Credit Derivative Woes

My first Flute Thoughts are on what's currently happening in the financial markets, though I'll go into other subjects later. This article is a summary of stuff I've written on various forums over the last few days. I'll try to include links to pages explaining any difficult terms I'm using.

Last week was eventful in the financial markets, to say the least. Read about it in Financial Times for example.

As I see it it's just a matter of time before we get the next bad news that will sink the markets. A hedge fund or bank will come out and say that they have big problems. Maybe already tomorrow, Monday? Or Tuesday?

Though we might see a short rally up in the stock markets until the next bad news comes out.

The liquidity injections into the markets by the central banks on Thursday and Friday probably averted a number of acute liquidity squeezes and gave banks and and funds a chance to get out of their most catastrophic positions. The biggest injections were by the ECB (€95 billion on Thursday, €61 billion on Friday) and the U.S. FED ($24 billion on Thursday, $38 billion on Friday). The ECB action was the largest one ever. Some really important institutions (e.g. major banks) must be in big trouble. To quote Erik Nielsen, the chief European economist at Goldman Sachs: "Someone must have called them and said 'we need liquidity now,' They did what a central bank is supposed to do."

These liquidity injections are extreme measures, that the central banks only take in extreme situations. These actions have a number of effects. First of all they save the banks from sudden unexpected liquidity crunches, which could very well topple them. Public faith in the banking system is vital, without it our current economic system won't work. Secondly it temporarily stabilises the markets, and might also imbue some optimism. But it also signals "danger", since it is an extreme measure, and many investors become scared and sell off their equities. In the long run, of course, it might lead to other side effects, such as more imbalances in the financial system. Anyway, these emergency actions by the central banks might mean that we won't get a fast financial crash, but rather a slow scenario.

However, I see some serious problems building up:

1. "Hedge Fund" has suddenly become synonymous to "toxic waste" and many investors will withdraw their funds from anything that smells of hedge funds. Since the hedge funds work with high leverage, often borrowing 5-10 times their capital, or even more, this means that they must sell off a lot to redeem those who wish to get out. Selloffs = markets down. Besides, certain financial instruments cannot currently be sold, since nobody wants to buy them, so they'll have to sell more liquid instruments, such as stocks or commodities (oil, metals, etc). If enough investors try to withdraw from a hedge fund, it could go bust, leading to more panic among investors. There's already a Hedge Fund Implode-o-meter to report on hedge funds that have hit the wall. The French bank BNP Paribas stated quite clearly what the problem was when they suspended three of their hedge funds last week: "The complete evaporation of liquidity in certain market segments of the U.S. securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating,".

2. What's happening in the credit default swap (CDS) markets? These have not been mentioned much yet, with most of the focus being on the U.S. subprime mortgage markets. Mike Shedlock wrote a good article about a month ago which mentions the CDS problem - "Who's Holding the Bag". The global market for CDSs is mindbogglingly huge. As of 2006-12-31, there were $34 trillion in CDSs outstanding globally. For comparison, the total world GDP was $48 trillion in 2006. Now that the global credit markets are drying up investors and funds will start reviewing their positions on the CDS markets too. It's already doubtful whether many issuers of CDSs can live up to their promises. Besides CDSs were never very liquid instruments to begin with, and even less now. This could lead to a crisis where further liquidity injections by central banks won't be of much avail. Note that the CDS market has grown explosively over the last few years - in December 2003 there were only $3.6 trillion in outstanding CDSs.

3. So far only a few hedge funds of a few billion dollars each and one smaller bank (German IKB) have gone belly up, and also a large number of subprime lenders (see the Mortgage Lender Implode-o-meter). The markets can handle this, but what happens if a larger bank hits the wall? There will be an unprecedented domino effect, considering the fact that most major banks and insurance companies in the world are interconnected by various loans and other contracts. Besides, there are probably lots of credit default swaps connected to banks, see #2 above.

4. Another issue connected to lending is that over the last few years there have been many loans issued to companies with bad credit ratings, so called junk bonds, and to rather low interest rates, since credit spreads have been so narrow. These are the company equivalent of subprime mortgages, and not much has been written about them yet. But there will be bad news soon here too, rest assured. Many funds and banks are now probably trying to get rid of these loans and their derivatives, e.g. collateralized debt obligations (CDO) and other funny abbreviations. This before the searchlight starts illuminating this part of the credit markets.
During the last few years, the percentage of company bankrupts has been low in the world (including the USA) because it was easy and cheap to get a loan. Now when credit spreads are increasing and credit is drying up we will instead see bankrupts increasing to above their historic averages. Especially since there is a "backlog" of companies with problems that have been saved by the easy credit of the last few years. This, of course, will be a long process, since all badly run companies don't run into problems at once, but rather gradually. Then remember that many of these junk bonds are "insured" through credit default swaps (see #2 above).

Number 1 is probably already happening. Number 2 can happen any time. We might have to wait a couple of weeks or months for number 3, or even a year. Number 4 will probably evolve slowly over the next year, gradually replacing the subprime mortgage crisis as a major concern for the financial markets.