Saturday, 1 December 2007

A note on sub-prime debt and derivatives

As time goes by, you will notice that I will talk quite a bit about Canadian, U.S., and foreign economy and markets. I can't help it because I am an economist by education and (some say) mentality.

Also, another feature of this blog will be reviews of and references to some of the other financial blogs that I regularly or occasionally read and/or am subscribed to. Some posts in these fellow blogs are very interesting and make me think about fresh aspects of a situation or issue that are non-standard and are not captured by the attention of general public.

A lot of media attention recently is on the sub-prime crisis that is the key factor why the financial sector in the U.S. and Canada has gone down over the last several months in 2007. The primary focus right now is on the sub-prime debt issues and trading in so-called CMOs (collaterlized mortgage obligations), MBSs (mortgage-backed securities), SIVs (structured investment vehicles), and other asset-backed-security schemes with sophisticated names, but frequently a shaky substance behind them. What has not grasped people's attention yet is a possible problem with other derivatives, in particular a family of credit derivatives.

The markets for unfunded and funded credit derivatives (including various types and variations of CDSs (credit default swaps), CDOs (collateralized debt obligations), and credit spread options) and other credit securities (such as loan guarantes) have grown tremendously during the last several years. However, they have not been put to the real test yet as the global economy has not experienced any severe recessions and financial crises during the last decade (the 1997-1998 Asian financial meltdown and the 2000-2002 equity market correction, although pretty significant, do not really count here).

Certinaly, one can think of credit derivatives as credit insurance on underlying loans, bonds, other securities/assets/liabilities. However, the problem with them is that they are also in essence highly leveraged securities with a great degree of risk exposure both to their sellers and buyers. In rapidly deteriorating market credit conditions, the probability of credit events (e.g., default on interest payments, decrease in an entity's credit rating, failure to repay a credit facility, etc.), which triggers insurance payments on credit insurance instruments, increases significantly.

The potential issue that we are facing right now can be described in plain terms by using an analogy from insurance markets (and we DO in fact discuss credit insurance here). On the one hand, we basically have credit insurers (mostly financial institutions) who wrote a lot of insurance contracts with above-average risk exposure, without creating and maintaining a proper capital base to honor possible insurance claims if most of them come due in the case of a major claim-triggering event. Another related problem here is incorrect pricing of credit premiums due to the biased information from credit agencies or due to the use of mediocre premium-pricing models. It means that credit-insurance premiums do not properly cover the underlying credit-default risks (most likely understating them).

On the other hand, we have buyers of this credit insurance who happily think that they are well protected against their risk exposure on the underlying insured contracts. Buyers include financial insututions and non-financial corporates.

We also have the third group here, which is associated with assets or liabilities covered by the underlying credit-insurance contracts. These companies or other types of organizations have earlier sold their assets (which may well be represented by asset-backed securities) to or borrowed from credit-insurance buyers. When the situation get tough, they may default on their payments or other obligations, which effectively triggers a credit event. Keep in mind that a credit event can happen even without default on the associated asset/liability. Credit event can be represented by deterioration in a company's credit rating, by a change in a company's financial ratio(s), by a decrease in a market or sector index, or by a company's default on its other obligations not covered by the credit-insurance contract. You name it. The credit markets have been very inventive in creating credit instruments of all shapes and colors.

Add speculators in credit derivatives to the overall mix, and you now have the picture of who is involved in the credit-insurance system.

To finish the story, when a credit occurs, a credit-insurance buyer calls a credit-insurance seller and asks for the insurance payment. The problem is that when credit events all of a sudden happen in large quantities and at once, such wave of claims may paralize the whole credit-insurance system, given its weakness in terms of capital coverage and potentially large underpricing of underlying risks. Since most of credit derivatives are associated with corporate debt markets (both long-term and short-term), you can figure out what consequences may be there for the real sector of the economy.

Anyway, what initially started as defaults on subprime mortgages amid the softening economic situation in the U.S., has now been spreading onto the other parts/sectors of the financial system both in the States and abroad. This contagion effect, partly due to the chain reaction through borrowing/lending/financing channels and partly due to the increasing panic in financial markets, may as well spread into the credit derviatives markets. If it happens, then the financial-services sectors and the economy, both in the States and other countries, may be in some extra serious trouble.

Most investors probably know what Warren Buffet, the icon of all serious value investors, said when asked about derviatives. "Time bombs" and "financial weapons of mass destruction" are some of the terms that he used. Here is the link to the old related article.

You can also read another interesting recent post on this issue here. I will use this link as an opportunity to mention Jesse's Café Américain blog and market analysis. I found it very recently and liked it. Very good market charts, analysis, and comments. As I said in the beginning of this post, I will comment on the other blogs that I more or less regularly read or look at

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