TOPICS IN POLITICAL ECONOMY

CREDIT DEFAULT SWAPS: RELAX

Finally, someone has thrown a bucket of cold water over the Chicken Little chorus complaining about "credit default swaps."  They have been touted as a major cause of current market turmoil and a threat to the entire financial system by people who should know better, e.g. Warren Buffett.

Take a look at the October 11 release from the Depository Trust and Clearing Corporation (DTTC).   This organization keeps the books on who owns what bonds and stocks - and operates the central registry for credit default swap (CDS) trades. They may not have records on every single CDS trade, but the vast bulk of all trades in recent years are on their books.

Following an auction last week to determinehow much sellers of protection against Lehman bond defaults would have to pay protection buyers, the DTTC estimates that total payments will be on the order of $9 billion.  That's a lot of change for you or me - but a pittance of the $400 billion some Chicken Littles had been peddling, and is unlikely to cause major problems on October 21, when payments are due.

Contrary to a highly misleading New York Times article last week attacking Alan Greenspan for his opposition to regulating derivatives while Fed Chairman, there is no fundamental problem with derivatives per se.  For example, other types of unregulated derivatives, such as interest rate swaps and foreign exchange forward contracts, have been around for decades, are widely used and can be highly effective in hedging risk. But you would never know it from reading Peter Goodman's article. 

if the transaction upon which a derivative is based is trash (e.g. a pool of poorly-underwritten subprime mortgages), you are going to have a trash derivative, too. And if sleepy managers and Boards of Directors permit gung ho traders to bet the ranch with derivatives of any kind, the results are likely to a very loud wake up call (cf Societe Generale's $7.2 billion loss last January in stock market futures). 

As a relatively new financial instrument, credit derivatives and the system for trading and settling them is still evolving under pressure from the market and an occasional push from the Federal Reserve.  However, recent "credit events" so far demonstrate that they can be a useful and efficient way to shift risk from those who wish to avoid it to those who are willing, for a price, to bear it.

Relax, Chicken Littles.

BORROWERS' PANIC: HOW TO FREEZE UP THE BANKING SYSTEM

If you want to know why the banking system has "frozen up," consider the Wall St. Journal's October 2 story about FairPoint Communications.

A newly-installed chief financial officer, with $300 million in untapped credit lines from a syndicate of banks, caught wind of Lehman Brother's impending bankruptcy in mid-September.  Lehman was one of his firm's lenders. To make sure that cash would be available, the CFO pre-emptively drew down $200 million from the unhappy banks, even though the money wasn't needed immediately. All of it ended up in money market funds that invest in U.S. Treasury bills.

I estimate this strategy is costing FairPoint around $500,000 a month (the difference between borrowing costs and money market fund returns).  But that is what CFOs are willing to pay these days for liquidity. Call it "borrowers' panic."  And borrowers with loans outstanding are probably slow to repay them with cash on hand, if they have it.  In a liqudity crisis, rather than draw on existing cash balances to meet operating needs, consumers and businesses try to increase their liquidity, fearing the worst is still ahead.

This type of behavior is every banker's  second worst nightmare (the worst being panic withdrawals).  All banks make binding commitments to lend to customers, knowing that it is extremely unlikely everyone will want to borrow at the same time.  That means they don't have to keep extra cash (or high-priced deposits) on hand all the time. 

Uncertainty Rules.  But the current crisis has thrown out all the traditional rules of thumb (or fancy econometric models) about what percentage of legally-binding commitments to lend were going to be drawn down by customers.  It looks like everyone who has a contractual right to borrow is showing up at the same time.

First came the borrowers who had "commercial paper backup lines of credit" that enabled them to run to their bank when money market fund investors abruptly ran for the hills (see my post of September 25) and demanded their money back. The banks have turned to the Federal Reserve for over $150 billion as of October 1 to help them take care of these borrowers.

But now we have unanticipated pre-emptive borrowing on what must be a massive scale.

At the same time, it turns out that "liability liquidity" - the ability of banks to raise cash quickly by issuing very large certificates of deposit isn't what it was cracked up to be.  Finally, every additional loan on the banks' books requires some capital behind it, and that is very expensive and hard to get these days. 

Thus, today's grinding uncertainty about how much cash and capital a bank needs for lending purposes appears to be  just as much of a deterrent to making any new loans as concerns about borrowers' creditworthiness. And interest rate cuts by the Fed won't make any immediate difference.

Light at the End of the Tunnel?  The only positive thought  at this point is that the cost of "pre-emptive borrowing" will eventually (in six weeks?) force its practitioners to sell their Treasury bills and either pay back the loans or switch into commercial paper.