Wednesday, February 20, 2008

New, improved ways to lose lots of money...

While the subprime/CDO fiasco has simmered to a slightly slower train wreck, another even more abstruse financial storm may be brewing: credit default swaps (CDS). [Late note: this didn't help much either.]

I know - say what? I've been working on this post for a coupla weeks, and still barely comprehend the scope and intricacy of the issue. [Feel free to add corrections/criticisms, gang] Let's start with the basics.
A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).

Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events such as a default on a debt obligation. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spread.

Credit default swaps are the most widely traded credit derivative product[1]. The typical term of a credit default swap contract is five years, although being an over-the-counter derivative, credit default swaps of almost any maturity can be traded. [More, and it doesn't get any easier]
This already complex instrument rose in popularity as things were booming. But the growth has been phenomenal. The NYT does a good job of explaining the problem.
The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity. [More of a superb article, with cartoon to help guys like me]
[Update 2/22: The $45T figure may be overstated. See a another opinion here.]
Like the CDO problem, nobody knows exactly what the meltdown could look like. But the effect for agriculture could be felt in at least two ways I think.

First, the Farm Credit System could have a harder time selling their bonds which in turn fund your operating/real estate loans. They also have some exposure (note the word "some") to CDS's.
The total amount of credit default swaps in use by the Farm Credit System is unknown, although, for the year ending December 31, 2006, the Funding Corporation stated, "we have reduced the credit risk of some real estate mortgage loans by entering into agreements that provide long-term standby commitments to purchase System loans and other credit guarantees, including credit default swaps. The amount of loans under credit guarantees was $3.2 billion at December 31, 2006 and$3.6 billion at December 31, 2005. [More]
With their unique status and relatively small needs, FCS would probably be one of the last bond originators to take a serious hit, but this can't be a good thing for them.

A particularly pessimistic, but well-documented opinion on the whole problem borders on the whimperingly-scary:
$45 trillion bet on swaps with the entire treasury market is a mere $4 trillion is simply absurd. Compounding the problem is lack of knowledge abut who the guarantors are and lack of liquidity in much of the derivatives market. There's always plenty of liquidity when times are good. However, liquidity is a coward. It runs and hides at the first sign of trouble.

Things are so illiquid now that even the municipal bond market has locked up. Insurance guarantees made by Ambac and MBIA are at the heart of it. See No Underwriter Support For Failed Muni Auctions.

Credit Default Swaps on Ambac and MBIA are trading 7 or more levels below investment grade (deep into junk) and 12-14 levels below the AAA or AA ratings assigned by Moody's, Fitch, and the S&P. Clearly this calls into question the competency of the rating agencies.

Banks and brokerages are unwilling to commit capital and who can blame them?

* No one knows what anything is really worth because there is no market at all for some of these securities.
* Banks and brokerage houses are afraid of a downgrade of Ambac and MBIA because it might require as much as $200 Billion more in capital to be raised.
* Mark to fantasy models have too much stuff on the books at unrealistic prices.
* No one trusts the ratings put out by Moody's, Fitch, and the S&P.
* Fears of counterparty failures are in everyone's minds.

Credit default swaps are going to blow sky high. If 10% of credit default swaps blow up, it would wipe out $4.5 trillion in capital. A mere 1% hit would wipe out $450 billion. We don't know when, but we do know the fuse is lit. [More of a view I don't fully share, but find credible nonetheless]
Second, as the staggering reality of the risks we have been blithely discounting in the Big Money arena become horrifying apparent, frightened and/or singed investors could fall in love with harder assets: commodities (especially gold) and the only strong player in the real estate sector: farmland.

While I think pressure from 1031 swaps has eased, the pure investment play for land is another story. This would seem to jibe with admittedly anecdotal evidence of insurance money flooding back into farm loans and demand for large tracts from land brokers.

The most worrisome aspect of this is the same problem we are having in the commodity pits - the sheer volume of cash dwarfs the assets available. Keep in mind that you can buy every acre of farmland in the US for about $2T. Now compare that to the numbers above.

My advice: do whatever is possible not to let land go to public sale. Talk to landowners about the importance of local, farmer ownership, and calculate carefully what your planning horizon is. Short term (your lifetime) may eliminate you from considering a purchase. But I would seriously contemplate devoting two generations of work - and (gasp) sacrifice - to establish a secure base for a third.


Anonymous said...

Ok, let me see if I have no idea what is happening
-We have debt that is "insured"
-The level of "insurance is far greater than the level of debt
-No one is watching the stove

Does it seem that there are just a few too many ways to move money these days- notice I did not say make money.

Technology is great, but sometimes the days of before seemed to work well too.

Anyone else want to go halfsies on an island in the southern part of Alaska?

John Phipps said...


Whew! I think we a pooling our ignorance here successfully.

I'll tell you what's really scary, there are more than few guys wearing suits that cost more than my pickup who don't have any more idea about this that we do.