Margins vs. Stability

The overall problem of today’s markets is one of conflicting incentives: custom products yield fat margins for investment banks while presenting the capability for widespread systemic risk. Hence, if innovators get lazy they sow the seeds of their own demise. But regulators are not recognizing the shortcomings, either. The Federal Reserve Bank of New York is proposing a clearinghouse for CDS, but clearinghouses for non-standardized contracts will not yield appreciable market liquidity and stability. Rather, it is the standardization, itself, that needs to be fostered, to the chagrin of Wall Street investment banks and the monolines. That means no more fat margins, but it does mean long-term stability and liquidity and therefore a steady stream of new applications for CDS.

There is a well-known tradeoff between financial instrument specificity (uniqueness) and liquidity. If a particular bespoke financial instrument becomes popular, firms using that instrument run the risk of illiquidity should their financial situations and needs change. In typical developing markets, as bespoke financial instruments become popular, the terms of the instruments become standardized so that the instrument can trade as a commodity. As instruments are commoditized, they can be bought and sold more freely on markets, where brokers and dealers routinely add liquidity. As those instruments become even more popular they may trade on organized exchanges, reducing counterparty risk and adding further liquidity. In summary, as product specificity (and asymmetric information) declines, liquidity rises and overall market stability increases.

That tradeoff has important implications for today’s credit crisis. Viewed through the lens of the model described above, markets for many financial products that have recently become commonplace were inadequately developed despite having grown to fund a large proportion of today’s financial marketplace.

Mezzanine ABS and RMBS were used to create CDOs, whose credit quality was bolstered by CDS either sold by monoline insurers or bought by them to hedge wrap insurance contracts. The roughly $9 trillion of securitizations were supported by roughly $0.5 trillion of CDOs, backed by a $50 trillion CDS market, none of which was written on the basis of standardized liquid contracts. SIVs and CPDOs leveraged the securitizations and CDS in various ways, vastly increasing the size of the relevant market and the concomitant risk.

Monolines are now proposing negotiating the commutation of many of the CDS they wrote for CDOs in order to relieve the monolines’ balance sheet risk. The process of commuting the commitment involves paying an agreed sum today in order to cancel the contract, which could potentially be worth far less at a later date or maturity. Of course, the trick is coming up with the money to commute the contracts. As it happens, MBIA has some $1 billion that it raised in December from Warburg Pincus LLC available to commit to the contract terminations. MBIA more recently announced, however, that those terminations for guaranteed investment contracts, alone, may cost in the neighborhood of more like $2.9 billion, combined with some $4.5 billion in its collateral that will have to be posted on its remaining CDS as a result of losing its AAA ratings. Hence, the market is clearly not stable and liquid.

The instability and illiquidity that has contributed to CDS market deterioration is nothing more than a manifestation of typical risks inherent in a less-developed market. We know that CDS are routinely exposed to credit risk, counterparty risk, model risk, rating agency risk, and settlement risk. But while no market fixes have been proposed for those shortcomings, the Street has continued to build CDS upon CDS to achieve a multiplicative effect of risk layering. So now, not only will commercial banks lose their credit hedges that lower their capital requirements, but CDOs will lose their credit hedges as well. But those are only the linear effects. Synthetic CDOs will lose their collateral value for reasons other than fundamental defaults and CPDOs will lose that base in a leveraged fashion. Immature financial products are poor building blocks for other innovative developments.

2 Responses to "Margins vs. Stability"

  1. Guest   July 4, 2008 at 10:05 am

    Excellent points Prof! But do you reccomend and propose to fix these problems? Having credit derivative traded over exchanges? or providing standardization and clearinghouses? Would be worth seeing the details of your policy/reform reccomendations.