Credit Risk Transfer and Crunches: Global Finance Victorious or Vanquished?

Abstract

Rather than in terms of the inevitable demise of a destabilising process of speculation, this article explores the ‘credit crunch’ as a window on the fabrication, and measure of the proportions of a political shift driven by market actors and financial innovation. The Basel process reconceptualised banks as risk navigators and generated a competitive hierarchy within the global banking industry determined on a gauge of this capacity. This private regulatory regime promoted market inflation and rendered institutional liquidity and risk transfer definitive of market power. In turn, a ballooning credit derivatives market broke the limits of financial production and defined state actions in the face of crisis. A shift from a central concern with solvency to that of liquidity thinly masks a profound redistribution of power from the public to the private. By swapping private assets of uncertain value for government bonds, central banks have effectively recognised that the products of innovation in the private sphere are global money. The state is in a curious bind. It takes on limitless exposure to private liabilities while its reform agenda is constrained to calling for greater levels of transparency and tackling the worst excesses. Promises of substantive reform remain only that, reflecting dissonance between reality and an entrenched faith in a progressive innovation spiral.

Keywords:

• credit derivatives
• risk transfer
• financial innovation
• crisis
• private governance

Notes

The author would like to thank the editors, Dick Bryan, Mike Rafferty, Earl Gammon, Grahame Thompson, Glen Morgan, Ronen Palan, Anastasia Nesvetailova, Kees van der Pijl, Sam Knafo and two anonymous referees.

Governments have two more immediate options. Imposing a sustained period of austerity with downward pressure on wages, high real interest rates and increased saving, or inflating the debts down the river. The choice rests on a balance between the political exigencies of austerity and the ostensible imperative of capital.

A CDO is a combination of numerous debts, such as bonds or mortgages, in one security. The ‘credits’ are placed in tranches, with the lowest, most risky ‘junior’ or ‘equity’ tranche being first to be impacted by defaults. A risky debt in the highest tranche will not be affected by defaults until all the credits in the lower tranches have defaulted. This ‘structuring’ supposedly transforms a risky debt into a safe investment. A ‘mezzanine’ tranche sits between the senior and junior.

This represents a 13.4 per cent decline in the total value referenced by derivatives over the six months from June 2008. ‘Notional’ refers to the value referenced by a derivative. The ‘real’ value of the derivative is a function of price movements after contract inception. Gross market values measure the cost of replacing extant contracts and are a more accurate gauge of market size. This increased over the same period by 66.5 per cent to £33.9 trillion in line with greater price volatility (BIS 2009).

The process revolves around the Basel Accords, which are recommendations on banking laws and regulations made by the Basel Committee on Banking Supervision. The New Accord, International Convergence of Capital Measurement and Capital Standards: A Revised Framework (BCBS 2004), supplements and updates the 1988 Basel Accord, International Convergence of Capital Measurement and Capital Standards (BCBS 1988).

Different assets on a bank's book carry different risks and the Accord applied a higher risk-weighting to higher risks. Thus, under Basel I cash and government bonds carried a 0 per cent risk-weighting and loans to a corporation 100 per cent. A bank with £10,000 of UK government bonds and £40,000 of corporate loans would thus be required to keep 8 per cent of £40,000 in reserve. The bank would effectively lock up £3,200 to guard against the eventuality that its borrowers defaulted.

Leverage is traditionally the ratio between equity and debt. In this context, it is the ratio between a bank's assets and the ‘cash’ it holds back to support its positions and in case of a rainy day. The estimate is taken from an informal interview (23 February 2005) with Nick Leeson, Senior Partner at Allen & Overy. The firm provided input for the UK position in the development of Basel II.

One of the most significant errors lay in the widespread resort to mark-to-model, as opposed to mark-to-market. This is a direct affront to the notion of market completion (Aglietta and Rebérioux 2005: 113–83). That prices do not exist on every contingency has not hindered the regulation of derivatives markets as if they did. For the more complex OTC and structured products there simply does not exist a market which produces a complete set of prices. In reaction, regulation has substituted privately fabricated prices for publicly observable ones. Ultimately, where the promise of precision is not met through the process of product innovation, it is privately conjured through mathematical technique.

Simon Hills, Director at the British Bankers’ Association (BBA), remarked: ‘The new framework … represents an expression of what most well-managed internationally active banks are already doing today. What the Basel framework will do is recognise for regulatory capital purposes the sorts of parameters banks are already using to manage their business’ (Risk 2004: S6).

In illustration, ABN Amro launched the first Constant Proportion Debt Obligation (CPDO), written on CDS indices in 2006. These structured products offered a yield 2 per cent higher than the risk-free rate of return and were initially rated Triple A by both Standard & Poor's and Moody's. Investors effectively sold protection with leverage on 250 names on the main Itraxx and CDX indices. Over time other assets were incorporated including Mortgage Backed Securities (MBS). If the protection moved ‘out of the money’, the CPDO borrowed more money in order to recoup the losses. In February 2007, Moody's discovered a mathematical glitch in their rating methodology which would mean the CPDO ratings could no longer be Triple A. Moody's adjusted their volatility assumptions down in order to maintain a sufficiently high rating to attract an audience with limitations on their investment mandates (Jones et al. 2008).

The US Securities and Exchange Commission (SEC) issued a scathing report on the performance of the Nationally Recognized Statistical Rating Organizations (NRSRO) in rating Residential Mortgage Backed Securities (RMBS) and CDOs prior to the crisis. The report raised questions ‘about the accuracy of their credit ratings generally as well as the integrity of the ratings process as a whole’ and concluded that, ‘Rating agencies do not appear to take steps to prevent considerations of market share and other business interests from the possibility that they could influence ratings or ratings criteria’ (SEC 2008: 2, 25).

As noted above, while notional values have recently decreased, gross market values have ballooned in line with increased volatility. This increase is most pronounced in the CDS market where gross market values expanded by 78.2 per cent to $5.7 trillion. Notably, the potential for large gains and losses in the CDS market is markedly larger, since CDS synthesise the insurance of the entire value of an asset whereas other financial derivatives merely capture price movements.

The prospect of a complete market appears on two levels. First, in that derivatives have now been applied to default probability in addition to the price risks on which other financial derivatives rest. Second, credit derivatives generate engineering possibilities. A CDS can split the returns on a corporate bond into the risk-free rate and a return associated with default probability. Thus, the CDS market synthetically produces an additional low-risk bond and a distinct market in default risk. Similarly, a dealer who has gone long on default risk in single-name CDS could hedge that position on standardised indices creating a unique residual exposure through an imperfect hedge.

See Morgan (2008) for detailed discussion of the ISDA's governance role in derivatives markets.

An SPV is a legally constituted entity ring-fenced from the parent institution, enabling the removal of activities from the balance sheet, and mutual protection from liability between the parent company and the SPV offshoot. This insulation is not air-tight in practice. The first such vehicle was created by Citibank employees in London in 1988 one year after the Federal Reserve relaxed Section 20 of the Glass–Steagall Act (1933) restricting commercial banks from affiliating with firms engaged in activities such as underwriting and dealing in securities (Kregel 2008: 10). In the wake of the onset of the ‘subprime’ crisis, banks were forced to re-intermediate many of these remote vehicles and carry the associated losses. The widespread utilisation of these ‘remote’ vehicles effectively constituted a ‘shadow banking system’.

Year-end 2006 total global CDO issuance stood at US$488,593.8bn, of which US$393,042.5 was accounted for by cashflow (securitisations) plus hybrid CDOs (securitisations plus ‘synthetic’ credit derivatives) and US$60,236.1 by synthetic CDOs (SIFMA 2008)

In 1999 Citigroup had a US$1.7bn exposure to Enron, four times the bank's internal limit on exposure to the company (CFO 2004). This is a function of CDS. Enron was subject of 800 credit default swaps with a notional value of US$8bn (ISDA 2002: 12). While Enron's stock price soared selling protection on Enron seemed a good bet. Citgroup placed AAA-rated bonds in a SPV. If Enron failed to pay on its bonds, Citigroup would replace these gilt equivalent bonds with Enron's. In the obverse, the investors kept the AAA bonds.

Martin Wolf (2008) commented, ‘The bailout is not efficient because it can only deal with insolvency by buying bad assets at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors’ (Wolf 2008

Helleiner and Pagliari (2009: 286) thus conclude that the 2008 G20 Washington Summit, ‘may be seen in retrospect as the highpoint of an ultimately failed effort to build an international coordinated regulatory response to the crisis rather than as the catalyst for a new kind of Bretton Woods moment’.