Wednesday, December 19, 2007

Crossing The Line - Cutting "The Line"

The ECB yesterday had to provide 348 billion euro ($500 billion) at 4.21% to cover its unprecedented promise to supply the market with unlimited funds in the two week period, which included the turn of the year. The bank had never before committed to satisfy all requests in any of its liquidity operations. This action crosses the line between "lender of last resort" and "major lender to the market". That it would do so reveals the increased pressure building inside the global financial system, ever since the credit problems surfaced in the interbank money market last summer.

At that time most analysts expected the troubles to quickly go away after central banks injected liquidity, in a repeat of the LTCM bailout of 1998. When that did not work, all manner of schemes were announced: MLEC to save SIVs, ARM freezes and TAF operations from a group of five central banks working in concert (FRB, ECB, BoC, BoE and SNB). None have so far succeeded in reversing the freeze gripping the interbank money market, the single most important financial market for the day-to-day workings of the economy.

Banks are presently unwilling to lend to one another. This has resulted in central banks having to raise the scope, size and frequency of their liquidity operations, increasingly assuming responsibility for the entire money market - not only as setters of interest rates, but as ultimate arbiters of who gets how much liquidity. This is an extraordinarily uncomfortable, unsuitable and unfamiliar position for central bank bureaucrats to find themselves in.

Some people are hoping that things will change for the better after the New Year, but I fail to see it. Given current conditions, banks' credit departments are surely already working at revising trading limits ("lines") to other banks and many of their trading customers. Such lines are usually reviewed annually and cuts are uncommon, at least amongst the major institutions. They are considered a slap in the face and are most commonly answered by retaliatory cuts. While this may sound childish, it is in fact very serious business reserved for the grown-ups in the banks' credit committees.

A bank faced with decreased lines from other banks cannot maintain its own lines to them at high levels. If it keeps providing more liquidity than it has access to, it simply won't have enough to run its own business - i.e. to fund its customers. Multiply this across the system and you have a shrinking of the overall credit available in the interbank market. This will immediately migrate to the customer side, first affecting the large speculators who depend on prompt access to margin funds (e.g. hedge funds). No need to spell out what this reduction in available credit means for securities markets.

The process of reducing risk in professional investment portfolios has already begun, judging from the sudden plunge in the State Street Investor Confidence Index, "a quantitative measure of the actual and changing levels of risk contained in investment portfolios representing about 15% of the world's tradable assets." State Street is one of the world's largest custodians ($15 trillion in custody), so they have a pretty clear picture of what is going on inside institutional accounts.

Data: State Street

Where does this leave the central banks vs. the money markets? Obviously, their relative importance will rise temporarily, tempting some participants to expect them to become perennial providers of massive liquidity. This is impossible, for two reasons:
  • They do not have the necessary monetary resources and suasion is powerless when everyone is scrambling for hard cash. Notice how it took the ECB "unlimited" amounts to finally bring rates down, instead of a simple round of calls to dealing rooms (known as "checking rates").
  • Their acts cannot overcome the commercial and investment banks' own credit committee decisions to cut credit lines to other banks and customers.
The one thing that will eventually restore order to the interbank market is its gradual deflation to a more manageable size. I believe this process is already in the works.


In a separate development dealing with the herein oft-discussed issue of Credit Default Swap (CDS) counter-party risk, the NY Times has a revealing article about ACA Capital Holdings. Notice, in particular, the booking of basis trade profits. Well worth a read.


  1. reg: ACA

    Now imagine what could happen if a bank has drawn credit insurance from ACA for some CDO´s it owns and - to "insure" against credit risk with ACA - bought some CDS on ACA.

    It could let ACA first go bankrupt, get they insurance payout on its CDS, put it into a pool to take over/buy the ACA senior claims and recapitalize ACA and payout to itself on its CDO-claim.
    Is this feasible?

  2. From the NYT article:
    "At the heart of many of the insurance contracts issued by the company is a popular transaction known as the negative basis trade. For example, a bank holding a bond that paid interest at o.50 percentage point over the London inter-bank offered rate would pay ACA 0.30 percentage point to insure it, pocketing the 0.20 point difference for the life of the contract. Accounting rules allow the banks to book that entire amount as income when the contracts are written.

    I am pretty sure this is completely wrong, you CANNOT book the 20bps as upfront profit. I have looked into trying to achieve this a number of times over the years, but it always boils down to having to mark both the CDS and the bond to market, so whilst it might be 20bps (basis points) today, tomorrow it can be something different.

    I think the gist of the article is correct though, I'm sure banks will have bought protection from ACA, and are now concerned that the profits on those contracts will have to be written off if ACA were to default.

    To quantify the numbers:

    $70bn of contracts

    lets assume they were contracts of 5 years or so, so we'll call it a duration of 4.

    Average widening lets assume 50bps (I'm sure it would have been the higher-quality stuff they sold protection on). Although could easily be something wildly different than this.

    So ACA are down 2 points (that's 2%, 50bps x duration of 4) on $70bn. So $1.4bn.

    The article mentions Merrill and Bear as two big counterparties to ACA, so lets say that 25% of this is attributable to each bank.

    So, if ACA went bust, Merrill and Bear would each have to take a write-down of $350mm (25% of $1.4bn).

    Bad, but not a killer.

  3. I read the NYT article on ACA before your posting and was going to recommend it but see that you did so.

    The veins of our borrower-creditor industrial complex are bulging and its eyes popping. Some credit deflation will be a wonderful thing for the long term. One positive outcome could be more democratic decision-making where power of the elites who control monetary, economic and trade policies is reduced. When those who were initially fans of securitizing start having doubts (e.g., Martin Wolf) and those who were initially doubters realize that much of this is fraud, we will return to old-fashioned banking where the loans are held on the books for the entire loan duration and the lender knows the borrower well enough to evaluate the risk. We will return to a day when credit grows to match incomes and not merely to prop up the paper value of assets.

    Right now, however, all means are being employed to prevent credit deflation because it will reduce the power of the elites (and also reduce their assets and their share of the national income).

    So, with regard to credit deflation, welcome it. However, the last time I looked, I found Y-o-Y reductions in total debt to be extremely rare events. Even in 1982 when Volcker targeted the money supply (heavens, the "free markets" determined interest rates) total debt went up. We did, however, have slight decrease in total debt in 2001.

  4. To CDS Trader

    Re: basis trade accounting

    You will be surprised at the stark difference between accounting rules for what is reported to investors and how accounts are kept internally, eg at a trading desk.

    As far as ACA is concerned they did the subprime CDO stuff, so...

    Judging from what is known so far the potential exposures are much larger.

    ...and they just got downgraded by S&P 12 notches from A to CCC. The usual suspects are looking to recapitalized it. Need to keep 'em on life support, otherwise the write-offs will be big.


  5. this is only the start of counterparty risk spiraling downward. there have to be hedge funds and investment banks with tons of this stuff on their books who will bust out. I am thinking LTCM x ??? before it is done.

  6. The dirty secret is exactly waht Dan says: vcoutnerparty risk in CDS etc. by hedge funds with no capital cushion. I suppose we syhould be thankful that the monolines have a cushion while the bulk of the hedge funds have "hedges"

    CDS is a complete house of cards. The systemic risk posed by this is crisis proportions. Why is there 0 discussion of the wealth being sytematically destroyed at all the hedge funds and investment complex that own the products of the sell side securitization churnhouses? Funny now we hear from the brokers and PE that they are rasiing money to buy the distressed assets. So they ride it on the way up, it gets marked down, they repurchase it at a "discount" and show more gains? Does this strike anyone as self dealing? This is a complete shell game and now we have the fed opening up its balance sheet to house this garbage. If the electorate wasn't so out of touch, there might be gaurds in the street versus White House platitudes about Help now.

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