March 17, 2008...11:50 pm
Episode 15 - Unravelling in the Credit Markets
The credit crunch, first evident in August 2008 is currently at its most intense, and there is no sign when and where it will all end. You have the sinking feeling that it will all end in misery and a giant loss of capital. But until it does, world share markets which are reflecting the troubles in the credit markets will continue in tight bearish conditions, where gains are small and the declines increase.
The worst is likely to be over when all the financial institutions involved disclose the size and extent of their credit losses and writedowns. All they are doing so far is to dole out disclosures in bits and pieces which is a foolish exercise, because it keeps analysts believing that there is a lot more losses to come. And the evidence points to how right they are.
London based UBS analyst Philip Finch (Feb 14 200 
estimated that in addition to the bank writedowns so far of $152 billion, there is an additional $203 billion of writedowns still to be revealed. This would make for a total of $355 billion in assets blown away, lost for good. I think that it is too low a reality check, and results will show over the long run a much higher loss. Indeed, at the early February 2008 meeting of G7 finance ministers, the credit losses were officially forecast at up to $400 billion, and even that may be a bit on the low side.
The financial innovation products of the last 30 years are all unravelling, one by one. It reminds me of the mythical beast, the hydra with the body of the serpent, and from five to 100 heads. Each of these heads is like one of the structured product market. The poison started with the subprime mortgage mess in terms of securitisation.
It quickly spread to the asset based short term commercial paper market. It then moved to structured investment vehicles and conduits. It has spread to auction rate securities and tender option bonds. Now it is damaging the heart of financial innovation itself, the credit default swap market.
The need for concern about credit default swaps was renewed a week ago, when the large insurer AIG by incorrectly valued its own securities losing $3.6 billion on these derivatives. Currently, the concern about corporate defaults is at its most intense in the European credit market, which is shown up in the iTraxx Europe index. Last Friday, Moody’s downgraded 16 CPDOs (constant proportion debt obligations), and the credit market was agitated. These securities are particularly noxious, given the notional leverage can be as much as 15 times.
Originally solely used as a form of insurance for lenders, the credit default swap market became the chosen vehicle of commonality and tradability to create some of the worst forms of derivatives. The growth of the market mushroomed in size from a level of $900 billion in 2000 to reach a staggering more than $45.5 trillion, (that is $45 thousand billion). This is about more than twice the size of the American stock market.
If the downgrading of 16 CPDOs set the European credit markets on edge, over the rumour they were going to be unwound, imagine the scary scene if there were a large number of synthetic CDOs which were unwound at the same time. This is an open market without a regulator, which is a dare devil approach. It’s like giving a suicidal person a loaded revolver with one bullet, and asking him to play Russian roulette.
Gretchen Morgenson (New York Times February 17 200 quotes Michael Farrell, chief executive of Annaly Capital Management in New York: “I think unregulated markets that overshadow, in terms of size the regulated ones are a real question mark.”
Officials of the International Swaps and Derivatives Association (ISDA), which represents 750 banks and securities firms says the credit default swaps market will “stand up, even under stress.” Robert Pickel, chief executive of ISDA is a little too confident in saying: “even if we have a series of credit events at the same time, we have the processes in place to enable the market to deliver.”
Let us hope he is right. Bill Gross, chief executive of Pimco, the world’s largest bond fund is certainly not as confident. In early February, he described the credit default swap market as “promoting a chain letter pyramid scheme of leverage, based on no reserve cushion whatsoever.”
Perhaps the last word on this should come from Richard Bookstaber, a former risk manager at Morgan Stanley and at Salomon Bros (now part of Citicorp). On January 21 2008 he said: “Can we lay out the intricate web of counterparty risk for swaps and derivatives- who owes what to whom? At this point, we cannot. And so we cannot map out how a failure in one segment of the financial market might propagate out to affect other segments.”
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