Tuesday, June 10, 2008

Like It or Not, the Credit Default Swaps Market is Too Big to Fail

(Naked Capitalism) A piece by John Dizard in the Financial Times, "Get used to underwriting big lenders," made me realize a bit of cognitive blindness. Central banks are committed to backstopping the credit default swaps market.

Of course, that should be obvious. The Bank of England, ECB, Fed, and other central banks have intervened in various ways to shore up the financial system. The CDS market is a subset of that, ergo it is included. And the most compelling reason for the Bear Stearns salvage operation was to prevent the nightmare scenario of cascading counterparty failures from becoming a reality.

Somehow, the idea that major monetary authorities are now underwriting the opaque, ill-understood, never-been-through-a-real-downturn CDS market seemed ludicrous. But as another FT writer, Lucy Kellaway noted apropos management fads, "No idea is too ridiculous to be put into practice."

Recently, plans to have a central clearinghouse and even put CDS on exchanges have been moving forward, and that's progress of a sort. The ideas of getting these contracts cleared centrally, and better yet, traded on exchanges, is one of the best and conceptually most straightforward reform ideas around (yes, clearinghouses can fail too, but historically they have done so far less frequently than individual institutions). But don't kid yourself that that will have much impact on the outstanding contracts. New ones can be done under the new regime; current ones are just about certain to stay where they are.

For instance, this Bloomberg story makes it sound as if changes can be implemented quickly:

Regulators and banks agreed to changes aimed at easing the risk of a collapse in the $62 trillion market for credit-default swaps.

Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. are among the 17 banks creating a system to move trades through a clearinghouse that would absorb a failure by one of the market-makers, the Federal Reserve Bank of New York said yesterday in a statement following a meeting with the firms. A guarantee may encourage more trading of default swaps, said NanaOtsuki of UBS AG, one of the banks involved in the agreement....

The group will reduce the volume of outstanding contracts through multilateral trade terminations. They also agreed to extend the changes in credit-default swaps to other derivatives contracts backed by equities, interest rates, currencies and commodities.

Clearing and settlement is a detail-oriented process, yet at the same time, procedures need to be standardized to allow for efficient processing of large volumes of transactions. Agreeing on documentation and procedures will take time, implementing it will take additional time. The article cited New York Fed president Timothy Geithner saying he planned to make "meaningful progress" in the next six months. That's about as ambiguous a commitment that one can make.

I have a good deal of trouble understanding the notion that existing bi-lateral contracts can be replaced with ones with a clearinghouse, If you are the CDS protection writer, you'll want to move it over, and arguably the protection buyer wouldn't mind, since the clearinghouse's credit would be presumably be better than that of the protection writer. But these contracts are customized, so the new ones would have to corresponding terms (otherwise, you have to renegotiate, which is time consuming and costly). Similarly, it would be difficult to design a computer system and back office procedures to handle heterogeneous instruments. Finally, there is great variation in how much margin has to be posted on current contracts; those with favorable arrangements will refuse to transfer to the clearinghouse.

Despite the central banks' belief that they can contain and contend with the risk of CDS counterparty failures, I keep thinking of a story I heard in business school. One of the professors, who came from a family active in government service and had had some posts himself, said he could distinctly remember the day in 1968 when he first realized that there were limits to what America could do, that it could not simultaneously combat poverty, fight a ground war in Asia, and send a man to the moon. Central banks would benefit from thinking through what their version of triage would be if their powers were tested.

From the Financial Times:
For at least another couple of years, if not considerably longer, counterparty risk in the credit derivatives market, and its associated trades, will be effectively underwritten by the central banks of the US, Europe, the UK, Japan, and, towed like a dinghy, Switzerland. Never mind the legislative or regulatory rule writing; the logistics and technology are not here yet for credit derivatives to substantially shift over to a clearing house-cleared, efficiently margined, mode. Yes, before the PR people send me the e-mails, I know the exchanges have put some software and facilities in place, but what is available does not have the scale or articulation necessary to replace the bilateral bank-and-dealer system.

So the central bankers, and, by extension, taxpayers, will be underwriting the present system for some time.

Not that they are happy about it, and their unhappiness will be expressed through harsher capital ratios and the forcing of common equity issuance on ever-worse terms. You can expect more contradictory public policies, such as calls for re-stimulation of the economy accompanied by regulatory insistence on putting more securitisations on the balance sheet, reducing lending capacity.

The process will be harder on the banks and dealers, and therefore on those who depend on them, thanks to the central banks' hesitancy in forcing recapitalisations last year and earlier this year. Back then, I thought it would make sense for central banks such as the Fed or the European Central Bank to push for big, co-sponsored roadshows to raise capital for the institutions under their umbrellas. The capital raises should have been larger, less piecemeal, and been done quickly.

Instead, the central banks were, it seems, hoping that the relief rally in financial stocks that followed the Bear Stearns takeover would go on long enough, and be strong enough, for sufficient capital to be raised on favourable terms. We are now seeing that relief rally peter out.

There was also a fantasy on the part of some regulators that it was possible to return in short order to a world where credit was priced and extended by committees within banks. This on-balance-sheet world, though, presupposed that the people, or, as they call them now, "skill sets" existed within banks. I remember the floors of company credit analysts at Chase and Citi in the 1970s and early 1980s. They aren't there now.

So until the misfiring, jerry-built structure of securitised, market-priced, semi-automated credit is repaired in a systematic way by people who know what they are doing, there really is no choice but to effectively guarantee the big institutions' debt.

When markets such as those for credit default swaps are transparent, one-price- for-one-credit systems, with reliable information from trusted sources (ie, not legacy rating agencies), then we can allow individual institutions to fail. Not now.

But regulators, taxpayers, and speculators can take out their frustrations with the lack of competence at the top of governments and financial institutions by relentlessly pounding down the institutions' stock prices, and voting the governments out of office.

That process will take a while. So the short-bank-and-dealer-equity-long-their-debt trade won't get "arbed away" any time soon.

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