This post comes in significant degree from jck at Alea, who has access to the report, “Counterparty risk in credit markets,” from Barclays Capital and was kind enough to post the summary of key points. Despite the link, I seem unable to download it, but the summary is sufficiently detailed that I don’t think I am missing much.
The bottom line is that the authors estimate the impact of a $2 trillion in notional amount failure (yes, that’s a big failure) at producing a maximum of $36 to $47 billion in losses. That is a comparatively low number when you consider that the size of the potential financial train wrecks these days for the most part have larger price tags attached. And while the Barclay’s report also said this number would be reduced by netting, it also pointed out that a large default could roil other OTC derivatives markets and that collateralization may be less than ideal.
My big concern with any analysis is that the knock-on effects are hard to anticipate. Two month agos, no one would have dreamed of massive failures in the auction rate securities markets. The reaction seems vastly disproportionate to the risk at hand, yet we are where we are.
Consider the panic with SIVs last year. Money market investors were fleeing them due to the perceived potential for losses. However, it was the investors in the subordinated slice, the capital notes, who were taking the hits (this is generally medium term, not money market paper); the commercial paper, which was the paper held by money market investors, was senior to that and thus at much less risk of losses.
I have never seen loss figures published across the SIV sector, but my impression is that the total damage across the $400 billion SIV market were 3% ish (that’s why the industry in the end decided to take the funds on balance sheet for the most part. The losses were painful but not catastrophic).
Money market funds are loss intolerant, ditto enhanced cash funds, but nevertheless, one would think a $12 billion-in-losses event wouldn’t have systemic consequences, particularly when they were second in line to take a bullet. Yet it led to the shutdown of the asset-backed commercial paper market, which it turn led a lot of borrowers to tap lines of credit unexpectedly and all at once, which led to unanticipated balance sheet demands on the part of banks (utilized credit lines have capital charges attached) which lead to banks being reluctant to lend to each other, which led to a big rise in interbank rates relative to risk free rates, which led to panic and extraordinary measures among central banker.
For the want of a nail a shoe was lost….
That is a long winded way of saying that my bet would be a big counterparty failure (or smaller related failures that add up to a biggish number) might well lead to not-so terrible direct losses, but the impact on psychology and the fear of who might have suffered losses and who might default next could lead to collateral damage out of proportion to the triggering losses.
Report: Key points
Counterparty risk is highly skewed towards the buyer of CDS protection
While the maximum potential loss to the seller of protection is the contract spread for the rest of the contract duration, the buyer of protection could arguably lose the full notional of the contract (in case of simultaneous defaults by counterparty and the reference credit and zero recovery). Thus, counterparty risk is evidently more of a concern for buyers of protection.
All ISDA contract holders are ranked pari passu to senior debt, in terms of claims on a defaulting counterparty
Hedge funds might be asked by dealer/brokers to post margin to cover closing-out risk going forward
Given their higher risk profile, margining for hedge funds tends to be somewhat more stringent. They typically post collateral at 100% of their current exposure, and furthermore might also be asked to post collateral to cover close-out risk on their contracts for a certain number of days going forward. The estimation of forward exposure is done through forecasting future scenarios.
Netting agreements are typically applicable across all derivatives that are traded on ISDA contracts
Netting agreements come into action in the case of actual counterparty default. Without such agreements, a surviving counterparty would legally have to fully meet its obligations to the defaulting counterparty, while only being left with a claim on its dues from the same. However, the provision for netting allows a bank to calculate its dues to a defaulter by netting out-of-the-money and in-the-money contracts and to arrive at a single figure for dues. In fact netting agreements are typically applicable across all derivatives that are traded on ISDA contracts, effectively building in a natural hedge to counterparty default risk on a firm-wide level.
Scenarios in case of an actual counterparty default
Even in the absence of reference entity default, a failure of a major counterparty could lead to losses across the financial system. Upon the default of the counterparty, OTC derivatives would be immediately and significantly re-priced, with credit spreads likely widening dramatically. This means that CDS contracts would be terminated at a spread significantly higher than the spread at which collateral was last posted, leading to the crystallisation of significant losses.
Illustrating potential gap risk losses on CDS positions
The total notional amount outstanding of OTC credit derivatives for broker/dealers is $42.5trn. There are approximately 55 broker/dealers who buy or sell protection. We analyse a scenario where a relatively large counterparty defaults. We assume that this counterparty sold $1trn of protection and bought $1trn of protection. We further assume that the proportion of IG protection sold by the counterparty is 65% and the average life of contract affected is five years. We continue to assume that the recovery rate on the counterparty is 40%.
We believe that a default of a major counterparty would cause a significant re-pricing in credit. Although consequences of such an unprecedented event are difficult to quantify, we estimate losses for a variety of scenarios. In our analysis, we allow the IG credit spreads to jump between 10bp and 60bp upon a counterparty default. We view the IG spread jumps of 30-40bp as the most likely in case of a default of a counterparty with $2trn of outstanding CDS. Assuming a beta of 4x between the Crossover and the Main, we imply that HY spreads could jump between 40bp and 240bp, with 120-160bp being most likely.
Our analysis shows that the failure of a major counterparty which had $2trn outstanding in OTC credit derivatives, could result in losses of $36-47bn in the financial system solely due to the immediate re-pricing of credit risk due to a counterparty default. We stress that these losses are crystallised by investors who had exposure to the defaulting counterparty. Additional to these, there would also be large, potentially concentrated, MTM losses for investors without exposure to the defaulting counterparty. These losses would result from a re-pricing of risk, which we do not account for here.However, we would add the caveat that netting could significantly reduce our estimated losses. The figures above are un-netted, as data on netted exposures is very hard to obtain.
There are two factors which could cause the realised losses to be larger than our estimates. The first is the fact that, while we assumed full collateralisation, in reality, collateralisation is imperfect. This would mean that at the point of last posting of collateral, there would be some MTM positions which are not backed by collateral and any losses on these positions would increase the loss from gap risk. The second is forward margining. Any collateral posted by hedge funds with the defaulting counterparty as part of forward margining would be subject to a loss. This loss would amount to the value of collateral less recovery.
Our analysis we have concentrated solely on credit derivatives. However, in terms of amounts outstanding, credit derivatives constitute only 8% of all the OTC derivatives, with interest rate derivatives constituting the largest proportion of 67% (Figure 17). We believe that a default of a major counterparty would cause a significant re-pricing in all OTC derivatives. This implies that these contracts would also be vulnerable to large gap risk. Given the enormous amounts outstanding of these derivatives, netted exposures could be large and therefore gap risk losses on other OTC derivatives could be significant.
One of the problems that no-one has addressed yet (and, in the view of the last six months should have), is that a major CDS counterparty defaulting would likely mean that the CDS markets (single name, not necessarily indices) freeze. It might be not just that anyone would not want to write the CDSes, quite contrary, it might be that the buyers realise that the parties with the highest incentive to write the CDSes are the parties who are just one step away from going down and have nothing to loose.
One of the immediate results of that would be that a number of parties who used CDSes as hedges would loose these hedges (blindingly obvious).
Less obvious is the fact that with Basel 2, it would mean that the assets that were hedged would come onto balance sheet and reg capital would have to be found against them. Now, normally the banks provision for this, but the provisioning is built on an assumption that if the cpty goes belly up, you can replace the contract in the market.
If you can’t and the asset you were hedging is 100% risk weighted all of sudden, you’ve just been hit by hedging loses and at the same time have to find capital for the assets that materialised on your balance sheet…
It’s indicative of how untransparent and virtually unfathomable the entire derivatives market is that estimates about this sort of thing vary so widely.
The idea that somehow CDS can be margined is, of course, ludicrous. As the article itself says, the ‘gap’ risk is significant.
The ‘gap’ risk is more severe for products such as Nth to default baskets that were oh so popular in the distant past going back to 2005.
And if a bank were to start assignging true vols to cover gap risk, the MTM of their own short CDS would suffer (as they typically have to use mid for MTM).
I shudder to think that Barclays might be talking their own book.
Part of the problem with the report is that it addresses the impact of a failure of one large counterparty. This kind of analysis relies on the fiction that counterparties are uncorrelated — that a failure is a firm-specific, idiosyncratic event.
In reality, its likely that a large number of hedge fund counterparties with similar capital levels and strategies exist. Their failures would occur en-masse, with liquidation from the weaker funds causing stronger funds to fail. The common denominator would be leverage and a forced sale of commonly-held liquid assets or purchase of liquid index CDS. The spread blow-outs on those instruments would have further knock-on effects.
Of course, with leverage, the system is like a sweater: pull on a yarn and the whole thing can unravel. Why is it so hard for analysts to envision this?
Sharon Haas, managing director of Fitch Ratings, admits investors “started to panic” and randomly slashed values on virtually all mortgage-backed securities, even those that aren’t at risk. “The market just doesn’t know how to value those securities,” she said. It had better learn soon, or the price of that education will become astronomical.
This is like going to a dog track and watching the “pros” leaf through the data on dogs and track history and then rush to the window to place bets on the perceptions of which dogs have the best odds of winning (in the next few minutes). It will continue to be watching these retards figure out how to make sense from chaos. Best of luck, and remember, the early bird catches the worm!
As a counter to that analysis, try this:
There are $1 trillion in outstanding subprime mortgages, with potential losses estimated at about $250 billion, said Bose George, an equity analyst with Keefe, Bruyette & Woods Inc. Columbia University professor Charles Calomiris pegs the losses even higher — at between $300 and $400 billion. Merrill Lynch’s Bostjancic said the biggest impact of rate resets, from a dollar perspective, will come in the third quarter of 2008. She sees losses from all loan defaults exceeding $500 billion in 2008.
1a. There are $1 trillion in outstanding subprime mortgages, with potential losses estimated at about $250 billion2. According to the report, the meltdown in the U.S. subprime real estate market has led to a global loss of $7.7 trillion in stock market value since October.
1b. …the biggest impact of rate resets, from a dollar perspective, will come in the third quarter of 2008. She sees losses from all loan defaults exceeding $500 billion in 2008.
2. Quoting Bank of America chief market strategist Joseph Quinlan ,”The crisis, which has spread beyond U.S. shores to banks and other sectors worldwide, is one of the most vicious in financial history”.
A report last week by Standard & Poors ratings agency showed global stock markets were devastated with a collective loss of $5.2 trillion in the month of January alone.
Sorry that was a mis-post, should read.
1. There are $1 trillion in outstanding subprime mortgages, with potential losses estimated at about $250 billion
2. biggest impact of rate resets, from a dollar perspective, will come in the third quarter of 2008. She sees losses from all loan defaults exceeding $500 billion in 2008.
3. A report last week by Standard & Poors ratings agency showed global stock markets were devastated with a collective loss of $5.2 trillion in the month of January alone.
4. Quoting Bank of America chief market strategist Joseph Quinlan ,”The crisis, which has spread beyond U.S. shores to banks and other sectors worldwide, is one of the most vicious in financial history”.
5. According to the report, the meltdown in the U.S. subprime real estate market has led to a global loss of $7.7 trillion in stock market value since October.
Sorry about that!! Wish I could go back…
Everyone one assumes that netting will survive bankruptcy.
If I were another creditor of the failed counterparty, I would fight to have the assets and liabilities treated separately.
Is there existing case law and precedent of bankruptcies resolved where the judge accepted netting of these contracts?
I suspect that they are too new for us to know for sure how they will be treated once they land in court. Also, do we even know which court will have jurisdiction (New York, London, a Caribbean island, all of the above)?
@norkawest: if you have an ISDA netting agreement with the cpty, it’s legally binding. Your legal teams make sure it’s legally binding in the right jurisdictions, too.
By default, you don’t have any netting. You still may agree netting on a specific transactions though (which, again, is a legal contract).
as of end of 2007 barcap has $5tn of cds in outstanding notional. compare this to the total of $51tn according to the latest triennial study by BIS. the only other dealer with larger outstandings is JPM with ~$8tn.
now the claim that losses would be ~$40-50bn in worst case scenario is absolutely insane. according to the same BIS study, gross mkt value of CDS outstanding is $11tn (this is the total market value necessary to replace existing contracts). so if netting and collateralization fails this is the dough at risk. btw, assumption that there is a PROPER kind of margining mechanism in place for cds is absurd. a well known fact being that e.g. mbia never had to put a margin with anyone. getting back to the BIS study, including benefits of collateral and netting, total net mkt value of CDS is $2.7tn, the figure BIS sounds to be pretty cool with. however, if we add all the dealer equity (55 biggest institutions) it will be way less than that. actually, barclays has only $60bn of equity, and that is all that supports its massive $2.4tn balance sheet. they must be shitting their pants down at the barcap.
Can someone tell me the total loss of wealth in the US property and stock markets over the last 12 months as well as the losses in Europe? Of course everyone is busy counting only the losses of banks and other financial institutions, without understanding the flow on effect of loss destruction and how it affects individuals and therefore the economy.
Why focus on CDS contracts only for counterparty risk. Look at any 10Q report. Counterparty risk spans all derivative classes off the balance sheet–after netting for master agreements (eg ISDA) and assigned cash scollateral.
Bunty is correct; don’t look at counterpaty risk being limited to CDS contracts. The original barclays article and a recent bloomberg article equate or suggest counterparty risk is limited to CDS contracts only (and gets into double defaults etc); note the most common reference entities have nothing in common with the names with the biggest counterparty.
In a nutshell, the $600 trill notional value fo derivatives (fx swaps, option, CDS etc) has to be trimmed off all netting agreements and also nettin gof collateral. Avoid double counting. The net after ISDA and cash collateral is counterparty risk. So for a firm like Lehman that may go bust, the risk to the financial system would be Lehman’s liabilities (net of cash and net fo ISDA etc,) of in their OTC derivatives (not LEhman’s assets via the OTC deriv)