Posts Tagged ‘CDS’

Is it a good time to buy Australian financial stocks?

Tuesday, September 30th, 2008

By the time you read this, the global financial markets will be in mayhem, thanks to Congress’s rejection of Henry Paulson’s bailout plan. Last night, the Dow fell 777 points, the greatest one-day drop since the crash of 1987. Central banks are busy pumping hundreds of billions of dollars worth of credit into the financial system as the credit market freezes up. Stock markets around the world are plunging.

Some people reckon that this is a good opportunity to buy Australian stocks, especially financial and bank stocks, which are hardest hit. After all, the mainstream belief is that the Australian banking system is rock solid and prudently regulated. That implies that the sell-off of financial and bank stocks will be overdone and lead to opportunities for value-oriented investors.

What do we think of this idea?

The problem with this idea is that it is only half-right. This half-right idea is dangerous. Sure, it may be true that the Australian banking system is strong. But this is based on the premise that the current situation will extend into the indefinite future. This leads to the very crucial concept of Black Swans. Due to a quirk in the human mind, it is very easy for one to understand Black Swans nominally, but when it comes to decision-making, act as if one has totally lost that understanding. To understand the concept of Black Swan, we highly recommend our earlier article, Failure to understand Black Swan leads to fallacious thinking. We must stress that it is crucial that you understand the content of that article before reading the rest of this article.

Now, what’s wrong with Australian banking and financial stocks?

Well, the issue is not with their future earnings. Based on statistical probability of the past, there is no reason to doubt the forecasts of their future earnings. The more cautious analysts may even adjust their forecasts downwards to account for the expected reduction in earnings due to the credit crisis. Thus, a sell-off in banking and financial stocks may lead to their prices looking very undervalued.

This is where the fallacy such thinking begins. As we said before in Two uncertainties of valuing a business- risk & earnings,

Between earnings and risk, the latter is the most subjective of all in the business?s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness.

In other words, earnings are very much ‘visible’ and taken into account. But risks are ‘invisible’ and therefore, get ignored and overlooked. That is where the grave error lies. Risk is the playground of the unknown unknowns. The problem with such stocks is that at this stage of the credit crisis, they are particularly vulnerable to the unknown unknowns. In other words, these unknown unknowns will have a massive and colossal impact on their earnings. As we explained before in Common mistakes in failing to see economic turning points,

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Why do we say that?

A simple word answers this question: leverage.

Due to the amount of leverage (in the Australian economy, banks balance sheets and the global financial system), when the unknown unknowns pops up, earnings can go terribly, utterly, totally and massively wrong (we are running out of adjectives here). For example, as we quoted Brian Johnson in How safe are Australian banks?,

?We?re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,? he said.

The Australian economy itself is highly leveraged. As we explained before in Outlook 2008,

Currently, Australia?s total private debt is around 160% of GDP, which is at a unprecedented level even exceeding the Great Depression (when it was just 80% of GDP). Australia?s economic prosperity is financed by debt. However, it is such high levels of debt that can accentuated the inevitable bust.

As we refuted Shane Oliver in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small.

The global financial system is still highly leveraged, particularly with derivatives (see How the CDS global financial time-bomb may explode?). As we said before in Potential global economic black hole: credit default swaps (CDS),

Currently [January 2008], the CDS market is valued at around $45 trillion, which is three times the GDP of the US.

The notional value of derivatives world-wide is said to be at the range of hundred of trillions of dollars.

Australian banks are highly leveraged to a highly leveraged economy in a highly leveraged global financial system. To put it simply, there is only a razor thin margin for ‘error.’ When there’s no ‘error,’ all will be fine. But if there’s an ‘error,’ there can be a colossal bust. Please note that we are not predicting financial Armageddon. For all we know, maybe there will be no ‘error.’ But should it slips in, the last thing you would want to hold are the banking and financial stocks.

Test for credit default swaps (CDS) begins…

Monday, September 15th, 2008

We are supposed to continue from yesterday’s article, What is the meaning of ?oversold?? Part 1: Technical analysis perspective, today. But the latest news on the financial markets takes precedence over the continuation of yesterday’s article.

As you will probably have heard by now, Lehman Brothers, one of the biggest investment banks in the United States has just gone bankrupt. Its peer, Merrill Lynch was bought over by Bank of America at a fire-sale price. Central bankers all over the world are bracing for vicious reactions from the financial markets. In Australia, the RBA had already injected extra liquidity into the financial system (see Reserve Bank injects extra liquidity). The Federal Reserve is intending to already made preparation for accepting stocks as collaterals for loans, as this news article says,

One of the biggest changes the Fed made was to accept equities as collateral for cash loans at one of its special credit facilities, the first time that the Fed has done so in its nearly 95-year history.

As we said before in Central banks and pawnshops,

Traditionally, the Fed would only accept the highest quality assets, US Treasury bonds, as collaterals. But due to the credit crisis, the Fed (along with other nations? central banks- see Reserve Bank of Australia entering the landlord business) is lowering the standards of collaterals to include top-rated residential and commercial mortgages. The Fed?s most recent statement indicates that they are lowering the standards even more (to auto loan and credit-card bonds). Using the pawnshop example, it?s like the pawnshop lowering the standard of the pawns that it will accept, say from gold jewellery to silver jewellery.

By accepting equities as collaterals, the Fed is lowering their standards even more. The central banks may be preparing and bracing for devastating fallout in the debt and equity market, but the question still remains: will the derivatives markets able to stand in the coming test? As we quoted Satyajit Das in How the CDS global financial time-bomb may explode?,

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

This introduces systemic problems to the financial markets that have yet to be tested. Here are the technical difficulties with CDS:

  1. Who problem– As we explained before in Potential global economic black hole: credit default swaps (CDS), CDS is like insurance against default by a specific entity. Let’s call this entity the reference entity. The problem is, modern companies work through a complex web of entities mainly for tax reasons. What if the reference entity in the CDS does not match exactly with the defaulting entity? Furthermore, what if there is a restructuring, merger, de-merger, sale of divisions, break-ups takeover, etc. The definition of the reference entity becomes murky.
  2. What problem– What events constitutes a “credit” event? The common ones are (1) failure to pay, (2) bankruptcy, (3) repudiation or moratorium, (4) restructuring. But sometimes in real life, “credit” event may not be that straightforward. Restructuring may follow further restructuring, followed by even more… Different countries may have different laws regarding the form, definition and handling of bankruptcy that is at odds with local laws, which in turn put the CDS contract into a conundrum of definitions. As we quoted Satyajit Das in Potential global economic black hole: credit default swaps (CDS),

    The buyer of protection is not protected against ?all? defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan…

    A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract.

    Imagine the economic mayhem it will create as companies push and jostle each other into bankruptcy at the slightest excuse to protect their own cash flow!

  3. How problem– How do you get paid the insurance payment in a CDS contract? Should you rely on publicly available information and use it as a basis to get paid? What if the reference entity makes a partial payment and then the news wire reported that it defaulted when it is going to pay the rest later?

By now, you can see how the idea of CDS can be mired into complex legal entanglements. This will have systemic ramifications for the financial markets. We will be holding our breath to see how the drama will unfold in the weeks and months to come.

Why are Australian banks not willing to lower mortgage rates?

Sunday, August 17th, 2008

Australian banks have been under pressure from many fronts to lower their mortgage rates in response to a possible interest rate cuts from the Reserve Bank of Australia (RBA). The government and opposition parties are demanding that the banks should do the ‘right’ thing by easing the strain of the working majority. The RBA added to the pressure by declaring that it sees no reason why mortgage rates should not lowered in response to monetary easing. The media poured fuel into the fire by accusing the banks of greed.

So far, none of the banks are committed to do so- none pledged to lower their lending rates to match the RBA’s cut in the cash rate. As we said before in Too eager for an interest rate cut?,

Fourth, an interest rate cut by the RBA need not necessary mean a cut in the mortgage rate. In fact, the opposite can occur.

Understandably, with Australian households under unprecedented debt stress, this has fuelled popular sentiments against the banks. They have become the new bogeyman to target. But as one of our readers said very well in Would the RBA?s rate cut do any good?,

It is not so much bank bashing (kind of pointless beyond the immediate feel good and but easy to slip into) but the realities do need to be looked at, and yes, I agree it may be far too late for the banks to do much else and are themselves to an extent pawns in the bigger global picture.

Here, we try not to pass moral judgements on banks. After all, banks are just impersonal profit-making institutions. Therefore, it is inappropriate to apply moral motives on non-person entities. What can expect from entities in which their clearly stated objectives is to make profits?

While it is true that the money market rates for the banks have fallen since the market’s expectation of an interest rate cuts has risen, does that automatically mean that this alone is a good reason to cut mortgage rates? Motives aside, what are the possible reasons why banks are not willing to lower mortgage rates? We can think of a few reasons here:

  1. Mortgages are long-term debt (typically up to 30 years). Cash raised from money markets are short-term credit (which ranges from 1 month to 1 year). How can we expect the banks to lower their long-term lending rates just because the cost of their short-term credit has fallen? Indeed, as the situation for the non-bank lenders like RAMS had shown, borrowing short-term money to fund long-term lending is a good way to become bankrupt, thanks to the credit crunch. This flows on to the next point…
  2. Because of the risk involved with funding long-term debt entirely with short-term credit, banks have to diversify their lending source. As this news article said,

    Our banks raise about half their cash from local deposits, a quarter from local bonds and the rest from the global market.

    While the RBA may have some influence on the domestic short-term money market rates, we can assure you that they have no influence on the global markets. Indeed, as we explained before in Can falling interest rates and rising mortgage rate come together?, there is insufficient savings domestically to fund all the loans. Therefore, the banks have to get the shortfall from overseas and submit themselves to the global credit conditions. The global credit conditions are far from settled and major eruptions can still occur any time. As we said before in The next financial time bomb- Credit Default Swaps, CDS is the next global time bomb to explode. Indeed as this news article reported,

    Most institutional investors expect another failure of a major financial services firm in the coming year and view credit default swaps as a serious threat to market stability, according to a survey by Greenwich Associates.

    Once the banks cut their mortgage rates, it will be very unpopular for them to raise them again in the event of further ructions in the global credit markets.

  3. What if the banks expect more bad debts in the future? Lending rates are proportional to the risk of default of the loans. The banks’ unwillingness to lower mortgage rates could be a sign that they are pricing in more risks on their loans.
  4. It is open knowledge that price inflation is still on the rise in Australia. In fact, the RBA expects price inflation to peak at around 5% before turning down again. For any given nominal rate, rising price inflation implies a lowering of real rate. As we explained before in Is property a good hedge against hyperinflation?, during times of hyperinflation,

    At the same time, you can expect bankers to raise borrowing rates very quickly to protect their profits.

    By not raising their lending rates when price inflation are trending upwards, banks are actually losing money in real terms.

Finally, we would like to point out that we are by no means defending the banks. Neither should this be construed as ‘predictions’ that banks will never lower their mortgage rates.

How safe are Australian banks?

Wednesday, July 23rd, 2008

There are widespread beliefs that the Australian banking system is safer and more conservative than their overseas counterparts. Thus, it is generally assumed that the sub-prime and credit crunch problems that affected the US will not happen in Australia. But is this a reasonable assumption?

First, as we showed in Australia has no sub-prime debt? Think again!, there are real-life examples of dodgy lending by Australian banks. The question is, how widespread is such lending? Are these examples of dodgy lending indications of a systemic problem? In any case, it is obvious that it is not in the banks’ best interest to be forthright about their dubious lending practices. Perhaps you may want to do your own scuttlebutt research on this. If you have any stories about dodgy lending practices or dodgy borrowing, please feel free to share them in the comments section below.

Next, our suspicion is that Australian banks are severely underestimating their vulnerability. As Brian Johnson, a banking analyst from JP Morgan was quoted in Banks to feel more pain: analysts,

Mr Johnson believes that Australia’s banks are failing to envisage the possibility of a loan-loss cycle where asset prices [such as housing] fall, and banks struggle to recover loans from defaulters and forced sales.

Mr Johnson said Australian banks are actually more vulnerable to the credit crunch than many of their global counterparts because of their high levels of gearing, or loan to capital ratios.

We’re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,” he said.

As we said before in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

In addition, the Australian banking system has a vulnerability not shared with other countries. As this news article, Fast rise of round robin lenders, reported,

The Reserve Bank of Australia has a dark worry about our banks: they get 90 per cent of their cash from each other. If one bank gets into trouble, the Australian financial system could be snap-frozen overnight.

We will give a highly simplified analogy of this problem. Imagine an economy of 3 people: Tom, Dick and Harry. Tom owes Dick $1000, Dick owes Harry $1000 and Harry owes Tom $1000. Each of them will have a balance sheet that looks something like this:

Asset: $1000
Liabilities: $1000

For each one of them, what they owe are their liabilities and what they are owed are their assets. Let’s say, for whatever reasons, Tom is unable to honour his debt repayment to Dick. In that case, Dick’s asset will go bad. As a result, he is unable to honour his debt repayment to Harry. This in turn caused Harry’s asset to go bad, which affected his ability to repay his debts to Tom. Therefore, one person’s debt problem becomes a contagion that spreads to everyone else.

In a similar way, this is the current vulnerability of the Australian banking system. It is unique to Australia because of the shortage of government debt that could be used as bank assets and collaterals, thanks to the previous government’s budget surplus. We suggest that you read our earlier article, Banking for dummies for more details about bank balance sheets.

Of course, though it may be possible that such things may happen, it does not necessarily mean that it will happen. It’s the job of the RBA and APRA to prepare the drills in anticipation of this worst case scenario. But should it happen, what can be the possible triggers? For the answer to this question, one news article, ANZ is the big local bank most at risk, caught our eye:

ANZ Bank has been singled out ahead of other big Australian banks as most at risk of further material provisions because of its long credit default swap positions, potentially running to $2.4 billion, based on international comparisons.

National Australia Bank is not far behind in the structured credit risk stakes.

As we highlighted before in How the CDS global financial time-bomb may explode?, Australia is not going to escape unscathed when this potential disaster strikes.

In view of all these, perhaps there is little wonder that, as Fast rise of round robin lenders reported,

At a recent conference held by one of the world’s largest banks, the Australian banking system was identified as one of the best investment opportunities, for going short.

How the CDS global financial time-bomb may explode?

Monday, June 2nd, 2008

Back in Potential global economic black hole: credit default swaps (CDS), we first introduce credit default swaps (CDS) and warned that it is a potential global financial time bomb that is waiting to explode. Should it explode, we will see another major panic in the global financial system, possibly even surpassing the panic back in January this year. So far, the CDS market has not yet been tested through a trial of fire and the risk is that it may turn out to be a house of cards when put under stress.

Satyajit Das, a character whom we introduced back in Is the credit crisis the end of the beginning?, has this to say about CDS in The Credit Default Swap (?CDS?) Market – Will It Unravel?:

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

As we explained before in Potential global economic black hole: credit default swaps (CDS), the buyer of a CDS is basically buying insurance against the default of a debt. The problem is that how do you define what a “default” is? If a defaulted debt cannot fulfil the technical conditions to satisfy the trigger of insurance payment, then the insured party may find themselves in danger of insolvency. As Satyajit Das wrote,

The CDS contract is triggered by a ?credit event?, broadly default by the reference entity. The buyer of protection is not protected against ?all? defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan.

As a result, this will have widespread systemic implication:

A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract.

As with most financial crisis and panic, decisions that make sense at an individual level will result in catastrophe if repeated en masse. If enough businesses are pushed into bankruptcies in order to fulfil the technical requirements of default, then losses will be exacerbated, triggering another around of credit deflation.

Then there is another problem. Since CDS is a derivative, the buyer of a CDS need not necessary owns the bond (debt asset). But in order to receive insurance payment for the debt payment, the bond has to be delivered. But what if there is more CDS than bonds (this may happen due to securitisation)? Then when the bond defaults, there will be a mad rush among the CDS holders to grab a slice of the defaulted bond (figuratively speaking), which pushes up the price of the bond. As a result, the CDS holder may not be as fully hedged as assumed to be.

If you think this is complex, this is because the murky world of derivatives is complex. Even central bankers do not understand it all.

Difference between OTC and ET derivatives

Thursday, May 1st, 2008

No doubt, as you read the financial news media, you will often see the word “derivatives” popping up here and there. For those who are not in the finance industry, you may wonder what derivatives are. Today, we will depart from our usual macroeconomic musings and delve into the world of derivatives.

“Derivatives” is a very broad term, just as the word “animals” is. Basically, a derivative is a financial instrument that derives its value from an underlying instrument, ranging from stocks to commodities. Examples of derivatives include options, futures, forwards, swaps (e.g. credit default swaps), contract-for-difference and so on.

In every derivative transactions, there are always two parties (obvious) and a legal contract. This gives rise to two types of derivatives based on how the contract is negotiated:

  1. Over-The-Counter (OTC)– For OTC derivatives, the contract between the two parties are privately negotiated and traded between the two parties directly. Therefore, the contract can be tailor-made to the two parties’ liking. This arrangement is very flexible, but there are disadvantages:
    • The value of your derivative is as good as the credit-worthiness of your counter-party. If your counter-party goes bust, your derivative becomes worthless.
    • It is very hard to pass on the derivative to a third-party because the contract is already signed between the two original parties.
    • It is very hard to discover the ‘market price’ of a derivative contract because there is no transparency in the pricing and it is very hard to value unique contracts uniformly on a mass scale.
  2. Exchange-Traded (ET)– For ET derivatives, the situation is different. They are traded via an intermediary, the exchange, which is a strong institution with deep pockets. Therefore, technically speaking, even if Tom and Dick trade a derivative between each other, their counter-parties are not each other- rather both of their counter-parties is the same exchange. In other words, if Tom sell an ET derivative to Dick, the exchange acts as a buyer to Tom and a seller to Dick. The advantages of such an arrangement is:
    • Since all market participants’ counter-parties is the exchange, the derivative contracts are standardised.
    • There is no credit risk between market participants. For example, if Tom has no need to fear if Dick defaults on the contract. If that happens, it is the exchange that has to bear the consequences.
    • There is a very visible and transparent market price for the derivatives.

So, since we have mentioned a lot about credit-default-swaps (CDS) in our past articles, we can now tell you that CDS is an OTC derivative.

Pressure on global financial system is still simmering away

Monday, April 28th, 2008

One of the financial veterans you have to respect is Peter Bernstein. As this Wall Street Journal article, One Guy Who Has Seen It All Doesn’t Like What He Sees Now said,

Peter Bernstein has witnessed just about every financial crisis of the past century.

As a boy, he watched his father, a money manager, navigate the Depression. As a financial manager, consultant and financial historian, he personally dealt with the recession of 1958, the bear markets of the 1970s, the 1987 crash, the savings-and-loan crisis of the late 1980s and the 2000-2002 bear market that followed the tech-stock bubble.

Today’s trouble, the 89-year-old Mr. Bernstein says, is worse than he has seen since the Depression and threatens to roil markets into 2009 and beyond — longer than many people expect.

If you look at the financial press today, you will find that the market is ‘optimistic’ that the credit crisis is turning for the better. It has hope that the situation will get better. Consequently, you get to see some recovery of financial stocks and the US dollar. But Peter Bernstein is not so hopeful. As he said,

If China goes into a recession, God knows. The Iraq war and the whole situation with terrorism, we really don’t know where that is going to come out. There are so many things that have got to get buttoned down before you say that the future looks good enough to take a risk.

In other words, there are too many unknown unknown lurking around (see Failure to understand Black Swan leads to fallacious thinking). We share his concern about China and had written a long article about it in Can China really ?de-couple? from a US recession?. Peter Bernstein will only start to get hopeful when he sees that

… housing trouble has to at least flatten out. As long as that is going on, I think the pressure on the credit system is going to persist. It is kind of the leading indicator. It is where the trouble started. We have to underpin the consumer. That is why this is different. That is why this is like nothing we have had before.

This brings us to the Credit Default Swaps (CDS). As we said before in Potential global economic black hole: credit default swaps (CDS),

What happens if these waves of bad debts trigger the contingent obligations of CDS sellers to honour these mass of credit defaults? If these CDS sellers default themselves, what will happen to those who depend on CDS to remain solvent in the event of defaults?

As long as the house price deflation is still under way, the solvency of the financial system will be under pressure, which in turn will lead to further deflation and contagion of credit default. That will test the CDS. As this Economist article said, Swap shop,

However, many market participants were equally reassuring about the health of the CDO market in early 2007?and look how that turned out. Independent observers will not be really reassured until the system survives the test of a big, juicy default. Given the weakness of the American economy and the scale of the credit crunch, it probably will not be long before that test comes along.

If the CDS time bomb explodes (and some will argue that it is a matter of when), the first share market casualty will be the financial stocks. Just as the Germans did not know when and where D-Day will occur (though they knew it was a matter of time), so will the day of CDS reckoning be.

The next financial time bomb- Credit Default Swaps

Wednesday, April 16th, 2008

Today, we were alerted to the fictitious story written by Jacques Attali, who is formerly the top aide to French President Francois Mitterrand and the founding president of the European Bank for Reconstruction and Development: Imagining the worst-case scenario.

One message from this story is clear: the next financial time bomb will be Credit Default Swaps (CDS). As we said before in January this year, Potential global economic black hole: credit default swaps (CDS),

Note: we are not predicting that such a time bomb will explode. But this is another potential Black Swan, which Warren Buffets calls the ?financial weapons of mass destruction.?

That story however, has a happy ending that finishes within a 2-year time frame. We have grave doubts on that ending.

P.S. Note that we are not in agreement with all of Attali’s fictitious story. The CDS part of the story is the one that we want to highlight.