Sub-prime has been on the forefront of the news for more than a few weeks now. I was recently asked to make some predictions about debt markets for buyouts, triggering a few e-mail and phone discussions with the debt mavens of the world (and long hours on the phone with the Debt Bitch, punctuated by brief moments actually talking about debt). This bit of internal research has brought me into the depths of the Credit Default Swap (hereinafter "CDS") market, credit derivatives and, by extension, insight into credit markets generally.
One of the key takeaways for me was something I understood intuitively before but never completely absorbed or intellectualized in this context. Specifically, the derivatives market on a given underlying security can be a lot "deeper" than the security. Credit Default Swaps (which permit the shifting of default liabilities and might be best understood as insurance policies on default) can be levered up almost arbitrarily by the market participants. The purse for the Australian Open might be $2,000,000 but Vegas might have $200 million riding on the results of the Open, for instance. This has implications.
Given the leverage I've described, the astute Going Private reader will easily see how it might be an awfully tempting choice for a bookie with large "Federer to Win" exposure to simply pay Federer to throw the game (the difference between the winning purse prize and second place) rather than deal with the loss (tens of millions). One can see why certain banks might feel themselves in a similar situation.
Buying out the entire block of recently flagging securities underlying a dangerous default swap market could, of course, cost a small fraction of the derivatives exposure such a bank would face in an actual default. This approach also serves up a very nice populist PR story for the bank's mouthpiece. They are generously helping out the beleaguered debtors. Poor souls that they are.
But is this really so? In the case of mortgage backed securities, buying a defaulted loan bundle at par (say $1.00) when actual value is near $0.50 has the effect of injecting cash into a mortgage backed securities bundle and propping up the appearance of credit worthiness of the bundle as a whole. This, of course, has no effect at all on the debtor, who is still on the hook for payments, and, further, has no viable economic purpose other than to shift losses away from the bundle (and therefore prevent technical default or a downgrade that might expose the entire bundle- indeed, the entire issuer- to a "mark to market" run). The slight of hand becomes obvious when the loan is later restructured for $0.66 after its purchase at $1.00, but who will complain?
Add to this the fact that there are any number of providers out there who will loan short-term to a mortgage bundle issuer to make a coupon payment or six. The quick eye of the Going Private reader wonders, of course, if related parties might not make these loans and then forgo repayment, again shifting the losses out of a mortgage backed securities bundle.
Going even farther, it isn't the smallest leap in the world to then wonder if a clever bank might not run up rather large default pools, intending from the very beginning to cover the default risk in one of the ways shown above and therefore fixing the default market. Like taking bets on a game you've already fixed, in addition to having a large line with another bookie for Federer to lose.
Add to this, the fact that the underlying securities often sit in proprietary portfolios and therefore on the books without markdowns to market, unless there is a catalyst event forcing the issue (and these catalysts are avoided via the loss-shifting described above). This means that it takes a downgrade, for instance (or an exploding hedge fund with angry and vocal equity investors) to force a new "mark to market." That, in turn, causes a hard look at collateral, margin calls and therefore more marks down to market. Lather. Rinse. Repeat. The question worth asking at this point is "can ratings agencies keep up," given that they are focused on credit worthiness analysis based on cash flows to the instruments and these are artificially kept high.
Now consider a entirely theoretical large bank with an internal hedge fund that has as its equity investors the management of the selfsame bank. I suppose problems within this fund and its credit default swap portfolio might take a long time to surface, given that all the triggers that would douse the practices in sunlight have been buried under the miasmal duo of accounting and silence.
An interesting dynamic, to be sure. I would love to entertain the thoughts of Going Private readers versed in the mechanics of these markets.
