I read a report recently that suggested the US credit derivatives market is worth at least 50 trillion with CDS’s making up the majority. These are estimates obviously but the bottom line is a figure so large that it could collapse a country never mind a bank. Admittedly that figure is believed to be the total amount of credit derivatives swaps outstanding in the US.
Because of the good old US belief in minimally regulated market freedom a reasonable sounding mechanism to transfer risk became the spring board for a range of financially engineered derivatives which multiplied both the number of parties involved and the net effect of any individual default. CDS’s require low capital backing so they’re risk that appears “cheap” to play with and potentially very lucrative. On the way up, this creates liquidity. However, the multiplying affect is probably 10 or more as the commercial loan market in the US is supposed to be worth around 5 trillion dollars.
So one bank fails and, simplistically, brings down another 10 financial services companies with it. As banks of differing sizes tend to buy credit from banks up the food-chain, Credit is almost like a commodity that can be manufactured and productised into other packages suitable for smaller financial services companies with different capitalisation, risk profile, timeframes etc. Therefore, it’s possible that a large failure, causes a catastrophe for a few smaller banks. If their problems are resolved, the effects are felt by even smaller banks etc. It’s a ripple effect that we can’t insulate ourselves from, even with an unlimited governmental guarantee.
This won’t “balance out” as they say due to the multiplying affect and the scale. There’s simply more risk-based derivatives out there than assets to protect. Even more so when you consider those assets are inflated. We already know European banks have participated in this market so even if no Irish bank has partaken in the CDS market directly, it is reducing and will further reduce the ability of Irish banks to get credit. It could also devalue their other foreign investments. No bank is an island 🙂
I think the size of this black hole of risk is what’s terrifying world governments into producing these massive bail out packages. As it’s cheaper to nationalise or recapitalise one bank than it is 10. Better to protect defaults at source than wait for the meltdown.
Essentially, this is the goal of the 700 Billion dollar bailout package that was passed recently in US Congress. Purchase the debt that’s in default or most likely to become “toxic” ASAP before the “ripple effect”. Now consider, the multiplier effect and you have 7 trillion of associated CDS’s sitting out there. Some has possibly been triggered already due to the events at Lehman Brothers. Although there are differences of opinion regarding exposure, the multiplier factor and the Net effect. Also, it’s worth remembering that you actually have to be able to get the money from the CDS counter-party. They could simply refuse to pay.
How to mitigate the risk of this happening again? Bubble-expert Yale professor Robert Shiller makes a few suggestions which are discussed over the at the freakonomis website. These focus on improving the information available between institutions and public so risk profile is less opaque. He also proposes the solution of creating derivatives on city-level real estate prices. I don’t like this solution as by his own admission markets are subject to mass delusion regarding prices going onwards and upwards. The ability to short these markets may limit control, but with leverage it IMO provides another mechanism for ordinary joe (popular guy recently) to see one of his life’s major investments exploited by profit-hungry hedgers. Reducing leverage capacities of both banks and individuals is an excellent idea. It’s tough love and many commentators suggest it damages liquidity but that’s arguably adopting a catastrophist attitude towards tighter regulation. What good is all that liquidity if it’s going to be channelled into trading timebomb credit derivatives? What’s wrong with telling someone who can’t afford to buy a house that they can’t have it? The only reason they wanted to buy was because of the mass delusion of the ever-ascending property ladder. If sub-prime buyers had been encouraged to wait it out the prices wouldn’t have overheated.
Or to use another(‘s) metaphor we could do worse than remember the world of John Maynard Keynes:
“A general bonfire is so great a necessity that unless we can make of it an orderly and good-tempered affair in which no serious injustice is done to anyone, it will, when it comes at last, grow into a conflagration that may destroy much else as well.”