, but with large gross counterparty exposure on purchases.)

14

Alex 02.17.08 at 2:03 pm

It’s all very reminiscent of JMK’s writings post-Economic Consequences of the Peace; essentially the problem is that everyone has ended up owing each other huge sums of (inflated) cash, so much so that no one actor can pay their debts down without calling in their loans to others.

For Citigroup, Morgan Stanley, IKB, et al substitute the UK For subprime MBS substitute Russian and Romanian sovereign paper. For CDOs, SIVs, CDO Squared and the like sub French and Italian government debt. For Citi stock sub sterling.

15

Balak 02.17.08 at 3:00 pm

“the nominal volume of outstanding contracts in the credit derivatives markets is in the tens of trillions, and interest rate swaps are in hundreds of trillions.

Such amounts cannot possibly be repaid by anybody…”

This was enough to tell me that the writer of this article is either a complete idiot, or merely counting on total financial illiteracy on the part of his readers. ‘Nominal’ value has nothing to do with repayable amounts.

16

sam 02.17.08 at 4:09 pm

None of this discourse matters. We are all screwed plain and simple. Our children and childrend children are screwed. ( trillion in debt and counting. Bill the gvt cant pay. Lets bring it down to simple terms. USA = Rome.

17

sam 02.17.08 at 4:14 pm

DAVID WALKER THE CHIEF COMPTROLLER FOR THE GAO RESIGNED (fired) for his speaking out on the hirrible mess we are in. watch the vidoes. Very enlightening

http://news.yahoo.com/s/afp/usgovernmentcongressquit

http://www.youtube.com/watch?v=I-16u9x3tfE

18

sam 02.17.08 at 4:17 pm

http://en.wikipedia.org/wiki/David_M._Walker_%28U.S._Comptroller_General%29

Walker has compared the present-day United States with the Roman Empire in its decline, saying the U.S. government is “on a ‘burning platform’ of unsustainable policies and practices with fiscal deficits, chronic healthcare underfunding, immigration and overseas military commitments threatening a crisis if action is not taken soon.[2] [3] [4]

Walker has actively taken a public stance against the accumulation of massive federal budget deficits and public debt. He has participated in community lectures through an effort organized by the Concord Coalition, in a set of public appearances known as the “Fiscal Wake-Up Tour.” This has consisted of a series of trips acros the country, along with Robert Bixby, director of the Concord Coalition, in which a group of speakers make presentations in various communities regarding the size and impact of the US National Debt. This has been chronicled in the 2008 film, I.O.U.S.A..

19

cold in my car 02.17.08 at 4:42 pm

Northern Rock to Be Nationalized By U.K. Government (Update2)

By Loveday Morris

Feb. 17 (Bloomberg) — Northern Rock Plc, the U.K. bank bailed out by the Bank of England, will be nationalized after efforts to sell the struggling bank to a private company failed, a person familiar with the matter said.
http://www.bloomberg.com/apps/news?pid=20601087&sid=ak7ihPj0e160&refer=home

20

cold in my car 02.17.08 at 4:43 pm

well gosh darn. AN LBO is happening that will be oversubscibed. all is good, we can all rest now.

http://www.marketwatch.com/news/story/hsbc-raise-42-bln-debt/story.aspx?guid=%7BB1B0C302%2D3FE8%2D490E%2DB17E%2D1CC30CF964ED%7D&siteid=yahoomy

21

Ken 02.17.08 at 5:16 pm

Are you saying a financecialized economy based on trading debt for profit has no future?

22

dian 02.17.08 at 5:22 pm

A first step in the USA would be immediate readoption of Glass Steagall, the 1933 Banking Emergency Act that placed a legal firewall between insurance, banking, and securites industries in response to the 1929 Stock Market Crash brought on by rich speculators. This firewall was repealed in 1999 when after almost 20 years, enough Ds and Rs in the US Congress and Executive Branch repealed this 66 year old law enacted under FDR.

I believe this is at the crux of the entire d*mn mess but noone has even mentioned it! Time to hold those responsible for its repeal accountable including Citigroup and Traveller’s Insurance. It was only a matter of a few years before the unleashed ogres of greed wrought havoc to the world’s financial markets.

23

Joe S. 02.17.08 at 5:28 pm

I am more inclined to side with GreatZamfir and Balak than John Quiggin. The financial community has spent the last 25 years ensuring that close-out netting contracts are legally enforceable, notwithstanding bankruptcy, in every major jurisdiction. If somebody goes broke, the enormous notional principal values will net into something far smaller. Illiquidity-without-insolvency is possible (e.g., Northern Rock), but dubious, especially for the money-center banks with the enormous derivatives positions. Even if it happens, we get close-out netting again.

Close-out netting represents large losses to the defaulting party–possibly 1 or 2 percent of notional principal value. That’s nasty, but we’ve seen plenty of multibillion dollar losses over the last few months. It ain’t Armageddon.

24

abb1 02.17.08 at 6:08 pm

Yeah, not the the end of the world, people tend to overdramatize. Rome, schmome. If there’s any institution the-powers-that-be are invested in – that’s a well-functioning economic system. They’ll fix it somehow.

25

Billy 02.17.08 at 7:11 pm

Here’s some interesting reading from the Washington Post, written by the Governor of the state of New York. It discusses the Bush administration’s participation in the creation of the sub-prime mortgage mess we have before us now.

Predatory Lenders’ Partner in Crime

How the Bush Administration Stopped the (USA) States From Stepping In to Help Consumers

http://www.washingtonpost.com/wp-dyn/content/article/2008/02/13/AR2008021302783.html

By Eliot Spitzer
Thursday, February 14, 2008

26

luci 02.17.08 at 8:11 pm

I’m sure Mr. Quiggin is aware that net exposure is a tiny fraction of the nominal contract amounts outstanding. Looks like he was using that as a rough gauge of the magnitude of the potential problems in credit derivatives/swaps, as compared to the problems we’re already experiencing from the relatively smaller markets for mortgages/MBS/CDOs.

Hundreds of trillions of dollars being several times the output of the planet.

And like others said, the distribution of the risk is surely not even.

27

John Quiggin 02.17.08 at 11:04 pm

Let’s separate the issues:

1. Does a market like this work to net out exposures under normal conditions? – Yes

2. Can a market like this ever fail? – Yes, the most recent instance is the market for auction-rate securities which locked up recently, rendering supposedly liquid assets unsalable

3. Will the credit default derivatives markets fail in this way? – as the post says, it’s now more likely than before, but no one knows

4. The big question: in the event of failure, does the gross volume of outstanding contracts matter? – Yes, the volume of auction rate securities is about $300 billion, so solvent but illiquid participants can unwind their positions, at a cost, by borrowing from banks, as many are now trying to do. With larger amounts, say up to a few trillion, governments can perform a bailout, assuming the liabilities themselves. But neither of these options is available when gross positions are in the tens of trillions.

28

GreatZamfir 02.18.08 at 8:19 am

John, I see your point. But still, the amounts people would have to borrow to unwind their positions would be significantly smaller than the nominal value of the contracts. For derivatives, I thought contracts usually didn’t require parties to actually hand over the underlying, just to pay the difference between strike price and market price. For swaps it would be the difference between the cash flows derived from the nominal value.

If that’s the case, then the amounts to borrow to unwind positions would be at least an order of magnitude lower than the nominal value.

Note that I am not arguing here, I know definitely not enough about these kinds of things to argue. I am just trying to get a fix on the amounts really involved.

29

John Quiggin 02.18.08 at 11:30 am

A fair point, but of course an order of magnitude less than hundreds of trillions is still tens of trillions.

30

shteve 02.18.08 at 12:32 pm

Plenty of excellent blogs out there (ALL American, God bless ‘em!) that focus on whether or not the system is heading for deflation owing to the destruction of credit.

My favourites:

http://suddendebt.blogspot.com/

http://globaleconomicanalysis.blogspot.com/

http://wallstreetexaminer.com/blogs/winter/

Econo-bloggers are an interesting phenomenon (once you learn how to avoid the gold bugs).

31

Ginger Yellow 02.18.08 at 12:44 pm

With residential mortgage-based CDOs now almost unsalable, concern has now focused on other credit derivatives. Delinquencies are already rising on CDOs backed by commercial real estate loans, and new issues of such CDOs have ground to a halt. The panic is now spreading to student loans, leveraged commercial loans and a range of collateralized loan obligations.

The “panic” spread a long time ago. There have been hardly any CLO issues since August, and the European market for all asset backed issues is basically shut (two deals this year, both from the same issuer). The big issue in the CLO market isn’t so much worries about the underlying collateral, although it doesn’t help, it’s a) that liability costs have increased dramatically, reducing returns for equity investors, and b) the triple-A paper was mainly bought by banks looking to do negative basis trades with the monolines, and that arbitrage disappeared when the monolines blew up.
In Europe it’s less credit based fear than liquidity and price volatility, but it’s very real.

The failure of ratings agencies has some implications for Australia. During the 1980s, the good opinion of the ratings agencies was taken as a critical indicator of national economic health. Even today, the economically dubious decision of the NSW government to sell its electricity asset has been sold on the basis of the supposed need to maintain the state’s AAA rating.

Given this massive demonstration of incompetence, the idea that US rating agencies should sit in judgement on Australian governments, none of which has ever defaulted on obligations to foreign creditors, is simply laughable.

There’s a much more direct impact – non-bank lenders in Australia are huge users of securitisation, and most of the investor base for those securitisations has disappeared. The volume of Aussie mortgage securitisation since August has dwindled to about A$2bn, which used to be one largish deal. And of course the lenders have had to put up their rates.

Also, why the parochialism? Would international investors really be more confident in an Australian rating agency’s judgement? They all use more or less the same analytical techniques (with differences at the margin, eg the Icelandic bank furore). Also, while the triple-A rating helps, it’s much less important for states than it is for institutions. Sovereign bonds are traded in a class of their own, and their price depends more on macro-economic issues and other sovereign bonds than it does on how other triple-A bonds are performing.

32

Ginger Yellow 02.18.08 at 12:46 pm

By the way, Bush Pilot, Moody’s dropped the Icelandic banks’ triple-A rating back in April.

33

Joe S. 02.18.08 at 4:51 pm

Great Zamfir at 28:
There are derivatives and derivatives. Some derivatives require “physical” settlement: tender of something other than cash by one of the participants. Other derivatives are cash-settled. Cash settlement sounds more rational, but since the cash value is set by some index, it is more subject to manipulation.

All derivatives are cash-settled if one of the parties defaults. Here, the index is not a public one like the S&P 500, but instead is a number provided by several friends of the non-defaulting party. (I’m not kidding; look at an ISDA contract.) The cost of default, then, can be substantial, because the defaulting party must settle at a price very favorable to the nondefaulting party.

John at 29:
Gross does not matter unless the close-out netting arrangement is not honored by the court. I think we are fairly safe in most jurisdictions, although your mileage may vary. (FWIW, IAAL.) However, as I said to GreatZamfir, the cost of default can be very high. This has no particular systemic implications unless one of the big banks in the derivatives counterparty business defaults.

34

Great Zamfir 02.18.08 at 5:14 pm

Thanks, Joe S. Do I understand correctly that you are mainly saying that the derivative and swap market could lead to very large redistributions within the financial sector, including bankruptcies, but that this would have little effect outside of the financial world?

On you note about big banks, isn’t John’s point that given the sizes of the positions, even big banks could be at risk? That is, if they are misjudging their positions only the slightest amount, and an unwinding of positions happened fast enough, their bankruptcies would be possible, with serious effects on the ‘real’ economy?

I used to be very sceptical about this, but the subprime crisis and the SocGen scandal offer two different ways how even the largest banks can misjudge their actual position.

35

Ginger Yellow 02.18.08 at 5:46 pm

Credit default swaps, which is what we’re talking about with the monolines, are almost always physical settlement.

36

robd 02.18.08 at 7:21 pm

I think the big problem is that banks A, B, C and D (in J.Q.’s comment 7)
don’t know if their claims are worth a billion dollars; not the other claims, and not their own.
So they don’t know if cancelling out will be zero-sum; so they don’t dare to do it…

37

John Quiggin 02.18.08 at 9:39 pm

#35 As I understand it, that’s part of the problem.

The gross volume of credit default swaps exceeds the actual volume of outstanding debt, so physical settlement is problematic, as in the case of Delphi.

38

Joe S. 02.19.08 at 1:27 am

Great Zamfir,
If a major bank goes under, it may well have consequences to the real economy. There are a lot of people who rely on continuing credit from banks. Their lines of credit go kaput when their bank goes under. If they are small businesses, it is difficult to find other banks to pick them up. (Credit information is much better for consumers.) The English Midlands textile industry was murdered by the BCCI insolvency, because BCCI was the bank of many of these folk.

Big banks could easily afford a few customers’ unwinds. If enough customers are in trouble, they are in trouble, even though they stand to benefit from defaults on derivatives contracts.

I’m not too worried about liquidity, at least for the big guy. To me, the question here is whether banks have the capital to withstand the hits they are going to keep taking over 2008. They have lots of capital. But they will be taking many hits: derivatives, credit, securitizations, dealflow, etc. It’s a log snoggle.

39

Bukko in Melbo 02.19.08 at 7:33 am

Let me add my backing to that globaleconomicanalysis site. The guy behind it, “Mish,” is several leaps ahead of the pack on all sorts of financial issues. No disrespect meant to John, but all of what he said in this post has been laid out months ago on Mish’s site. He came to the same conclusions as John, just faster.

I’d advise checking it out. (No, I have no connection to it, other than as a reader.) It’s free, people post a lot of interesting links in the comments, but it does have a subset of those gold bugs that must be avoided. It’s U.S. focused, but also touches on Aussie issus.

One question that another commenter asked me about Oz finance, which I could not answer, is WHY Australian banks dabbled so much in dodgy U.S. CDOs. It’s not as if there weren’t profitable investments here. I haven’t been able to find any logic why ANZ etc. would take flyers on shonky seppo paper. Any ideas?

40

lemuel pitkin 02.19.08 at 4:17 pm

With larger amounts, say up to a few trillion, governments can perform a bailout, assuming the liabilities themselves. But neither of these options is available when gross positions are in the tens of trillions.

John, what practical obstacle would prevent the U.S. government, if it wished to, from buying up whatever quantity of bad assets is necessary to resolve the crisis?

41

Ginger Yellow 02.19.08 at 6:00 pm

“One question that another commenter asked me about Oz finance, which I could not answer, is WHY Australian banks dabbled so much in dodgy U.S. CDOs. “

They didn’t. ANZ, CBA and Macquarie and NAB all say they have no direct exposure to US subprime RMBS or CDOs. They do have corporate loan exposure, for example to Countrywide. And they have a lot of indirect exposure to the fallout from the subprime RMBS/CDO mess.

42

John Quiggin 02.19.08 at 10:12 pm

Lemuel, there would be nothing to stop the US government issuing trillion-dollar notes in the required quantity. But doing so would run the risk of hyperinflation.

43

burritoboy 02.20.08 at 1:35 am

Uh, no, guys. Go to the close to idiotic globaleconomicanalysis website where Mish suggests the same thing and read the comments by a fellow naming himself “cds trader”. He’s right, and Mish (and John, though John makes a more macro and generally better thought-out argument) are simply incorrect.

1. The large notional value of credit derivatives, for instance, is misleading. Since it’s a derivative, the longer the derivative exists (generally) the lower it’s real value – because the underlying bond or occurance hasn’t yet happened and now simply has less time to happen. (Of course, on a specific company or event level, the circumstances might be that that particular company or event has weakened, bringing that particular bond or other closer to happening. But that’s not systemic – older derivatives will, as a group, be less valuable). Some of notional value of derivatives are actually more or less defunct stuff from years back that have little real value now.

2. You only have to physically deliver on CDS when the underlying bond actually, really defaults. Not when the bond is stressed, not when the company has a bad earnings report, not when the company has financial problems, not when the rating is lowered. It won’t (much) matter that, say, a muni bond’s rating is lower because the insurer of that muni goes bankrupt – the muni itself is closer to default (now that it lacks insurance) but the default rate of the muni is still probably quite low.

Will the default rate go up? Probably. But the physical settlement will actually only occur comparatively rarely (unless we’re asserting the economy will simply collapse, in which case we have plenty of more pressing problems).

And, of course, the occurance of companies or entities defaulting on their debt that underlies the CDS is somewhat idiosyncratic – GM may default, but Ford doesn’t. Or they both do, but in different years. Etc.

3. There are many flavors of credit derivatives. CDS are not really much like CDO’s, for instance. Interest-rate derivatives are not much like CDS or CDO’s.

4. The only real concern is if bad directional bets exist in a concentrated form somewhere within the system. I.E., that the banks are all very net long credits when the underlying credits are defaulting and the hedge funds are all net short. Or the insurers are all particularly net long, etc. This WAS the case with mortgage derivatives since the banks were the issuers / suppliers / servicers of those mortgage derivatives and made guarantees to clients about some of those mortgage derivatives – guarantees that are usually not common with other derivatives. That particular cause is not necessarily the case with other classes of derivatives.

5. The only real question is counterparty risk IF bad directional bets are highly concentrated somewhere within the system but especially so within the largest American money-center banks. While it’s certainly possible that bad directional bets are concentrated there within the system, it has to be this scenario to really be a major worry. Generally, the bank’s philosophies on CDS is (or, at least, was) to use them as hedges against their long exposure (their long exposure from the actual outstanding loans). Thus, those books should be relatively well-hedged. Other entities (hedge funds, but others as well) traded all sorts of strategies, but the collapse of a hedge fund (even an entire class of hedge funds) isn’t the problem that a collapsing bank system is. (And if the hedge funds bet wrong, that may actually rebound to the benefit of the banks, if the banks are on the other – the right- side of the hedgies’ wrong bets. Of course, that also hinges on who exactly supplied what leverage for those collapsed hedge funds.)

6. Now, if the banks used their CDS trading book as a seperate profit-making center, then that book could decline in value – but largely from bad bets (not probably outright defaults, since they’re fairly rare and idiosyncratic) that any trader could make, whether they’re working at a bank, hedge fund or any other trading desk. Again, the only huge worry here is if the banks’ trading books were all effectively betting the same wrong way. But that has little to do with the derivative markets’ size(s) or that they are derivatives, but just a critical part of the financial system making concentrated bad bets (just like making bad outright loans to South American countries in the Seventies, for instance).

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John Quiggin 02.20.08 at 7:23 am

These are all good points burritoboy, and as I’ve already said, I didn’t intend to imply that the failure of the subprime CDO market and now the auction rate market necessarily implies a breakdown in the credit default market, let alone the interest rate swap market. As you say, there are all sorts of differences between markets, and balancing forces present in the swaps market that are absent in others.

But I don’t think any of that amounts to “No need to worry”.

I agree that a breakdown in the credit default swap market would require both a spike in actual defaults and a big increase in counterparty risk, say because of actual or threatened insolvency of one or more money-center banks.

As you say, some increase in defaults is virtually certain at this point, and the volume of outstanding securities is far larger than last time this happened back in 2001. I don’t think anyone knows how big an increase in defaults would be needed to generate substantial stress in the market as a whole.

As regards failure of a money-center bank, I agree that still looks unlikely, but I think its far from impossible. Suppose that two or three of the shocks we’ve seen recently (“rogue” traders (or maybe scapegoats for failed internal controls, unexpected writedowns, failure of a subsidiary) hit one of them at once, and the governments involved mucked up the regulatory response.

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Ginger Yellow 02.20.08 at 10:31 am

“You only have to physically deliver on CDS when the underlying bond actually, really defaults”

Technically, delivery happens after one of a number of defined “credit events”, including but not limited to default. You’re right that simple financial stress isn’t enough, but depending on the nature of the underlying (eg investment grade corporate bond, high yield corporate bond, corporate loan, asset backed security), non-default events include restructuring and bankruptcy.

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Ginger Yellow 02.20.08 at 10:32 am

Incidentally, I’m very curious to find out what happens to CDS hedges banks have taken out on monolines if they split up their muni and structured finance businesses.

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Bukko in Melbo 02.20.08 at 12:06 pm

Thanks for the perspective, Ginger. I hope it’s true, what the Aussie banks say about their exposure. I have my local money in CBA, and there’s no FDIC insurance here!

And Burritoboy, you find Mish close to idiotic? I thought his overall analysis is shrewd, but I could be wrong. I’m no financial genius — I couldn’t follow the half of what you said — but I was astute enough to sell out of the U.S., move my money to a friendly European country known for its chocolate and emigrate to Australia. (Years before I ever heard of Mish.)

If you have a moment, could you elaborate on why you think Mish (not that CDS Trader commenter) is on the nose? Here I’ve been feeling smug because his doom-laden scenario mirrors mine. You think perhaps the future is NOT black? Mate, I’m bummed!

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Ginger Yellow 02.20.08 at 12:50 pm

” I have my local money in CBA, and there’s no FDIC insurance here!”

Seriously, don’t worry. Even banks with huge exposures like Citigroup aren’t in any real danger of going bust. And the big Australian banks weren’t even dependent on the securitisation market for funding, so the impact on them is much more limited than on non-bank lenders. They did a fair bit of securitisation for capital and funding diversification purposes pre-Basle II, but there’s much less incentive for that now. I suspect that by far the main impact of the crisis on the big four was having to provide liquidity support to ABCP conduits, and even that’s something that affected smaller institutions more.

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burritoboy 02.20.08 at 4:40 pm

“Just as housing became a one way bet, so did bets on corporate bonds.”

He’s talking about the CDS market, which is a necessarily win/lose bet. I.E. he doesn’t understand the basics of what he’s talking about.

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Ginger Yellow 02.20.08 at 4:57 pm

FWIW, there’s an intersting article by a partner at Linklaters on settlement/delivery issues in monoline CDS here.

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John Quiggin 02.20.08 at 8:49 pm

Thanks for that reference, ginger yellow. The statement at the end “counterparties that have bought credit protection on monolines as a hedge against their exposure to those monolines under an insured credit default swap will not be able to Deliver that CDS to the protection seller under the monoline CDS. They will instead have to find a monoline-insured obligation meeting the definition of “Borrowed Money” to deliver.” supports the general view that default by the monolines could be probablematic for the CDS market.

And I agree that the proposed split between muni and other businesses is exceptionally problematic, since it leaves the buyers of non-muni insurance in a single toxic pool, when they thought they were joining a much larger and safer pool. In fact, I would say it marks a step towards the kind of abrogation of existing contracts that will be required in the event of a larger breakdown.

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Ginger Yellow 02.20.08 at 10:41 pm

I spoke to the lawyer earlier today, and he said some interesting things. One, he said that he’d heard there was unlikely to be an industry agreement to set up a cash settlement protocol to resolve the deliverables issue, but he wasn’t sure what the source of resistance was. Two, he said that if the existing capital of the monolines was transferred to the “bad bank” in a split, and the “good bank” was funded entirely with new capital, this would probably be enough to prevent successful lawsuits. As for the CDS split I mentioned earlier, it depends on the proportion of deliverable obligations – if between 25% and 75% of them go to the muni bank, then the original CDS is split 50/50. Otherwise, it succeeds in toto to the predominant “bank”.

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John Quiggin 02.21.08 at 3:49 am

But if they are going to set up a “good bank” with entirely new capital, they might as well have accepted Buffett’s buyout offer, which would have done the same thing. Admittedly, his price was a bit sharp, but presumably bargaining would have produced an outcome as good as can be achieved with the split, and with much less risk of something going wrong.

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nnyhav 02.21.08 at 1:43 pm

Felix Salmon has more on the Morgenson piece as well (hardly the first indication of crises in either credit derivative markets or gretching interpretation thereof).

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Ginger Yellow 02.21.08 at 3:51 pm

“But if they are going to set up a “good bank” with entirely new capital, they might as well have accepted Buffett’s buyout offer, which would have done the same thing. Admittedly, his price was a bit sharp, but presumably bargaining would have produced an outcome as good as can be achieved with the split, and with much less risk of something going wrong.”

Not at all. From the market’s perspective, Buffett’s plan is probably the best proposed so far, but from the monoline’s perspective it’s one of the worst. A split allows them to keep their existing book and keep doing new business. Buffett’s plan would have deprived them of their existing book at an expensive price, given their dangerous new competitor huge market share instantaneously, and left them with less hope of doing new business in municipal finance. If they’d accepted it their shareholders would probably have sued.

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John Quiggin 02.21.08 at 8:19 pm

I guess my point should really have been directed at the regulators like Dinallo(?) who seem to be pushing the split plan.

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Ginger Yellow 02.21.08 at 9:28 pm

Most people I speak to think Dinallo’s pushing of the split option was/is a stick to persuade the banks to bail out the monolines, and possibly the monolines to try harder to raise capital. He has stated that the preferred option is to keep the monolines as single entities.

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