Monday, March 10, 2008

Business Risks From Current Credit Derivatives Market Turmoil

Financial Times reported today on the Credit Derivatives Market Turmoil:

“Turmoil in the credit derivatives markets is having an increasingly brutal impact on the wider financial system as a vicious cycle of forced selling drives risk premiums on company debt to new highs.

The trend accelerated on both sides of the Atlantic last week as investors rushed to unwind highly leveraged positions in complex structured products. The cost of protecting US investment grade debt against default soared to a high of 188 basis points, from 80bp in January.”

With the current turmoil in the credit derivatives market, the business risks have substantially increased. Here are a few of the risk factors rising from the credit derivatives turmoil that I think any prudent financial manager should take into consideration:

Counterparty Default Risk: For those investors who are “In the Money,” the focus is on whether the counterparty, the party who is on the other side of the trade and owes the money, can pay on the trade. As the uncertainty of the counterparty’s ability to pay increases, investors will choose to buy credit default swaps (CDS) to hedge against the possibility of the counterparty not being able to pay.

Leverage Risk: For those investors, such as hedge funds, who had borrowed money to buy credit derivatives, managing their leverage risk becomes important. Typically, being leveraged 10 to 1 or more, any drop in the value of their credit derivatives will trigger a margin call from the lender. If the investors do not have sufficient cash or cash-equivalents, typically UST, to provide additional collateral to the lender, the lender may force the investors to liquidate some or all of their credit derivatives holdings. This forced liquidation drives down the value of the credit derivatives.

Market Risk: As more investors begin selling credit derivatives to meet margin calls, the risk of these investors not being able to meet the margin call or going out of business increases. This will force lenders to buy new or additional CDS as insurance. As more lenders buy CDS, the price of CDS increases. This is clearly evident in current markets as reported by the Financial Times.[i]

Liquidity Risk: As more lenders worry about whether they will be made whole on credit derivatives trades, their expenditure on CDS increases, resulting in lower earnings. As the risk of counterparty default increases, there is less desire on lenders to lend. As lenders slow or even stop their lending, a liquidity crunch will occur, forcing borrowers to seek alternative and more costly sources of funds.

Modeling Risk: As the volatility in credit derivatives pricing increases, the risk of the models used to price the credit derivatives being inaccurate increases. The underlying variables used to value the credit derivatives may not be updated on a timely basis, causing incorrect position marking and financial reporting requirements. This may result in material financial losses. As models' complexities have increased over the years, teams of ‘quants’ are now required to maintain the integrity of the models used to price and trade credit derivatives. For investors who rely on monthly review of their models' integrity, their risk of mis-pricing and/or mis-marking their credit derivatives positions have increased.

Financial Risk: Due to the complexity, lack of transparency, and difficulty in properly pricing and marking credit derivatives, the risk that an investor may incorrectly price their credit derivatives positions has increased. This may result in material financial losses from the incorrect mark-to-model pricing.

Reputational Risk: Some counterparties who have reported or to report financial losses may see rating agencies reviewing their credit ratings for possible downgrades. Although the downgrades may not occur, the perception of credit weakness will result in higher cost of CDS to the lender, should they decide to lend. This perception will reduce their ability to borrow at a favorable rate or miss investment opportunities.

According to the Federal Reserve Bank of Atlanta, the credit derivatives market as of second half of 2006 had a notional of $35 billion[ii]. According to ISDA, International Swaps and Derivatives Association, the notional value of the CDS (credit default swaps) in 2006 was $34.6 trillion, an increase of 102% from 2005[iii]. According to the Fed Reserve, the total outstanding corporate debt at the end of 2006 was $6.3 trillion[iv]. In other words, the credit derivates market is equivalent to the CDS market, both of which are 5.5 times greater than the actual outstanding corporate debt.

What this implies is that majority of the credit derivates are speculative and nearly fully hedged. However, this picture will become very sullied as the counterparty default risk continues to increase. If that happens, which I think will be the next phase of the credit unwinding, the cost of CDS will continue to go higher.

Ed Kim
Practical Risk Manager

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