The failure of a single major financial institution could result in losses to the OTC derivatives market of $300-$400 billion, a new working paper* finds. What’s more, since such a failure would likely cause cascading failures of other institutions, the total global financial system losses could exceed $1,500 billion, according to the paper by International Monetary Fund staff. The paper does not represent the IMF’s official view.
The over-the-counter (OTC) derivatives market has grown sizably in the past two years. Notional amounts of all categories of the OTC contracts reached almost $600 trillion at the end of December 2007. These include foreign exchange contracts, interest rate contracts, equity linked contracts, commodity contracts, and credit default swaps (CDS) contracts.
The paper attempts to quantify counterparty risk that may stem from the OTC derivatives markets. The risk is measured by losses that may result via the OTC derivative contracts to the financial system from the default (or fail) of one or more banks or broker dealers.
If indeed the results of our scenarios are illustrative, counterparty risk is large (and especially large where cascade effects result in more than one bank or prime broker failing).
“In addition, the re-pricing risk following a counterparty failure cannot be easily quantified. Pressure to re-hedge at such times will be enormous and perhaps unaffordable, which could lead to unanticipated pressures on the financial system.”
In light of this, the paper offers the following suggestions to reduce counterparty risk in the OTC derivatives
market:
- “Cross margining” requirements across product silos could be encouraged further. For example, allow cross netting across legal entities for CDS and repo contracts.
- With the Fed offering previously unavailable facilities to prime brokers (e.g.,Term Auction Facility Loans and Primary Dealer Credit Facility), all major derivative players (not only commercial banks) might be induced to go through a central clearing system, irrespective of their idiosyncrasies.
- The recent voluntary “commitment” to reform by the major dealers (now commercial banks) may be a quid-pro-quo for the Fed; this includes 75 percent of OTC equity and derivative trades being on electronic platforms by January 31, 2009 and an auction-based settlement mechanism for CDS contracts.
- Collateral should be liquid securities and not merely of a high credit quality. Moreover collateral should be allowed to be rehypothecated. If collateral could not be rehypothecated, though, the entire financial system would be put at risk, as this is the basis of so much activity in the system.
- Changes to increase the offsetting of new trades against old ones should be allowed. This could be done by increasing the standardization of CDS contracts, by reducing the number of dates to quarterly on all CDS (EM is now monthly) and limiting the premiums eligible for new trades, such as in 25bps or 50bps increments.
*Counterparty Risk in the Over-The-Counter Derivatives Market - by Miguel A. Segoviano and Manmohan Singh.
Technorati Tags: bank failures, credit-crisis, credit-default-swaps
Anyone watching the performance of Japanese banks and brokerages lately probably wasn’t surprised by Japan’s official declaration of a recession Monday following the release of negative third quarter GDP figures.
Exposure to the global credit crisis has hit the credit and equity performance of Japanese banks and brokerages hard, and a government economic minister warned the economic situation is getting worse.
CreditSights’ weekly recap of global financial institutions pointed out that while Asia-Pacific bank stock performance was negative, down 4 percent on the week ended Nov. 14, the Japanese bank and broker sector fell 12 percent.
Sumitomo Mitsui Financial Group’s (SMFJY) 51-percent drop in profits reported for the period ended Sept. 30 was accompanied by a full-year forecast of a 61 percent earnings drop, CreditSights noted.
Meanwhile, Standard & Poor’s highlighted the dismal second-quarter results of Japanese brokerages Daiwa Securities Group (DSECY), Nikko Citi Holdings Inc. and, notably, Nomura Securities, whose broad exposure to the credit crisis prompted a ratings downgrade from S & P.
The ratings agency noted that all three banks came into the global crisis with strong capitalization, which could absorb earnings declines going forward, with a caveat:
The ratings may come under downward pressure if losses from trading positions increase significantly due to continued turmoil in the global financial markets, or if earnings do not recover due to a prolonged slump in the Japanese securities market.
Stock trading volume by individuals dropped 26 percent in the second quarter, said S & P, and with Japan’s stock market remaining under pressure, as well as the sharp rise in the yen, the ratings agency is not looking for an immediate rebound in the sector.
Technorati Tags: (DSECY), (SMFJY), Asia-Pacific-region, credit crunch, credit-crisis, Daiwa Securities, GDP, japan, Japan recession, Japanese banks, Japanese brokerages, Nikko, Nikko Citi Holdings, Nomura Securities, Sumitomo Mitsui
European corporate default rates are expected to rise as Europe, Middle East and African banks ration scarce capital to all but the highest quality corporate credits, said Fitch Ratings in a special report.
Unlike during previous periods of corporate downturns, this time the bank environment is not readily able to step in to allocate capital.
Fitch estimates that EMEA banks have some EUR3 trillion in lending commitments to corporations. The banks have been recapitalized to varying degrees by European governments, but with few mandates for how the capital must be used.
Fitch said banks will favor the following kinds of corporations in their lending decisions:
- The top 200 to 300 corporations with global operations
- Well-managed, investment-grade corporations with ready cash
- Corporations that can offer other fee-based income, such as swaps, cash management or foreign exchange activity
Corporates which do not fulfill the above requirements are at risk of being refused refinancing, and/or being charged penal pricing.
For details, see European Corporates’ Demands upon Banks’ Capital.
Technorati Tags: corporate-debt, corporate-default, credit-crisis, EMEA, European corporates, european-banks
Looks like China grabbed the Olympic torch this summer and is bringing it to Washington DC to claim its place at the head G-table. Though it is uncertain what, if anything, the G-20 summit will accomplish, one thing is clear: China is striking a claim to a major role in global economic and financial policy. Its aggressive stimulus program makes US policy actions look half-baked. What once looked like bold moves by Paulson and Bernanke are now looking increasingly tentative and malleable, just what a market looking for clarity and certainty does not want. It all goes to show that China ‘s experience at dealing with toxic products is paying off, and that China is much better at the Socialism thing than recently converted free market groupies.
Certainly, you would never see senior Chinese officials arguing publicly over who has the best mortgage relief plan. Treasury and the FDIC’s Sheila Bair had better sort this out in hurry: CreditSights cites an alarming increases in subprime mortgage delinquencies as unemployment rises and the stimulus rebate checks are long since spent.
Whatever flaws the TARP may have, they are magnified by a failure to communicate. Ever since the botched rollout of the “bank bailout” plan Paulson has been on the back foot, alternately pleading for support and protesting that people just don’t understand. Maybe he should send everybody a copy of Research Primer: Understanding the Credit Crisis.
President-elect Barack Obama, meanwhile, is keeping a safe distance from the perils of Paulson, but will eventually have to nail his colors to the mast, to thoroughly mix metaphors. His healthcare agenda came under scrutiny this week with several reports on Research Recap garnering attention. This includes Moody’s handicapping of the winners and losers under the plan. A PricewaterhouseCoopers analysis came to the shocking conclusion that the plan might turn out to be more expensive and deliver fewer savings than claimed. In addition, Standard & Poors noted that the weak economy is posing increased risks for health insurers.
And as if things weren’t bad enough already for real estate, the mounting problems of retailers such as Circuit City are adding to their woes, as noted in CMBS Outlook Uncertain as U.S. Retail Sector Nosedives.
Research Recap Quote of The Week:
The ongoing adjustment in housing markets still has a long way to go. - OECD
Technorati Tags: china, CMBS, credit-crisis, G-20, health insurers, Healthcare, housing, mortgage-backed-securities, retailers, TARP, zei
Fitch Ratings says the high degree of support extended by the US government to AIG (NYSE: AIG) has removed the risk of adverse rating action on global structured finance transactions where AIG or one of its subsidiaries is a counterparty.
Fitch affirmed AIG’s Issuer Default rating (IDR) at ‘A’ on 10 November 2008, among other rating affirmations, and removed its ratings from Rating Watch Evolving (RWE). This followed the announcement by the US Treasury and the Federal Reserve of a series of actions to provide a high level of explicit and implicit government support to AIG. Furthermore, Fitch believes the US government has significant incentives to ensure AIG is successful in implementing its restructuring plan.
Fitch expects the assumed ‘government support floor’ for AIG to remain in place until AIG fully executes its restructuring plan, thereby limiting immediate AIG counterparty risk in existing structured finance transactions.
Many of the transactions involved were exposed to AIG counterparty risk in the form of interest rate and FX swaps or other derivative contracts and, to a much lesser extent, in the form of rental guarantees of rental payments in certain CMBS transactions. Each contract has specific remedies to mitigate counterparty risk. In most instances collateral was posted by the relevant AIG entity for the benefit of the transaction following AIG’s downgrade in September 2008.
Had the RWE, prior to its removal, resulted in adverse rating action for the insurer, AIG would have breached Fitch’s current criteria for counterparties that support structured finance transactions with the highest investment-grade ratings, which incorporates a minimum rating expectation of ‘A’/'F1′. In that event, Fitch would have expected AIG to take remedial action in the form of either replacement or guarantee of AIG’s commitment or collateralisation of the position, in order for the structured finance ratings to be maintained at current levels.
Fitch is currently reviewing its counterparty criteria in light of recent market turmoil. For more information see “Counterparty Criteria for Global Structured Finance Under Review”, published on October 15 2008.
Technorati Tags: (AIG), credit-crisis, credit-markets, structured-finance
Rising unemployment is pushing up delinquencies in US subprime mortgages at an “alarming” rate, according to CreditSights.
“The latest numbers from our Subprime RMBS sample show a huge jump in delinquencies 
in the past two months, ” CreditSights says in a new report: Subprime Pool Performance Update: Delinquencies Rocket as Unemployment Rises. “All three of the vintages that we track posted their largest one month increases in October and the largest three month increases since March. As the chart shows, delinquencies as a percentage of the remaining balance in 2005 subprime RMBS had even started to fall despite the remaining balances continuing to shrink.”
“It is possible that delinquent borrowers are making payments to keep their mortgages at the same degree of delinquency while they wait for mortgage investors to jump on board HOPE for Homeowners.”
“However, we believe the rise is driven firstly by delinquency growth returning to trend after a tax-rebate slowdown and secondly by rising unemployment and rate resets creating disposable income shocks for borrowers.”
CreditSights has suggested that the slowdown in delinquencies in the second and third quarters might have been the result of the second quarter tax rebates.
Unfortunately the benefits from the rebates have proved short-lived and the scale of the recent deterioration is alarming.
Technorati Tags: credit-crisis, mortgage-backed-securities, RMBS, structured-finance, subprime
U.S. subprime residential mortgage-backed securities, or RMBS, originally rated “AAA” and issued from mid-2005 through mid-2007, will see much smaller write-downs than the $180 billion projected for the underlying mortgages, said Standard & Poor’s RatingsXpress Credit Research.
As a result, while RMBS investors will see significant losses — an estimated $85 billion – that is far less than the losses generated by the underlying collateral, S&P said, mainly due to they way RMBS are structured.
We expect realized collateral losses in U.S. subprime RMBS transactions to accelerate as the current residential inventory is liquidated. As a result of significant collateral losses, we project that many subprime RMBS certificates will be written down. Depending on where a class is in a transaction’s capital structure, it may be written down by as little as 1% or by as much as 100%.
In S&P’s analysis, the ratings agency forecasts that subprime mortgage delinquencies will continue to climb and that by the end of 2009, home prices will have fallen nearly 30 percent from the July 2006 peak.
Home prices are down about 20 percent over the past two years, according to the S & P Case-Shiller Home Price Index, with declines accelerating over the summer.
For details, see “U.S. Subprime RMBS Losses For Original ‘AAA’ Bonds May Be Significantly Less Than Market Projections.”
Technorati Tags: collateral, credit-crisis, delinquencies, home prices, housing crisis, mortgage delinquencies, residential mortgage-backed securities, RMBS, S&P Case-Shiller Home Price Index, subprime, subprime lending, subprime-mortgage, write-downs
It’s nice to see that we now seem to be back to mere financial turmoil rather than a full blown crisis, judging by the OECD’s indicators of financial market stress.
The OECD’s indicators for bank credit default swap rates and the three-month Treasury eurodollar spread rate have both declined from the crisis peak from mid-September to mid-October and are closer to the “turmoil” rates experienced from August 2007 to mid-September. However, they remain several times higher than the “routine” rates that prevailed prior to August 2007.
The one worrying sign is that the three-month EURIBOR-EONIA swap index spread indicator stands at 162, up from 118 during the peak of the crisis, from 62 during the turmoil period and only 6 under routine conditions.
In a preview of its Economic Outlook, the OECD says economic activity is expected to fall by 0.9 percent in the US next year, by 0.5 percent in the Euro area and by 0.1 percent in Japan as OECD countries enter a protracted slowdown.
Presenting OECD’s gross domestic product (GDP), inflation and unemployment forecasts for these three major economies ahead of the G20 summit, Jorgen Elmeskov, Director of Policy Studies in the OECD’s Economics Department, said a high degree of uncertainty surrounds the outlook. Much depends on the depth and duration of the financial crisis, the main driver of the current recession.
The ongoing adjustment in housing markets still has a long way to go.
GDP for the OECD countries as a whole is expected to fall 0.3 percent year-on-year in 2009 before recovering slightly to grow by 1.5 percent in 2010. The average unemployment rate in the OECD area, estimated at 5.9 percent this year, is forecast to climb to 6.9 percent next year and reach 7.2 percent in 2010. Inflation should continue to ease as economic slack puts downward pressure on prices and if, as assumed, commodity prices maintain their recent lower levels. “Against this backdrop, additional macroeconomic stimulus is needed,” said Elmeskov.
Technorati Tags: credit-crisis, credit-default-swaps, economic-forecast, housing, OECD
Commercial mortgage-backed securities (CMBS), or bonds backed by a pool of commercial retail properties, are under close scrutiny for possible downgrades as U.S. retailers see their sales nosedive, according to Standard & Poor’s Credit Research.
So far, store closings and bankruptcies such as Circuit City Stores (NYSE:CC) have not resulted in widespread retail CMBS downgrades, S&P said.
The ratings agency has also concluded that CMBS with exposure to mall operator General Growth Properties (NYSE: GGP) are not at immediate risk of a downgrade. General Growth Properties warned Tuesday it would be forced to file for bankruptcy unless it could raise capital or refinance its debt.
To date, retail bankruptcies and store closings have not contributed to widespread downgrades, reflecting in our opinion, diversity and limited exposure to troubled tenants. We believe, however, that continued weakness in this sector will likely cause more retail loans to underperform, which would trigger increased delinquencies and could ultimately translate into more retail-related downgrades.
S&P identified only 14 CMBS transactions with a greater than 2 percent exposure to troubled retail tenants. CMBS with exposure to bankrupt retailers are more of a concern than those with exposure to retailers that are simply closing stores.
For details, see “The Potential Impact of the Troubled Retail Sector on Rated U.S. CMBS.”
Technorati Tags: (CC), (GGP), bankruptcy, Circuit-City, CMBS, commercial mortgage-backed securities, credit-crisis, General Growth Properties, mortgage-backed-securities, retail, retail delinquencies, retailers, shopping malls, store closings, structured-finance
State and local government pension fund losses upwards of 35 percent so far in 2008 will likely trigger increased funding requirements in the next few years, said Moody’s Investors Service in a special comment this week.
But the ratings agency sees little near-term impact on the credit ratings of public issuers as a result of pension losses.
As is often the case in the downside of the economic cycle, the additional funding requirements will hit at the worst possible time for state and local governments – just as budgets are constrained by the deteriorating economy, Moody’s said.
As public pension systems’ investment losses are phased in, they will put upward pressure on state and local governments’ contribution requirements. For governments required to make the full actuarially determined annual required contribution, or ARC, the losses will exacerbate the fiscal stress caused by weakened revenues.
Moody’s emphasizes that long-term “smoothing” of pension fund losses, which are phased in over a period of time, usually five to seven years, means that municipal and state government budgets won’t be affected until at least fiscal 2011.
In some cases, Moody’s said states may eventually need to issue pension obligation bonds (POBs) to deal with pension funding shortfalls. Research Recap has written before about the likely need for more state debt issuance as tax revenues slow during the economic downturn.
Moody’s said some states, such as Illinois and Massachusetts, may successfully push back part of their required annual contributions, as they did in the 2001 recession.
For details, see “Pension Funding May Suffer from 2008 Stock Market Declines.”
Technorati Tags: ARC, bank credit, credit-crisis, Illinois, Massachusetts, pension contributions, pension-funds, pensions, public issuer, Public Sector, public-debt, state-and-local-government