Financial Research Report: Credit default swaps severely exacerbated the financial turmoil

FUKAO Mitsuhiro
Former RIETI Faculty Fellow

The financial turmoil in the United States that began with the deepening subprime mortgage loan problem last summer has evolved into a global financial crisis encompassing countries in Europe. The situation deteriorated particularly after the failure of Lehman Brothers on September 15, when the global short-term dollar market reached an impasse in response to a series of events that included the rapidly worsening state of American International Group (AIG), the largest insurance company in the U.S., underwater money market funds (MMF), and the withdrawal of a significant volume of assets deposited with investment banks such as Morgan Stanley. We are now experiencing the most serious economic crisis since the 1930s. This paper looks at the reason why the financial turmoil, which at first was contained in the U.S. housing market, has spread throughout the world, and analyzes the impact of the crisis on the Japanese financial system.

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The first thing to note is that many financial institutions in Europe incurred substantial losses related to the subprime loan crisis in the United States. Financial institutions in Switzerland, the UK, and Germany were aggressive players in the U.S. asset management market and held a substantial amount of subprime mortgage instruments. As the problem deepened, these firms suffered losses and rapidly burned through their capital. In some EU countries, such as the UK, real estate prices also fell, which heightened the sense of concern over the soundness of financial institutions.

The second point is that many commercial banks and investment banks were linked together in a chain of credit risk through enormous volumes of credit derivatives transactions. The most important of these transactions involves a credit derivatives product known as a credit default swap (CDS).

A CDS is a derivative product similar to a credit guarantee. For example, let's assume Bank B holds a five-year bond with a face value of $100 million issued by Company A (e.g., Lehman Brothers), and wants to protect itself against the possible failure of Company A. In this case, Bank B purchases a five-year CDS with a notional principal amount of $100 million from credible Insurance Co. C, and pays Insurance Co. C a certain percentage of the notional principal (e.g. 1%) every year as a debt guarantee fee. If Company A does fail and the bond goes into default, Insurance Co. C pays Bank B an amount of guarantee money equal to its impaired loss on the bond.

In fact, when Lehman Brothers failed, open bidding was held for Lehman bonds to determine the exact impaired loss, and 91 cents in guarantee money was paid for every one dollar of principal (the loss ratio was 91%). Using the above example, Insurance Co. C pays Bank B $91 million.

While a CDS can serve as a debt guarantee as described above, it also tends to be used for purely speculative purposes. For example, Bank B can purchase a CDS for Company A from Insurance Co. C even though Bank B does not hold any bonds issued by Company A. By placing such a bet on the failure of Company A, Bank B will make an enormous profit if Company A does in fact fail.

The volume of CDS transactions has ballooned, with the total notional principal of all CDS outstanding reaching $54.6 trillion at the end of June 2008.

This amount compares with global GDP in 2007. In fact, the notional principal amounted to approximately $400 billion in the Lehman failure alone. Despite the high credit rating given to Lehman until just prior to its failure, the financial institutions that underwrote the risk could have been forced to fulfill their guarantee obligations at the time of settlement for the CDS, and could conceivably have incurred enormous losses due to the 91% loss ratio. However, most CDS positions had been hedged before the failure and the actual loss has been estimated to be only $6 billion to $8 billion, and it is fortunate that no large chain of defaults has been reported.

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It was the sudden vulnerability of AIG that drew attention to the sizeable risks associated with CDS transactions. AIG has a subsidiary operating under its umbrella in London that deals with derivatives products. According to The New York Times, 17.5% of the total profit reported by AIG in 2005 was attributed to income from huge guarantee fees on CDS products. However, as losses rapidly mounted on subprime mortgage-related guarantee obligations, AIG was forced to post substantial losses that led to its credit rating being downgraded significantly from its previous AA level. The downgrades triggered alarms in agreements between AIG and its trading partners, forcing AIG to provide huge amounts of collateral for the counterparties to whom it had issued credit guarantees in the form of CDS. AIG effectively failed when its counterparties' demands for collateral exceeded its liquid assets on hand, forcing the company to seek three separate financial support packages worth more than 15 trillion yen from the U.S. government.

If AIG had not been able to receive government support, leading investment banks that had purchased credit guarantees from AIG for troubled assets could have lost their indemnity and sparked a chain reaction of defaults.

Given that revenues from providing guarantees in CDS transactions are supposed to cover future guarantee obligations, it is necessary to set most of them aside as reserves. However, it seems that AIG recorded most of the guarantee fees it received as income.

U.S. and European financial institutions across the board rank high on the list of leaders in CDS transactions, and large investment banks in particular have played the role of bookmakers, so to speak. CDS were once easy to use for profit manipulation, but have now become landmines that are scattered around the global financial markets and set to explode in a chain reaction. With insufficient information disclosure, it is difficult to see where they are hidden. This is why the global financial markets have stalled.

Changes in the three-month dollar LIBOR rate and short-term Treasury bond (TB) yield indicate that the interest rate differential between them, which had been widening since last summer, rapidly expanded after the failure of Lehman. The interbank market has become paralyzed.

Thanks to the passage of the Emergency Economic Stabilization Act of 2008 by the U.S. government on Oct. 3, specific measures for stabilizing financial markets have finally been set in motion. However, the money market is still far from a normal state of operation because financial institutions and corporations remain dubious about the soundness of the counterparties in their transactions.

To normalize this situation, it is necessary to gradually alleviate the sense of distrust through a full disclosure of financial information, particularly the evaluation standards and state of bad debts and risks involved in CDS transactions. A long-term contract of around five years is often used in CDS transactions, and their evaluation standards are not clear-cut.

To reduce the risks associated with CDS and long-term derivatives products, and to increase the transparency of accounting, it is advisable to establish a central clearing house for CDS and other derivatives, as recommended by the Federal Reserve Board and the Financial Stability Forum in Basel. The amounts "won" and "lost" by the parties involved in the transactions should be recorded by establishing a neutral derivatives pricing organization. Also, if past bilateral transactions were to be converted to transactions with an exchange as the counterparty, it would be possible to avoid the situation where "winnings" cannot be collected due to a sudden bankruptcy of the counterparty.

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The effect of this turbulence on the financial markets and falling stock prices is also evident in Japanese financial institutions. Looking back on the performance of Japanese banks, we note that gross profits, which had been recovering before fiscal 2005, declined for two consecutive years in fiscal 2006 and fiscal 2007. The reduced earnings reflect the impact of declining fee and commission income that had previously offset a fall in interest income. The drop in fee and commission income was due to lackluster over-the-counter sales of insurance products and investment trusts as a result of falling global stock prices and the Financial Instruments and Exchange Law that was announced during the first quarter of fiscal 2006 and became effective in September 2007.

Additionally, the capital ratio of banks has declined markedly with the fall in stock prices that began in September. Let's look at the actual effective capital ratios of Japanese banks at the end of March 2008, along with the ratios estimated at different levels of the Nikkei 225 Index (Figure). The effective capital ratio, which is a stricter version of the standard core capital ratio, is estimated by the Japan Center for Economic Research by making adjustments for deferred tax assets and an allowance for bad debt. In Case A, which uses figures at the end of September 2008, the capital ratio has already dipped about 0.3 percentage point below the level from six months earlier.

Figure: Push-down effect of falling stock prices on the effective capital ratio of Japanese banks

In October the index fell below 8,000 points, which coincides with Case B. The effective capital ratio on an all-bank basis in Case B is 1.54% and the ratio in Case C, which assumes that the Nikkei 225 Index is at the 7,000 point level, drops even further to 1.32% These figures are only slightly above their lowest point at the end of March 2003, when Japanese banks were struggling with falling stock prices and bad-debt write-offs.

By estimating the effective capital ratio of individual banks at different stock price levels, we discovered that nearly 20 of the 124 Japanese banks have an effective capital ratio of less than 0%, which represents negative net worth, when the Nikkei 225 Index is at 7,000. As such, the banking industry in Japan is still vulnerable to falling stock prices, and the capital adequacy of quite a few banks has become suspect because of the recent declines. Insufficient capital will impede the economic recovery in Japan as banks become more cautious about lending. The Japanese government should be taking action to help encourage banks to rebuild their capital bases as quickly as possible.

>> Original text in Japanese

* Translated by RIETI.

October 29, 2008 Nihon Keizai Shimbun

November 27, 2008

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