Is Counterparty Risk Set to Explode?

These days it seems like the global financial system is hanging on by a thread. Watching the shares of Fannie (FNM), Freddie (FRE), Lehman Brothers (LEH), and to a lesser extent, Merrill Lynch (MER), get decimated this week makes me wonder whether this global financial Ponzi scheme is set to implode in a catastrophic way.

My biggest concern right now is counterparty risk post-bailout. As I mentioned a few days ago, we still do not know how the bailout of Fannie Mae and Freddie Mac will impact the credit derivatives market.

Today I read that counterparty credit concerns are at a six-month high:

The CDR Counterparty Risk Index, which measures the average credit spread of the 15 largest credit derivative dealers, jumped 26.5 basis points on Thursday to 208.2 basis points, according to Credit Derivatives Research, which manages the index.

The index is 49.3 basis points weaker on the week.

Lehman's swaps were the weakest performer, widening 136 basis points, while Merrill Lynch and Wachovia widened 71 basis points and 60 basis points respectively, CDR said.

Lehman's credit default swaps reached a record of 775 basis points early on Thursday before retracing to around 650 basis points, according to broker Phoenix Partners Group.

Swaps on Bear Stearns had traded over 800 basis points before the government intervened in March to facilitate its acquisition by JPMorgan.

In fact, Lehman CDS now imply a 20% default risk in the next year:

Credit default swaps typically start trading on an upfront basis when concerns grow that a default is more likely, as sellers of protection grow nervous that a default could happen before they receive the quarterly premiums for the insurance.

Lehman's one-year default swaps closed on Wednesday at 1,156 basis points, according to data by Markit.

Five-year credit default swaps on Lehman, which are the most liquidly traded contracts, widened to around 650 basis points on Thursday after earlier jumping near 800 basis points.

These swaps imply that there is a 35 percent to 40 percent chance Lehman will default over the next five years, Backshall said.

I don't think Lehman will be around in five weeks, let alone five years if things keep going like this past week.

It is important to remember that credit deflault swaps (CDS) are a common type of derivative contract that pay out in the event of default. When the difference, or spread, between rates on these contracts and rates on U.S. Treasury bonds increases, that suggests investors are willing to pay more to protect against defaults.

The CDR index focuses on the 15 banks and brokerage firms that control most of the trading in the credit default swap market. Credit Derivatives Research estimates that these companies are counterparties on roughly 90% of all CDS trading. If the spread of this index is rising, it means that counterparty credit risk is rising.

Importantly, in an age where pension funds are increasingly swapping into all sorts of indexes, this means that pension funds might be heavily exposed to serious counterparty credit risk.

Now, I do not want to alarm you because I am sure most pension funds have taken the measures to mitigate counterparty risk as much as possible, but the fact remains that 15 banks and brokerage firms account for roughly 90% of all CDS trading. If a systemic crisis develops, many pension funds might suffer untold losses.

The Financial Times published an article yesterday that insurers and banks face huge CDS losses after the default of up to $500bn of Fannie Mae and Freddie Mac credit derivatives contracts triggered by the US government’s seizure of the mortgage groups :

The potential losses, as well as uncertainty about exactly how the derivatives contracts will be settled and unwound, is putting strains on the unregulated $62,000bn credit derivatives market, which has been a target of regulators worried about the hidden risks it could hold for the financial system.

The exact number of credit default swaps – a kind of insurance against debt default – outstanding on Fannie Mae and Freddie Mac are not known, reflecting the private nature of the sector. However, according to the latest estimates from dealers and analysts, there could up to $500bn of contracts outstanding

...

Currently, the recovery value of the Fannie Mae and Freddie Mac CDS is expected to be about 95 cents in the dollar, leading to a potential 5 per cent loss for insurance companies or banks who offered protection against a default. On CDS worth $200bn-$500bn, losses would come to $10bn-$25bn.

The Fannie Mae and Freddie Mac defaults are highly unusual.

The $1,600bn of actual debt issued by the mortgage groups is regarded as safe after the US government’s move to take control of the companies. Yet their seizure into “conservatorship” counts as the equivalent of a bankruptcy in the credit derivatives contracts. This means the contracts have to be unwound.

Dealers are working to determine how that will be done. The International Swaps and Derivatives Association is expected today to announce which of the bond issues from Fannie Mae and Freddie Mac will be eligible to be used to settle CDS.

Most analysts remain confident that this credit event will not result in severe market dislocations:

Auctions to close out the swaps will be held in October by the International Swaps and Derivatives Association, a trade group. Complexity abounds but most dealers think the market can cope. If so, its credibility will receive a boost.

The episode might also be a badly needed catalyst for change. The auctions will involve “cash settlement”, rather than a physical exchange of the underlying bonds, which is needed because the value of swaps far exceeds the face value of those bonds.

Regulators have also been urging dealers to tighten up trade processing and to move to centralised clearing, especially since the demise of Bear Stearns, with its vast derivatives exposure, laid bare a huge “counterparty” risk—that it might not be able to honour contracts it had written.

The launch this week of a service to cut the level of capital at risk by batching trades in a process called “compression” is another encouraging sign that the market can heal itself. The quicker it does so, the better. The woes of Lehman Brothers, like Bear a big CDS counterparty, hint at even bigger tests to come.

Keep in mind that it's not just insurers and banks that are anxiously awaiting this CDS settlement. I know of at least one large Canadian public pension fund that used their AAA government balance sheet to sell CDS and are now hoping (more like praying) that credit markets will rebound in 2009.

Anyone selling CDS in this environment is taking a huge gamble because they are long the credit of the underlying company (or index of companies) and they are assuming counterparty risk because in the case of a default, they are on the hook for paying the premiums to CDS buyers who are short the credit of the company (see this video for an explanation of credit default swaps).

I hope everything does proceed in an orderly fashion but I remain very concerned that something is going to explode in the next few weeks.

Today, Federal Reserve Vice Chairman Donald Kohn said that there was no clear evidence that the plunge in U.S. house prices was coming to an end:

"The jury is still out on whether housing prices are close to finding a bottom," Kohn said in prepared remarks for delivery at a Brookings Institution conference where he was commenting on a series of academic papers.

He said some researchers have noted some easing in the pace of home price declines in some markets but said mortgage conditions have tightened since spring and that may have a further impact on prices since it makes it harder for buyers to qualify.

Finally, please take the time to listen to Charlie Rose's excellent interview with Larry Summers and Robert Rubin (click here to watch it). They met up yesterday to discuss the current financial crisis and what measures are needed to mitigate the fallout from this crisis.

Both commentators see this current credit crisis going on for an extended period of time given that there several vicious cycles reinforcing themselves. Rubin questioned whether marked-to-market valuations exacerbated this crisis, but Summers said that the industry has failed miserably in governing itself so we can't expect them to value securities properly without some market clearing exchange.

Summers also stated that the risks of not engaging in more fiscal stimulus in the short run are high. Second, he stated that we need more active government intervention in the U.S. housing market.

Rubin who ran Goldman Sachs at one time stated that you are dependent on the traders and independent risk managers to understand the credit risks of the CDOs. He said that what happened was a "very, very low probability event" that people did not foresee.

Now where did we hear that again? Oh yeah, it was in Roger Lowenstein's excellent book on LTCM, When Genius Failed: The Rise and Fall of Long-Term Capital Management. Those "geniuses" failed in a spectacular fashion after a "once in a lifetime" event.

Summers reacted to this by stating that we have a system that is prone to financial crises but we need to balance the flexibility of the system with proper regulation.

On the issue of moral hazard, Summers raised the point that we need to develop mechanisms that allow an institution to fail without doing enormous damage to the system because "ultimately preserving market discipline has to be a central part of giving people the right incentives."

Summers' warning is prescient given that he warned about Fannie Mae and Freddie Mac back in 1999. Let's hope policymakers and regulators are paying close attention and take the right measures to make sure that future financial crises will not bring down the global economy.