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Today, the market did not primarily sell off because of Ben Bernanke or the Philadelphia Fed Survey. It sold off because Hurricane Subprime, the credit storm that began to form this summer was upgraded to Category 5 and its path zoomed in on Wall Street. From Bloomberg,
"Credit-default swaps tied to MBIA's bonds soared 10 percentage points to 26 percent upfront and 5 percent a year, according to CMA Datavision in New York. That means it would cost $2.6 million initially and $500,000 a year to protect $10 million in MBIA bonds from default for five years.
The price implies that traders are pricing in a 71 percent chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co. valuation model...
...The contracts trade upfront when investors see a risk of imminent default. MBIA and Ambac are trading at levels reached by Countrywide Financial Corp., the mortgage lender besieged by speculation it would file for bankruptcy before agreeing last week to be bought by Bank of America Corp.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite."
Naked Capitalism in covering this story writes, "I'm not in that market, but I can't recall ever seeing figure like that."
Fortunately, I have had the unique perspective of seeing something similar a couple years prior. In the beginning of 2006, I was working at a major reinsurance broker as an analyst in the Capital Markets group. In 2005, Hurricanes Rita and Katrina crippled the insurance markets - especially the market for wind in the Gulf. Many insurers and reinsurers, still recovering from Hurricane Ivan in 2004 as well as the losses from 9/11 found themselves with insufficient capital for the hurricane season of 2006, which was supposedly going to be even worse than 2005 (it turned out to be very very mild). In the Capital Markets Division we helped this companies securitize this insurance risk and place it with hedge funds and other private investors because of a lack of capacity (aka capital) in the traditional market. As you can imagine, the rates were very large. Most of these transactions were done through Catastrophe Bonds and Industry Loss Warranties (ILW's) structures.
(Re)Insurers of most lines of business - whether it be Catastrophe or Monoline, share a very common trait - they tend to write tons of business during soft markets (when prices are low because there hasn't been a loss in an industry in a while) and much less business in hard markets (when prices are high because losses are recent and usually large). This is due to the fact that the industry is very undercapitalized and periods of loss result in writedowns and limit the ability for a (re)insurer to maintain its credit rating due to a shrinking balance sheet. Does this sound somewhat familiar?
The Insurance Linked Securities market developed as a response to this phenomenon after Hurricane Andrew and grew even more over the past few years. Hedge Funds and other Investors who are not subject to capital requirements (at least externally) are able to create a collateralized form of reinsurance that eliminates virtually any type of counterparty risk.
During the aftermath of Katrina in 2005 and 2006, as many reinsurers were facing credit downgrades, there was a mad scramble for catastrophe insurance. Rates on line (Premium/Indemnity) were going for about 40% and Energy Companies and Insurers of Energy Assets in the Gulf faced an insurance market in the gulf that had basically seized up. Those seeking any other types of CAT coverage found themselves in similar situations. It even affected most other lines such as Casuality and Marine/Aviation as the industry itself was dealing with a lack of capital.
In this market, however, the main concern of the insurance industry at the time was not of wind or any other event. Instead, it was basis risk. In general, basis risk is the risk involved by using an imperfect hedge. Reinsurance is just a hedge, so every contract involves not just event risk, but basis risk. In a standard indemnity based insurance contract basis risk is the disconnect between payout on contract and ceding insurers losses. Since the ceding insurer has more information the the reinsurer, it introduces the concept of moral hazard risk. In addition to event risk, an indemnity reinsurance contract essence transfers moral hazard risk to the reinsurer and counterparty party to the insurer. The some of these two should equal the basis risk of the hedge. Parametric triggers involved with Cat Bonds and other ILS are objective and have no moral hazard risk have very little counterparty risk, but still have basis risk as an insurer can suffer losses, but a bond may not be triggered and vice versa. It is in essence a derivative based on the actual event risk and takes underwriting standards out of the deal altogether.
In 2005-2006, the market arrived to a point at which standard insurers no longer wanted to take on counterparty risk, and hedge funds would not assume any more basis risk. The result was a hard market affecting many lines of business and many insurers and companies they insure ended up self-insuring their own CAT risks. This turned out to be a winning strategy as no big hurricane occurred in 2006.
That situation, however was very simple compared to what we have today. In today's market we have monoline insurers and reinsurers, who like their counterparts years prior, wrote too much insurance at too low a price. The risk they insured was credit risk on corporate, municipal, and asset/mortgage backed securities. In recent years an retrocession market for credit has developed through the use of Credit Default Swaps and other credit derivatives. Hedge Funds and large Investment Banks are the biggest buyers and sellers in the $30 trillion CDS market and also large holders of the securities that the monoline insurers have insured - perversity at its finest. If the insurers lose their credit rating, those holding the securities will face a downgrade and decline in value. So let's follow the logic in the worst case (not necessarily least likely) scenario,
- Bonds default on Hedge Fund or Investment Bank holding them.
- Bond insurers downgrade causes holders of securities and other speculators to buy CDS to cede their risk.
- Bond insurers default and go into bankruptcy
- Hedge Funds and Investment Banks suffer losses on these securities (as well as others due to poor financial market conditions) and find their balance sheet reduced and credit rating on watch.
- Derivative contracts decline due to the increase in counterparty risk throughout the market, causing further writedowns.
- Massive Market Failure.
(Merrill Lynch started the party early today, when they wrote down all of their bond insurance with ACA a sum totaling $3 billion - which marked that insurance to market at zero)
This explains the price action in the markets today. If you are a major holder of these securities, you may want to try to hedge your risk in the CDS market. If you wrote that contract, you may want to hedge your risk by possibly shorting the stock. Upfront payments are being required by those writing the CDS contracts because of the counterparty risk involved in the system. This is a very spooky situation that could result in a massive deflationary spiral.
In the market for CAT coverage in 2005-2006, the market dislocation would not have been solved if the companies were given tons of cash. Hedge funds had plenty of it and still would not write any more coverage at any market clearing prices. As mentioned previously this was due to the idea of basis risk.
If there was a Fed for Insurance Markets (although the current Fed still affects them now), who cut insurance rates and providing retrocession to the reinsurers who would then be able to reinsure someone who could insure and so on, it still would have been difficult to stimulate that market to create liquidity. If the Fed operated like it did in the banking system through open market operations, knocked down the target rate that reinsurers charge for reinsurance buy reinsurance select, less risky layers, the problem would not have been solved. The reinsurers would have no moral hazard since these layers are the ones they wouldn't reinsure anyways, and the Fed has no counterparty risk. Thus they indirectly would assume basis risk by paying to cede something they would not have otherwise ceded. Since the reinsurers could find no way to cede the risks they wished to at the rates they wanted to they would have little incentive to swap their counterparty risk, for moral hazard risk, unless prices were higher. Ceding insurers who don't realize that they even have moral hazard risk let alone quantify it, would choose to keep the risk on their books. Thus, the extra capacity would not matter, because there is insurance in the system that was not underwritten properly at the bottom and has been bundled and made its way to the top with little sources of retrocession. The problem was basis risk.
When markets are soft, all this cheap reinsurance allows the underlying assets to increase in value as the cost of carry becomes lower. In the bond markets we saw this as the CDS market caused corporate spreads to narrow like crazy. As the assets increase in price and interest rates stay low, the desire for asset protection becomes greater causing this crappy underwriting to float all the way to the bottom of the reinsurance ladder as ceding the risk becomes easier, eventually causing underwriters to operate at a loss for years without even knowing it. When an event finally occurs, a system exists where the senior debt holders (reinsurers) hold the most risk, and are unable to pay the insurers, who are unable to pay the insured, causing all the basis risk that was hidden for years in the form of moral hazard to rise to the surface causing losses for everyone involved.
Today, the moral hazard risk was introduced by the Fed slashing interest rates and banks used this to lend like crazy and transferred it to holders of CDO's and other securitized vehicles, with liquidity puts transferring the counterparty risk back to the banks. These were then insured by the monolines transferring the moral hazard risk to the insurers and counterparty risk to the holders of the bonds. All these entities tried to get rid of this moral hazard risk by entering into many different derivative contracts such as CDS's and swaps further complicating the issue. Now as the moral hazard risk is coming to light, the counterparty risk is starting to surface in different pockets. But all this was created by the Fed assuming the basis risk in trying to hedge against an economic downturn. It has assumed great counterparty risk through its repurchased of Treasuries, but the cash it has given has not helped as its actions have slashed the rate it is willing to take counterparty risk well below what a bank is willing to assume that risk, since they are less and less able to take moral hazard risk. This is evident in the amount upfront that is necessary to purchase a CDS on the monolines. The problem in this market shock much like the shock borne by Katrina is of basis risk. Although more complex, the reality of the situation is that there are way too many hedges in the system that are not accounted for properly, understating the basis risk. If the rate that they target is much less than the rate that the banks will do business, a lower rate will not solve anything, and may make this worse.
Hopefully, we will see this summer turn out like the summer of 2006, but I'm afraid that this risk, unlike weather risk is too correlated with other risks in the system and may magnify as this plays out and as interest rates go lower.
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Posted by: Mike Thomas | September 30, 2010 at 03:19 PM