$45 trillion in credit default swaps: a number of concern

When we heard George Soros on CNBC talking about $45 trillion in credit default swaps outstanding, we were skeptical and wondered just what side of a trade he was on. $45 trillion sounded implausibly large, and after all, Mr. Soros has something of a history of influencing rather than simply describing events. But it turns out that $45 trillion is correct. Now we find Bill Gross of PIMCO echoing many of the same sentiments as Soros did in his piece in the FT the other day:

Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant “black swan” run that might break them. Jimmy Stewart—they hardly knew ye! According to the Bank for International Settlements (BIS), CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.

Defenders might claim no harm, no foul. Theoretically, many of these trillions represent side bets between risk seeking or risk avoiding parties—both adults at a table where the calming benefits of diversification work for the systemic good of all. Originators and existing supporters of these securitized WMDs might also point out that their reserves come in the form of equity and subordinated tranches comprising 10 or 20% of the repackaged loans. They do. But as this equity/subordination shrinks due to underlying defaults, the pyramid begins to unravel. Rating servicer downgrades can and do lead to the immediate liquidation of certain CDOs. The inability to rollover asset-backed commercial paper does and has led to the liquidation of SIVs or, pray tell, a misguided attempt to restructure them as super SIVs. CDOs and even levered municipal bond conduits known as “Tender Option Bonds” have been and will be similarly vulnerable to “Jimmy Stewart-like” runs as the monoline insurers that theoretically stand behind them are themselves downgraded to less than Aaa status.

The withdrawal of deposits from our new age shadow banking system has frightening potential consequences because a thinly capitalized banking system is always at risk relative to its more conservative counterpart. Visualize, as does Chart 1, in crude yet understandable form, today’s shadow system versus that of two decades ago.

While the exact amount of reserves supporting the Bank of Shadows is undeterminable, let’s go back to the $45 trillion BIS estimate of outstanding CDS for more insight. If total investment grade and junk bond defaults approach historical norms of 1¼% in 2008 (Moody’s and S&P forecast something close) then $500 billion of these default contracts will be triggered resulting in losses of $250 billion or more to the “protection selling” party once recoveries are inserted into the equation. To put that number in perspective, many street estimates ascribe similar losses to subprime mortgages, a derivative category substantially distinct from CDS insurance. Of course, “buyers of protection” will be on the other “winning” side, but the point is that as capital gains and capital losses slosh from one side of the shadow system’s boat to the other, casualties and shipwrecks are the inevitable consequence.

It’s pretty appalling that there is no effective mechanism in place — whether by the Fed, the BIS, or some informal consortium of central banks — for the effective regulation of hedge funds as lenders, as well as for using the credit default swap process as a substitute for capital. It is certainly possible that the system of international finance may yet dodge another bullet through the reflating by the Fed and other central banks, but this is no substitute for an appropriate regulatory scheme with a high degree of transparency.

As we have stated on a number of occasions, human history is characterized by great discontinuities that occur relatively frequently — both of a positive and negative nature. If we make it through this financial crunch relatively unscathed, that is no reason for complacency. Rather, it should serve as a reason to move much faster to correct the structural deficiencies of the international financial system that have the potential to cause devastating problems.

6 Responses to “$45 trillion in credit default swaps: a number of concern”

  1. Canucklehead Says:

    I guess the big question in all of this is who has entitlements/liabilities related to all of this and can these entitlements/liabilities be enforced in a court of law, and in the court of public opinion?

    In a shadow banking system, you natually have shadow self-regulation. When that fails (because the sun sets) do you have shadow losses? Can these shadow losses materialize as something more than shadows, or do the shadow parties affected need to go to a shadow court to have their claim adjudicated in a shady manner?

    Is there anyway to get to the chase here or do we rely on the opinions of inside players of the shadowy game who suddenly don’t like the light shining on their actions?

  2. Canucklehead Says:

    Here is an interesting read…

    http://www.typepad.com/t/trackback/20123/25423292

  3. Canucklehead Says:

    Here is an interesting read…

    http://nakedshorts.typepad.com/nakedshorts/2008/01/new-standards-q.html#more

  4. staghounds Says:

    Once upon a time, I participated in a bank fraud trial. The defendants owned several banks. They created a large pool of fake assets- in this case, unsigned promissory notes which reflected loans that were never made. They used this “asset” to permit making new, genuine loans to insiders. They then moved the fake loans on to another of the banks and did the same, et cetera.

    The key to this was that they had friends in the banking regulators’ offices, so when Mr. Carter was on his way to one of the banks, the Defendants could shoot the bogus assets onto its books before he arrived from Elmira.

    Of course when those damned voters changed administrations and the regulators descended on all the banks the same day…

    Sound familiar?

  5. gs Says:

    I accept that something is seriously askew with the US financial system. How to preserve the benefits of financial innovation while discouraging Wall Street wise guys from perverting the system; while minimizing the risks of unintended consequences; and without driving markets offshore as Sarbanes-Oxley is said to do?

    Beats me. It is a capital mistake to theorize before one has data..

    If sunlight is the best disinfectant, how ’bout the gummint creates a humongous data storage volume and requires that the particulars of every US-traded financial instrument–CMO, CDO, OTC derivative, whatever–be placed therein? Counterparties’ identities need not be divulged, but prices, trade dates, ratings and rating agencies must be.

    After the think-tank community and financial academy have made sense of the data–shades of the human genome project?–, an appropriate, uncomplicated level of regulation can be formulated. The intent is that, for a given financial instrument, mandatory transparency will add value that more than compensates the counterparties for low compliance costs.

    I suspect that the big merchant banks’ first preference is for no oversight so they can oligopolize their markets; their second preference is for heavy regulation that stifles the birth of agile entrepreneurial competitors.

    They should be allowed neither.

  6. Will Barrett Says:

    Our Economy is a “house of cards”. It will fall sooner or later, and I prefer sooner. There will be much pain, but that will be the case regardless. Many companies will go bankrupt, but the sooner and quicker this happens, the faster we can pick up the pieces.

    We should use that 700B to provide loans to entrepreneurs to start up local banks and buy corporate assets at auction.

    We have antitrust laws that have been ignored, and now these companies are too big to fail? Special interest will cry foul either way. Fed Chairman Paulson has said many times, that “the markets are the best regulator”. Let the chips fall when they may.

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