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Derivatives Counter-Party Credit Risk: Lessons from AIG and the Credit Crisis
Damien Laker CIPM, CompoundingHappens.com
22nd September 2008
The insurance company AIG received an emergency US federal
government loan of $85 billion on Tuesday 16th September 2008. Over the
previous three quarters, AIG had incurred losses of $18 billion on mortgage
insurance that it had written. The popular press have been describing this
as a "bailout". This seems to suggest that the management and shareholders
are being rewarded by the government for their misallocation of capital.
However, the US government has taken 80% equity in AIG, and is charging interest
on the $85 billion loan at an 850 basis point premium over 3 month Libor.
(See
Business Spectator's report on AIG for an account of the facts). This
is certainly not a sweet deal for existing AIG shareholders: the government has
taken most of their equity, and is charging them a swingeing interest rate on
the loan. The government may not get the full principal of the loan back
if there are difficulties in unwinding AIG's portfolio of problem assets, but
let's be clear about this: AIG shareholders are not getting a free handout from
the government. Rather, they are losing most of their investment to the
government. Admittedly, some aspects of the US government response to the
credit crisis do seem rather unfocused and hastily cobbled-together (see the
New York
Times critique published by fabled economist Paul Krugman). But,
looking strictly at the AIG affair, it is hard to make a case that the
shareholders are being given a handout from the taxpayer. There are more
interesting ways of thinking about this question.
The two most interesting questions are perhaps:
1. How did AIG fall into such a weakened state? and
2. Why did the US government decide to intervene?
As it turns out, the answers to both these questions are
related. They have to do with credit risk, which is the risk that a
financial counterparty will not be able to pay all its obligations when they
fall due.
Credit risk is a double-edged sword. Keynes
supposedly once said, "If you owe your bank a hundred pounds, you have a
problem. But if you owe a million, it has." This dictum carries a very
important insight into the allocation of risk. If you are dealing with a
risky counter-party, the risk of the counter-party's portfolio exploding is also
a significant risk for you.
AIG wrote a lot of credit default swaps (CDS) and similar
instruments. The purpose of these instruments (from the standpoint of the
person who purchases them) is to provide insurance against a counterparty
failing to repay its debts. So, for example, if you owned bonds issued by
XYZ Bank, you could buy a CDS (at perhaps 3.5% a year) to insure against the
risk that the XYZ Bank bonds would fail to make their payments of interest or
principal. By using Credit Default Swaps, companies were able to hold
portfolios of bonds where they had (at least in principle!) eliminated the
credit risk.
Inevitably, more complicated strategies quickly emerged.
By buying and selling CDS at the right times, one could make bets on whether the
market's perception of a bond's creditworthiness would go up or down.
Instead of investing in corporate bonds, people started "slicing off" the
component of a corporate bond's return that depends on credit risk, and they
traded this return with one another.
Some interesting aspects of this story are told in the
article
Buffet's "time bomb" goes off on Wall Street by James B. Kelleher.
According to Kelleher, the CDS market increased from $631 billion in the year
2000, to $46 trillion in the first half of 2007. Credit default swaps are
an "over the counter" instrument, which means they are simply traded between one
party and another. This stands in contrast to exchange-traded instruments,
where brokers and exchanges sit between the parties to a contract.
Kelleher reports that one hedge fund insured an institution called UBS (Used to
Be Smart, previously known as Union Bank of Switzerland) for the credit risk on
$1.3 billion of subprime mortgages. The hedge fund took about $2 million a
year of annual premium for insuring this risk. The risk was backed by a
subsidiary of the hedge fund, capitalised at only $4.6 million. So long as
the mortgages held strong, the hedge fund made wonderful profits. Once
things headed south, the hedge fund's problem swiftly became UBS' problem.
As Glenn Stevens, the governor of the Reserve Bank of Australia pointed out last week, "a lot of the risk
ended up being concentrated on the books of highly
leveraged institutions". "High risk and high
leverage proved to be a fatal combination," Glenn
Stevens said. "It always does."
What about the US government rescue package (known as the
TARP: "Troubled Asset Relief Program")?
Viewpoints about USA politics are very polarised at the moment. Hence a
lot of the commentary on US government attempts to alleviate the crisis are
either pro-government cheerleading, or anti-government quasi-socialist rhetoric
about "privatising profits and socialising losses". Neither of these
diametrically-opposed viewpoints offers any useful insight into the problem.
Indeed, these viewpoints seem to entrench ignorance. Leaving all of the
politics aside, the interesting financial questions about these recent events
concern counterparty risk. Somehow, financial markets allowed a situation
to develop where a small number of under-capitalised counterparties held a large
amount of credit risk. Moreover, these counterparties paid a lot of
attention to their accounting profit and loss, but very little attention to
their market exposure.
From our humble viewpoint at CompoundingHappens.com, where
we have tried to help some firms implement meaningful analysis of their
investment performance, the source of the problem has often been astoundingly
clear. Ask a large US financial institution their accounting profit or
loss, and they can tell you to the exact cent. Ask them their market
exposure, and they will admit to being completely clueless. How can a
large financial institution possibly navigate their way through the complex
world of derivatives when they are not even measuring their
exposure in any
systematic way?
There have been many causal factors behind the current
crisis, including lax monetary policy, poor lending practices,
a disastrously incompetent US President, poor regulation of banks and hedge
funds, not to mention lashings of greed on the part of everyday folk who used
debt to finance speculation in real estate markets. But, if was necessary
to identify the most critical point of failure in the whole system, we think it
was the unprecedented use of debt derivatives (Credit Default Swaps (CDS) and
Collateralized Debt Obligations (CDO)) to spread credit risk into every nook and
cranny of the world financial system in a way that was poorly understood.
Many firms that use derivatives have grossly inadequate operational processes
for dealing with them. For example, trading, settlement, and novation are
often not automated. Also (this is our main bugbear) many large firms
persist in the antediluvian practice of analysing portfolio performance using
the accounting profit and loss, with no reference to the economic
exposure of the instruments they are holding.
These firms are "penny wise and pound foolish" by not using modern techniques
for analysing their portfolios taking exposure
into account. This is an operational weakness. But the current
crisis has demonstrated very clearly that operational weaknesses can combine
very potently with other factors to create financial losses on a scale that
could hardly have been imagined. This is an aspect of the current crisis
that we think is gravely under-estimated. With respect to the learned
economists and central bankers, they usually have little knowledge or experience
of the operational processes in financial firms. Enough operational
weaknesses combined together can become "an accident waiting to happen".
We write below about regulatory initiatives to improve the
trading and settlement of credit derivatives.
We hope that regulators will also become enlightened about
the need to dispense with any kind of investment performance analysis that
doesn't properly take exposure into account.
It is just plain misleading.
Insurance has always been a business that involves small
regular profits punctuated by large irregular losses. For example, a
number of high-net-worth individuals discovered this when they suffered huge
losses as a result of their activities as Names in the Lloyds of London
insurance market. A
TIME
Europe article describes how many Names learned the hard way that pledging
the full extent of your personal wealth was no mere ritual involved in becoming
a Name. In most years, a Name would simply receive a cheque in the mail
rewarding them for their capital pledge. However, when asbestos claims
reached their height, many Names faced the threat of bankruptcy. What they
had failed to consider was their market exposure - instead, as so many investors
do, they only considered the annual profit and loss statement.
The celebrated writer Nicholas Taleb has ignited many
imaginations by describing investment strategies that resemble writing options
as "picking pennies in front of a steamroller" [1]. People like
consistently profitable investment strategies, even if the downside of that
strategy is the possibility of suffering catastrophic loss once in a blue moon.
This is why people so easily focus only on the profits, and forget the
counterparty risk, and the total exposure of their position. These
strategies easily become leveraged, but the person implementing the strategy may
be oblivious to the leverage, based on the mere fact that they have not actually
borrowed money.
In conclusion, we suggest that the four main lessons to be
learnt from the credit crisis are:
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1. Financial institutions need to understand and
report their exposure, as well as their accounting profit or loss. Without
understanding both these dimensions, and analysing them together, there is no hope for meaningful risk
management. Pragmatically, we think that any decent financial institution
in the 21st century should be running a portfolio performance analysis system
that calculates daily weights and returns using exposures and accounting market
values. Anything less is obsolete technology.
2. Participants in financial markets need to think
carefully on the difference between exchange-traded and OTC derivatives.
Most exchanges have complicated sets of rules to contain the contagion by the
failure of one counterparty. Brokers are required to know their client,
and to use daily margining to keep track of whether the client's capital base is
being overstretched. Brokers are supposed to monitor the parties who trade
through them, and if a broker's client fails to pay their obligation, the
exchange rules may require the broker to draw on its own capital to rescue the
counterparty. In contrast, when you trade OTC with a counterparty, you
need to understand that the counterparty themself could be your largest risk
exposure. The whole credit crisis has involved OTC derivatives.
Perhaps the brokers and exchanges that facilitated an exchange-traded system
really did add some risk control and stability. And perhaps they should be
favoured in the future.
3. Counterparty risk. If your counterparty is
losing on a deal it did with you, you may feel that you have protection.
But think for a second: is that counterparty losing on many other deals also?
If so, you could get sucked-down into the loss.
4. Strategies that are like writing an option have
unintuitive payoff curves. In most periods, the payoff will be to earn a
relatively small premium. But, just occasionally, the payoff will be a
potentially destructive loss. Think carefully about how much you want your
business to have this sort of payoff curve. You will also need to think
about how much you want to deal with counterparties who have this kind of
payoff curve. Gathering information about your counterparties' payoff
curves can be costly or even impossible.
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See Also
References
1. Taleb, Nassim Nicholas, The Black Swan: The Impact of the Highly
Improbable, Random House, 2007.
Update (26 September 2008)
Amid all the emotional hand-wringing about the proposed rescue plan (TARP), we have
found two pieces of lucid commentary:
- Bill Clinton did a
TV interview, in which he clearly explained the source of the crisis and
why it needs to be solved. He pointed out that many rescue plans in
the past have turned out to be profitable for the government, and that this
plan could also be profitable. This stands in total contrast to the
misconception that a rescue plan would necessarily involve ordinary US
taxpayers handing out free money to wealthy financial market
participants.
- Vikas Bajaj, of the International Herald Tribune, contributed a
perceptive story on the key issue of how the distressed securities might
be valued. He reports that, in July, Merrill Lynch sold $31 billion of
mortgage-linked securities for 22 cents on the dollar. Also, in
November 2007, a Chicago-based hedge fund bought $3 billion of
mortgage-related securities at 27 cents on the dollar. An example of a
relatively high valuation is at Citigroup, where similar securities are
valued at 61 cents on the dollar. He also reports that Robert Hansen,
from the Tuck School of Business, said that the government might possibly
make a profit on the rescue plan.
It is interesting to note that purchasing "distressed debt" is an established
profitable strategy for hedge fund investors (see
http://en.wikipedia.org/wiki/Distressed_securities). In the current
environment, market failure has taken place, and the financial markets are
unable to digest the enormous volume of ill-conceived securities that are on the
hands of large financial institutions. The US government needs to
alleviate the failed market in order to prevent a dreadful downturn in the
economy. So some form of rescue plan is necessary. This necessity
seems to be fooling many people into overlooking the prospect that a rescue
plan, if conducted at all competently, will most likely be one of the most
profitable distressed debt portfolios in the history of the world. The US
government is in a unique position to ensure the profitability of any investment
they make, because they control the regulatory agencies, and they have
law-making ability (subject to the whims of Congress).
Update (2 October 2008)
The popular press have done a very poor job of covering the financial crisis.
A recent exception to this appeared in the New York Times on 30th
September 2008. In
"Rescue the
Rescue" by award-winning journalist Thomas L. Friedman (NOTE: Free
registration may be required to view this web page), the author describes
the enormous risk that Congress is running by rejecting (or at best delaying)
the rescue plan. He writes:
"I’ve always believed that America’s government
was a unique political system — one designed by
geniuses so that it could be run by idiots. I was
wrong. No system can be smart enough to survive this
level of incompetence and recklessness by the people
charged to run it.
"This is dangerous. We have House members, many
of whom I suspect can’t balance their own checkbooks,
rejecting a complex rescue package because some
voters, whom I fear also don’t understand, swamped
them with phone calls. I appreciate the popular
anger against Wall Street, but you can’t deal with
this crisis this way."
The issue Friedman doesn't mention is that those of us who live outside the
USA are still dependent on the decisions of Congress, even though we have no say
in the US political process.
At the time Friedman wrote his article, the fate of the world financial
system seemed to depend on the decisions (or non-decisions) made by small number
of US politicians who are under extreme duress from a pool of largely
ill-informed and short-sighted voters. These voters, in turn, are mainly
basing their views on heavily distorted media reporting about the proposed
"bail-out". This is not democracy (or financial decision-making) at its
finest.
Update (3 October 2008): The Legislative Process Descends into Farce
It has now been reported by the San Francisco Chronicle ("House
bailout legislation larded with - yup, you guessed it - earmarks" by Zachary
Coile) that the rescue bill has expanded from 3 to 451 pages, and that it now
contains a large number of earmarks. An earmark is a spending proposal --
unrelated to the primary purpose of a bill -- that is added to the bill in the
hope that it will pass into law without receiving proper scrutiny on its own
merits.
According to the report, the bill now includes:
- "a $2 million tax benefit for makers of wooden arrows for children;
- a $100 million tax break to benefit auto racetrack owners;
- $192 million in rebates on excise taxes for the Puerto Rican and Virgin
Islands rum industry;
- $148 million in tax relief for U.S. wool fabric producers; and
- a $49 million tax benefit for fishermen and other plaintiffs who sued
Exxon over the 1989 tanker Valdez spill".
When the bill was first proposed, many commentators expressed concerns that
the money in it would be used wastefully. This urgent bill, aimed at
unclogging the arteries of the world's financial system, now contains these
extra measures (added by politicians from both sides) that are undoubtedly "pure
pork".
We reiterate our observation that this is not democracy (or financial
decision-making) at its finest.
Update (20 October 2008): Reducing Counterparty Risk in Derivatives
The largest participants in OTC derivatives markets are well aware that the
absence of any exchange or similar centralised counterparty raises concerns
about counterparty credit risk.
Risk magazine
reported in May 2008 on a proposal to create a clearing-house for Credit Default
Swaps (CDS). The clearing-house would be a central counterparty, reducing
systemic risk through its ability to net-out gross exposures, and to require
daily posting of variation margins from all participants.
Without a centralised clearing-house, the failure of one institution could
lead to a "domino effect", as other institutions in turn suffered losses in the
OTC market. A proposed clearing house would do checks on the
credit-worthiness of each market participant, and it might include a default
fund, which would serve as a shock-absorber in the event of the failure of an
institution.
In August 2008, The Economist
reported further on the proposals to establish a clearing-house for credit
default swaps. They reported that only half of all OTC interest-rate
trades are automated. This leads to backlogs in the processing of trades,
and the bigger the backlog, the bigger the risk. Hence, regulators such as
the Fed are urging large institutions to agree on improved trade processing
systems.
The legendary hedge-fund investor George Soros has been quoted as saying that
the risk of counterparty failure in the CDS market "hangs over the financial
markets like a sword of Damocles that is bound to fall". His comments were
reported quite thoroughly in
Foreign Policy. Soros sees the problem of counterparty risk in OTC
derivatives as something that has to be fixed. Soros sees increased
regulation as a necessary part of the solution. It is self-evident that
the large market participants have not done enough to safeguard the system
against failures in OTC derivatives, so it is difficult to escape Soros' view
that, where the market has failed, regulators must dictate more stringent
safeguards.
Update (28 October 2008): Paul Krugman Interview
The celebrated economist Paul Krugman recently received the Nobel prize for
Economics. We think his many qualifications in the field of economics mean
that his views on the crisis are worth very serious attention. Here is a
recent TV interview, in which he discusses the causes of the crisis, and
(more importantly) the policy choices that are necessary to stop the forthcoming
recession turning into a depression.
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