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Friday, September 19, 2008

Gnome-o-gram: Financial Derivatives II: Counterparty Risk

Much of the discussion in the legacy media of the bailout of financial institutions caught in the financial derivatives meltdown, such as AIG, about which I wrote yesterday , predictably misses the point of why these bailouts are being done and, as a result, fails to explain just how dire the risk is to the economy as the mountain of junk derivatives is unwound. The key phrase in understanding this is one which you may not have heard before, but are almost certain to hear many, many times from all sides before this mess is finally sorted out: “counterparty risk”.

Our previous discussion of derivatives used exchange-traded wheat futures as an example, but at the heart of the present problem are “over the counter” or privately negotiated derivative contracts between two parties. Consider, for example, an airline who wishes to lock in the price of the Jet A fuel its planes will require in the next year. Knowing the price it will pay, and being therefore insulated from fluctuations in the price of fuel, allows the airline to budget and pre-sell seats at a known price without having their profit margin depend upon whatever fuel happens to be selling for when the flight actually departs. There are actually now exchange-traded futures contracts for Jet A , but they are a recent innovation and still thinly traded, so the airline looking to hedge its fuel requirements may prefer to conclude a private forward purchase contract with a financial institution such as AIG. (An earlier pioneer in such contracts was Enron, which gives you a sense of how rapidly the financial community learns from experience.)

There are two parties to such a contract: the airline and the financial institution. Each is thus the “counterparty” to the other. To the airline, the financial institution is its counterparty and vice versa. The financial institution does not, of course, manufacture or sell jet fuel, so in assuming the risk of a rise in price of that commodity, it will usually balance its exposure on the contract with its own hedge, for example by concluding a forward sale contract of about the same quantity and delivery date with a refiner of Jet A or (since it's unlikely a precisely balancing contract can be made) by buying crude oil futures based upon a model of the relationship between the price of crude and that of jet fuel worked out by all of the erstwhile string theorists in the back room who didn't get tenure at the university. The cost of putting on the countervailing hedge is priced into the premium the airline pays for the forward purchase contract.

Unlike exchange-traded derivatives such as futures and options, these private derivatives are bespoke contracts between the two parties—they can be (and often are) arbitrarily complicated, incorporating aspects of futures, options, and insurance, and bewilderingly difficult to completely hedge. They are also exempt from regulatory scrutiny and, unlike exchange-traded contracts, not marked to market until the contract comes to term and the settlement payment between the parties is computed and paid. This means that there is almost complete opacity about the obligations undertaken by an issuer of derivative contracts, and that their financial situation can deteriorate to the brink of insolvency without any indication of the approaching crisis until a payment comes due and there isn't any money to make it.

Let's go back to the simple case of the airline with the forward contract for jet fuel. Suppose the forward was made when fuel was 50 dollars a barrel and when the contract expires a price spike had doubled the price to 100 dollars a barrel. The airline is counting on the profit from the forward contract to compensate for increased price it will have to pay when purchasing fuel on the open market. If it has presold seats and budgeted based on the locked-in 50 dollars per barrel fuel price, having that price suddenly double may push it over the edge into bankruptcy, but the forward insulates it from that risk.

But only if the counterparty pays up! Suppose that, the night before the settlement date on the forward contract, the financial institution goes belly up due to something entirely unrelated to the jet fuel contract: for example, a contract with a major computer manufacturer denominated in the user satisfaction level with Windows Vista. Now the airline has a contract which covers the increased price it will have to pay for fuel, but the financial institution, the counterparty, is bankrupt and cannot pay. That's counterparty risk. It's like having all your assets in bearer bonds in your safe deposit box and a meteor hits your bank: you did everything right and now you're wiped out. The airline, faced with twice the fuel price and no forward contract profit to cover it, files for bankruptcy, lays off employees, shrinks its fleet, and the economy as a whole takes a hit.

Much of the legacy media coverage of the recent bailouts has followed the usual populist narrative that the bailout is a rescue of the fat-cat shareholders and the miscreant executives who ran the institution into the ground while collecting their unconscionable salaries and bonuses. Now, I am not here to defend either investors stupid enough to buy a piece of a company with an opaque and unquantifiable exposure to who-knows-what, nor the idiots in the executive suite who assume such risk without thinking “what if”. But they aren't the reason for the bailout! In fact, in the recent rescues of Fannie Mae, Freddie Mac, and AIG, the investors were essentially wiped out even before the bailout, and the executives are soon to be cleaned out, both from their offices and in the financial sense by shareholder suits and prosecutions. No, the reason for the bailout is the consequences of default on all of the counterparties of the derivatives they had written. In the case of a company like AIG, they are all over the economy and all around the world, and even compiling a list of them, no less assessing the consequences of a default, is a major undertaking. For example, there are bonds whose rating is based on insurance from AIG. Take away that insurance, and the current value of the bond plummets. Now who owns those bonds, and what happens when they have to report their holdings at the end of the quarter? This is not a made-up example; if you've been reading these gnome-o-grams for some time, you've probably gotten a sense of how sceptical of the financial conventional wisdom and careful I am of the assets I hold, but my portfolio includes one such bond insured by AIG, and had I sold it on Monday, it would have been at about 40% of face value. (Got better—come on November!)

That's the nature of counterparty risk, and why it poses such a peril to the global financial system. I've been expecting FNM FRE , and AIG (and several more, which I won't name here to avoid being accused of precipitating a bank run among my dozens of readers) to inevitably pack it in for over a year: the fundamentals were obvious, and the only question was when. So certainly, I wouldn't go anywhere near securities issued by these politically driven hollowed out accidents waiting to happen. But gotcha, counterparty risk from AIG that I never knew I had more than halved the value of a bond I owned overnight. That's counterparty risk, even though I wasn't the direct or a knowing indirect counterparty.

When regulators have to decide whether to bail out a financial institution or let it fail, they aren't thinking of the shareholders or management. Instead, they're trying to assess the hit to other enterprises and the economy as a whole of of the counterparty risk if the derivative contracts written by the institution on the brink are defaulted upon. “Too big to fail” is a real phenomenon, but the legacy media often assume “big” is measured by assets, employees, or some other irrelevant quantity. In the age of derivatives, and at the moment they are brutally being marked to market and rendered visible by insolvency of those who wrote them, “big” is measured by counterparty risk, and that's why that if you've just encountered the term for the first time here, you're sure to be tired of hearing it everywhere within the next six months.

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Posted at September 19, 2008 00:37