Tuesday, January 29, 2008

Net exposure is the best guide to derivatives' market impact

(ISDA's Bob Pickel in the FT) In recent weeks, otherwise sophisticated commentators have made some basic yet potentially damaging errors about the amount of risk exposure held via credit derivatives. These assumptions, including those made by William Gross, Pimco's chief executive, significantly overstate net settlement flows that would result on default of "underlying" entities. There is a danger this might create a climate of fear in financial markets in which companies, including Pimco, operate and which are already dealing with severe market volatility.

Critically, these errors ignore conventional market use of economically offsetting positions, which reduces the amounts at stake sharply. We seek here to illustrate some more down-to-earth assumptions; not to forecast the future. This is how the numbers really work:

First, the $50,000bn "notional" or nominal amount is just that; a nominal figure that references the "underlying" bonds and loans being protected by use of credit derivatives.

Focus on the net exposure of these transactions, many of which hedge or offset one another. A recent Fitch Ratings survey estimates net exposure at less than $1,000bn. Factor in a probability of default of 2 per cent and a 25 per cent recovery rate and protection sellers would have to settle an aggregate $15bn of losses. None of these amounts would be "lost" to the system; a credit derivative simply transfers a potential gain/loss from one party to another. Clearly, while $15bn is not trivial, it is a small fraction of aggregate write-offs to date on loans and securities; and less than a 10th of Mr Gross's suggestion.

And our figures are conservative: we use a slightly higher ($50,000bn) figure for the total reference amounts; we round up the net exposure figure; we use a higher default rate than the 1.25 per cent used elsewhere; and our projected recovery rate is much lower than the 50 per cent used by Mr Gross.

Also, defaults in a downturn are usually considered to eliminate a much higher proportion of lower-rated companies, whereas surveys show that only about one-third of credit derivatives are written on subinvestment grade credit. So the impact of default would not necessarily be the same for credit derivatives as for credit markets as a whole. And such trading losses would be unlikely to hit simultaneously.

Even if default rates prove higher than those used here, settlement flows in credit derivatives would likely be much lower than in Mr Gross's assumptions. This is not just theory. Settlement has occurred on this basis for several "credit events" where participants have organised net settlement through ISDA, with wide-ranging support, including from major bond funds.

Strip out the conservatism we build in here and those overstatements look extreme. While variations in each of these factors will have some impact on the final numbers, these are clearly most sensitive to the distinction between the aggregate reference amount of $50,000bn and that for net risk transfer of $1,000bn. Meanwhile, industry and regulators remain focused on refinements to the critical discipline of counterparty credit risk management. Netting and collateral are important mitigants here, reducing so-called "presettlement" market exposures substantially.

Similarly, it is worth bearing in mind that not all defaults occur suddenly. A market participant that has written net protection will probably have an opportunity to manage its position in response to what is usually a gradual decline in creditworthiness by the reference entity. While this does not alter the net amount of protection written, it clearly reduces the financial impact on that individual participant of the entity's default.

It is appropriate that a debate occur and that lessons be learnt from the way credit markets function. But we should recognise that privately negotiated credit derivatives markets have not only played a key role in allowing prudent and dynamic hedging of credit risk but have stayed open for business in spite of reduced liquidity in securities and interbank deposit markets.

The main point, however, remains a more basic one. Gross numbers are no basis on which to estimate the impact of the market in credit derivatives; net exposure is the place to start.

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