Imagine walking down the street and finding a $100 bill. Wow, you say, this must be my lucky day. To take advantage of this good fortune you decide to go to the race track. After reading the racing sheet you place a bet in the 3rd race on the long shot 'Never Wins'. 'Never Wins' has finished last in every race that he has run. Also in the race is the favorite, 'Always Wins'. 'Always Wins' has finished in first place in every race that he has run. You still go ahead and make the bet because you strongly believe that today 'Never Wins' will win. The bet is made for $100 and the odds are 100 - 1, if he wins your payoff will be $10,000.
It turns out that on this day a number of other bettors feel the same way as you and they place the same identical $100 bet that you did. The track executives while monitoring the incoming bets notice the large size of 'Never Wins' bets but they do not change the odds as they are so confident that history is on their side. After all 'Never Wins' never wins and 'Always Wins' always wins.
At race time you take your seat. The bell rings and 12 horses bounce out of the gate but five of them run into each other and fall to the ground. Then four more horses fall into a puddle and stumble onto the ground. Out of the three horses remaining, one gets disqualified as his jockey falls off. There are now two horses left - your horse the 100 - 1 long shot 'Never Wins' and the great champion 'Always Wins'. 'Always Wins' is about 10 lengths ahead of 'Never Wins'. As they reach the final turn, a bird flies into 'Always Win's' eyes; he becomes temporarily blinded and stops running. About 10 seconds later, the long shot 'Never Wins' runs right by 'Always Wins' and crosses the finish line in first place. You jump up with excitement and are beaming with joy. Time to collect. You say to yourself, what were the chances of all of those things happening in one race?
As you approach the pay off window, you see a large crowd gathered around and they seem upset. They are yelling things and asking questions and pounding on the closed payoff window. As you get closer you find out that about 200 people placed identical $100 wagers that you had and they were looking to collect their $10,000. You quickly do the math in your head and realize that the total payoff the track has to pay is $2 million. You make your way to the window and see a sign that reads, 'No More Winning Tickets on 'Never Wins' Are Going to Be Paid.' You are angry, in shock and say to yourself what about my money? Who is going to pay off my winning bet? Why did the race track take so many long shot bets? What kind of risk controls did the track have in place? How can this happen? How can the track or the counterparty not pay up?
Something similar to this is going on in the financial markets today. Here is a fictitious example. If an Investment Bank has large exposure to the subprime mortgage market and the executives at that bank feel uncomfortable with it, they will hedge some of their risk. They do this by purchasing insurance. Another financial entity or counterparty will sell the investment bank an insurance contract or credit derivative. This contract will pay off if large numbers of subprime borrowers default on their mortgage payments. The counterparty can be another investment bank, insurance company, bank, hedge fund etc.
In this example I will use the insurance company. The executives at the insurance company believe that insuring subprime mortgages is a good bet and that the likelihood of substantial payouts is small. The insurance company's analysis of the past data shows that insuring the subprime sector of the housing market has been profitable and that it likely will be so in the future. Their analysis also shows that the only way for large amounts of subprime defaults to occur is if housing prices were to decline nationally. The executives think that this is a very unlikely scenario. These stats convince the executives at the insurance company that it would be a wise decision to increase the amount of insurance they are selling and so they do. The first couple of years turn out to be very profitable for this insurance company as subprime mortgage defaults are low due to rising housing prices. However, the pendulum begins to swing the other way and more subprime mortgages go into default and then all of a sudden the unlikely happens...
The insurance company receives word that a large number of subprime mortgages are in default and that it now has to pay up and make good on its insurance contracts to the investment banks. The amount they have to pay out is much more than the capital it holds. The insurance company comes under siege as thousands of payoffs are due. It is able to make some payments but it does not have enough money to pay all of the claims off. So the insurance company closes its doors and stops making payments and files for bankruptcy. Many investment banks who thought they were hedged now receive no payments from their counterparty. The investment banks now have to take the subprime exposure back onto their balance sheet. It turns out their hedges were worthless because their counterparty is bankrupt. The investment banks are now faced with large losses.
Counterparty risk, or the risk that an institution does not pay out on a derivative, insurance contract, bet or trade when it is supposed to, is a real risk. It is occurring more frequently than before. The U.S financial system is based on market participants paying off their bad bets. What if the counterparty can't pay off? What if a financial entity that assumes it is hedged, is not? How does one ensure that a counterparty is strong enough to make a payout? If an insurance company decides to stop payments because it has no reserves left, what does that do to the financial system? These are the issues facing financial institutions today. As bets go wrong and payouts missed, counterparty risk will become a larger problem in our financial system. A number of the investment bankers have mentioned this potential problem during their earnings conference calls. I have recently become aware of the acuteness of this problem and will be writing more about it in the future.