Saturday, February 23, 2008

Barclays on CDS counterparty risk

(Naked Capitalism) This post comes in significant degree from jck at Alea, who has access to the report, "Counterparty risk in credit markets," from Barclays Capital and was kind enough to post the summary of key points. Despite the link, I seem unable to download it, but the summary is sufficiently detailed that I don't think I am missing much.

The bottom line is that the authors estimate the impact of a $2 trillion in notional amount failure (yes, that's a big failure) at producing a maximum of $36 to $47 billion in losses. That is a comparatively low number when you consider that the size of the potential financial train wrecks these days for the most part have larger price tags attached. And while the Barclay's report also said this number would be reduced by netting, it also pointed out that a large default could roil other OTC derivatives markets and that collateralization may be less than ideal.

My big concern with any analysis is that the knock-on effects are hard to anticipate. Two month agos, no one would have dreamed of massive failures in the auction rate securities markets. The reaction seems vastly disproportionate to the risk at hand, yet we are where we are.

Consider the panic with SIVs last year. Money market investors were fleeing them due to the perceived potential for losses. However, it was the investors in the subordinated slice, the capital notes, who were taking the hits (this is generally medium term, not money market paper); the commercial paper, which was the paper held by money market investors, was senior to that and thus at much less risk of losses.

I have never seen loss figures published across the SIV sector, but my impression is that the total damage across the $400 billion SIV market were 3% ish (that's why the industry in the end decided to take the funds on balance sheet for the most part. The losses were painful but not catastrophic).

Money market funds are loss intolerant, ditto enhanced cash funds, but nevertheless, one would think a $12 billion-in-losses event wouldn't have systemic consequences, particularly when they were second in line to take a bullet. Yet it led to the shutdown of the asset-backed commercial paper market, which it turn led a lot of borrowers to tap lines of credit unexpectedly and all at once, which led to unanticipated balance sheet demands on the part of banks (utilized credit lines have capital charges attached) which lead to banks being reluctant to lend to each other, which led to a big rise in interbank rates relative to risk free rates, which led to panic and extraordinary measures among central banker.

For the want of a shoe a horse was lost....

That is a long winded way of saying that my bet would be a big counterparty failure (or smaller related failures that add up to a biggish number) might well lead to not-so terrible direct losses, but the impact on psychology and the fear of who might have suffered losses and who might default next could lead to collateral damage out of proportion to the triggering losses.

From Alea:
Report: Key points

Counterparty risk is highly skewed towards the buyer of CDS protection
While the maximum potential loss to the seller of protection is the contract spread for the rest of the contract duration, the buyer of protection could arguably lose the full notional of the contract (in case of simultaneous defaults by counterparty and the reference credit and zero recovery). Thus, counterparty risk is evidently more of a concern for buyers of protection.

All ISDA contract holders are ranked pari passu to senior debt, in terms of claims on a defaulting counterparty

Hedge funds might be asked by dealer/brokers to post margin to cover closing-out risk going forward
Given their higher risk profile, margining for hedge funds tends to be somewhat more stringent. They typically post collateral at 100% of their current exposure, and furthermore might also be asked to post collateral to cover close-out risk on their contracts for a certain number of days going forward. The estimation of forward exposure is done through forecasting future scenarios.

Netting agreements are typically applicable across all derivatives that are traded on ISDA contracts
Netting agreements come into action in the case of actual counterparty default. Without such agreements, a surviving counterparty would legally have to fully meet its obligations to the defaulting counterparty, while only being left with a claim on its dues from the same. However, the provision for netting allows a bank to calculate its dues to a defaulter by netting out-of-the-money and in-the-money contracts and to arrive at a single figure for dues. In fact netting agreements are typically applicable across all derivatives that are traded on ISDA contracts, effectively building in a natural hedge to counterparty default risk on a firm-wide level.

Scenarios in case of an actual counterparty default
Even in the absence of reference entity default, a failure of a major counterparty could lead to losses across the financial system. Upon the default of the counterparty, OTC derivatives would be immediately and significantly re-priced, with credit spreads likely widening dramatically. This means that CDS contracts would be terminated at a spread significantly higher than the spread at which collateral was last posted, leading to the crystallisation of significant losses.

Illustrating potential gap risk losses on CDS positions
The total notional amount outstanding of OTC credit derivatives for broker/dealers is $42.5trn. There are approximately 55 broker/dealers who buy or sell protection. We analyse a scenario where a relatively large counterparty defaults. We assume that this counterparty sold $1trn of protection and bought $1trn of protection. We further assume that the proportion of IG protection sold by the counterparty is 65% and the average life of contract affected is five years. We continue to assume that the recovery rate on the counterparty is 40%.

We believe that a default of a major counterparty would cause a significant re-pricing in credit. Although consequences of such an unprecedented event are difficult to quantify, we estimate losses for a variety of scenarios. In our analysis, we allow the IG credit spreads to jump between 10bp and 60bp upon a counterparty default. We view the IG spread jumps of 30-40bp as the most likely in case of a default of a counterparty with $2trn of outstanding CDS. Assuming a beta of 4x between the Crossover and the Main, we imply that HY spreads could jump between 40bp and 240bp, with 120-160bp being most likely.

Our analysis shows that the failure of a major counterparty which had $2trn outstanding in OTC credit derivatives, could result in losses of $36-47bn in the financial system solely due to the immediate re-pricing of credit risk due to a counterparty default. We stress that these losses are crystallised by investors who had exposure to the defaulting counterparty. Additional to these, there would also be large, potentially concentrated, MTM losses for investors without exposure to the defaulting counterparty. These losses would result from a re-pricing of risk, which we do not account for here.However, we would add the caveat that netting could significantly reduce our estimated losses. The figures above are un-netted, as data on netted exposures is very hard to obtain.

There are two factors which could cause the realised losses to be larger than our estimates. The first is the fact that, while we assumed full collateralisation, in reality, collateralisation is imperfect. This would mean that at the point of last posting of collateral, there would be some MTM positions which are not backed by collateral and any losses on these positions would increase the loss from gap risk. The second is forward margining. Any collateral posted by hedge funds with the defaulting counterparty as part of forward margining would be subject to a loss. This loss would amount to the value of collateral less recovery.

Our analysis we have concentrated solely on credit derivatives. However, in terms of amounts outstanding, credit derivatives constitute only 8% of all the OTC derivatives, with interest rate derivatives constituting the largest proportion of 67% (Figure 17). We believe that a default of a major counterparty would cause a significant re-pricing in all OTC derivatives. This implies that these contracts would also be vulnerable to large gap risk. Given the enormous amounts outstanding of these derivatives, netted exposures could be large and therefore gap risk losses on other OTC derivatives could be significant.

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