Credit Derivatives: Caveat Adstat!!

Credit (or Debt, depending upon which side one is) Derivatives  were famously described by Warren Buffet as :financial weapons of mass destruction:. Trouble is that entire derivatives business is *self regulated* by the very financial institutions that caused the financial crisis in 2008 creating a gridlock of distrust. No one knew how much they were exposed to the risk of defaults, because no one knew how much exposed the counter-parties to the deals were. Self Regulation is really a euphemism for what are really unregulated markets, which are consistently *fixed* by members of a select club. How incestuous the select club is can be seen from the following table I have tabulated from the information available on the website of  International Derivatives and Swaps Association (IDSA). The IDSA has various regional committees, which decide whether a *credit event* has occurred; and if the answer is yes, then & then alone the *protection bought* by a credit derivatives’ buyer kicks in. Now see the composition of  these committees:
A similar select club acts in determining the LIBOR, which was recently hit by the LIBOR fixing scandal. Though the revelations are recent the fixing has been going on for some time. The London Inter-bank Offer Rates for major currencies are arguably the most vital interest rates in the field of finance. Barclays Bank has already been fined  GBP 290 Million for its role. It looks like a huge fine, but really is a rap on the knuckle considering the consequences of such fixing. LIBOR is fixed every working day through a consultation process between various major financial institutions. So, obviously there are other *rogues* who were party to the fixing.
The credit derivatives market is mindbogglingly humongous. Bank for International Settlements (somewhat like Central Bank of Central Bankers) or BIS for short has put the *Notional Amounts Outstanding(NAO)* on the *total contracts* for December 2011 at US Dollars 647,762 Billion. The *Gross Market Values(GMV)* of these total contracts however are put at a modest US Dollars 27,285 Billion at same point in time. The total contracts aggregate the Foreign Exchange Contracts (FEC), Interest Rate Contracts (IRC), Equity Linked Contracts (ELC), Commodity Contracts (CC), & Credit Default Swaps (CDS). IRC form the largest chunk of total contracts, followed by FEC and CDS.  Each type of contract can be *naked* except perhaps IRC, wherein one can *buy or sell* a contract without having interest or control over underlying asset. The buy or sell therefore is like waging a bet. That should clarify the huge difference between Notional Amounts Outstanding and Gross Market Values. Just before the credit derivatives bomb burst in the face of world financial markets, the BIS in December 2007 had put the NAO of Total Contracts at a staggering US Dollars 1,144,000 Billion or more than 75% of the 2011 figure. This climbed further in the first half of 2008, before unwinding down sharply in the 2009.
Putting a perspective to these numbers would be educative.
1. The World GDP in 2011 stood at US Dollars 69,972 Billion Dollars, roughly 1/10th of NAO of total contracts..
2. The World Market Value (Market Capitalization) of Publicly trades shares in December 2010 was US dollars 56,600 Billion, roughly 1/12th NAO of total contracts.
The instruments which were originally and avowedly created for minimising or hedging risks, or for converting open ended liability as happens with floating interest rates to assured liability as in case of fixed interest rate regime, and for passing risks of Foreign Exchange fluctuations to seasoned players from those whose primary business was something else; have now transmogrified into monstrous betting machines that are capable of bringing the world economy to its knees as they did in 2008.
Coming back to Warren Buffet, who had correctly understood the nature of the beast way back in 2002,  one finds even he has exposure to credit derivatives and was recently in the news for terminating the US Dollar 8.25 Billion swap protection on municipal debt his companies had sold: ^^The move comes as many investors, including Berkshire Chairman billionaire investor Warren Buffett, foresee an uptick in U.S. municipal bankruptcies. Buffett said last month that the bankruptcies of three California cities in as many weeks was making traditionally objectionable Chapter 9 municipal bankruptcy filings more palatable to local governments in financial crises^^. But instead of dwelling upon what he does, it would help us to dwell upon what he said in the Berkshire Hathaway annual Report-2002

For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

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