Counterparties

I participated last week in a Berkeley-UCLA conference on the Mortgage Meltdown.

Two distinguished scholars said things that surprised me. One noted that the net position of derivatives was zero (a correct statement) and therefore derivatives were nothing to worry about. The other said that the size of the subprime losses would likely be around $400 billion, which should have been managable. I should note that I made a similar statement about subprime losses around a year ago, but I didn't really think through the implications of it.

Had the $400 billion of subprime loan losses been held with equity, the implications of the crisis would have been much smaller. This is why the collapse of the tech bubble, while meaningful to the economy, resulted in only a mild recession. The problem is that the $400 billion in losses on subprime mortgages and the derivatioves they support are being realized by highly levered institutions, and so losses precipitate a chain of events that go well beond he original losses.

Let's start with the loans themselves. Suppose a bank owns subprime loans, and assumes a loss rate of 5 percent, and holds sufficient capital to bakstop those loans. Now suppose the loss rate doubles. The bank may still be solvent (i.e., have positive value), but its capital position has been eroded, perhaps to the point that it can no longer make loans. This is not hypothetical--I have recently talked to some community bankers who have told me this is exactly their position.

The inability to make loans means the value of the banking business falls--and so share prices fall. This means it is difficult for banks to recapitalize, because issuing stock is expensive. Credit markets freeze up, and the implications of losses arising from subprime get transmitted to the general capital stock--banks lose the ability to finance P&E. The reduces the future value of the broader economy beyond the initial subprime loss.

But now let's consider a bank that was smart enough to buy credit default swaps so that its balance sheet would remain healthy in the event of poor subprime performance. The bank gives up cash flow to pay premiums to insure against future problems. But the bank is assuming that the counterparty with which it has contracted can make good on its obligations. If the counterparty is highly levered, a subprime meltdown will produce bankruptcy. It is here that the ex post net derivative value goes negative: the payouts from the insurance company are smaller than the losses incured by the bank, because the value of the insurance company is truncated at zero. This creates its own set of multiplier effects.