Re: Financial Crisis and Black Swans
hattip Rickk
Australia's Big Four banks are all exposed to the default of Lehman Brothers via credit default swaps (CDS) - a noxious bull-market derivative which threatens further contagion in the ailing global financial system.
National Australia, ANZ, Westpac, Commonwealth Bank and the nation's biggest insurer AMP are listed on the ISDA's (International Swaps and Derivatives Association) Lehman Protocol. The five have written "adherence letters'' to the ISDA asking the Association to act as their agent in settlement negotiations arising from the Lehman default.
This Wednesday is the deadline for lodging settlement notices for CDS trades and October 20 is the date for settlement.
BusinessDay contacted all four banks. Three were unable to provide meaningful details of their exposures and we were unable to contact Commonwealth Bank prior to deadline. Their total CDS exposures are dealt with later in this article.
For those who have not had the pleasure, a CDS is a synthetic instrument which provides insurance on a company's debt.
The global CDS market has a notional value of $US60 trillion-odd, there is no central exchange, no regulator to speak of, and no known reserving.
That is, it is akin to an insurance market in which nobody has got around to setting aside any provision for losses which might arise - indeed which are arising now - in the event of a company's default.
'Elephant in the room'
Nor was anybody asked to - such has been the "play it by ear'' philosophy towards regulation of markets.
Weekend announcements by the Group of Seven and assorted national authorities demonstrate the "play it by ear'' approach is now giving way to worldwide regulatory dictatorship.
The market for CDS is often dubbed "the elephant in the room''.
In theory, failures trigger recourse to swap issuers, but once the chain fails it means the system fails as linked trades begin to unwind.
In theory CDS should ``net out''. Yet they are an ``over-the-counter'' product with no central exchange to facilitate netting.
In other words, there is a $US60 trillion market for credit enhancement, entirely unregulated and which nobody seems to know much about, whose retail equivalent is borrowing with no more than a personal guarantee, and without having to stump up one red cent in collateral.
The more bizarre examples of risk involve the likes of tin-pot hedge funds insuring giants like rescued insurer American International Group (AIG) for a fee. This is cowboy stuff which would not have been tolerated by the auctioneer in a Wild West horseflesh sale 200 years ago, let alone by the local sheriff.
It is important to note that the Lehman CDS settlements are more of a loss transfer than a loss. In other words, there will be winners and losers. You can buy CDS credit protection and you can sell credit protection.
So, provided no one party took on too much of the Lehman exposure, the spread of loss should render the default of Wall Street's former No. 4 investment bank containable.
The rub lies in whether assorted parties can settle their obligations, and in what they have to sell to meet their obligations. Trading on Monday and Tuesday this week will go some way to revealing the damage.
Domino theory
The fear is of a potential domino effect. One wonders whether this was a significant factor in the Government's decision to guarantee all bank deposits yesterday.
Are the banks in more strife than they make out or was Kevin Rudd simply keen to trump Malcolm Turnbull's call for a guarantee on deposits up to $100,000?
This promises to be one hell of a week on world markets.
The unwinding of Lehman CDS was a factor in the dramatic drop on world markets late last week and, as yet, no major party has toppled over.
However, a weekend story in the Financial Times said the payouts on the $US400 billion of Lehman CDS is ``likely to be higher than anticipated after initial results from auctions to settle these CDS resulted in a lower recovery price''.
``The initial auction results were settled at 9.75 cents in the dollar, meaning banks and other investors who had agreed to make these payments in the event of Lehman's default will have to pay out 90.25 cents on the dollar.
``The final auction for Lehman credit default swaps (CDS) was due to settle in the New York afternoon. The final prices were likely to be lower than the initial ones because there were a lot more sellers of bonds to settle the auctions than buyers, according to traders.''
More to CDS claims to come
It all goes to the banks' proclivity to horde cash and their reluctance to deal with each other.
The collapse of other institutions such as Washington Mutual and the banks in Iceland are likely to spawn a wave of credit derivative claims too.
In some circles, the bail-out of US insurer AIG was put down to its enormous CDS default potential.
It is not just banks who play in the CDS "cloud", it is insurance companies and shadowy, unregulated hedge funds domiciled in tax havens.
It now appears the G7, led by the UK, is going to effectively stand behind their core banking systems and the CDS market may, at a pinch, be allowed to collapse. Who knows?
Sovereign support will enable credit markets to continue to facilitate savings, mortgage lending, trade finance, foreign exchange and so forth. Without central bank support for the core functions of banking, civil society would cease to function.
The drawback has been that while the stock exchanges have been telling us there is a problem, politicians in the West have been somewhat in denial.
Recaps for banks
There is an emerging consensus now, though, that collective action needs to be taken to recapitalise the banking system through temporary nationalisations and massive liquidity injections, perhaps accompanied by further rate cuts and probably assisted by guarantees on interbank transactions.
Large-scale government intervention may not be particularly palatable but it is preferable to the other option: mayhem.
The ad hoc response so far of plugging holes in the exploding dyke has failed, as evinced by the Paulson mates' bail-out proposal.
Big government intervention has worked before in other markets such as Sweden and parts of Latin America and Asia and it will simply have to work for developed countries now. A ``muddle through'' is the most likely outcome.
The risk, however, is to bonds. If there were a forced selling of bonds, the consequences would not bear contemplating.
Whole countries have put themselves in the front line with their recent rash of guarantees. It is Columbus Day in the US on Monday so Australia will be trading in the dark without two days of action to look to in US bonds.
Equities after all are more or less a warrant on a bond.
Some glimmers
There are some positive signs, however. The commercial paper market is loosening up, and the US Federal Reserve will take AAA paper.
So even if the banks won't lend there are some corporates which can act as intermediaries. They may even find they have a new business, by endorsing paper handing it to the Fed and acting as a credit conduit. Someone has to do it.
Back to CDS. It is no longer acceptable that banks - which now have an explicit guarantee on their deposits - continue to hide their tricky exposures.
It was leverage, accounting chicanery and silly synthetic products devised, bought and traded by banks which landed the world in this maelstrom in the first place. It was the collapse of trust which made the problem worse.
Yet the banks still conceal their exposures and muddle through with public relations about everything being fine.
Nobody believes it now. And until the banks come clean the trust factor will continue to wreck confidence in the entire system. There are myriad rumours doing the traps, suffice it to say that lack of disclosure only makes things worse.
CDS and Aussie banks
A Citibank report from mid-July shows ANZ at the top of the CDS pile in Australia. It had $45.7 billion worth of CDS in its conduits.
While all the banks used CDS to hedge their credit risk, ANZ actively traded them.
In other words, as with its primacy in stock lending (of Opes Prime fame), it took the greater risks.
As of March, the bank had some $23.4 billion in ``long'' CDS positions and $22.3 billion in ``short'' CDS positions.
``ANZ entered short CDS positions with counterparties who desired credit protection whilst simultaneously purchasing offsetting protection for a cheaper premium from different counterparties (we understand these counterparties were "monoline" insurers on around half of all occasions). The spread differential between the short premium and long premium generated trading income,'' says the Citibank report.
When one such monoline insurer, ACA, was downgraded from investment grade to CCC in February 2008, ANZ was forced to recognise a provision of $226 million based upon a $1.5 billion notional contract value.
``In effect, they were saying that the long leg of the trade was not suitable in terms of providing insurance - as the rating of the insurer was sub-investment grade the hedge was no longer viable.''
As with other financial stocks now underperforming their peers, ANZ partied hard in the good times by indulging too much in high-yield securities. Now it is clear they were not high-yield for nothing.
Its rivals carry risk but not to the same degree.
CBA has $5.9 billion ($3 billion bought and $2.9 billion sold), Westpac has $15.6 billion ( $9.4 billion and $6.2 billion) and NAB, which Citigroup rates second to ANZ on risk has $24.4 billion in CDS ($13.7 billion and $10.7 billion).
This, of course, is all before we get to CDOs, CLOs, ABS and so on.
There will be nasties to come, and before the banks come clean and tell us who their counterparties are, the mystery will continue to erode confidence.
That said, the Federal Government's guarantee on deposits will circumvent the ultimate disaster scenario of a retail run on the banks and, in that, it is to be applauded.
Times are tough, but some look for levity, as one joke doing the rounds goes:
"This is way worse than a divorce ...I've lost half my net worth and I still have my wife."
mwest@fairfax.com
BusinessDay
http://business.smh.com.au/business/time-to-come-clean-20081013-4z8w.html?page=fullpage
