It has been a while since the 8 word subprime has dominated the business and financial headlines. Last few days, it seems a new 3 word CDS (credit default swap) has emerged and discussed more often. Bond insurers and banks are the major players in this field. At last Friday (1/18) WSJ front page, there is a discussion about bond insurer ACA Financial Guaranty Corp which had only $425M capital to provide credit protection to $69B of corporate and mortgage debt, a leverage making LTCM look risk averse. Then on Dec 19 last year, when S&P lowered ACA rating from single A to triple C, it basically put ACA out of business. There has been also many articles lately talking about rating agencies potentially lowering rating on the two largest bond insurers of Ambac and MBIA.
This should not surprise Bill Gross who is the founder and money manager at PIMCO. At their website about a week ago, Bill has published an eye-popping article "Pyramids Crumbling" as his 2008 investment outlook, detailing the substantial risk and potentially huge loss associated with CDS, the most aggressive vehicle in the OTC derivative market. He provided a simple calculation:
The total outstanding CDS is about 45 trillion, and historical norms of defaults is at 1.25%, so about $500B of these CDS insurance contracts will be in default. But some of the loss can be recovered, say 50%, the total loss would be $250B. This is about the same write-offs Wall St estimated to be on subprime, a different and separate category from CDS.
It seems that Bill's estimate is very conservative and at the low end. First of all, default rate rarely at average, they are either much higher or lower than historical average at a certain time. With real estate value going down and delinquency rate going up, with recession when corporate bond default rate going up, the default rate might turn out to be doubling the 1.25% historical norms.
Secondly and more importantly, last 5 years, the composition of bonds insured has changed dramatically, from less risky to highly risky area. Majority of the revenue and income growth for bond insurers last 5 years are not from the traditional and typical municipals or investment grade corporate bond area, but from the insurance policies on the highly risky corporate junk bond and especially the SIVs in the mortgage area, with default rate possibly in double digits and not much to be recovered. Just to be conservative, say 2% default instead of 1.25% as Bill Gross assumed, the default contracts would be at $900B. By using 45% recoverable, the total loss would be around $500B.
As Bill Gross pointed it out, the worst is since CDS market is unregulated like hedge fund and private equity sectors, there is no regulatory reserve requirement to cover this kind of wild side bets among banks and financial institutions. This makes subprime loss an appetizer to the upcoming CDS loss of this whole credit crisis. When Jeremy Grantham, founder and money manager at GMO, last summer predicted that a major bank or financial institution will fail by the end of this credit crunch, originally I thought the usual suspects of Countrywide, Bear Stearns or maybe even Citi as front runner, but this CDS new crisis totally changes the running field. Now it seems the major bond insurers such as Ambac and MBIA become the front runners. Latest Barron's issue has a article about how MBIA is undervalued and due for a rebound, sure, have we heard that before on Countrywide, Citi and Merrill?
If you add this $500B CDS loss to the $250B from subprime, loss from other higher quality residential mortgages, plus commercial real estate development projects currently under extreme difficulty to obtain refinancing, also how about the ticking time bomb of increasing consumer credit card default, will the loss of this whole credit crisis approach $1 trillion mark someday before it is over? Yes, $1 trillion US dollar of bank book value to be written off.
Can we imagine an $1 trillion being wiped out from our banks and financial institutions? Currently banks have written off around $100B and raised capital also close to the same amount from about 10 countries of their sovereign wealth funds. 10% done, 90% more to go! They need to get real busy soon. At least there are still another 180 countries left in the World they can try if these countries have the so-called sovereign wealth funds available.
The downgrade of rating agencies has a very profound impact not only on the bond insurers themselves but also to the bonds they are insured. We see S&P downgrade from single A to triple C (4 notches down) put ACA out of business. What would happen to Ambac and MBIA if their rating goes to from triple A to triple B (only 3 notches down)? Anyone is still willing to ask them to provide insurance? How can they still be getting new business with a junk bond rating? No wonder the government needs to get Warren Buffett into the bond insurance business quickly in order to at least cover the municipalities of state and local governments.
More importantly, can we imagine what will happen to the many trillions of debt they have already provided insurance to? Those bonds, especially the shaky corporate junk bonds and highly risky SIVs such as those "creative" but value destroying MBS, earlier received a higher than deserved rating partially due to insurance contracts and guarantees from the bond insurers which are triple A rated and assumed having close to zero chance of going under. However, if now the guarantor itself is in trouble and in the junk territory and has high risk to default, with the original rating assumption invalid, should the rating agencies downgrade those many trillions of "insured" loans as well?
Insurer is always acted as the last resort in this banking pyramid scheme by holding the bag. If this bag is suddenly gone, the loss of default will be falling to all the counterparties and bring all major investment banks at Wall St to their knees. It will create a domino effect rippling across the whole financial system, much deeper than LTCM, much larger than S&L, for Fed to save it this time.
Only GOLD can save us now.
