Tuesday, January 22, 2008

ISDA says CDS losses will only be $15 billion

(Naked Capitalism) My only comment on the attempt to alleviate concerns about the statement on the $45 billion credit default swaps market by the International Swaps and Derivatives Association: while the logic of Bill Gross' $250 billion loss estimate was subject to question, there doesn't appear to be any analysis supporting what amounts to an assertion by the ISDA (the reason for my doubts is first, the lack of reference to any research release, and second, the fact that the market is entirely OTC and hedge funds are substantial protection writers impedes any systematic study).


The basis for their view is that swaps contracts tend to offset each other as dealers hedge (or attempt to hedge) exposures. True enough, but the market as a whole has never been tested in a credit downturn. All it has seen is single name defaults, not concerns about cascading counterparty failures, which seems the overarching risk now. While Gross' estimate may (and hopefully will) prove high, the ISDA estimate seems awfully cheery, particularly since tsuris at the monolines will hit pricing of certain bonds hard, which will in turn lead to marked changes in large numbers of CDS prices, which will in turn trigger requests to post more collateral.

From Bloomberg:

The International Swaps and Derivatives Association said global losses on credit-default swaps will be nearer $15 billion than the $250 billion forecast by Pacific Investment Management Co.'s Bill Gross.

Losses on the contracts used to protect against the risk a company won't pay its debt may help push the U.S. economy into recession as corporate defaults rise, Gross said earlier this month. Gross calculated the potential declines by applying the historical average default rate of 1.25 percent to the notional $45.5 trillion of debt that ISDA says is outstanding on credit- default swaps, and then halving the amount to allow for the recovery of 50 percent of the debt.

``Commentators who point to notional values as a measure of market size risk exaggerating potential loss by at least an order of magnitude,'' Robert Pickel, the head of New York-based ISDA, which represents 750 banks and securities firms, said in an e-mailed statement yesterday. ``Many of these contracts in practice offset each other, as participants constantly adjust their portfolio of risk.''

Credit-default swaps jumped to a record in Europe today on concern falling profits and higher borrowing costs will make it harder for companies to repay debt, according to the benchmark Markit iTraxx indexes. ACA Capital Holdings Inc., the bond insurer being run by regulators because of subprime-mortgage losses, said Jan. 20 it has one month's grace to unwind $60 billion of credit-default swaps that it can't pay.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.

ISDA said in April that the global market for credit- defaults swaps more than doubled for the third year running. Trading isn't subject to the same regulations as stocks or bonds because the market is conducted over the counter, or outside exchanges.

Banks and other investors hold overlapping contracts and their net risk is less than $1 trillion, said Pickel, citing industry surveys. Banks are net buyers of protection and insurance companies are the sellers, according to Pickel.

If 2 percent of companies linked to credit-default swaps fail to pay their debts and there's a 25 percent recovery rate ``you might see an aggregate $15 billion of losses on the books of protection sellers,'' Pickel said.

``Clearly, while $15 billion is not a trivial sum, it is a small fraction of the aggregate industry write-offs to date on loans and securities,'' he said. ``It is less than a tenth of some numbers posited for potential settlements in credit derivatives.''

Gross was named fixed-income manager of the year in 2007 by Chicago-based Morningstar Inc. His $112.7 billion Pimco Total Return fund returned 9.07 percent last year, in the 94th percentile, Bloomberg data show.

``The $45 trillion CDS market obviously includes many positions which have to be netted out and which are hard to calculate,'' Gross wrote in an e-mailed response to ISDA's comments today. But with the ``losses sloshing from one side of the boat to the other,'' the net sellers of default protection will be ``experiencing huge losses and potential liquidation of their firms.''

Gross described credit-default swaps in his Jan. 8 commentary on Pimco's Web site as ``perhaps the most egregious offenders'' in today's banking system. The market ``craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.''

While there will also be winners among investors that bought credit-default swaps, ``the losers in many cases will not be back for a return match,'' Gross wrote.

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