(Bill) Grossly Overstated

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.

Comments

[calvino:]

<Factor in a probability of default of 2 per cent>

Go factor. Am I supposed to take this assumption as some sort of a universal constant. Since the thesis rests on this assumption, do you think that I am not going to notice as you glide by, with an offhanded, mention. Nothing but us here chickens, said 2%. Really, I am not going to posit major defaults, but perhaps 2% is a tad conservative, at the tail end of a long period of steady financial inflation.

2008 Jan 29 01:24 PM

[Gregory Ski...:]

Tom's a smart guy, we had him on our radio show a month or so ago.

belraycommunity.com/ra...

2008 Jan 29 01:41 PM

[helplessobs...:]

If nothing is being "lost to the system" how come MER has written down the value of bonds insured by CDSs issued by ACA Capital? In the wings Ambac and MBIA arpreparing to shed counterparty responsibilities on their swaps on actual, not notional, billions in CDOs. A few years back the swaps nearly brought down the financial system, now it is getting a second chance.

2008 Jan 29 06:59 PM

[VP of Commo...:]

So if 1/3 of countrywide's subprime mortgages are in default, that would be a long way from 2%, right?

2008 Jan 29 08:40 PM