Government Risk Rises: Credit Markets Face Structural Collapse

As credit default swap spreads for 5-year British government debt rose to 150 basis points last week, one European regulator raised a significant concern regarding the balance sheets of banks on both sides of the Atlantic. "If you follow the rating agencies, well and good, but if you apply default risk prices to banking assets, capital adequacy ratios of nearly all western banks are open to question," she warned, after watching Euro-based spreads on U.S. government debt rising to 75 bps, and after noting that few CDS price-makers were willing to provide firm quotes for longer-dated sovereign reference instruments.

The issue is not as technical as it appears in the first instance, given that professional debt traders are no longer predicating their strategies on the credit ratings generated by the mainstream rating agencies.

Also, with the unprecedented amount of sovereign debt (and sovereign guarantees) required for all the bailouts and rescues, the old "countries-don't-default" maxim has become an acceptable subject for debate. As one badly-burnt investor in Argentina bonds said last week, "each time they (the governments) restructure their debt, you are forced to take a haircut, so I'm not really sure what a sovereign default means any longer."

Needless to emphasize, as the relatively liberal interpretation of the definition of sovereign default gathers momentum, those pricing credit default swaps will be encouraged to take spreads on U.S. government risk well into the 150-200 bps range over the next few months, for three reasons. Firstly, there is not enough evidence yet to show that the latest round of stimulus packages will achieve, in part or whole, their lofty objectives.

Secondly, CDS dealers are slowly warming up to the possibility that the Obama administration will simply introduce another bailout package, for another hundreds of billions of dollars, if economic conditions worsen in the second half of 2009. And, thirdly, if CDS spreads (and related default probabilities) on government risk are applied to the valuation of assets within the banking and insurance industry, the "systemic risks" Fed Chairman Ben Bernanke talks about are still very much intact.

When pure technical grounds are applied to the deterioration of U.S. government credit, it is apparent that the structural core of the credit markets is being destroyed. For instance, viewed from the prism of default risk coverage, the risk-neutral yield on 5-year treasuries should be closer to 2.40% (instead of 1.63%). Or, to take another example, interest rates on government-backed debt issued by banks and other bailout candidates should incorporate CDS spreads pertaining to the government offering such guarantees.

In the broader debt marketplace, investment-grade securities need to be thoroughly re-priced unless, of course, one is prepared to acknowledge that certain American corporations must be rated higher than the U.S. government, a position which more than a few hedge funds are adopting of late. And if default risk on the U.S. government continues to rise, what are the pricing consequences for mortgage rates?

Numerous portfolio managers appearing on CNBC and Bloomberg have been stressing that the fate of the treasury yield curve is inextricably linked to the fate of the U.S. dollar, and that default perceptions will have only a limited impact on the credit environment. That may be so, in theory. However, since interest rate adjustments, and currency interventions and central-bank swaps, are being engineered globally on a haphazard basis, it is difficult to predict where the dollar will be even three months from now, let alone in three years.

Complicating the domestic bond scenario is the proliferation of multi-tiered government-guaranteed debt issues in the U.K. and Europe, which are now providing banks, insurance companies and asset managers with a unique ability to arbitrage between credit ratings, CDS spreads and effective yields. The availability of such arbitrage, which does not require any high degree of sophistication, signifies serious structural flaws which, in turn, are an essential ingredient of the overall systemic risk matrix.

Finally, the inability of the rating agencies to keep pace with the fundamental and far-reaching changes in the underlying economic climate is by itself a sign of the times. Which brings us to two final, all-important concerns with respect to systemic risk within the credit markets. [1] What percentage of assets listed in banking and insurance balance sheets are over-valued today, with the benefit of investment-grade ratings? [2] And how many collateral debt obligations [CDOs], CDS and index put insurance contracts are retaining good-standing status today due to the inability of the ratings agencies to properly quantify counterparty risks?

In the absence of specific descriptions of assets (Levels 1, 2 & 3, per FSAS 157) in the balance sheets of Citigroup (C), Bank of America (BAC), Goldman Sachs (GS), Morgan Stanley (MS), JPMorgan Chase (JPM), American International Group (AIG), Wells Fargo (WFC) and General Electric (GE), it is impossible for even institutional investors, let alone individuals, to ascertain the true extent and nature of systemic risks which continue to threaten the financial system. Perhaps the SEC can help and make such disclosure mandatory with immediate effect. Perhaps.

Disclosure: Short GE, GS

Comments

[User 72034:]

"Overall systemic risk matrix" ? Doesn't anyone speak English anymore?
You're advancing the thought that the CDS market is being used to drive financial stocks lower and those spreads are affecting the creditworthiness of the underlying bonds? You're taking that one step further and saying this malaise is starting to affect sovereign debt and the US treasury market too? Thanks for the brilliant, but hardly fresh insight -----
The author has a service that prices derivative risk. I wonder what his outlook was on CDO's in 2007. It's getting awfully popular to be a 'Roubini'-doomsayer -------- now.

Jan 26 09:06 AM

[Ishortyou:]

the problem is who is going to trust government bonds when the government accounting books are already bankrupt and in deficit, I mean who is going to take the risk of not getting paid from bankrupt governments, maybe the Chinese or Japanese are willing to take the tremendous risk in buying those bonds or I owe u's but not just the regular investor, specially when bankrupt governments start printing money to pay their obligations.

Jan 26 09:32 AM

[Ishortyou:]

these derivatives or contracts have a lot of bets on it, a lot of gambling from investors money, so no one really knows how much is at stake, but I certainly will call my money away from these risky bets for sure.


On Jan 26 08:19 AM Ebenezer wrote:

> Don't forget...Robbins, Kaplan, Miller and Ciresi Law firm has uncovered
> WFC traders investing in derivatives market when it was flying with
> funds targeted to low risk investments by customer contract agreement.
> The company then apparently kept the larger spread profits while
> paying near money market rates to its customers. Now that the derivatives
> market has been in trouble, requests for certain customer withdrawal
> of funds has been met with resistance due to loss of the investment
> funds' value on the derivatives trading side. How much more of this
> has been going on without the knowledge of the investors, who were
> under the impression their dollars were being handled with much lower
> risk?

Jan 26 10:34 AM

[Rakesh Saxena:]

Tom: The traditional definition of default has been the failure to make full payment on maturity dates. But, certain countries (e.g. Argentina & Ecuador) have started offering partial payment along with a new instrument where the principal includes the balance of the principal plus accrued interest. The "liberal definition" I refer this trend towards restructuring. Many thanks - R


On Jan 26 07:23 AM Tom Armistead wrote:

> Rakeesh, could you please explain what is meant by "the relatively
> more liberal definition of sovereign default" gaining momentum.
>
>
> Unless the definitions can get around the problem, it would seem
> that the power of the printing press would make CDS protection on
> the US government meaningless.

Jan 26 11:12 AM

[Rakesh Saxena:]

Dear hefaistos: I guess the Fed will start with the secondary market-- it has already indicated that it will do that. What they do if that measure fails is anybody's guess right now. Many thanks - Rakesh


On Jan 26 07:34 AM hefaistos wrote:

> Excellent article!
> I want to add one component. This week there are some big treasury
> auctions, and there is a worry there won't be enough demand from
> foreign investors, leading to higher yields. That's easy to understand
> given the high dollar rate and the low yields, and the prospect for
> inflation in not too distant future. Is it likely that the Fed steps
> in in these upcoming treasury auctions to avoid having higher yields?
> How would such instant monetization be perceived? Or will they act
> only on the secondary market?

Jan 26 11:14 AM

[madmilker:]

psst!

Jan 26 11:15 AM

[Rakesh Saxena:]

Dear User 72304. For clarity, we have been pricing CDOs in 2007 and we continue to do so now. I am not offering any wisdom in hindsight, just the facts as they present themselves today and how best can those facts be interpreted. Unlike Dr. Roubini, I am not interested in any doomsday predictions. My interest is highly specific: what short-term trading and arbitrage opportunities are being thrown up today? I trust that provides the clarity you are seeking. Many thanks - Rakesh


On Jan 26 09:06 AM User 72034 wrote:

> "Overall systemic risk matrix" ? Doesn't anyone speak English anymore?
>
> You're advancing the thought that the CDS market is being used to
> drive financial stocks lower and those spreads are affecting the
> creditworthiness of the underlying bonds? You're taking that one
> step further and saying this malaise is starting to affect sovereign
> debt and the US treasury market too? Thanks for the brilliant, but
> hardly fresh insight -----
> The author has a service that prices derivative risk. I wonder what
> his outlook was on CDO's in 2007. It's getting awfully popular to
> be a 'Roubini'-doomsayer -------- now.

Jan 26 11:18 AM

[Oscar Gonzalez:]

It has been a while that nobody has mentioned anything about foreclosures.
I would like to know where we are at now.

Jan 26 12:09 PM

[carey_jim:]

Rakesh:

I think it's dangerous to rely too much on economic and financial models right now, and especially on the classic connection between a country's currency exchange rate and its interest rates.

If the dollar continues to rise (classical theory predicts that it will fall at some point in the future, of course) then U.S. interest rates will continue to fall.

I think politics and the relationship between government and business elites will determine immediate future results rather than economic laws which will not cease to have their inevitable influence but an influence that is deeply distorted by the elites who are playing outside the rules.

That doesn't mean these 'movers and shakers' will get what they want or even a reasonably good outcome, just that they will be a larger force than economic laws, in the short run at least.

If the economy continues to get worse, they might be forced to deal with unreasonable (uneconomic) demands from the general population also which would further distort the underlying financial and economic forces.

In my opinion this inevitable, continued political intervention will produce more volatility and unpredictability than normal and investment strategies using traditional financial tools will fail.

Mass behavior has always been irrational but, from time to time, the irrationality climbs to very high levels! We might be entering such a time in world history.

Jan 26 12:16 PM

[thannagan:]

Rakesh - Thanks for the insights. I like your contantly referring to the risk-adjusted rates as the best reflection of likely (real world) returns on various instruments - and therefore their relative actual value. I think the systemic implications (cascading market imbalances) are largely related to the lack of sufficient risk-based pricing, and net asset values.

I discuss some of these issues realted to bank lending in my blog: decisionanalyticsblog....

Please continue to publish.

Jan 26 12:55 PM

[Rakesh Saxena:]

Dear thannagan: I am not able to access your blog. Could you send me the details. It is certainly worth looking at the state of bank lending now in more detail, particularly foreclosures etc (per "Oscar" above). Many thanks - R


On Jan 26 12:55 PM thannagan wrote:

> Rakesh - Thanks for the insights. I like your contantly referring
> to the risk-adjusted rates as the best reflection of likely (real
> world) returns on various instruments - and therefore their relative
> actual value. I think the systemic implications (cascading market
> imbalances) are largely related to the lack of sufficient risk-based
> pricing, and net asset values.
>
> I discuss some of these issues realted to bank lending in my blog:
> decisionanalyticsblog....
>
>
> Please continue to publish.

Jan 26 01:48 PM

[Leftfield:]

I'm always struck by the consensus that seems to form around the idea that the public might get irrational, then we're really in trouble. Like inflation statistics that say, "we're" only in trouble when wages rise. A result has been decades-long lousy and deteriorating conditions for lower-income masses who would once have been middle class.

They've been irrational for years, and, sure it probably will get worse. Look at election results. The same fools voted in over and over. But, how could they be actually worse than the elites? Who engage and coerce all the lousy statistical modeling that is being slowly outed?

Jan 26 02:04 PM

[carey_jim:]

Leftfield:

Don't get me wrong, I agree with everything you just said. I just think we could be in for even MORE irrationality, in the near future, and even if the masses (including the middle class) manage to take on the elites successfully and bring more real equality (which the minority and womens' rights groups wrongly think they have already brought us) it will bring danger and more chaos than we are used to.

It's ironic that we've entered a time when asking for a more free markets and more regulation of monopolies and oligopolies, which most people on this board want, seems subversive to the elites both in government and business.

And Ron Paul seems more radical than Vladimir Lenin (or even John Lennon!)

Famous Chinese curse on one's enemies: 'May you be condemned to live in interesting times!'


On Jan 26 02:04 PM Leftfield wrote:

> I'm always struck by the consensus that seems to form around the
> idea that the public might get irrational, then we're really in trouble.
> Like inflation statistics that say, "we're" only in trouble when
> wages rise. A result has been decades-long lousy and deteriorating
> conditions for lower-income masses who would once have been middle
> class.
>
> They've been irrational for years, and, sure it probably will get
> worse. Look at election results. The same fools voted in over and
> over. But, how could they be actually worse than the elites? Who
> engage and coerce all the lousy statistical modeling that is being
> slowly outed?
>

Jan 26 02:54 PM

[thannagan:]

R - sorry - try this url:

www.decisionanalyticsb...

Tom

Jan 26 04:02 PM

[SeekingTruth:]

Back in the days when I was buying triple tax free Muni's paying 10%, and Us Treasuries paying 14%, and Zerocoupon bonds at enormous discounts, and High rated Corporates paying 12% +, I made sure I got the Weiss ratings on the non US Treas. issues , and pretty much ignored the other rating agencies.
What is the story today, as I have not purchased bonds in years, and do not know the quality ratings of the other agencies, except to be aware that a lot of them have been even more discredited than before?. Is Weiss still high rated and reliable, anyone?

Jan 26 07:49 PM

[ebenezer:]

Let us not forget a fundamental risk character of the derivative contract: No rule/law requires the maintenance of an "appropriate" reserve to pay off on the contract if its terms are not met. If the seller is unable to pay off a CDS default, for example, the buyer has gained nothing. These things are not sold like an insurance policy by a regulated insurance company required to maintain certain amounts of capital for potential statistically anticipated payouts. Close up the seller's company, sorry the premium was paid in salary, commission and overhead, and nothing is left to pay on default. Ultimately, the loss goes back to the banks loaning the money at the point of purchase, the shareholders of the funds investing in the contracts, or the issuers themselves. Lord knows, you'd think even the politicians could figure this one out...

Jan 28 12:02 AM

[Rakesh Saxena:]

Dear Ebenezer: You have a point. My point, however, is that the proper recognition of such contracts on balance sheets is vital, now and in the future. The FSAS 157 guidelines are too vague, and subject to subjective interpretations. Many thanks - Rakesh


On Jan 28 12:02 AM Ebenezer wrote:

> Let us not forget a fundamental risk character of the derivative
> contract: No rule/law requires the maintenance of an "appropriate"
> reserve to pay off on the contract if its terms are not met. If the
> seller is unable to pay off a CDS default, for example, the buyer
> has gained nothing. These things are not sold like an insurance policy
> by a regulated insurance company required to maintain certain amounts
> of capital for potential statistically anticipated payouts. Close
> up the seller's company, sorry the premium was paid in salary, commission
> and overhead, and nothing is left to pay on default. Ultimately,
> the loss goes back to the banks loaning the money at the point of
> purchase, the shareholders of the funds investing in the contracts,
> or the issuers themselves. Lord knows, you'd think even the politicians
> could figure this one out...

Jan 28 02:32 AM

[monday1929:]

We have HAD a Systemic collapse. We have NOT seen all the ramifications of that collapse. Yet.


On Jan 26 08:18 AM RiskTrade wrote:

> The reason some traders have bought protection on the US Sovereign
> is not because they expect the US to default but because they think
> things could get worse and spreads will widen thereby allowing them
> to close their position at wider spread levels. If the U.S were to
> run in to trouble with its budget deficit we would more likely see
> a downgrade rather then an outright default/ or debt restructure.
> Downgrades are not credit events and so the CDS is unlikely to be
> triggered.
> Honestly, if the US were to default the rest of the world would be
> in far more problems as they are dependent upon u.s consumers, and
> investors.
>
> Yields on treasuries will no doubt rise, and the u.s dollar will
> at some point fall, and markets will take a while to recover but
> we are not in danger of a systemic collapse.

Jan 28 09:02 AM

[monday1929:]

I have long stated that ANY fiduciary who invests other peoples' money in the Banks or other entities with undisclosed level three derivative exposure will be legally liable for negligence. My own and others exposure of the Trillions in hidden off-book losses will form the basis for such law-suits.
No fund should hold Citi, JPM or any other criminal bank. Their mis-deeds are now apparent to all.
Andrew Coumo MUST launch a RICIO prosecution of these banks if he is to maintain any credibility or hopes of political advancement.

Jan 28 09:10 AM

[ebenezer:]

Rakesh...

I agree with you, wholeheartedly. If you recall the Enron mess, Fastow was an expert at off balance sheet activity involving not only implicit guarantees backed by Enron stock, but by derivative-like structuring of the vehicles to hide Enron business losses and offset business deal declines in value. However, when the stock prices dropped, and capital calls came due , the true nature of the "short term" loan character of many of the vehicles had to be reacted to by the investment banks/banks who had funded the quarterly infusions of capital into Enron's P&L. With the help of Anderson and Company looking the other way, these deals continued to be restructured until there was no more willingness to support them due to Enron's failing balance sheet.

Enron used "Mark-to-market" for their compensation awards, but then failed to account for the long term decline in intrinsic business value (as many of the deals lost money) using the same methods. Me, I'm all for the M-to-M method to gain a realistic view of the present economic value of assets/deals with regard to P&L, balance sheet and shareholder interest exposure.

Considering we have all had the benefit of Long Term Capital's and Enron's messes...I can't believe Congress has not wailed for greater regulation, transparency and trading controls over derivative contracts along with the hedge fund businesses who love the vehicles the most. Today, even a good bank doesn't know its own exposure if the hedge fund it is lending to keeps its other banking relationships confidential.

For Greenspan to argue hedge funds need no regulation was always beyond my comprehension...greed drives too many beyond self interest for the benefit of their own survival. And, as we have now seen, a true lack of self interest toward the preservation of the system that allows one the "play" has wreaked havoc on us all.


On Jan 28 02:32 AM Rakesh Saxena wrote:

> Dear Ebenezer: You have a point. My point, however, is that the proper
> recognition of such contracts on balance sheets is vital, now and
> in the future. The FSAS 157 guidelines are too vague, and subject
> to subjective interpretations. Many thanks - Rakesh

Jan 29 12:57 AM