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February 09, 2007

Hivemind, what's the matter with the credit derivatives market?

There's a very interesting story in today's New York Times about the credit derivatives market. That may sound like a contradiction in terms to some people, but stay with me... Apparently, there's a $26 trillion credit card derivative market that nobody really understands, not even the world's top financiers:

High on [the head of the Federal Reserve Bank of New York]'s to-do list is understanding and monitoring the $26 trillion credit derivatives market — twice the size of the United States economy — the fastest-growing financial market there is. Its explosive growth has greased the wheels of the global economy, increasing liquidity, spreading risk and minting money for Wall Street along the way. But it has surged at a time when volatility has been low, debt has been historically cheap and defaults have been virtually absent. When this market gets tested, no one knows for certain how it may react.

Even the heads of some of the world’s biggest banks seem overwhelmed by the size and complexity of credit derivatives. “It makes my head swim,” said Kenneth D. Lewis, the chief executive of Bank of America. [NYT]

Maybe some economically savvy readers can help me out here. It sounds like "a market nobody understands" is actually a euphemism that for a looming disaster that nobody knows how to fix.

In 2004, Mr. Geithner’s staff conducted an extensive review of counterparty risk. But rather than dump its conclusions on the industry, he chose to stay behind the scenes while encouraging Mr. Corrigan to reconvene the group. In January 2005, Mr. Corrigan brought together a group that included some of the most senior executives on Wall Street. Six months later, the group produced a report that made 47 recommendations on issues from the very technical to the philosophical.

Central to the report’s findings were shocking weaknesses in the way credit derivatives were being assigned and traded around without any sense of who owned what. The so-called “assignment issue” was simple: credit derivatives were negotiated by two parties, say JPMorgan and Goldman Sachs. But banks were “assigning” the contracts out to others — like hedge funds — without telling each other. It was a little bit like lending money to a friend who is really rich who in turn lends it to her deadbeat brother and fails to mention it. [NYT]

You've got to read the whole article to get a sense of the anxious bafflement of the financial establishment.

Is this portrayal accurate? If so, what's the underlying problem?

[Edit: I initially surmised that the credit card derivative industry had to do, at least in part, with speculation on unsecured consumer debt (credit cards). I misunderstood. However, I'm still baffled why nobody understands the credit derivatives industry and why there's such widespread anxiety about the state of the market.]

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Based on the article, this doesn't have to do with credit cards:

"A credit derivative is a contract by two parties that allows a participant to reduce its exposure to the risk of default on bonds, loans, government securities or corporate securities."

Yeah, this isn't related to credit cards...I think it's like investing in whether or not you think some debtor is going to default, or something like that. As with other derivatives, they quickly get incredibly complicated, with all kinds of complex feedback effects all over the place. Wikipedia has some confusing information: http://en.wikipedia.org/wiki/Credit_derivatives

I get that the derivatives market is a kind of meta-speculation about which lenders are going to get paid, and which are going to get stiffed in certain credit deals (which may or may not involve credit cards).

But the underlying anxiety seems to have something to do with the possibility that there may be massive defaults.

I'm far from economically savvy, but I smell a euphemism also. Maybe there's an inherent problem with an economy based on people spending money they don't have.

Derivatives have been around a long time but took off a couple of decades ago. For the most part they seem to function fairly well. They represent vast bets opposing each other to insure against loss. The actuall market for derivatives is up above 250 trillion dollars.

Long Term Credit Management or LTCM went belly up a few years back and demonstrated some possible things to watch for. The Fed and the big banks immediately bought the debt for a couple of billion dollars in order to keep the couple of trillion dollars of attachments throughout the industry being affected from unwinding (as they say) into a much bigger loss.

Derivatives notoriously can be poorly documented and some drives toward forcing them to be more than a handshake in a bank vault have been explored. Some of the big banks have so much leverage in derivatives they outweigh the whole U.S. economy, though it is not clear how they could exert influence.

About a decade ago Alan Abelson of the Wall Street Journals weekly magazine; 'Barrons Magazine' constantly harped on the possible global danger of derivatives. Global means all the derivatives insurance protections go out the door if say a global dollar devaluation goes a little haywire. Since no one in the industry knows the whole (that is a secret the banks covet) this complicated system will probably erupt into an abrupt exposure of debt.

And there are a variety of scary scenarios about how rocky the derivative markets are. But so far nothing has happened, and they continue to grow because banks make a heck of a lot of money off them. Fannie Mae and Freddie MAC are based on mortgage package swaps which are derivatives. So all the attention on them these huge quasi government agencies was about how they could go bankrupt. The U.S. governement guarantees their debt by the way. So alarmists envision the whole world meetings the financial apocalypse. But the bad tiimes keep getting postponed and postponed.

No one can penetrate that world because of their current state of secrecacy and government regulation would probably not get done until a crisis hits. Or the banks finally decide they'd better get a hold of things because they can't get hold of things. Got that last one? No one else does either, but that is what the banks tell us.
thanks,
Doyle

I'm not claiming I fully understand the issue at hand here, but it seems the best way to describe this is like the banks function as a giant casino, and as most of us (except the enteral optimists/gambling addicts) know the house is always suppose to come up the winner at the end of the day. The banks appear to have some anxiety over the possibility "the house" (meaning them) could come out the loser in this particular game.

I'm trying to wrap my head around this. Is this at all analogous to speculating on oil or any other futures?

AL

credit card-related derivatives are not the primary concern right now. there is anxiety about the credit derivatives market because financial institutions relaxed lending standards at the height of the housing bubble and now lots of "subprime" borrowers are sitting on negative home equity with rising mortgage interest payments which they cannot pay. the derivatives market is supposed to parcel out the risk of risky loans among lots of different parties so that no one party is overexposed to the risk of any particular loan. however in this case there are a number of parties--nobody knows who they are--who in order to earn a higher return on their investment took positions based on the assumption that subprime mortgage loan defaults would not exceed a certain rate which however they are now exceeding. so the inability of some borrowers to pay interest on their loans is rippling its way through the financial system and since credit derivatives have never been applied to the mortgage market before and the parties most at risk are unknown no one is quite sure what is going to happen.

derivatives are a sound idea in principle but periodically scare the hell out of people, including some very knowledgeable ones like Warren Buffett. I believe that the derivatives market is too large and is mutating too quickly for anyone to understand or regulate effectively but nevertheless provides more benefits to society than detriments. it does make Wall Street richer, but also cushions the extremes of the economic cycle, increases productivity and makes it easier and more affordable for people to get loans. that said, there are plausible doomsday scenarios where a market failure brings down a major financial institution like JP Morgan and plunges the nation into recession. if the possibility alarms you, I recommend Marcus Aurelius.

This is an incredibly gross oversimplification, but here goes:

Let's say I lend you some money, $10,000 at 5% APR. You agree to pay it back over the next 12 months in 11 payments of $860 and a rump payment of $852. I'm ignoring compounding, so at the end you will pay back $10,500.

Now, there's various factors that I could take into account to assess the risk of loaning you this money, your job, your location, health, what collateral you offer, etc.

Adding all of those factors together, I decide that there is some risk, small, but some that you won't be able to pay back the money. I could accept the risk, with no mitigation, or I could attempt to offset the risk by trading it with someone else, say someone who has also just loaned out $10,000 at 5% in Denver instead of Brooklyn.

Theoretically, if I've swapped risks and nothing happens, each side earns what we would have earned. If you don't pay back, then the lender I swapped your debt with will take the hit, with me taking some sort of hit. If the debt I've picked up from Denver fails to pay back, I get hit.

Now, in theory I've done due diligence on the debt I've swapped, in practice though that may be impractical since such debts are not swapped individually but packaged up.

But that swap may not be enough to pare away my risk.

So, instead I package up 100 of the $10k loans I've made this month at 5% interest into a security. I offer that security into the market for $1.05MM.

Now that doesn't make sense, right, I'm not "making" money off the sale, and the purchaser doesn't seem to gain anything.

But what I get out of the sale is the $1MM back that I can now turn around and lend to other people, plus the expected interest, regardless of whether or not any of the 100 loans end in default.

The purchaser of the security gets a place to park money for a year (and depending on the terms of the sale, perhaps makes a haircut, perhaps I sell it for $1.025MM so if every loan pays off the purchaser makes $25k on the money).

Now, I can keep recycling that $1MM over and over, packaging up the debt and reselling it and shifting the risk off to someone else, as long as someone is willing to buy the debt.

When we were dealing with swaps of equal risk there was only so big that the market could get, however if I can actually sell off my risk, bank the money and lend it out again, I add liquidity to the market that may not really be supported by the market.

Put another way: it has some of the potential of a (legitimate or at least not illegal) ponzi scheme, which continues to work as long as the underlying assets retain or increase in value (the collateral), most of the payments continue to be made, and someone continues to buy the debt.

As I see it, there are three broad reasons to be concerned about a crash in the credit derivatives market.

First, you should be concerned if you're invested in this market. This is the greatest risk, of course. If you have diversified investments, including pension plans and insurance plans, you probably have some risk this way. That's only fair, since you've probably been making money off this market the same way.

Second, your local government may have invested its assets in this market. Big city managers probably know better, but I know some small towns went bankrupt this way back in the 90's. The return was great for a while...

The third and potentially scariest reason for concern is that it's possible a collapse of the derivative market will somehow have an effect on the real economy, slowing it down and causing a recession.

Well, I work in a very quant-heavy field, and do some limited work with credit derivatives. Here's a brief-ish summary of the reasons AND the problems.

Credit derivatives are basically bets on future loan repayment and/or interest rates. As such, they isolate one sort of risk. This can be very useful if, for example, you own a corresponding risk. For example, if you are an insurer, who has incoming cash flows from premium, you can buy a guarantee on the rate at which it can be invested. (Remember the business case with a stand selling umbrellas and suntan lotion? If you sell both, your income is much more predictable than if you only sell one.)

There are two big problems with the whole derivatives market. One is a real problem, the other is a "paper" problem. (It's serious, but it has to do with accounting rather than cashflows.)

The real problem is counter-party strength. If I sell you a promise that if Megan doesn't pay you, I will--it matters whether I actually have the money to do so. Unlike insurance, the law of large numbers doesn't help much, since defaults are correlated. (In non-geek language, if I promise to pay $1000 to you if Megan dies, my losses get predictable as I insure more people; Megan dying doesn't make Joe more likely to die. If I promise to pay you $1000 if you are caught in traffic, and I make that promise to everyone who lives and works in the same areas you do, my losses don't get much more predictable--if there's an accident, everyone is caught in traffic. Businesses not paying their loans off is like the second scenario--you have waves of losses.) There is a lot of worry about whether the parties selling some of these derivatives will be able to cope with another year like 1981. Since a lot of deals have A owing B if C doesn't pay D, and A has another deal where E pays A if F doesn't pay D, exactly how much risk A has can get real hazy real fast.

The paper problem is the one that scares Buffett. Credit derivatives are individualized, and privately sold. If you own traded stock, you know how much it's worth; if you own bonds, you know how much they are worth. You can look at the market price, and see--and everyone will have the same price. That's not how privately-sold securities work; you need a way to price them, so you build a model--with assumptions. So you can get a situation where A sold B a credit derivative for risk X. B says that their protection is an asset worth $1000; A says that it's a negative asset of $500. Both are being legal and ethical, but the valuation mismatch is a dangerous result.

OK, so the raison d'être for the credit derivatives market is to spread the risk around from prior loans, get the outlay back and flip it into new loans. What happens when a substantial number of borrowers default? How quickly does this house of cards collapse? I guess that's why these big banks are trying to get a handle the market.

I've been concerned for at least a year now that our economy is in serious danger. Without even considering the clear problems of the Federal deficit and the ballooning cost of the "GWT", I see trouble looming. I cann't trust any positive figures touted by the Bush administration. Unemployment info alone is misleading as a number of folks have given up and/or living off the grid.

Locally, I've noticed alarming trends. I've noticed a lot more people living beyond their means. Here in Orange County NY, a lot of McMansions have been built in the last 5 years. Some are now suddenly up for sale in a rapidly softening real estate marked. New construction has slowed noticeably. Just this week it was reported that in 2006 Massachusetts foreclosure filings were the highest in recorded history.

Regionally, layoffs are starting to impact across the board: another 3000 pink slips at Kodak on top of the 15000 already announced, Time Inc., Capitol and Virgin Records merge, 4% of NY Times work force, etc.

I have a feeling that it's going to get much worse before it gets better.

AF

One thing to keep in mind w/ derivatives and the like is that the money amounts mentioned are nominal in a way- there's that much money "at risk" in some sense- some in a stronger sense then others- but much much less then that actually changes hands.

"Maybe there's an inherent problem with an economy based on people spending money they don't have."

In his history of capitalism, the French historian Fernand Braudel says that the Amsterdam stock exchange of the 1600s was already the scene of fairly complicated put and forward option plays. And at that time, Amsterdam was the most advanced economy in the world. So "an economy based on people spending money they don't have" has been around for a very long time, and advanced financial instruments have historically been associated with the advanced nature of an economy. I'd be wary of making the simple assertion that complicated financial instruments are a sign of weakness.

The Braudel work Civilization and Capitalism: 15th-18th Century is a great read - it made it onto my "best books" selection. But while primitive financial instruments may have existed in the 1600s, I think there are new systemic risks introduced by the speed of modern communications and the range of instruments available.

Epc's description was helpful, keep in mind there is a failsafe in banking that does not exist in all industries. Banks can borrow from the Federal Reserve at prime. If there are many defaulting derivatives the interest rate will rise but this will spread the risk over the whole country whereas a regional financial network would be ruined.

I'm not saying I'm confident in this system, but it is how it is supposed to work.

There are many other things the Federal Reserve can do, whereby it does hold the reins of this economy, for good or for ill.

The thing which puzlesme is the example given in the NYT:

"It was a little bit like lending money to a friend who is really rich who in turn lends it to her deadbeat brother and fails to mention it."

And what is wrong with that? The loan to the friend is based on his credit— he will pay it back no matter. When I take out an unsecured loan the bank doesn't ask me what I will do with the money. If I lend it to a deadbeat brother then that is my problem. And to be strictly scrupulous, it would indeed show up on my own balance sheet as an asset should my lender be asking me for updates, which it is entitled to do.

Now I am not saying there is no problem -- I just don't understand it yet.

Do you have any other articles or info on credit derivatives pricing or trading? I found some interesting information on the following sites:

http://www.axiomglobal.com

http://cdsaxiom.com

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