Counterparty Risk Could Spread Beyond Credit Markets

Oxford Analytica analyzes the risks associated with credit default swaps in a new report and warns that counterparty risks could worsen or spread to other markets, such as energy derivatives.

Participants in modern derivatives markets may not have devoted sufficient time, resources and systematic thought to the subtleties of the theory of counterparty credit risk, OxAn says

The concept of ‘wrong-way risk’ is as old as the modern derivatives market. Yet in part because its systemic effects are relatively difficult to model, the threat it poses in particular derivatives transactions — and to the financial system more generally — is often overlooked.

Over the past year, wrong-way risk has chiefly been a problem on credit derivatives markets. However, it could easily worsen, or spread to other markets — such as energy derivatives.

This variety of counterparty risk can be effectively priced and modelled, but this is very time consuming, expensive and often does not fit well with other forms of mathematical risk modelling, OxAn says. The risks associated with wrong-way risk have not been dealt with effectively, and are increasing.

Moreover, the most pernicious type of counterparty risk — the danger that counterparty transaction risk might increase for all counterparties, simultaneously — has become systemic. This threat, known as ‘wrong-way risk’, has become a chronic problem in the developed world.

This situation represents both a failure of risk management modelling and a failure of imagination.

The trouble with credit derivative hedges emerged due to the parlous financial health of some derivative dealers and the monoline insurers that, in effect, act as credit insurers. Dealers and banks are facing the unsettling thought that the credit default swap (CDS) hedges that they had entered into with monolines to help manage risk on their structured credit origination activities will become worthless if these troubled counterparties themselves lurch into bankruptcy.

OxAn says the key to quantifying wrong-way risk is to model correlation between contract values (across a portfolio of derivatives) and counterparty credit quality. The most common generic theoretical approaches include :

• simulation of counterparty default and exposure jointly;
• simulation of exposure conditional on counterparty default; and
• adjusting the expectation of (unconditional) exposure in order to approximate the risk expectation conditional on default.

Significantly, when wrong-way risk is modelled, it is often done via the last approach, due to the fact that it is less computationally expensive and time consuming, and it generates measures of exposure that risk managers find easier to incorporate into their overall risk management framework. However, given the gravity of the crisis, this approach may have been insufficient, OxAn says.

More details are available in the full report, Wrong-way risk’ could exact heavy toll.

Comments

[helplessobserver]

Warren Buffett inheritated thousands of CDSs with his take over of GenRe Insurance. It took 4 years and $400M to track down and close all the contracts. A major financial enity is going to fail and the FED and Treasury will appoint a comission to sort out and payout these contracts. Meanwhile the DOW will be below 8000 as the comissioners start their work.

[Andrew Clifford]

I agree 100% with #1 and further that the $400m loss was incurred in fantastic market conditions for unwinding CDSs. To do today what Buffett did is impossible.

[Ashish S]

@helpless No major financial institution is going to fail -- the Fed won't let it. Meanwhile, though, CDS and other derivative contracts are going to have to move towards exchanges to greatly reduce the counterparty risk. This will also hopefully increase price transparency and prevent a liquidity crisis. Problem is banks are making too much money keeping them OTC.

[Reclined]

This article is a disappointing advertisement.

[squashnut]

(H)Ashish the Fed doesn't have the save all these banks. The Treasury will have to get out the wheelbarrows.

[squashnut]

"the clout"

[nickgogert]

Netting delays could lead to counterparty failures even in light of the ability to cover notional obligations. Hersttat risk is real in this situation. Single point failures in the netting network tend to cascade from the failure point (institution), considering the rather thin tier 1 capital positions of many firms, systemic risk is currently very high indeed.

A minsky moment of illiquidity could unfold in the rush for higher quality assets. One could argue the TAF and related fed facilities already acknowledge this is an ongoing issue with major banks.

The Fed, BOE etc.'s options are only to substitute lower credits for higher credits and garuntee failed netting banks obligations a la Barings circa 1998. We are already in a stage with a "soft lender" of last resort.