Interest Rate Roundup

Tuesday, January 08, 2008

Bill Gross: CDS to cause $250 billion in losses

PIMCO's Chief Investment Officer Bill Gross is weighing in with an interesting piece on Credit Default Swaps, or CDS. He lays out how these contracts, which are like an insurance policy for bondholders, could mete out $250 billion in losses to the writers of the contracts.

Here's one excerpt (with my emphasis added):

"But today’s banking system as pointed out in recent Investment Outlooks, has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant 'black swan' run that might break them. Jimmy Stewart—they hardly knew ye! According to the Bank for International Settlements (BIS), CDS totaling $43 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks."

And here's another:

"While the exact amount of reserves supporting the Bank of Shadows is undeterminable, let’s go back to the $45 trillion BIS estimate of outstanding CDS for more insight. If total investment grade and junk bond defaults approach historical norms of 1¼% in 2008 (Moody’s and S&P forecast something close) then $500 billion of these default contracts will be triggered resulting in losses of $250 billion or more to the "protection selling" party once recoveries are inserted into the equation. To put that number in perspective, many street estimates ascribe similar losses to subprime mortgages, a derivative category substantially distinct from CDS insurance. Of course, 'buyers of protection' will be on the other 'winning' side, but the point is that as capital gains and capital losses slosh from one side of the shadow system’s boat to the other, casualties and shipwrecks are the inevitable consequence. Goldman Sachs wins? Fine, but the losers in many cases will not be back for a return match. Much like casinos depend upon a constant stream of willing gamblers believing that this is their day, so too does Wall Street."

And finally, one last bit:

"The unfairly 'Ben Stein pilloried' Jan Hatzius of Goldman Sachs estimates that mortgage related losses of $200-400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Even if this occurs gradually, he writes, 'The drag on economic activity could be substantial.' Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession."

As I've talked about out in a few past posts (including this one), the growth in overall derivatives, and CDS in particular, has been nothing short of astounding in the past few years. Mr. Gross attempts to answer the question: "How large will CDS losses get?" I think there's a separate, important question that also needs to be answered: Who wrote all these insurance policies and can they really afford to pay up if bond defaults surge? If not, we're going to have one heck of a counterparty risk problem on our hands. There was a good piece by Fil Zucchi at about the topic the other day.


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