S&P Ratings Downgrade Forces Risk Repricing

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Includes: DIA, IWM, QQQ, SPY
by: Evans Osemwegie

Summary

Britain has been plunged into crisis.

This will force the market to reprice risk.

This repricing is likely to precipitate the next global financial crisis.

Whoever gets the unenviable role as the next Prime Minister of the UK could also be facing the very real possibility of losing Scotland and Northern Ireland, especially if the economic conditions continue to worsen.

These are some of the potential outcomes that have prompted the S&P to downgrade the UK. It is likely that the other rating agencies will also follow.

What is also a concern is that further downgrading of the UK has not been ruled out, that is dependent on how conditions progress over the next six months.

Considering that volatility will continue to dominate especially over the next six months as the political limbo is gradually resolved, further downgrades remain a real possibility and it will certainly force the hand of major banking houses in London to relocate, which will result in more job losses and a fall in tax revenues, which should lead to more volatility.

Another risk in the background will be in the details of the negotiated exit because as the details of the thousands of various bylaws, regulations, directives, treaty amendments and sub amendments begin to be revealed, the true enormity of the withdrawal will start to become clear and will cause widespread disillusionment.

It is my belief that this event may be what precipitates a global economic crisis, not necessarily because of the economic effect of the divorce proceedings but how it is likely to force the market to begin to reprice risk again.

When we speak about financial risks, we will tend to measure it on the basis of probability and standard deviations from the mean. Undoubtedly, the markets as a whole did price the risk of Brexit as an outlier or more accurately a once in a generation opportunity to make a killing.

Never did they think it would actually have happened. Now that we know that it did happen and there has been real risk consequences in terms of a ratings downgrade with more to follow, financial models will now have to begin to be recalibrated to accommodate these events.

In doing so, it will not just be the risk emanating from the UK, there will also be a recalibration of risks coming from Greece and its financial instruments, Spain, Portugal, Italy, the Eurozone as a whole and even the USA because in risk management, when one risk parameter is moved then every other parameter has to be moved to maintain a true reflection of risks across the market and thus the pricing of financial instruments across the board.

Further, when this repricing takes place, this will affect derivative instruments, particularly instruments like credit default swaps, interest rate swaps, etc.

It will also affect option pricing both in terms of interest rates expectation and volatility particularly creating a significant divergence between implied and historical volatility.

This will affect prospective risk pricing but it will also cause market participants to also take a fresh look at their portfolio in light of all that has transpired and as a result of this, they will begin to shed numerous assets.

I believe it is this selling that will be the catalyst for the financial crisis; it is likely to start with the riskier assets like high yield bonds, credit default swaps and currency swaps particularly those involving emerging and frontier markets.

This will then begin to creep into assets that are higher up the investment rating scales as it will begin to bite into the Eurozone and the South East Asian economies and eventually we will have a full financial crisis in the global economy.

Brexit poses such a danger because the markets as a whole have priced risks really low for at least the last 15 years since the dot com bubble crisis.

As a result of this, it can be said that for all of this time, market risks have been priced far lower than they should have been and in such instances where there is such a pivotal point in the market that goes beyond the bounds of normal expectations, market participants look to their social environment to get their cues on how to price the new market risks. Doing this will result in an erroneous mark to market model and still leave many market participants widely exposed to global market risks because of this contemporary market price bias.

Solution

In order to discover a truer price of risk, it will be necessary to expand the historical data to 1990 as this will also capture Black Wednesday in September 1992 and the Asian financial crisis.

One must then use the higher bounds of the average of this as the foundation of any risk management strategy.

This is because this will give a more normalized risk measure and a truer price of risk. Institutions that use this type of measure despite how the current market is pricing risk will find that their reserves and hedges will be far more robust than those who simply rely on mark to market hedging.

Current market risk pricing will leave many market participants horribly exposed because the crisis reference point for many firms and investors is the Lehman Brothers crash but this was not a major market event because it was managed and coordinated by the central banks.

If Brexit precipitates the next financial crisis, market participants cannot expect the same support from the central banks because they cannot do much more than they have already done so investors and firms will have to look after themselves.

Taking extra precautions in this time is essential. For those who say that Brexit could not cause a financial crisis are not following recent history because in the last crisis in 2007, it was not the failure of what was a relatively small number of homeowners to pay their mortgage payments that caused the reflection but it was the repricing of the risks in those assets that forced the whole industry to start to reprice the risks in their mortgage instruments and then the selling began.

It is never the initial event that causes the damage but it is the after effect and especially now with little wiggle room left for the central banks, when the panic sets in, it will be very significant particularly for banking and financial stocks.

Certainly, this repricing of risk is set within what is a very weak global economy

In conclusion, there are many unknown unknowns particularly in the shadow banking sector, huge derivatives overhang from 2007 and significantly more created since then and finally with weak global growth, overvalued financial markets and negative interest rates, it is really a cocktail for disaster.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.