5 October 2008

Reasons to hoard cash, CDS settlement season next week

Another Reason for Cash Hoarding: Big Credit Default Swaps Market Test Imminent

Most observers have taken as a given that the increased disinclination of banks to lend to each other is counterparty risk, that is, the fear the money they lend out won't come back, or at least on the initially promised timetable (bankruptcy proceedings take time and usually lead to losses by unsecured creditors). Some wags have said that financial firms are unwilling to provide loans to each other because they know how bad their own books are, and won't want to be exposed to anyone in that shape.

But it turns out there may be a specific reason that the banks are hanging on to cash for dear life. Reader Glen pointed to a Financial Times piece that discusses the upcoming settlement of credit default swap payouts triggered by recent defaults. The banks apparently lack a good estimate of their exposures (settlement prices are to be set by auction). And banks that don't have enough to meet their obligations may fail. And more failures would trigger more credit default swap settlements, which could trigger more failures...

In other words, this process could take down an institution or two, and in a downside scenario, could lead to a cascading credit- default-swaps-induced failures, the financial equivalent of a firestorm. The FT article also pointed out that there could be banks that show large gains, but in these fragile markets, the costs of concentrated losses are vastly greater than the benefit of concentrated gains. Note also that the Fannie and Freddie settlements should in theory not be problematic (there should be no losses on the underlying bonds), but with exposure that large, there are worries about failure to settlement due to documentation or procedural irregularities.

From the Financial Times (hat tip reader Glen):

The $54,000bn credit derivatives market faces its biggest test this month as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual are settled.

Because of the opacity of this market, it is still not clear how many contracts have to be settled and whether payouts on the defaulted contracts, which could reach billions of dollars, are concentrated with any particular institutions.

According to dealers, insurance companies and investors such as sovereign wealth funds, which are widely believed to have written large amounts of credit protection through credit default swaps on financial institutions, could have to pay out huge amounts....

The "auction season" starts tomorrow, when the International Swaps and Derivatives Association has scheduled an auction for Tembec, a Canadian forest products company. This is followed by Fannie Mae and Freddie Mac auctions on October 6. Then, Lehman is settled on October 10, and Washington Mutual is scheduled for October 23.

Even though it is possible that some participants in the credit derivatives market will have to make large payouts, the flipside is there could also be big winners. For every loss in credit derivatives, there is a gain.

The amount of contracts outstanding that reference Fannie Mae and Freddie Mac alone is estimated to be up to $500bn. The default was triggered under the terms of derivatives contracts by the US government's seizure of the mortgage groups, even though the underlying debt is strong after the explicit government guarantee.

The CDS contract settlement could result in billions of dollars of losses for insurance companies and banks that offered credit insurance in recent months. The recovery value will be set by auction. Usually, the bond that is eligible for the auction that trades at the lowest price - the so-called cheapest-to-deliver - is the one that sets the overall recovery value for the credit derivatives.

In the Lehman case, numerous banks and investors have already made losses due to exposure to Lehman as a counterparty on numerous derivatives trades. The auctions next week are for credit derivatives which have Lehman as a reference entity. There are likely to be fewer contracts outstanding than for Fannie Mae and Freddie Mac because Lehman was not included in many of the benchmark credit derivatives. However, exposure remains unclear, which is one concern that regulators now have about the credit derivatives market.

Lehman's bonds have been trading between 15 and 19 cents on the dollar, meaning investors who wrote protection on a Lehman default will have to pay out between 81 and 85 cents on the dollar, a relatively high pay-out.

The previous biggest default in credit derivatives was for Delphi, the US car parts maker that went bankrupt in 2005 and which had about $25bn of CDS.

Update 2:30 AM: The Independent provides further detail:

The "auctions" to decide the value of bonds in default and the amounts the derivative insurance will have to pay out on them are organised by theInternational Swaps and Derivatives Association (ISDA), based in New York. ISDA has held only nine auctions since 2005, but this month will see five that will include many of the former giants of the US financial scene. The CDS market is opaque because contracts are only registered between the buyer and seller of the insurance, with no central record of the value or whereabouts of outstanding contracts....

The auctions will also be a big test of investment banks' procedures when the authorities are scrutinising certain securities firms for lapses.

"It is significant because it is probably going to be a good opportunity for investment banks to prove to regulators that they have their house in order. Any big investment bank will want to make sure that nothing is dropped on the floor," said an analyst at oneinvestment bank.

A record 409 firms had alreadyregistered for the Fannie and Freddie auction yesterday, with 300 having signed up in the previous 24 hours and hundreds more in the pipeline. The value of derivatives contracts covering the two US mortgage finance agencies, which were effectively nationalised last month, is estimated at between $400bn and $600bn.

The size of the Fannie and Freddie auction dwarfs the previous biggestdefault in credit derivative markets, which was for Delphi, the US car-parts producer that went bankrupt in 2005.

The auction system was put in place seven years ago to centralise agreement of the recovery rate on company bonds in default.

ISDA calculates an average value for the underlying bonds from varioussubmissions by market makers. If the average is 40 per cent, for example, then the issuer of the protection pays the "lost" 60 per cent to the CDS buyer.

Before the system was brought in, the buyer of protection had to physically find some bonds and present them to the insurer in return for the payment. The insurer then had to get back as much as possible from the defaulting company. The system has become increasingly important because, as the CDS market has grown, for many companies the value of outstanding CDS contracts vastly exceeds the value of the actual bonds issued.

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