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Bankruptcy

: Credit Slips

When is a market too big?

By Stephen Lubben

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The emerging details of the Administration's securitization regulations have got me to thinking about an issue I first began to consider with regard to CDS. Namely, at what point do apparently useful tools allow a market to become "too big," in the sense that the market begins to generate systemic risks. And what can be done about it?

In the case of CDS (credit default swaps, see here and here), the existence of CDS allows for a magnification of the underlying debt market in ways that may create systemic risks. For example, although I have generally argued that GM would have been better off filing for chapter 11 a few years ago, doing so would have have had the potential to result in several collateral failures of financial institutions, because of the massive amount of then-outstanding CDS in which GM was the "reference entity." Indeed, a simple downgrade of GM's rating during this period almost completely unhinged the CDS market. In this respect, GM's slow glide into bankruptcy court was actually helpful, in that it allowed the market to "burn off" a lot of outstanding CDS, which simply expired before the bankruptcy.

The problem is that there is no clear limit on the amount of CDS that can be written on a particular reference entity. A selling firm is only limited by its own risk-management policies, and we have recently seen that those often leave a lot to be desired. Moreover, in the absence of a global regulator with an overall picture of the total CDS risk outstanding the market, each CDS seller can practice appropriate risk management for that specific firm, while still contributing to an increase in overall systemic risk. Imagine, for example, if GM's bond debt ($27 billion) was supporting one hundred times as much default risk represented by CDS contracts ($2.7 trillion), all well distributed among the world's financial firms (including hedge funds, insurance companies, etc.), pension funds, and maybe even a few of GM's larger trade creditors -- the effects on June 1 would have been tremendous, especially to the extent that once "balanced books" had become unbalanced by things like the Lehman collapse.

The same effect occurs in the mortgage market, where the combination of CDS with securitization means that one "rotten" pool of mortgages can have outsized effects once the pool has been replicated several times over, using CDS contracts to create synthetic securitizations.

In the case of asset securitization, distinct from the synthetic securitization issue, this issue arrises from the ability of banks to "recycle" their capital into multiple loans if they are able to sell off the old loans through structured finance. As Paul Krugman points out in a recent post, the Administration's new "skin in the game" requirement does little to address the temptation to recycle funds into increasingly risky investments, an effect which may contribute to systemic risk not only at the banks themselves but also in the underlying markets that are inflated by this injection of credit.

One way to address these issues is to simply outlaw a particular instrument, as George Soros has suggested with regard to CDS. That strikes me as a short term solution, because as soon as you outlaw CDS you can expect the new rage will be "Unbalanced Total Return Participations," or some other instrument that gets to the same result, but generates a bit more fees for the investment banks because of the added complexity.

The more plausible scenario is better risk regulation. But even this suffers from a few problems, one being the issue of "offshoring" that I previously addressed with regard to CDS. Whatever risk regulation develops, it has to not only address the fragmented nature of domestic regulation, but also the ability of firms to cabin important parts of the overall operation in offshore jurisdictions, be they London, Zurich, or Mauritius.

There is also a core question of whether we believe that the government can create a regulator that is competent to evaluate these risks. Recent evidence is not encouraging in this regard.

Full post as published by Credit Slips on June 16, 2009 (boomark / email).