Life After Credit Derivatives

Ah, the life of a banker. Fast cars, expensive restaurants and the most presentable specimen of your preferred gender. Unfortunately, it's time to switch off Wall Street and get with 2008, where the first casualty of the year is an entire asset class: Credit Derivatives.

Me: I built trading models for credit derivatives.
Them: Credit Derivatives?
M: Yes, you know what stock options are, right? It's just that we are not taking bets on whether a share price will rise, but on whether a company goes bankrupt.
T: And that's legal?

Well, let's put it this way: not only it is legal, for a while, many people lived very happily off it. Investors received coupons that were higher than for any other investment that rating agencies thought was 'Triple-A' (that's as good as a US government bond - so really, really good), and that was even after banks had deduced their fair share of the proceedings.

Sounded like a great deal, until things started to go pear-shaped.

Last year it turned out that - surprisingly to some - lending money to people with bad credit and insufficient funds is not a good idea. Unfortunately, a lot of banks thought it was a very good idea because they could sell on the credit risk of the mortgages (i.e. the risk that a lender does not pay his mortgage) on to investors. They did so by applying some alchemy called 'Financial Engineering' to turn dodgy assets into something that rating agencies appreciated very much indeed and labelled AAA.

Banks thought they would signal to investors how positively they felt about these risks by leading by precedence. They took the risk for the riskiest pieces of these mortgages on their own books, therefore saying: don't worry if a few of these lenders default - we will generously cover the losses. They must have been figuring that somebody who earns $2,000 USD a month will always be able to service a USD $500,000 mortgage. (I leave you to do the maths).

Given the fact that in the meantime banks have written down about USD $160bn (and counting) in mortgage-related products, maybe it was not such a great idea after all.

Then banks started to become cautious about lending each other money. If another bank calls you up to borrow a few hundred million, is that because they need to fund their business, or because they need to fill another hole they found somewhere in the bottomless pit of sub-prime mortgages? They started charging each other a lot of money to borrow, if they were doing it at all.

Suddenly, credit became more expensive and the worries continued. Insurers that had guaranteed the least risky portions of the mortgage pools became concerned that they'd actually have to pay out on their insurance. And since quite a few had sold much more insurance than they could ever pay out on, this in turn concerned banks again, who thought: maybe we should safely assume that the insurance we bought is not really worth anything.

And another round of 'asset write-downs' occured and just like that, financial institutions did not look that rosy anymore.

Now, the chance of companies going bankrupt is suddenly much higher, in particular the chance of multiple companies going at the same time. That's what the financial wizards call 'Systematic Default Risk' which is just jargon for meaning 'Everything Must Go'. The consequence is that the credit risk that investors took a while ago (when it was AAA, although it might still carry this label) is now much higher.

Maybe all AAA assets are equal, but some are definitely more equal than others. Investors realised that when they called up for the monthly valuations of their investments, and what used to be worth 100 suddenly is only worth 70 - if they are lucky. If they are unlucky, they get a notice from their bank that the unfortunate strategy that was pursued with their money has actually lost all its value. How's that for an investment as safe as US government bonds?

Banks who need to hedge the bets they have entered into with the customers find themselves in the situation where nobody wants to hedge their bets anymore. So the market runs riot, and even if you want to get out of a position, you can't, since nobody wants to trade with you.

The model that is commonly used to price the likelihood of a lot of credit events happening simultaneously tells us these events are off-the-scale correlated. So correlated in fact, that it can't be expressed in numbers anymore.

To summarise, investors have not fared particularly well, banks have un-hedged bets they can't get out of, and even the wiz kids can't come up with a reasonable framework to put prices on these bets.

When I said, I build trading models, I meant: I made best efforts to build trading models.

Have I failed?

A former boss of mine always blamed market dislocations for everything.

It's worth bearing in mind that the market can stay irrational for much longer than you can stay liquid.

So on that note, I will prepare for a life after credit derivatives, and I take my own personal precautions to stay liquid.

Originally published on HereIsTheCity Life on 28/Feb/2008. View the original here.