Credit Default Swaps doom and gloom

Wolfgang Munchau writes in the Financial Times today
that the issues we faced in subprime in 2007 are just a mere drop in
the ocean, and that this is more than just a subprime crisis:

“If
this had been a mere subprime crisis, it would now be over. But it is
not, and nor will it be over soon. The reason is that several other
pockets of the credit market are also vulnerable. Credit cards are one
such segment, similar in size to the subprime market. Another is credit
default swaps, relatively modern financial instruments that allow
bondholders to insure against default.”

Let’s take the credit card area first.  According to The Guardian, “America's
card debt is around $900bn compared with a relatively modest £56bn in
Britain.”  However, the UK actually has similar levels of exposure per
capita.  As I blogged about Peter Farley, Managing Director of Financial Insights Europe, last year when he presented at the Financial Services Club and
said “we have reached a position where personal debt in the UK has
risen to a total of £1,291 billion at the end of 2006, more than 10%
higher than a year earlier and nearly triple the level it stood at 10
years ago.”

So, we should be worried about the personal credit market collapsing although the real concern, according to Mr. Munchau, is the total risk exposure in Credit Default Swap (CDS) derivatives.   

A year ago, I stated a little around this issue in discussing the quest for alpha
and noting that “hedge funds account for 32% of credit-default swap
sellers and 28% of buyers, up from 15% and 16% in2004".  But the real
base of this concern goes back to trading strategies, which I discussed
back in April 2006. 
That discussion was focused upon trading strategies and algo systems
and, since then, we’ve seen several market movements to create
additional market risk. 

Back then, I stated that Credit
Default Swap (CDS) derivatives were a $12 trillion market.  Today, Mr.
Munchau estimates that the CDS derivatives market is worth about $45
trillion.  This isn’t far off, as hedge funds have exacerbated this
market as mentioned and CDS derivatives were up 107% in the first nine
months of 2007 according to Tim Keaney, Co-CEO, BNY Mellon Asset Servicing.

So, what’s the problem with CDS? 

Well,
the way these systems work is like an insurance policy for a bank’s
credit risk.  For example, the bank takes a basket of loans that mix $1
billion to Panama, $5 billion to Mexico and $2.5 billion to Columbia,
and then offers the option on these loans defaulting as a credit
derivative.  The investor only has to pay on the derivative if the
borrower defaults.  Meanwhile, if the loans are paid off, then the
investor has made a packet of cash from the premiums the banks pays to
offset their credit risk.  That is why, in simplistic terms, credit
derivative are an insurance policy for a bank’s loan book and is one of
the major reasons contributing to the acceleration in lending over the
past decade.

This is fine in times of a boom, as there are
virtually no insolvencies.  However, during a recessionary period,
insolvencies rise and KAAABOOOOOMMMMMMM ...

... bang goes CDS derivatives and we have a major market explosion.

Now
we all recognise that there is market and credit risks in the financial
world, but we manage them.  What Mr. Muchau's column raises in my mind
is the question of whether there is a systemic risk in the markets?

Have
all of our debt-based tools and instruments created a systemic market
risk which could bring down the financial markets worldwide?

Certainly,
our debt instruments are untested.  That is why Warren Buffett calls
derivatives "weapons of financial destruction".  Certainly, subprime
has been a problem and, if CDS derivatives explode too, then we do have
a major issue.

Mr. Munchau's contention is that these instruments
have not been tested during a major recession and, if the USA enters a
recession, then the markets could implode.

Let's have a think about this then.

America
has enoyed a boom period for the past half century, much of it fuelled
by manufacturing and technological innovations.  As a result, the
dollar has been the world’s globally trusted currency and America has
used this strength to leverage debt.  However, this has changed as, in more recent times, some of the American economy has been fuelled by consumer demand and
government borrowing, based upon a strong dollar and driven by debt.

This
is all fine in periods of boom where America has strength but, with the
dollar weak, inflation on the horizon and a recession looming, Mr.
Munchau’s contention is that we should be worried.  Especially if this
recession is a deep and long one – of the sort not seen since the
mid-1970’s – as this would test the financial markets like they’ve
never been tested before.  After all, thirty years ago we did not have
the multitrillion exposures created by debt-based derivatives and
credit-based products.  As a result, the fact these products will be
tested for the first time in 2008 should be cause for concern.

Mr. Munchau also cites a report produced last week by Bill Gross of Pimco,
which roughly calculates loss exposures in CDS derivatives to be around
$250 billion.  Add that to the $400 billion plus in subprime losses,
along with a tasty little credit card crisis, and you can see why he’s
worried.

However, one thing he fails to mention is the
strength of Sovereign Wealth Funds (SWF) in China, India and the Middle
East and elsewhere.  Therefore, maybe we are actually seeing a balance
shift in capital ownership, which is why I predicted a US bank will be majority owned by a foreigner last week.

In addition, you always have two sides of the coin, a little like Alan Greenspan’s  gloomy view of the world versus Steve Forbes.

Anyway,
I’m sitting here on a Monday morning in a rainy London that has dark
grey clouds and no sunshine, so maybe that’s the reason why Mr. Munchau
wrote such a dark and gloomy report.

Are the doomsayers being far too pessimistic?

We shall see.