How much damage could unstable credit derivatives do to the financial system? An enormous amount, reckons Bill Gross, a well-known American fund manager, who puts the potential losses from such contracts at a whopping $250 billion—almost twice the amount that banks have written off to date against their dodgy subprime-related exposures. Nonsense, says the International Swaps and Derivatives Association (ISDA), which represents the derivatives industry. It reckons the amount at risk is a comparatively trifling $15 billion and accuses Mr Gross of scaremongering.
In fact, both sides’ conclusions are suspect. In a report from PIMCO, the money-management firm that he co-founded, Mr Gross estimates that $45 trillion of credit-default swaps (CDSs) were outstanding at the end of 2007, up from $43 trillion reported by the Bank for International Settlements in the middle of the year. These swaps are used to speculate on the likelihood of a borrower repaying its debt. If, as seems likely, the default rate approaches 1.25% this year, Mr Gross reckons about $500 billion-worth of contracts will blow up in traders’ faces. Assuming half of this amount can be recovered, that still leaves a $250 billion problem.
The snag with this arithmetic is that it ignores the fact that many CDS contracts overlap or offset one another. For instance, a bank might sell $50m of protection on a firm and then buy $30m of protection on the same company from elsewhere. The contracts total $80m, but the bank’s net exposure is only $20m. In a practice known as netting, institutions such as PIMCO that trade in CDSs work out their remaining exposure after accounting for their positions on various contracts. This cuts the amount at risk to $1 trillion. Assuming a default rate of 2% and a conservative recovery rate of 25%, ISDA reaches its $15 billion figure.
But if their net exposure is so low, why have banks been so coy about it? The answer is that ISDA’s number-crunching doesn’t take sufficient account of counterparty risk—the danger that a party to a trade will fail to keep its end of the bargain. This is a very real threat: America’s monoline insurers, which have sold protection via CDS contracts, are in dire straits. “The netting-of-contracts concept tries to suggest that it is impossible to drown in a stream with an average depth of two feet,” says Mr Gross. “Not so.”
Still, most firms should keep their heads above water. Andrea Cicione of BNP Paribas has made a stab at assessing the robustness of protection sellers. His analysis concludes that CDS-related losses could range from $32 billion at best to $158 billion at worst. Those are net figures, by the way, not Gross ones.