Fed's rescue halted a derivatives Chernobyl
telegraph.co.uk
"For now the meltdown panic has subsided. Yet the hottest
document flying around the City last week was a paper by
Barclays Capital probing what might happen in a counterparty
default."
And, here it is:
ecommerce.barcap.com
See pp. 14-16, "Illustrating potential gap risk losses on CDS
positions"
I'd be careful out there - hedge funds, too, are counterparties.
Illustrating potential gap risk losses on CDS positions
The total notional amount outstanding of OTC credit derivatives for broker/dealers is $42.5trn. There are approximately 55 broker/dealers who buy or sell protection. In this exercise we analyse a scenario where a relatively large counterparty defaults. We assume that this counterparty sold $1trn of protection and bought $1trn of protection. We further assume that the proportion of IG protection sold by the counterparty is 65% (please refer to Figure 8) and the average life of contract affected is five years. We continue to assume that the recovery rate on the counterparty is 40%.
We believe that a default of a major counterparty would cause a significant re-pricing in credit. Although consequences of such an unprecedented event are difficult to quantify, we estimate losses for a variety of scenarios. In our analysis, we allow the IG credit spreads to jump between 10bp and 60bp upon a counterparty default. We view the IG spread jumps of 30-40bp as the most likely in case of a default of a counterparty with $2trn of outstanding CDS. Assuming a beta of 4x between the Crossover and the Main, we imply that HY spreads could jump between 40bp and 240bp, with 120-160bp being most likely.
Our analysis shows that the failure of a major counterparty which had $2trn outstanding in OTC credit derivatives, could result in losses of $36-47bn in the financial system solely due to the immediate re-pricing of credit risk due to a counterparty default. We stress that
these losses are crystallised by investors who had exposure to the defaulting counterparty. Additional to these, there would also be large, potentially concentrated, MTM losses for investors without exposure to the defaulting counterparty. These losses would result from a re-pricing of risk, which we do not account for here.
However, we would add the caveat that netting could significantly reduce our estimated losses. The figures above are un-netted, as data on netted exposures is very hard to obtain.
There are two factors which could cause the realised losses to be larger than our estimates. The first is the fact that, while we assumed full collateralisation, in reality, collateralisation is imperfect. This would mean that at the point of last posting of collateral, there would be some MTM positions which are not backed by collateral and any losses on these positions would increase the loss from gap risk. The second is forward margining. Any collateral posted by hedge funds with the defaulting counterparty as part of forward margining would be subject to a loss. This loss would amount to the value of collateral less recovery.
Other derivative contracts could be significantly affected
Thus far in our analysis we have concentrated solely on credit derivatives. However, in terms of amounts outstanding, credit derivatives constitute only 8% of all the OTC derivatives, with interest rate derivatives constituting the largest proportion of 67% (Figure 17). We believe that a default of a major counterparty would cause a significant re-pricing in all OTC derivatives. This implies that these contracts would also be vulnerable to large gap risk. Given the enormous amounts outstanding of these derivatives, netted exposures could be large and therefore gap risk losses on other OTC derivatives could be significant. |
