Interest rate derivatives still healthy

liverless
0 Comments| January 25, 2008


There is no shortage of bearish analysis. Articles that describe a coming Armageddon are more prolific then hedge fund managers. It is easy to be driven into a fearful panic by this analysis.

When the urge strikes, you have to take a step back and ask: Is the argument justified? The bearish argument that I want to deal with goes something like this: There is a market out there composed of hundreds of trillions of derivatives. With the collapse of the housing market (usually referred to as sub-prime, though that is only a small part), we should expect more credit problems that could further affect the derivative market. If the derivative market implodes, the losses will be catastrophic, and stocks will collapse. The stocks can be bought back much cheaper at that time so they should be sold now.

This is not the only bear argument. But it is, in my experience, the most common. It has popularity because its authors can make use of the $500 trillion figure; the current notional amount of derivatives outstanding as estimated by the BIS. Enormous numbers beyond our everyday comprehension are always good at generating fear.

The problem with the argument is that most who express it rely almost solely on the size of the derivative market to justify their fears. But its existence, regardless of the size, is not in itself a reason to sell. There has to be a mechanism, and the details of that mechanism need to be described. Causality is absent in most all of the bearish analysis. Let’s take a look at the derivative market.

According to the June 2007 BIS statistics, there are $530 trillion in derivatives outstanding. Of this product, 67% are tied to interest rates, and 11% are tied to FX (foreign exchange), 8% are tied to CDS (credit default swaps), and the rest is a mix of commodity, equity and other.

The first thing to note is that interest rate derivatives make up the vast majority of the market. To predict a meltdown in the derivative market is essentially to predict a meltdown in the interest rate derivative market.

Yet the interest rate derivative products carry the risk of rising interest rates. Rising interests could be a worry in the near future. But they are certainly not a worry right now. Interest rates have been falling across the curve. And with expectations of further cuts by the Federal Reserve, there is no threat on the near-term horizon.

The second largest segment of derivatives is linked to changes in foreign exchange. Given the size of the carry-trade, it seems reasonable that more then anything else, these products are tied to the carry-trade and to the dollar. The Yen, the Euro and the dollar make up almost all of outstanding FX derivatives. The fact that we have not experienced a calamity as the Yen has risen dramatically over the past few weeks (from 114 before the New Year to a high of 106), and as the dollar has fallen over the past few months, is encouraging. 

Moreover, most of the carry-trade is done by hedge-funds, so the mechanism of carry-over into the economy is not as clear as it was for the MBS problems. And for each side of a losing trade, there will be a winning side.

The portion of the derivative market that I see posing risk in the immediate future are those tied to corporate defaults. This is known as the credit default swap market, or CDS. The CDS market makes up 8% of outstanding derivatives. CDS instruments transfer the risk of default upon bankruptcy. Bankruptcies will, of course, increase in a recession. Given my view that this recession is more likely to be shallow than deep, I don't think we are going to be overwhelmed with corporate defaults. But we will, undoubtedly, get our fair share.  

So what sort of losses should we expect from these instruments? Bill Gross makes a good analysis of this. He describes that of the $45 trillion outstanding we might expect 1.25% defaults, resulting in around $500B in nominal losses, and $250B in net losses after recoveries are included.

This is not a small number. I am not going to pretend that it is insignificant. But neither is it apocalyptic, as some would have you believe. To give some perspective, this is quite a bit less then the $400-$800B in losses that have been anticipated from mortgage backed securities (MBS) due to the decline in housing.  

Moreover, these instruments are owned in large part by risk-seeking institutions outside of conventional banking. This is not the same as the MBS market, which was widely held by banks.  According to the Comptroller of the Currency (OCC), “net current credit exposure for U.S. commercial banks increased… in the third quarter to $252 billion.”

$252 billion refers to the total exposure of the US banking system. Losses are going to be a fraction of this, even if the recession is deep.

Is this squeeze on the CDS market, coupled with the current squeeze on the MBS market, going to producer tighter lending conditions? Most assuredly. Will hedge funds go belly up? Definitely. Will the stock market take a significant hit? Maybe. But will this produce a financial great depression? Hardly. A credit contraction on the scale suggested by the above numbers does not imply a general economic “malaise.”

We are going to have a recession. We are going to experience tighter lending conditions from the banks. So investors need to be careful what they put their money into. But overstating the risks to the system, and extrapolating current conditions into a frenzied future panic does not help this process. I have spoken numerous times on my blog about the reasons to think that this recession will be relatively benign. I would recommend reading through those reasons, and coming to you own conclusions.

If I were going to draw a general conclusion from all that I have described, it would be this: The time to really worry about credit implosion will be when we have a sustained period of rising interest rates. This will put the trillions of dollars of interest rate related derivatives at risk. If the environment at that time is inflationary and therefore perceived to be sustained, the outcome could be very nasty.

But now? I just don’t see a mechanism that will lead to Armageddon. We will get defaults in the CDS market. There will continue to be losses in the FX market. But the evidence suggests it will not tip the scale.

To read more work by liverless, visit his blog at Reminiscences of a Stock Blogger.

This article was written by a member of the Stockhouse community.



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