The Monoline/Credit Default Swap Nexus (Not for the Fainthearted)

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.

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  1. Anonymous

    This line of reasoning makes no sense at all: if you applied it for example to GE (rated AAA) whose counterparties are mostly non investment grade, and whose clients are mostly non-investment grade (read their book of risk is JUNK), you would also have to conclude that they are not AAA.

    Clearly that’s false, and there’s a lot more to a rating than the credit quality of your counterparties or book of risks. Cash (capital) for starters, makes a huge difference, plus more importantly, the temporal distribution of your obligations and the overall character of your revenue streams and outflows. The risks that the monolines take on are not debt: if you like, they are contingent debt: if one of the risks in their book has a default, they have to pay (timely interest and principal – not 100% of principal at the time of default). The non-defaulted risks are not obligations to make payment at a given point in time, they are only an obligation to make payments if the credit defaults.

    So “leverage” has a completely different meaning when you apply it to corporate debt and when you apply it to a monoline’s par outstanding. This difference is crucial, and it is only by understanding it that you (1) can know what the heck you’re talking about when it comes to monolines and (2) can know how eggregious the blurring of these definitions is – and self serving, when it’s perpetrated by funds that are massively short these stocks.

  2. anonymous2

    “The monolines’ balance sheets fill up with poor-quality debt”

    No they don’t. This is symptomatic of errors that permeate the analysis. And I would echo the comment above.

  3. Anonymous

    Do you know what you are talking about? The article was clear, and what you said isn’t even remotely sensible. The article did distinguish between the risks of monolines insuring weaker rated credits, which is their sole reason for being, versus its impact on counterparties in the CDS markets if they lose their ratings. What does this have to do with GE, which is in a ton of businesses, even in its financial services area?

    Yves (along with other blogs) has had a lot of posts on the outlook for the monolines, particularly a very good one yesterday. It is clear the monolines are toast. And the guy who wrote this article is a consultant, not an investor talking his book.

  4. Anonymous

    I don’t know much about insurance statutory accounting, but insurers are required to show potential losses as a liability. They have much more latitude in the way they do that than non-insurance financial companies, which are on a mark-to-market basis, which is probably why the monolines have been able to camouflage the state they are in, at least until recently.

    While it is a colloquial way to put it, the “filling up with poor quality debt” doesn’t sound inaccurate to me in light of the consideration above, particularly since their liabilities due to their guarantees vastly exceed their funding liabilities (medium term notes, etc.).

  5. anonymous2

    Anon 8:52

    You obviously understand perfectly the distinction I’m getting at.

    “Filling up with contingent liabilities” would be a more accurate cut at it.

    Given the enormous scope of each of cash funding and derivative categories that is being tossed around in the global discussion of impending catatrophe, I think its better to use words and their meanings accurately.

  6. Anonymous

    Surely the point the article makes is a valid one? The fundamental point is the suggestion that by extending cover to bonds that are of poor quality, the monolines are going to incur liabilities when they default which will not be covered by the premiums charged or by their reserves?

    If this is true, they will like any other insurer, go belly up?

    So the question is, if the bonds you bought as a pension fund are AAA because insured by MBIA or Ambac, and would otherwise be BBB, what happens when all this stuff starts defaulting? First, the insurers go, second, the holders lose.

    I don’t quite see what is so silly about this scenario. The point is not who holds the bonds, the point is that huge credit defaults are coming, and this is going to mow down everyone in its way. Starting with the insurers.

    Or are you anonmymouses saying this is not going to happen at all, and in particular not to MBIA and Ambac?

  7. foesskewered

    I agree with anonymous 9:31. As for the earlier anons, Yeah, the accounting standards allow for contingent liability but won’t be surprised if the final accounts show adjustments due to significant post balance sheet events, in other words, they may have to recognise it as “loss” vs mere contingent liability.

  8. RK

    In the end, the market will be the judge. This morning, Ambac is casting its vote. Anonymi, stay tuned for latest updates.

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