Most observers have taken as a given that the increased disinclination of banks to lend to each other is counterparty risk, that is, the fear the money they lend out won’t come back, or at least on the initially promised timetable (bankruptcy proceedings take time and usually lead to losses by unsecured creditors). Some wags have said that financial firms are unwilling to provide loans to each other because they know how bad their own books are, and won’t want to be exposed to anyone in that shape.
But it turns out there may be a specific reason that the banks are hanging on to cash for dear life. Reader Glen pointed to a Financial Times piece that discusses the upcoming settlement of credit default swap payouts triggered by recent defaults. The banks apparently lack a good estimate of their exposures (settlement prices are to be set by auction). And banks that don’t have enough to meet their obligations may fail. And more failures would trigger more credit default swap settlements, which could trigger more failures…
In other words, this process could take down an institution or two, and in a downside scenario, could lead to a cascading credit- default-swaps-induced failures, the financial equivalent of a firestorm. The FT article also pointed out that there could be banks that show large gains, but in these fragile markets, the costs of concentrated losses are vastly greater than the benefit of concentrated gains. Note also that the Fannie and Freddie settlements should in theory not be problematic (there should be no losses on the underlying bonds), but with exposure that large, there are worries about failure to settlement due to documentation or procedural irregularities.
From the Financial Times (hat tip reader Glen):
The $54,000bn credit derivatives market faces its biggest test this month as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual are settled.
Because of the opacity of this market, it is still not clear how many contracts have to be settled and whether payouts on the defaulted contracts, which could reach billions of dollars, are concentrated with any particular institutions.
According to dealers, insurance companies and investors such as sovereign wealth funds, which are widely believed to have written large amounts of credit protection through credit default swaps on financial institutions, could have to pay out huge amounts….
The “auction season” starts tomorrow, when the International Swaps and Derivatives Association has scheduled an auction for Tembec, a Canadian forest products company. This is followed by Fannie Mae and Freddie Mac auctions on October 6. Then, Lehman is settled on October 10, and Washington Mutual is scheduled for October 23.
Even though it is possible that some participants in the credit derivatives market will have to make large payouts, the flipside is there could also be big winners. For every loss in credit derivatives, there is a gain.
The amount of contracts outstanding that reference Fannie Mae and Freddie Mac alone is estimated to be up to $500bn. The default was triggered under the terms of derivatives contracts by the US government’s seizure of the mortgage groups, even though the underlying debt is strong after the explicit government guarantee.
The CDS contract settlement could result in billions of dollars of losses for insurance companies and banks that offered credit insurance in recent months. The recovery value will be set by auction. Usually, the bond that is eligible for the auction that trades at the lowest price – the so-called cheapest-to-deliver – is the one that sets the overall recovery value for the credit derivatives.
In the Lehman case, numerous banks and investors have already made losses due to exposure to Lehman as a counterparty on numerous derivatives trades. The auctions next week are for credit derivatives which have Lehman as a reference entity. There are likely to be fewer contracts outstanding than for Fannie Mae and Freddie Mac because Lehman was not included in many of the benchmark credit derivatives. However, exposure remains unclear, which is one concern that regulators now have about the credit derivatives market.
Lehman’s bonds have been trading between 15 and 19 cents on the dollar, meaning investors who wrote protection on a Lehman default will have to pay out between 81 and 85 cents on the dollar, a relatively high pay-out.
The previous biggest default in credit derivatives was for Delphi, the US car parts maker that went bankrupt in 2005 and which had about $25bn of CDS.
Update 2:30 AM: The Independent provides further detail:
The “auctions” to decide the value of bonds in default and the amounts the derivative insurance will have to pay out on them are organised by theInternational Swaps and Derivatives Association (ISDA), based in New York. ISDA has held only nine auctions since 2005, but this month will see five that will include many of the former giants of the US financial scene. The CDS market is opaque because contracts are only registered between the buyer and seller of the insurance, with no central record of the value or whereabouts of outstanding contracts….
The auctions will also be a big test of investment banks’ procedures when the authorities are scrutinising certain securities firms for lapses.
“It is significant because it is probably going to be a good opportunity for investment banks to prove to regulators that they have their house in order. Any big investment bank will want to make sure that nothing is dropped on the floor,” said an analyst at oneinvestment bank.
A record 409 firms had alreadyregistered for the Fannie and Freddie auction yesterday, with 300 having signed up in the previous 24 hours and hundreds more in the pipeline. The value of derivatives contracts covering the two US mortgage finance agencies, which were effectively nationalised last month, is estimated at between $400bn and $600bn.
The size of the Fannie and Freddie auction dwarfs the previous biggestdefault in credit derivative markets, which was for Delphi, the US car-parts producer that went bankrupt in 2005.
The auction system was put in place seven years ago to centralise agreement of the recovery rate on company bonds in default.
ISDA calculates an average value for the underlying bonds from varioussubmissions by market makers. If the average is 40 per cent, for example, then the issuer of the protection pays the “lost” 60 per cent to the CDS buyer.
Before the system was brought in, the buyer of protection had to physically find some bonds and present them to the insurer in return for the payment. The insurer then had to get back as much as possible from the defaulting company. The system has become increasingly important because, as the CDS market has grown, for many companies the value of outstanding CDS contracts vastly exceeds the value of the actual bonds issued.
I am a little confused as to what needs to be determined by auction. I had though the CDS terms were clear-cut: you pay me x basis points; in the event of a default I pay you the nominal face value and you deliver the physical bond. What am I missing?
This strikes me as a good reason for the extreme haste in proposing the 700 Bn bailout.
Finally a date of an event to justify the rush.
You don’t have to deliver the bond. In Delphi, the amount of CDS outstanding was a significant multiple of the amount of cash bonds. From a recent post:
In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, the volume of CDS outstanding was estimated at US$28 billion against US$5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.
Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called “auction system”. The auction is designed to be robust and free of the risk of manipulation.
In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100% – 63.38%) or US$3.662 million per US$10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi’s senior unsecured obligation equating to a 0-10% recovery band ….
This is the shit Paulson is in a Fuc-ing rush to buy — before the market in Japan opens Monday — because taxpayers really need to bail out this crap ASAP (before the world falls apart) — and of course, someday, this stuff will gain in value — but I swear to God, I see no reason as to why that isn’t just some dumbass theory from a retarded speculator running from a casino at the speed of light! There is no where on Earth that this shit can run to and there is no future space or time where it will have value, and that includes Hell, where Paulson will return to with this worthless material that has no place on Earth to go!!!!!
Furthermore, we should reward these cleaver speculators and let them run away while we taxpayers reload their bazookas with more play money, so they can get back to keeping America running like a Swiss watch!
Just one of the many reasons why anybody who ever referred to unregulated swaps as “insurance” should be in jail for fraud.
Insurers only insure insurable interests (which would mean in this case you need to have an interest in the bond). Insurers who pay a claim are subrogated to the interests of the insured (which would mean they have a right to collect if the loss doesn’t turn out as badly as the original claim).
So the person who actually bought the swap as “insurance” ends up with a payout determined by a market process that assumes the swap holders were just speculators who suffered no actual loss, and asks the speculators how small of a windfall they are willing to take in settlement.
In the current market conditions, it seems inevitable the bonds will go for less that “fair value’. Maybe not so much for Fannie and Freddie, since they’re almost government bonds, but certainly for Lehman and Wamu. Between Lehman and Wamu there are going to be almost 1 trillion in losses. If their bonds are overinsured by speculators I don’t see how the financial system can handle it. I wonder how much CDS is out there for them, and I’ll bet there’s no way to find out.
Bah, I’m too tired. 1 trillion is assets. Bond losses are more like $130 billion. Still a huge test if overinsuried.
I love this blog and reading everything you say Yves, but your up at 1:15 am??? Get some rest – we need your Friday insights!
I am extremely pessimistic about the entire situation, but there are a few tiny glimmers of hope that we may be able to arrange a very hard landing for the economy, rather than a crash landing.
First, the lengthy CRMPG process is finally beginning to bear fruit. Most notably, its latest incarnation (CRMPG III) has been enormously helpful in pushing the likely opening of a prototype CDS clearing house by the Thanksgiving Holiday. This is an extraordinarily complex undertaking, but it is being accomplished in record time and will surely help.
Secondly, the notional value of credit default swaps has been routinely quoted at around 65 trillion. Although there is still a long way to go, that number has now been reduced to 50 trillion, thanks in very large part to this same CRMPG process.
As I stated in a previous comment, October should indeed be a turbulent month for the markets because of these three critical auctions referred to in the article Yves cites.
With “only” $4-600B of CDS to work out, this suggests there wasn’t much actual bond insurance struck, particularly vs. the total of bonds outstanding. Is this a netted number?
I’ve seen very little discussion of the hedge funds selling CDS insurance. and I thought they were the 2nd biggest writer after the Banks. Recently, insurance companies have been fingered as the next shoe to drop. (I suppose following AIG). Up to now, the hedge funds have been thought to have better risk management prowess than the banks. Will this change during this month’s CDS settlement process now that many are reeling under the LEH bankruptcy?
Can someone explain for the dullards among us (me) why the notional value of the insurance is so much higher than the bond value, and what this means in terms of actual money changing hands at payout time? It sounds a little too much like the Bialystock & Bloom scheme.
Primer is on line here: http://www.creditfixings.com/information/affiliations/fixings/auctions/current/credit_event_auction_primer.pdf
Thanks, I think. That was, uh, perfectly clear. Still sounds like a game of fizzbin to me, but that is why I am not rich, I guess.
Does this sound familiar?
On October 14,  the DJIA dropped 95.46 points (a then record) to 2412.70, and fell another 58 points the next day, down over 12% from the August 25 all-time high. On Friday, October 16, the DJIA closed down another 108.35 points to close at 2246.74 on record volume. Treasury Secretary James Baker stated concerns about the falling prices. That weekend many investors worried over their stock investments.
The crash began in Far Eastern markets the morning of October 19.
. . . .
The trader Paul Tudor Jones predicted and profited from the crash, attributing it to portfolio insurance derivatives which were “an accident waiting to happen” and that the “crash was something that was imminently forecastable”.
Black Monday/Tuesday II:
October 6-7, 2008.
An historic opportunity for your cash.
2 fundamental mistakes (assumptions) were made by those who insured bonds. The business model of this industry is flawed (read details below).
I cannot believe that our regulators, and professors missed these two simple/obvious observations (which are at the heart and are well understood in the traditional insurance industry).
I am fascinated by the idea of settlement of FRE/FMN bonds.
They are worth more now that they have explicit US support.
These suckers should expire worthless. Or maybe get their premiums back.
Not talking about the stuff that tanked (if there were cds’s on em (junior stuff)).
imagine, than CDS is a thing that could manage our national debt through a trap, maded by FED to the rest of the world