This cross-dependency on other institutions is why counter-party risk may be the next problem child to raise its ugly head and may be the greatest risk of them all. We have been hearing the murmurs of counter-party risk for the last several years. The last measure of the credit derivatives market is $45 trillion (yes with a T) which didn't happen overnight. Like any big disaster, it didn't reach its tipping point in an instant but rather built up over a substantial time period where warnings were not heeded.
The risk isn't just that the other party to your derivative trade suffers a financial meltdown and can't pay. Counter-party risk really seems to take on three types of events. In the most widely understood event, a trade in which you are winning and are owed money by the counter-party isn't paid to you because of their inability. This first risk is pretty simple, but even so these kinds of failures may cause you enough pain to pass the problem down the line by creating an inability on your part to pay your obligations. This is a daisy chain effect.
The second kind of counter-party risk is that these private transactions which are agreed to in complicated legal documents have not been properly documented. Many credit derivative transactions don't simply involve two parties but are often times the risk is passed from one party to the next several times. When an event occurs it causes a careful examination of the complicated legal documents which spell out the specifics of solving a default event.
In a legal case from last year, Bear Stearns loaned $10 million to a development in the Philippines which was backed by a Philippines government agency. In order to protect itself from default, Bear Stearns purchased protection from AON for about $425,000. AON was then short exposure to the Philippines government agency, and so then purchased protection from Societe Generale for $328,000. Offsetting the risk gave AON an easy $97,000, right? Well the project went bust, the developer did not pay and neither did the Philippines government agency. Bear sued AON for $10 million to reclaim their loss under the Credit Default Swap it had purchased from them and AON paid. AON then went and sued SocGen for $10 million asking for a summary judgment claiming that since the one CDS had been resolved it should automatically create a resolution for the second CDS. After several courts opined on the case, AON lost their case, and lost $10 million. The final court ruling was that the language in CDS1 and CDS2 were not identical and that the risk was not purely offset. So instead of making $97,000 they lost $10,000,000. Seems like documentation is a real counter-party risk.
The third kind of counter-party risk is one of hesitation. When you are in the finance business you require funding and counter-parties in order to produce your products and to keep a massively leveraged balance sheet in place. Even if your funding and transaction sources simply hesitate to do business with you for fear of creating additional risk for themselves, you can suffer nearly instant insolvency. We saw this with Drexel Lambert, Long Term Capital Management, and a host of others over the years. Currently we are seeing this with the SIVs and the CDOs that require continuous short term funding in order to keep the balance sheets alive. We nearly saw it with Countrywide late in 2007, and I fear that we are going to see it again during this credit unwinding. But with the leverage in place today, these possible events will likely be much larger.
This issue has reached a critical state which is term reserved for events that have built up enormous pressure and cannot be relieved gently. Only three things can happen to debt. It can be paid off; serviced (pay the monthly interest) or it can be defaulted. We have long since passed the point where there are enough financial resources to pay off the debt, and we are probably nosing past the point where the monthly minimum can be covered. This only leaves us with one more possible event and that is default. The intricate web of risks that criss-cross the financial world and have been cleverly distributed among the players will be difficult to resolve.
The big question now is, if you have a derivatives contract, CDS, or CDO with another institution, you may start to wonder if your counter-party is sound, and if it is properly documented. I have a sinking feeling that this may be the next, and biggest shoe to drop, and the shoe that will potentially wreak havoc on credit markets and even the global equity markets. Your derivative trade may have turned out to be a great idea and conceptually there is a positive payoff due to you. But what if your counterparty is embroiled in some other mess with AMBAC, MBIA or some exotic basket of CDO's and they cannot make good on your trade? Do you have recourse? Even for a simple trade, with no leverage, based on liquid markets like S&P 500, these are private deals between two parties, and the trade was an obligation of your counterparty.
This is the largest risk we see going forward for the financial markets, when investors do not trust their counterparties, when counterparties suddenly decide to pull your financing due to 'balance sheet constraints' (this has actually happened to many funds, corporations and municipalities of late), and when financial institutions do not trust each other that 'the other side of the trade will settle'. This helps explain the large spike in LIBOR versus the effective Fed Funds rate last summer, a situation that was eventually corrected by the ECB injecting $500 billion into the money markets to bring LIBOR rates down in line with the Funds rate. LIBOR spiking versus the Fed Funds rate is likely the most reliable sign that financial institutions fear counterparty risk. Unfortunately, we think that was Act I in a larger story that will unfold in the future and we will be closely monitoring LIBOR rates in relation to the Funds rate. While the $500 billion injection by the ECB and the emergency measures taken by our Fed (such as emergency discount windows, surprise rate cuts, unlimited cash and other rhetoric) worked for a short time, Act II will likely be much more hostile and catch many unseasoned, poorly positioned investors by surprise.