(Bill) Grossly Overstated

by: Tom Brown

ISDA CEO Robert Pickel says that Bill Gross, who's argued that CDS losses could reach $250 billion in the event of a corporate credit crackup, doesn't know what the heck he's talking about:

First, the $50,000bn "notional" or nominal amount [of CDSs outstanding] is just that; a nominal figure that references the "underlying" bonds and loans being protected by use of credit derivatives.

Focus on the net exposure of these transactions, many of which hedge or offset one another. A recent Fitch Ratings survey estimates net exposure at less than $1,000bn. Factor in a probability of default of 2 per cent and a 25 per cent recovery rate and protection sellers would have to settle an aggregate $15bn of losses. None of these amounts would be "lost" to the system; a credit derivative simply transfers a potential gain/loss from one party to another. Clearly, while $15bn is not trivial, it is a small fraction of aggregate write-offs to date on loans and securities; and less than a 10th of Mr Gross's suggestion. [Emph. added]

Pickel adds that, to get to his $15 billion total loss number, he uses a much higher default rate and lower recovery rate than Gross assumes. Plus, the reference entities on which CDSs are written skew more toward investment grade than the bond market as a whole. Fifteen billion dollars is not nothing, Pickel concedes.

But it's hardly the type of number that would bring about the financial doomsday that the Bill Grosses of the world seem to have in mind.