The Other Derivative Problem

The story of how CDO investors were poisoned by the mortgage meltdown is old news – but Nathan Lewis points out that there is another derivatives party going on.

By now everyone can recite how crummy mortgages got packaged into asset-backed securities, and how, after the tastier tranches were sliced off, the meat by-products got sent along to the CDO sausage factory to be made palatable again. Now CDO investors are puking up all over town.

But there has been another derivatives party going on, where the bubbly is still flowing to a large extent. That, as many will relate, is the explosion in credit default swaps (CDS) that has appeared over just the past few years.

Structured finance has been around since the 1980s, but the CDS market is essentially brand new. The CDS was invented in the mid-1990s but it was minor until the last four years. Since 2003, this market has exploded in size by 10x, to a total notional amount of about $45 trillion. Yes, that’s trillion with a "t". This market has never been tested in any kind of economic downturn, not even the most recent one of 2001-2002.

The credit-default swap is insurance against a credit accident. The seller of CDS receives a small monthly payment. If the insured bond fails to perform, the buyer of CDS receives a large one-time payment from the seller. At first, in the 1998-2002 period, this was mostly a way for holders of bonds to insure themselves. However, in recent years, the CDS market has become a way for CDS buyers to wager on credit deterioration, and a way for CDS sellers to act like banks.

Banks are a wonderful business, when everything is working right. They have returns on equity that can range from 15% to as much as 25%. These are the kinds of returns that get hedge funds, and their investors, interested. However, it is difficult to enter the banking business. You need offices, branches, depositors, employees, advertising, and so forth.

Banks traditionally profit on the interest rate difference, or "spread", between the money they borrow, from depositors for example, and the money they lend, to corporations for example. They may lever up ten to one, supporting $100 billion of assets on $10 billion of equity. Thus, if their spread is 2%, and they are levered 10:1, their return on equity is a juicy 20% (actually more like 24% because of the return on the underlying capital).

The CDS contract allowed hedge funds to act like banks. The monthly premium on the CDS is a spread between the equivalent Treasury yield and the implied yield on the underlying bond. This can be considered payment for the risk of default, which the Treasury bond presumably does not have. Imagine you’re a fund with $1 billion in capital. You could try to borrow $9 billion – from whom? – and then buy $10 billion in bonds, and enjoy the spread, like a bank. However, that $9 billion would probably have a higher interest rate than a Treasury bond, because the fund also has risk. And, the maturity of the borrowed money would likely be very short, while the bond has a long maturity, introducing duration risk (this didn’t seem to scare the SIVs however).

The CDS solves these problems. You just sell CDS on $10 billion of bonds. This doesn’t cost any money. You don’t have to put up any collateral. You don’t have to hire a single bank teller or loan officer. You just call your broker, put in the order, and start getting your monthly payments, just as if you had borrowed $9 billion (at the same rate as the Federal government) and lent $10 billion.

And the fund manager who made this one single phone call? If we assume a 20% return, and $1 billion of capital, he collects about $60 million per year. Which explains the explosive growth of the CDS market in the last four years.

Ah, there’s something. You "call your broker." Actually, you call your dealer. It’s not so easy to just find a buyer for your $10 billion notional of CDS. This is an over-the-counter market. This is where the big broker-dealers, like JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC), and Citibank step in. Over-the-counter markets are lovely for dealers because of the fat spreads – there’s that magic word again that pricks up bankers’ ears – between bid and asked in this market. So, what happens is you sell the CDS to your dealer, such as JP Morgan? JP Morgan then sells CDS – of its own issuance – to its customers that want to buy CDS.

So, you see that JP Morgan now sits in the middle, like a banker should. JP Morgan is "long" the CDS you sold to them, and also "short" the CDS it sold to someone else, and is thus theoretically hedged from risk while collecting the spread between the prices it bought and sold at. This is a lot like bankers’ traditional business of pocketing the spread between the rate it borrows and the rate it lends.

So, it should be no surprise that the big broker/dealer banks (JP, BofA, Citi) account for 40% of the CDS outstanding. Hedge funds account for 32%. This reflects banks’ monkey-in-the-middle dealer strategy for CDS. The remainder is likely insurance companies, synthetic CDOs, CPDOs, and other weird fauna that will soon become extinct. (Thanks go to Ted Seides of ProtÈgÈ Partners for aggregating this information.)

Now, that 32% of CDS sold by hedge funds has a notional value of $14.5 trillion. This means that, if all those bonds underlying the CDS were a total loss, the funds would have to pay $14.5 trillion. Not very likely. However, if there were only a 5% loss – not so impossible these days – the CDS-selling hedge funds would still be on the hook for $725 billion. Hedge funds, all together, have estimated assets of around $2.5 trillion. However, only a small fraction of those are CDS-sellers. Let’s take a guess at 10%, or $250 billion of capital. (It’s probably less than that.) How do you pay a $725 billion bill with $250 billion of capital?

There’s an easy answer to that: you don’t. So, who pays? The banks, remember, are in the middle. If the CDS-selling hedge fund doesn’t pay up on its $725 billion, then the bank is unhedged regarding the CDS that it sold. In this case, the banks would be liable for $475 billion. This is known as counterparty risk.

That’s four-seventy-five billion. More than four times the entire capital of Citigroup – capital which has already come under pressure from losses elsewhere.

So, what happens if there is a CDS counterparty-risk event? Do the big banks go bankrupt? Probably not, although there would be much wailing and gnashing of teeth. Instead, they would probably get a nod and a wink from the government to simply ignore their own CDS obligations. The counterparty risk shifts to CDS-buyers.

The CDS buyers can take the hit, because they aren’t really out any money. They paid their monthly insurance bills, but never got a payout after the credit market car crash. So, in a sense, this drama would likely end in more of a whimper than a bang. In fact, everyone got off OK: the CDS-selling hedge fund manager made a killing in management fees, before the fund went bust; the bank made a killing in dealer income, before kissing their obligations goodbye, and the CDS-buying hedge fund manager raked in the fees on the enormous mark-to-market profits of his CDS portfolio (20% of the aforementioned $725 billion), before these profits were eventually shown to be uncollectible. A perfect Wall Street happy ending.

However, the kind of situation in which large banks ignore multi-hundred billions of legal obligations is very extreme. The last time something like that happened was in the early 1930s. At that time, they called it a "bank holiday," which has a nice festive ring. The celebration included a devaluation of the dollar, the first permanent devaluation in U.S. history. At least president Roosevelt had the good sense to repeg the dollar to gold at $35/ounce, parity it maintained until 1971. Feel free to make your own guesses as to what Paulson and Bernanke might try.


Nathan Lewis
for The Daily Reckoning
December 11, 2007

"It’s Tuesday, isn’t it? Isn’t Bernanke supposed to cut rates today? And isn’t the stock market going up in anticipation? Aren’t investors sure that the zoo keepers will always protect the animals and keep them happy?"

Yes to all of the above.

But to each question you could give a much longer answer…with plenty of nuances.

To the simple question: "What day is this?" for example. The answer depends on where you are.

"It’s Tuesday morning, mate," said an Australian colleague.

"What day is it in America?"

"It’s a day earlier…its Monday; we’re about 12 hours ahead."

"How could it be different days in different places? Isn’t time universal? Doesn’t it actually have to be the same moment everywhere at the same time?"

"No, no…it depends on where you are. Here, our workday will be over…it will be the next day…just as it is just beginning in America."

We’ve always yearned for the ability to read tomorrow’s newspapers today. Here in the antipodes, we can finally do it. We picked up the paper this morning – and read Tuesday’s news – while it was still Monday (at least in the U.S.A.).

What do we find? "Sub-prime fallout sinks $12 billion deals," says the local paper. You will find this in tomorrow’s news, dear reader: credit is getting crunched all over the world – including Down Under.

Tomorrow’s paper in America will tell us what the Fed is up to. But whatever it does, the answer to the ‘what happens next’ question depends on where you are…if you are at the beginning or the middle of a credit expansion, you get one answer. If you are at the end, you get a much different one…

*** We turn to our friends at The 5 Min. Forecast for their opinion on today’s Fed decision…

"38% of the economists in the U.S. agree with The 5 Min. Forecast…at least, according to a poll the Wall Street Journal published this morning.

"The poll says 38 out of 100 economists think the U.S. economy will be in recession in 2008. That number is up 5% from last month’s poll. The same group of economic thinkers also drastically lowered their GDP forecast for this final quarter of 2007, from an annualized 1.6% down to 0.9%.

"Of the economists surveyed, 96% think the Fed will cut rates today. Most say 25 points. The Fed makes their announcement at 2:15 this afternoon (EST). We’ll fill you in on the fallout from their decision tomorrow.

"But to fulfill our namesake: the Fed will cut 25 points, the market will rally briefly then stall, the dollar will sell off slightly. For the most part, this rate cut is already baked into price levels…"

*** "Well…which is it?"

We put yet another question, rhetorically, to a group of dear readers, in Melbourne last night.

The background for this question is as follows:

To Err is Human, we had told them. Mistakes are always being made. In a properly functioning economy, these errors are always being made…and corrected. People go broke. Investments go bad. Projects are cancelled…discarded…and rejected.

But in the last quarter century, interest rates were generally falling. This created a very forgiving economy. Mistakes were still made. But the cost of them went down. You could pay more for a house than you should have paid…but no problem; you could refinance at lower interest! And then, the price would go up – problem solved. Or, you could overpay for a stock. Again, falling interest rates were generally pushing up stock prices – you almost couldn’t lose.

Then, in the last six years, mistakes almost disappeared. People might have wanted to go broke – but lenders wouldn’t let them. The lenders kept showing up with more money! You could buy a house…or a Structured Investment Vehicle; no matter how big a mistake you made, you’d be rescued by easy money and rising asset prices.

Looking at the economy itself, as the flood of money gushed in…mistakes disappeared beneath the surface. Typically, in the United States, there was about one quarter of correction – with negative growth – to every four or five quarters of expansion. But more recently, the ratio of correction to growth fell to only one quarter out of every 19. Which was where our question began:

Either humans are less prone to error than they used to be…or there are a lot more mistakes in need of correction.

But we’ll have to explain this tomorrow. Today is already over here in Melbourne…stay tuned.

Until then,

Bill Bonner
The Daily Reckoning