After bond fund giant Pimco’s Bill Gross gave a back-of-the-envelope estimate of a possible $250 billion in losses resulting from the impact of deteriorating corporate credit and bond defaults on the $45 trillion (notional amount) credit default swaps market, other commentators have been making improved (but still quick and dirty) calculations.
One interesting effort appears in today’s Financial Times “The fire threatens credit insurance,” by David Roche of Independent Strategy. Roche looks at a topic near and dear to our hearts, the impact of the just-about-inevitable downgrading of the monoline insurers. He focuses on them by working through the question: what happens if we start witnessing counterparty failure on top of mere required default payments? He sees the bond insurers like Ambac and MBIA as the most probable flash points, and the resulting damage in the ballpark of $400 billion.
From the Financial Times:
Fahrenheit 451 is the temperature at which paper ignites. Subprime is a spent bonfire already. Junk credit is already on fire. The next lot to ignite will be credit insurance in the form of credit default swaps and monoline insurance contracts.
There are three potential hits to banks and others from a crisis in the credit derivatives market. First, there will be market price losses as risk is repriced as corporate and household credit quality deteriorates. Second, there will be corporate default losses on the loan or bond underlying the credit default swaps (CDS). And finally, there could be counterparty losses if financial intermediaries in the market go under.
The notional value of CDS contracts globally is $45,000bn. That represents real underlying credits of about $5,000bn. The maximum rate of corporate defaults was about 3 per cent in the 1990s recession. However, corporate speculative grade bond defaults run as high as 10 per cent. A weighted default ratio of 5 per cent (3 per cent for investment grade and 10 per cent for sub-investment grade) would mean that credits with a par value of $250bn would default. Assuming an asset recovery ratio of 30 per cent, the hit would be $175bn.
But this forecast would pale into insignificance if a big counterparty bank went bust.
The most likely place for this to happen is among financial guarantors, the so-called “monoline” insurers.
Monolines write insurance on debt. But here is the trick. Entities with a worse credit rating than the monoline company can get their bonds insured so that they can have the same rating as the insurance company itself (mostly AAA). So relatively poor-quality debt becomes investment-quality debt because the monoline will pay the interest and principal if the borrower defaults.
This business model is self-limiting, some might say self-destructing! The monolines’ balance sheets fill up with poor-quality debt as the monoline insures only the risk of debt with a worse financial quality than itself. As long as the ratings agencies maintain the monolines’ AAA rating, the trick can work.
But eventually, the market may decide that the poor quality of the debt the monoline insures has irreparably eroded the quality of its own balance sheet. Once that happens, the monolines’ guarantees are worthless and the debt it insures will be downgraded from monoline credit quality to the debts’ own inherent credit quality. Our analysis shows that the monolines’ balance sheets reached the tipping point around June last year.
If the monoline guarantees on bonds and credit derivatives were to be removed, the rule of thumb is that every 1 per cent decline in the price of insured bonds would give rise to $10bn of losses on bond portfolios elsewhere in the system. We estimate bond portfolio losses of $150bn-200bn were this to happen – or equivalent to the impact of the subprime crisis on the US banks.
Much of this pain (loss) would have to be absorbed through the CDS markets as additional losses to the cost of defaults. Also, the decline in credit quality would also hit CDS prices to the tune of about $40bn-$50bn. In total, we estimate that global losses in CDS markets and the underlying credits they insure would be $365bn-$425bn. That is about equal to the losses likely to accrue from the current crisis in subprime and other pools of debt for global banks and non-bank financial intermediaries.
These losses will destroy another slug of capital in the banks and non-bank financial intermediaries. As every $1 of bank capital gets multiplied into $8-$10 of credit, the result of capital destruction is shrinkage of credit and liquidity.
So the impact on risk appetite and liquidity creation by brokers, hedge funds and investment banks is even bigger. In all, we reckon global liquidity is set to shrink by 8-10 per cent. As we have shown elsewhere, most of this liquidity gets used to boost financial asset prices.
So the inevitable consequence for a credit-junky world is a thumping bear market in equities and a world economy in recession.