EU Public Debt Crisis Does Not Explain the Market Turmoil

Sep 22, 2011
Category: General
Posted by: cdgradm

Guest Editorial in Helsingin Sanomat

Helsingin Sanomat is the widest circulation daily in Finland.
(Translated from Finnish)

Investors are concerned of potential losses due to Credit Default Swaps, which would be much larger than those even theoretically possible in the public debt market.

Urho Lempinen
The author is a financial risk management consultant and the Managing Director of CD Financial Technology.

Investors are concerned of the growth of public debt of several EU countries and the USA. In Europe the main concern is due to the situation in Greece, Portugal, Ireland, Spain and Italy.

If all the above countries of the euro region would terminate payments of all their debt, the nominal loss to the investors would be approximately 4 200 billion dollars. The loss would represent about 4 per cent of the total stock of bonds in circulation in the global market, which is ca. 96 000 billion dollars.

The situation in the public debt market cannot explain alone e.g. the large fall of stock prices and the underlying uncertainty. The market turbulence during the last few months has been so large that investors are concerned of losses, which would be much larger than those even theoretically arising from the public debt market.

According to the statistics of BIS (Bank for International Settlements) there are ca. 30 000 billion dollars notional amount of credit risk derivatives i.e. credit default swap products (CDS) in circulation in the global market. This is approximately equal to twice the GDP of USA and to half of the global GDP.

From the buyer's viewpoint a CDS is an insurance which pays remuneration when the reference entity - a rated large corporation, a bank, an insurance company, or a portfolio of these entities - is not able to serve its debt obligations on time or according to the terms. Reference entities are in no way parties of CDS contracts, and there is no direct connection between the realization of a contract and sale of assets of the reference entity.

From the technical viewpoint credit default swaps are risk management products, but in practice many of them are sold as parts of complex structured investment products enhancing the yield of investments. By packaging a sale of a CDS together with rather standard bonds or notes an investor may have received a yield enhancement of e.g. 150 basis points over a conventional fixed income investment with similar counterparty risk. When market yields have been low for a long time large institutional investors such as investment funds and insurance companies became interested in yield enhancement. Few such investors realized that enhanced yield is not paid for nothing in properly functioning markets and that some real risk is imbedded in the sale of CDSs.

The risk of CDSs are directly linked with the short term liquidity of reference entities. Large corporations typically have liquidity under their direct control for payment of 2-6 weeks of operating expenses.

When the general economic situation gets weaker liquidity management becomes more difficult. Corporations slow down payment of invoices to each other, and banks restrain respectively short-term lending to corporations, in contrast to it being routinely extended under normal conditions.

Sellers of CDSs face increasing margin call demands for cash collateral. This mechanism was a key reason for the take-over of AIG in September 2008 by the US Government.

Tightening liquidity conditions rapidly increase pressure among corporations to prioritize payment of invoices. At the latest when payment of wages and salaries on time begins to be difficult, corporations begin to consider restructuring their financing arrangements. This further increases the pressure of banks to tighten corporate lending. A vicious circle may start.

Following the inception of such a circle it is possible that sellers of CDSs incur losses in a short period of time which may amount to more than the annual GDP of the USA. This would imply restructuring of wealth such that private investors would not be sufficiently capitalized to wield the situation. Wealth valuations would crash, a banking crisis and eventually a credit crunch would emerge, leading to a global recession which could be as deep as or more severe than the US Great Depression of the 1930's.

The entire EU public debt problem amounts to a small fraction of the problem imbedded in the CDS market. Its main role may, however, be that it may erode market confidence and visibility, potentially leading to lack of liquidity in the market.

In the autumn of 2008 the US and EU authorities engaged in a number of exceptional measures, by which an impending credit crunch and then a global recession were stopped - or at least the start of the process was delayed. The results of the expansionary economic policy have yet been weak and economic growth slow. Ability of the authorities of both the regions to engage in further stabilization measures is rather restricted.

CDS market constitutes a complex risk concentration developed by the financial markets, in which it is very difficult to intervene. In the autumn of 2008 and afterwards several proposals and demands were presented among others towards increasing regulation of the derivatives markets. In practice central banks, ministries of finance and regulators have adopted a passive and accommodative policy stance: direct market intervention has mostly been avoided or minimized.

This maintains and further creates incentives for the financial markets in developing new complex investment products. Successful new products are very profitable for the developers, issuers and investors, as long as they do not need to bear the systemic risk.

It would be better for the well functioning market and the global economy, if all the risks were born by those who benefit from creation of those risks: winners of the financial markets, beneficiaries of the bonus schemes, and shareholders. Otherwise the global economy will repeatedly face systemic financial crises where the bailout falls on the tax payers.