Press acknowledges potential for new catastrophic financial losses
1. Bond Insurer Problem
UBS (big swiss bank) issued yesterday a profile of the likely damage should the top bond insurers (MBI, ABK and FGIC) get either downgraded from AAA status or get split into pieces (to segregate and thus protect their municipal bond clients from the diseased structured finance bonds they also insure).
The likely toll: another $203 billion in losses at banks, insurance companies, pension funds, etc worldwide.
The same day FGIC — downgraded now by all three major rating agencies — announced that it would indeed pursue a split.
So far the losses on structured finance bonds explicitly written down by banks etc (mostly CDOs and mortgage bonds, it seems) have totalled about $150 billion.
2. The Wider Universe
The vulnerabilities, however, across the universe of these “derivative” bonds are measured by the trillion.
The bulk of these trillions are “swap agreements” in which parties agree with each other to do certain things in the future upon the occurrence of specified trigger events.
(Asset-backed securities like mortgage bonds and credit card bonds, more complex things like CDOs, and swap agreements — all these fall under the general heading “structured finance” and exploded into the trillions when personal computers gave so-called bankers (“spreadsheeters”) new tools to play and wreak havoc with.)
The most common type of swap agreement, I guess, are interest rate swaps, where one party agrees to compensate the other if interest rates change dramatically, in exchange for a small regular premium payment thru the course of the agreement.
(Typically a CDO, for one example, has two swap agreements re interest embedded in it — an interest rate agreement and an interest cap agreement — to help the parties to the CDO control their interest rate risks across the life of the deal.)
3. Credit Default Swaps in Particular
A riskier pool of swap agreements, and huge — $45 trillion currently in outstanding contracts according to today’s shocked, shocked NY Times story — are credit default swaps, where “Credit Events” (eg, failure to timely pay interest on bonds, rating agency downgrades, etc) of a particular corporate entity are the triggers of the deal.
In these credit default swaps, one party (again) pays to the other a small premium each quarter thru the life of the deal, to buy “protection” against future Credit Events. And then receives compensation from the “protection seller” should a CE occur. The Times story linked above provides a good overview of the worries here.
Note however that the market for CDS has not frozen up across the last year — in contrast to that for CDOs and mortgage bonds and other asset-backed securities. Perhaps there’s a good reason. One hopes, at least …
For one: After the CDS embarassment re auto parts maker Delphi’s bonds (see the Times article), people turned away from “physical delivery” (of troubled bonds of the subject corporate entity) to cash payments as the preferred way to settle a CDS. So that’s one problem that one hopes shall not arise.
In the end the economic effect of a CDS is indeed that of an insurance policy. (One party pays a regular small premium. The other assumes risk for future bad events.) With the major institutions so heavily invested in these swaps, buying and selling protection across the universe of corporate entities, one hopes that in the event of a big 1930s-type breakdown — when the universe may suddenly be hit with tsunamis of Credit Events — that when the dust/cash settles the net debits for major institutions are manageable.
But who knows. If there are banks, insurance companies, etc out there that have used CDS to place large speculative one-way bets, they could sink overnight.
I remember, while drafting CDOs earlier this decade, chatting with a lawyer about what would happen if one of the major swap counterparties — eg, Lehman Brothers Special Financing, Inc. (I don’t mean to imply there’s anything particularly wrong here) — should default or (much less) weaken to the point of being downgraded by the rating agencies — either of which could trigger sudden wind-ups and/or defaults on the zillion swap agreements to which it is a party.
This would be another global tsunami. And if it happened at several large counterparties at the same time …
The answer, perhaps: When everyone is insolvent, no one is insolvent.
(Note that the obligations of LBSF in its zillion swaps are guaranteed by the parent company atop the Lehman empire: Lehman Brothers Holdings Inc. So the meltdown of LBSF as a swap counterparty would only occur it seems if LBHI failed to provide backstop.)
(Again — I’m not implying anything especially wrong with Lehman. I just happen to know something about their swap operations.)
