Tuesday, September 29, 2009

Credt Default Swaps and Counterparty Risk

This is a summary of a recent publication by the European Central Bank on the topic of credit default swaps and counterparty risk. It is a worthwhile reading. Given that the length of the paper is somewhat extensive, I have provided a brief report of its content. The full version of the paper can be read here.


· Credit default swaps (CDS) are bilateral contracts that work similar to insurance policies. A purchaser of a CDS agrees to pay a periodic fee (i.e. premium) and/or an upfront payment in exchange for a payment by the CDS seller in case of a credit event (e.g. bankruptcy, credit downgrade, etc.) in the underlying reference.

· In terms of notional amounts outstanding, CDS comprises about 7% ($42 trillion) of total OTC derivatives as of year-end 2008. Interest rate swaps are the lion’s share of OTC contracts.

· In terms of gross market value, which considers the cost of replacement, CDS grew from $133 billion in December 2004 to approximately $5.7 trillion in December 2008.
Several key observations:

· High concentration of CDS dealers. The top 5 firms comprised approximately 50% of the total outstanding notional amount according to DTCC data. Four are ANC firms: JP Morgan (#1), Goldman Sachs (#2), Morgan Stanley (#3), Barclays Group (#5).

· CDS market has come to demonstrate a high level of interdependence (i.e. connection), which manifests itself in various ways:
(1) Market values of financial firms tend to fluctuate together.
(2) There is an increasing correlation between counterparty and reference entities (e.g. a bank that received government assistance and at the same time sold CDS on the sovereign credit risk of the country that is domiciled—this is known also as “wrong-way risk”).
(3) It was noted that less important CDS players in fact turned out to be critical for the market, as their failure would have severely impacted the “too big to fail” firms (e.g. AIG and its counterparties).

· Circularity of risk. This term relates to when national governments provide economic support to financial institutions. This results in the latter firms being stabilized, however the national government’s additional burden increases sovereign risk; thereby increasing the risk for bank.

· A CDS has a call-type option for the defaulting counterparty. That is, the increase in the contract’s market value is a benefit for the defaulting counterparty. The party suffering the loss typically uses 3 approaches to minimize this risk:
(1) Price the CDS to consider counterparty risk. This may entail different price for each counterparty.
(2) Hedge in such a way to consider the counterparty defaulting during the life of the CDS. (3) Require collateral to cover replacement cost. · Collateral is the primary way for firms to manage this risk. In a CDS framework, CDS buyers receive collateral when spreads are widening and vice-versa when spreads are declining.

· Unlike other OTC derivatives, CDS contain both credit and counterparty risk.

· What makes CDS particularly risky vis-√†-vis other derivatives is the credit risk distribution of the underlying reference entity is skewed (i.e. non-symmetric). As a result exposure levels during market turbulence for the CDS buyer from the CDS seller could increase significantly. This could cause potentially enormous payouts from the latter to the former. In such instances not only counterparty risk is an issue but also liquidity risk.

· CDS markets are used as price indicators for other markets, including loan, credit, and equity markets.

· CDS spreads tend to lead changes in bond spreads in the short run.

· In theory, CDS spreads should provide a pure measure of default risk.

· A rough approximation of CDS spreads = (PD)*(1 - recovery rate) = PD*LGD.
PD = Probability of Default
LGD = Loss Given Default

Research demonstrates that PD and LGD may be cyclically positive correlated, implying that during economic downturns recovery rates suffer disproportionally in relation to PD, which will ultimately increase CDS spreads. Systemic risk can also negatively affect spreads.

· In abnormal market conditions, there is a breakdown in the interrelationship between CDS market and the underlying cash bond market as a means of reference pricing. Cash market reflect credit risk and funding risk, whereas the CDS market focuses on credit risk and counterparty risk. This mismatch has been attributed to periods of reduced liquidity.

Thursday, September 17, 2009

Some fires are best left to burn out

By William White
Published: September 16 2009 19:01 (Financial Times)

[Note: The writer is former economic adviser, head of the monetary and economic department at the Bank for International Settlements.]

Forest fires are judged to be nasty, especially when one’s own house or life is threatened, or when grave harm is being done to tourist attractions. The popular conviction that fires are an unqualified evil reached its zenith after a third of Yellowstone Park in the US was destroyed by fire in 1988. Nevertheless, conventional wisdom among forest managers remains that it is best to let natural forest fires burn themselves out, unless particularly dangerous conditions apply. Burning appears to be part of a natural process of forest rejuvenation. Moreover, intermittent fires burn away the undergrowth that might accumulate and make any eventual fire uncontrollable.

Perhaps modern macroeconomists could learn from the forest managers. For decades, successive economic downturns and even threats of downturns (“pre-emptive easing”) have been met with massive monetary and often fiscal stimuli. This was the case when the global stock market crashed in 1987, and it was repeated when the property boom in many countries collapsed in the early 1990s. Interest rate rises were put on hold during the Asian crisis of 1997, even though traditional indicators said some industrial countries were overheating. Rates were then sharply reduced in 1998, after the collapse of the hedge fund Long-Term Capital Management, and were lowered again when the stock market collapsed in 2001. Today, policy rates in most industrial countries are close to zero, in response to the financial crisis.

What needs reflection, against this backdrop, is whether the policy reaction to each successive set of difficulties laid the foundations for the next one. Worse, the encouragement by lower interest rates of debt accumulation and spending imbalances was the equivalent of undergrowth accumulating in the forest. This undergrowth not only made subsequent downturns more dangerous; it also made the available policy instruments less reliable in response. Looking back over successive cycles, interest rates have had to be reduced with ever more vigour to get the same (and sometimes reduced) response from spending. Most recently, new and untried policies such as quantitative and credit easing have had to be introduced. Logically, the end point of such a dynamic process would seem to be the mother of all fires and few if any means of resistance.

The current Keynesian mindset rightly observes that we have a shortage of aggregate demand. It then concludes that demand stimulus, from whatever quarter, is to be welcomed. However, in addition to the undergrowth problem on the demand side, we can also have an undergrowth problem on the supply side. This was the core of Friedrich Hayek’s position when he debated Keynes in the early 1930s. In response to demand stimulus over recent decades, with investors implicitly assuming that the future would be like the recent past, there has been a massive increase in supply potential in many industries. The upshot is that many of them are now too big and must be wound down. This applies to automobile production, banking services, construction, many parts of the transport and wholesale distribution industries, and often retail distribution as well. Similarly, many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them.

In this supply side context, policies such as “cash for clunkers” and value added tax cuts in countries with very low household saving rates and massive trade deficits are clearly suboptimal. So too, in countries with large trade surpluses, is resistance to exchange rate appreciation along with a continuing reliance on export demand. Such policies are equivalent to trying to resuscitate a patient long since dead. Not only will time prove that such attempts are futile, but they also impede the desirable adjustment from declining industries to those that should be expanding. In effect, relying solely on macroeconomic stimulus may well head off a more violent downturn, but only at the expense of a more protracted recession. Maybe this is the principal lesson to be drawn from Japan’s almost two decades of sub-par performance. Indeed, resisting structural adjustment could also imply a decline in the level of “potential growth” in the years ahead. This would bring with it the threat of a stagflationary outcome, if the demand stimulus from Keynesian policies were not to be adjusted downwards in consequence.

Where to go from here? In terms of future crisis management, governments should give more weight to the longer-term implications of their policies. Those that threaten to make future crises more costly, or that impede required structural adjustments, should be moderated. Such inter-temporal trade-offs imply, from time to time, accepting a temporary economic downturn to avoid even bigger future costs. In this sense, good crisis management also contributes to crisis prevention.

But still more might be done with crisis prevention. Just as good forest management implies cutting away underbrush and selective tree-felling, we need to resist the ­credit-driven expansions that fuel asset bubbles and unsustainable spending patterns. Recent reports from a number of jurisdictions with well-developed financial markets seem to agree that regulatory instruments play an important role in leaning against such phenomena. What is less clear is that central bankers recognise that they might have an even more important role to play. In light of the recent surge in asset prices worldwide, this issue needs urgent attention. Yet another boom-bust cycle could have negative implications, social and political, stretching beyond the sphere of economics.

Tuesday, September 8, 2009

Why some economists could see the crisis coming

By Dirk Bezemer
Published: September 7 2009 (Financial Times)

(Note: The writer is a fellow at the economics and business department of the University of Groningen in the Netherlands).

From the beginning of the credit crisis and ensuing recession, it has become conventional wisdom that “no one saw this coming”. Anatole Kaletsky wrote in The Times of “those who failed to foresee the gravity of this crisis” – a group that included “almost every leading economist and financier in the world”. Glenn Stevens, governor of the Reserve Bank of Australia, said: “I do not know anyone who predicted this course of events. But it has occurred, it has implications, and so we must reflect on it.” We must indeed.

Because, in fact, many had seen it coming for years. They were ignored by an establishment that, as the former Federal Reserve chairman Alan Greenspan professed in his October 2008 testimony to Congress, watched with “shocked disbelief” as its “whole intellectual edifice collapsed in the summer [of 2007]”. Official models missed the crisis not because the conditions were so unusual, as we are often told. They missed it by design. It is impossible to warn against a debt deflation recession in a model world where debt does not exist. This is the world our policymakers have been living in. They urgently need to change habitat.

I undertook a study of the models used by those who did see it coming.* They include Kurt Richeb√§cher, an investment newsletter writer, who wrote in 2001 that “the new housing bubble – together with the bond and stock bubbles – will [inevitably] implode in the foreseeable future, plunging the US economy into a protracted, deep recession”; and in 2006, when the housing market turned, that “all remaining questions pertain solely to [the] speed, depth and duration of the economy’s downturn”. Wynne Godley of the Levy Economics Institute wrote in 2006 that “the small slowdown in the rate at which US household debt levels are rising resulting from the house price decline, will immediately lead to a sustained growth recession before 2010”. Michael Hudson of the University of Missouri wrote in 2006 that “debt deflation will shrink the ‘real’ economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse”. Importantly, these and other analysts not only foresaw and timed the end of the credit boom, but also perceived this would inevitably produce recession in the US. How did they do it?

Central to the contrarians’ thinking is an accounting of financial flows (of credit, interest, profit and wages) and stocks (debt and wealth) in the economy, as well as a sharp distinction between the real economy and the financial sector (including property). In these “flow-of-funds” models, liquidity generated in the financial sector flows to companies, households and the government as they borrow. This may facilitate fixed-capital investment, production and consumption, but also asset-price inflation and debt growth. Liquidity returns to the financial sector as investment or in debt service and fees.

It follows that there is a trade-off in the use of credit, so that financial investment may crowd out the financing of production. A second key insight is that, since the economy’s assets and liabilities must balance, growing financial asset markets find their counterpart in a growing debt burden. They also swell payment flows of debt service and financial fees. Flow-of-funds models quantify the sustainability of the debt burden and the financial sector’s drain on the real economy. This allows their users to foresee when finance’s relation to the real economy turns from supportive to extractive, and when a breaking point will be reached.

Such calculations are conspicuous by their absence in official forecasters’ models in the US, the UK and the Organisation for Economic Co-operation and Development. In line with mainstream economic theory, balance sheet variables are assumed to adapt automatically to changes in the real economy, and can thus be safely omitted. This practice ignores the fact that in most advanced economies, financial sector turnover is many times larger than total gross domestic product; or that growth in the US and UK has been finance-driven since the turn of the millennium.

Perhaps because of this omission, the OECD commented in August 2007 that “the current economic situation is in many ways better than what we have experienced in years . . . Our central forecast remains indeed quite benign: a soft landing in the United States [and] a strong and sustained recovery in Europe.” Official US forecasters could tell Reuters as late as September 2007 that the recession in the US was “not a dominant risk”. This was well after the Levy Economics Institute, for example, predicted in April of that year that output growth would slow “almost to zero sometime between now and 2008”.

Policymakers have resisted inclusion of balance sheets and the flow of funds in their models by arguing that bubbles cannot be easily identified, nor their effects reliably anticipated. The above analysts have shown that this is, in fact, feasible, and indeed essential if we are to “see it coming” next time. The financial sector is just as real as the real economy. Our policymakers, and the analysts they rely on, ignore balance sheets and the flow of funds at their peril – and ours.


*‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models, MPRA

Saturday, September 5, 2009

S&P 500: Welcome To Fantansy Island

S&P 500 Statistics (As of August 31, 2009)

Total Market Value ($ Billion) 8,981

Mean Market Value ($ Million) 17,961

Median Market Value ($ Million) 7,494

Weighted Ave. Market Value ($ Million) 72,830

Largest Cos. Market Value ($ Million) 337,432

Smallest Cos. Market Value ($ Million) 700

Median Share Price ($) 31.200

P/E Ratio* 129.19

Indicated Dividend Yield (%) 2.10

*Based on As Reported Earnings.

Banks’ Balance Sheets: Getting Worse

Following up on my previous report (http://tinyurl.com/mlxxk8), banks’ balance sheets show no signs of improvements during the Second Quarter of 2009. In fact, key ratios demonstrating bank weaknesses have increased—in some instances they have surpassed all-time highs. All the charts demonstrate an uninterrupted upward trend since 2007. The caveat of my analysis is that the data are backward-looking; that is, we can only extrapolate from the past to give us an adequate assessment of the future. In addition, it takes the St. Louis FED about 6 weeks after the closing of the quarter to publish these figures (this time it took them close to 8). Considering the present condition of commercial real estate, along with the upcoming ARM and Alt-A mortgage resets, there is no light at the end of the tunnel for bankers. Given the information I will present, it is inconceivable that the FED will pull the plug on its intervention in the market any time soon. At the very least, until these figures reverse, all talk about “green shoots” and “economic recovery just around the corner” must be taken with exceeding caution.

Net Loan Charge Offs-to-Total Loans at commercial banks increased to an all-time high of 2.06%, up from 1.76% as of 3/31/09 and up from .96 reported during 4th Quarter 2008. The ratio has more than tripled year-over-year from .64 in 3/31/08. The most recent recorded figure supersedes the prior peak of 1.81% reached in 12/31/91 [see Note 1].

Loan Loss Reserves-to-Total Loans ratio increased to 2.94 from 2.65% reported on 3/31/2009. Year-over-year the recent ratio is up from 1.79% [see Note 2]. In particular to banks whose assets fall between $1 billion to $15 billion, the increase was from 2.10% to the current figure of 2.28% [see Note 3]. For the biggest banks, that is those with assets in excess of $15 billion, the current figure stands at 3.32%, up from 2.96% reported the previous quarter [see Note 4]. Reserves act as a buffer to capital losses resulting from asset deterioration. From a historical perspective, however, reserves at these institutions are low. For example, for the largest banks (assets > $15 billion), reserves reached a high of approximately 4.65% in terms of total loans during the late 1980s. The fact the current trend is up is good news. The bad news is that it’s not growing fast enough.

Considering Net Loan Losses-to-Average Total Loans, there is no evidence of a turnaround in business condition. The most recent figure broke the previous all-time high of 2.03% reported in 1Q2009. Currently, the ratio stands at 2.36%, which is more than doubled on a year-over-year basis [see Note 5]. For banks with average assets of $1 billion to $15 billion, the ratio currently stands at 2.08%, up from 1.63% in the previous quarter. The recent figure is an all-time high, surpassing the mark of about 1.8% in 1991 [see Note 6]. For institutions exceeding the $15 billion average assets threshold, the figures continue to be abysmal: The ratio currently stands at 2.68%, up from 2.35% in the previous quarter. During the last twelve months, this ratio has more than doubled, which indicates a worsening banking condition [see Note 7].

The next key statistic to consider is Non-Performing Loans-to-Total Loans. You may recall that Non-performing loans constitute past-due principal and interest in excess of 90 days. These are bank assets that will most likely turn toxic. The current figure stands at 2.78%, up from 2.20% reported the previous quarter and up from 1.71% reported on 12/31/08 [see Note 8]. At its peak for all commercial banks, the ratio stood at 4.88%, so the trend is evidence that the figures will continue to deteriorate. The same ominous gap is present for all banks exceeding $1 billion in average assets [see Note 9]

As I stated previously, banks’ balance sheets have deteriorated and will continue to get worse. The trend demonstrates that non-performing loans will continue to increase. Many of these loans will be charged-off. Loan loss reserves, which buffer against defaults, are not sufficient to cover the potential losses:

* * * * * * * * * * * * * * * * * * * * * *

(Note 1)

(Note 2)

(Note 3)

(Note 4)

(Note 5)

(Note 6)

(Note 7)

(Note 8)

(Note 9)