Counterparty risk -- live it and learn it, even if you don't love it
Say you purchase default insurance (like a credit default swap) on a $100 million pool of bonds. If the hedge fund/investment fund/bond insurance firm/whomever selling you that insurance has tons of money in reserve and plenty of liquidity, there's nothing to worry about. That counterparty can cover your loss if those bonds do in fact default. But what if the "insurer" took on too much risk? What if he can't make good on your "policy." Then you're (to use the official term) S.O.L.
That's the situation potentially unfolding with ACA Capital Holdings. As the Journal story notes:
"ACA is a stark example of the perils of counterparty risk. Earlier this year, as the subprime-mortgage debt market was melting down, some Wall Street banks rushed to offload the risk of the troubled assets they held. Few were willing to take on that risk. ACA did, writing nearly $20 billion of credit protection between April and September, according to its financial statements. Now that it has been downgraded, ACA may not be able to raise the capital to make good on those commitments.
"Yesterday, Crédit Agricole SA joined Canadian Imperial Bank of Commerce in warning that it could take further write-downs of its holdings of CDOs in light of ACA's problems and credit-rating adjustments for other bond insurers.
"ACA is scrambling to work out a solution with its 30 counterparties, who have temporarily waived their rights to demand that the insurer come up with roughly $1.7 billion in collateral to support its guarantees. It has a capital cushion of just $650 million. Its parent, ACA Capital, was delisted from the New York Stock Exchange this month and the shares now trade on the over-the-counter bulletin board.
"A company spokesman said ACA so far hasn't had to make any payouts on the CDOs it insured, and those bonds are still rated AAA by S&P.
"As the bond insurers' problems mount, more investors are focusing on the risk at banks and brokers themselves, which in turn entered into credit default swaps with hedge funds and other investors. A bond-insurer insolvency that triggers losses at financial institutions could set off a chain reaction affecting many investors.
"In recent weeks, counterparty fears have spread to other parts of the market. Some hedge funds that were using credit default swaps to bet on a further downturn in the mortgage market say they have exited some of their positions, in part because of concerns that the financial institutions on the other side of their trades may not be able to pay up."
If derivatives volume were minuscule, you could pretty much ignore this risk. In fact, that's what most investors have been doing for years. But global derivatives volume has exploded. According to the Bank for International Settlements (BIS), the notional amount of global, over-the-counter derivatives (PDF link) was $516 TRILLION in June. Yes, that's half a quadrillion dollars. It's also up roughly six-fold (this link opens a spreadsheet) from the turn of the century. CDS volume alone has more than quadrupled in only two years -- to $42.5 trillion notional from $10.2 trillion in 2005.
Now, let's be clear: "Notional value" is not a measure of actual money at risk. The glossary on page 8 of this Office of the Comptroller of the Currency PDF document explains notional value and some other buzzwords from the derivatives world, if you find you're having trouble sleeping and aren't inclined to take Ambien. But the sheer size of the derivatives business, the complexity of these contracts, and the fact we're seeing so much credit market turmoil all increase the chance of an even-bigger meltdown. Indeed, if counterparties start failing, all those "hedges" that financial firms have supposedly taken out to protect their positions could turn out to be as worthless as some of the mortgage paper itself. Interesting times for sure.