A bad market? You ain't seen nothin'
Nearly seven decades ago, the eight months between Germany's invasion of Poland in 1939 and its invasion of France in 1940 was known as the "phony war" -- a period of escalating anxiety, denial, appeasement, danger and death, but nothing like the murderous global train wreck soon to follow.
Likewise, we may come to look at the period between July 2007 and January 2008 as a sort of phony war in the worldwide credit crisis, because although the market has fallen 15% since summer, there have been no defaults of key bonds or asset-backed securities. The curious lack of real blowups has led even seasoned observers to believe that fears were exaggerated and that chaos will be averted.
In reality, however, the skirmishes we've seen so far might be little more than a prelude to a deeper, harsher, longer decline than most yet perceive possible. And in a very postmodern twist, it is beginning to look like unexpected consequences of an investment instrument designed to mitigate risk could turn out to be the nuclear option that bombs the globe into the financial equivalent of World War III.
Banks left exposed
That instrument is the credit default swap, or CDS. It was developed as a way for bondholders to buy insurance against the possibility that companies might fail to pay their debts, and later it morphed into a way for big traders to actively bet on the likelihood of the default of bonds and other credit instruments. But what is only now becoming clear is that major U.S. and European banks and hedge funds bought up to $20 trillion worth of that insurance to offset their exposure to mortgage-related securities they owned. And those banks and hedge funds are discovering the sellers of the swaps may not pay up.
This leaves already deeply troubled banks virtually naked at just the moment they most need protection, as the pace of credit defaults is likely to accelerate this year so long as the Federal Reserve remains behind the curve in cutting interest rates. It's as if the banks already have pneumonia, and they're now being marched into a snowstorm wearing little more than bathrobes.
The problem surfaced to an important degree in a footnote to the news last week that Merrill Lynch (MER, news, msgs) would take an $11.5 billion write-down of bad debts for the fourth quarter. Of that amount, $3.1 billion was a write-down of credit default swaps that Merrill had purchased from bond insurer ACA Capital to hedge the risk of owning a lot of collateralized debt obligations, or CDOs, which are leveraged bundles of asset-backed securities. (In a typical CDS transaction, a debt holder or speculator agrees to pays 1.5% or more per year for $10 million worth of insurance on a specific slice of a debt security.)
This means that not only is Merrill unprotected against a default in the CDOs, but it has lost all the money it has paid for that insurance. It's as if you had paid $200,000 in premiums over the years in a $1 million life insurance policy for your spouse, and when a death occurs not only does the insurer tell you it's broke and can't pay -- but your premiums are down the drain, too.
Don't count on insurers
Several other major banks and brokers, such as the Canadian Imperial Bank of Commerce (CM, news, msgs) and Lehman Bros. (LEH, news, msgs), have been stiffed by ACA to the tune of billions, and all have let the insurer seek more capital before forcing it into bankruptcy. So the case gives us just a taste of what may come. Consider that ACA was no fly-by-night outfit. It was AAA-rated and met all standard benchmarks for safety. Yet those benchmarks now look ridiculous, as the company was allowed to provide $60 billion worth of guarantees on a capital base of just $500 million.
Can you imagine, as a citizen, if you were allowed to collect fees on $60 million worth of loan guarantees because you owned a house worth $500,000? It's nuts.
Specialty bond insurers such as ACA and troubled Ambac Financial Group (ABK, news, msgs) at least are well-known companies subject to modest scrutiny. But because we are coming out of a long period in which debt defaults have been unusually low, hundreds of little-known hedge funds, pension funds and insurers worldwide were lulled by a false sense of complacency into the practice of selling CDSs -- and their ability to pay up in the event of widespread defaults amid a long, hard recession is not just in doubt but completely unlikely.
In other words, if you think it's hard to get your insurance company to pay off in the event of a car accident, just wait until you hear the screaming from CDS holders in the next couple of years. Here are a few ways insurance sellers will try to jump off the hook, according to derivatives expert Satyajit Das, who spoke to me this week from Pune, India:
Documentation difficulties. Ever go into a store to try to return a piece of merchandise and forget your receipt? Or have you had clerks point out that the return period expired two weeks ago, or that the fine print says the warranty is not good if the package been opened or if the item was bought on a Tuesday, or that they're sorry, but Bob, the guy who wrote the receipt, doesn't work there anymore, and current management can't honor it? Das says CDS sellers' attorneys have innumerable ways of claiming your contract does not apply. The big problem is that the standard CDS contact is a trading instrument that is standardized for simplicity and may not match the risk in the way its owner expects, even if the owner is a sophisticated investor like Merrill. It cannot be tested except by a real default, and by then it may be too late.
Weakness in the instrument. If you bought a CDS contract on the bonds of a company that has been bought by another firm, the new owners may not be obligated to pay up. This is particularly true if the original "reference obligor," as they say in the business, is based in one country and the new owner is based in another. Foreign courts might not enforce contracts. Ownership change can also change the credit risk of a derivative in unforeseen ways, preventing you from even having a seat at the table to protect your interests.
Credit event definition. CDS contracts rely on a trigger to go into effect -- typically a sharp downgrade, failure to make a payment or bankruptcy. But CDS buyers may not be protected against all defaults in all currencies, particularly if a bondholder restructures rather than enter bankruptcy. CDS holders may thus have trouble proving a default has taken place. Additionally, CDS sellers may be in such dire straits that forcing them into bankruptcy may exacerbate losses.
Settlement and collateral problems. The CDS holder must deliver a defaulted bond or loan, but today CDS sales are six to 10 times larger than all bonds outstanding due to the way they were resold and leveraged. In the case of car-parts maker Delphi (DPHIQ, news, msgs), protection buyers received an average of just $3.6 million per $10 million CDS contract, meaning they were not fully hedged and had no further legal recourse to recover.
Counterparty risk. This is when you realize that CDS contracts don't eliminate credit risk -- they only transfer it. Instead of just worrying if a bond will pay off, now you have to worry about the health of the insurer. Transference of risk was the main reason to buy CDSs, but in an era of extreme leverage, the example of ACA Capital shows that no counterparty is safe, especially as many banks and funds have "daisy-chained" their risks together.
In September, Das told us he believed the unwinding of the great post-millennial credit bubble had barely begun. Now he thinks that the game is finally in the first inning, with much more pain and heartache to come. He points out that all of the new capital raised by UBS AG (UBS, news, msgs), Citigroup (C, news, msgs) and Merrill Lynch has only made up for the losses they have acknowledged so far in the fourth quarter of last year, and that if they continue to need to write off their credit default swaps and loans as customers sink under the weight of recession and default on loans, they will be taking equally large deductions against earnings in every quarter of this year and into 2009.
With at least $1.5 trillion in off-balance-sheet debt coming onto their books and tens of billions of dollars in CDS contracts potentially up in smoke, Das figures the banks will need $200 billion in new capital to shore up reserves at the same time they suffer $100 billion in real loan losses. If they need $300 billion -- and so far the sovereign wealth funds have, with some reluctance, put up only around $25 billion -- you start to see the potential size of the problem that lies ahead.
"The hole is bigger than they or their investors expected," Das said. "And they're still digging."
In short, though it appears the Federal Reserve has answered its wake-up call with an interest-rate cut of unprecedented size, I continue to recommend that you treat financial stocks with skepticism. Their Maginot Line has been breached, and reinforcements are bogged down.
To learn more about bond insurer ACA Capital, visit its Web site. To learnmore about Merrill's ACA write-down, check out this Bloomberg story. . . . Satyajit Das occasionally publishes a blog on quantitative finance at his publisher's Web site. His latest book, "Traders, Guns and Money," is a very amusing and detailed look at the "knowns and unknowns" in the Wild West world of structured finance. It's the best book to help you understand the underpinnings of modern credit and currency markets. . . . The Economist published a good primer on credit derivatives last April. Read it here. . . .
Business is booming for professionals skilled in unwinding and auditing the credit-derivatives wagon trail. One pro on the case is Janet Tavakoli. Check out her Tavakoli Structured Finance site here. She calls the whole mess the "largest Ponzi network in financial history." . . . The leader in credit-derivatives indexes and trading is International Index Co. and its Markit brand. Visit its site here. . . . The business is fully international, as you can learn at Vinod Kothari's Credit Derivative Web site. To learn more about the "phony war" phase of World War II, click here. Learn about the Maginot Line here.
A bad market? You ain't seen nothin' - MSN Money