A good explanation from the Wall Street Journal:
Default Fears Unnerve Markets
Partners in Credit Deals
Face Big Write-Downs
As Bond Insurer Teeters
By SUSAN PULLIAM and SERENA NG
January 18, 2008; Page A1
The turmoil on Wall Street is beginning to rock a foundation of the financial system: the ability of institutions to make good on their many trades with one another.
Today, a struggling bond insurer, ACA Financial Guaranty Corp., will ask its trading partners for more time as it scrambles to unwind more than $60 billion of insurance contracts it sold to financial firms but can’t fully pay off, according to people familiar with the matter. The contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own.
The problem is that the insurer itself is teetering — with repercussions across the financial world. Some of its trading partners, called counterparties, already are writing off billions of dollars because of its inability to pay.
Yesterday Merrill Lynch & Co. wrote down $3.1 billion on debt securities it had tried to hedge through ACA insurance contracts, as part of a larger Merrill write-down. Earlier this week, Citigroup Inc. set aside reserves of $935 million to cover the likelihood that trading partners won’t make good on trades in this market. Such risk helped pummel the stock market yesterday as well.
At the center of these concerns is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults. This isn’t like life insurance or homeowners’ insurance, which states regulate closely. It consists of financial contracts called credit-default swaps, in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast: about $45 trillion, a number comparable to all of the deposits in banks around the world.
Not everyone who buys one of these contracts has bonds to insure; because the value of an insurance contract rises or falls with perceptions of risk, some players buy them just to speculate. In much the way gamblers make side bets on football games, a financial institution, hedge fund or other player can make unlimited bets on whether corporate loans or mortgage-backed securities will either strengthen or go sour.
If they default, everyone is supposed to settle up with each other, the way gamblers settle up with their bookies after a game. Even if there isn’t a default, if the market value of the debt changes, parties in a swap may be required to make large payments to each other.
This being Wall Street, the investors often use heavy borrowing to magnify their wagers.
Relying on Strangers
With many bond values falling and defaults rising, especially in the mortgage arena, some institutions involved in these trades are weakened. This has investors and regulators worried that, through such swaps, some market players could spread their own problems to the wider financial system.
“You are essentially counting on the reliability of strangers” to pay up on their contracts, notes Warren Buffett, the Omaha billionaire. In some cases, he says, market players can’t determine whether their trading partners have the ability to pay in times of severe market stress.
The issue is raising broader concern among regulators and investors over what Wall Street calls “counterparty risk,” the danger that one party in a trade can’t pay its losses. A recent survey by Greenwich Associates found that 26% of investors were worried about counterparty risk, nearly double those who said so in a poll last March.
Federal Reserve Chairman Ben Bernanke, testifying before Congress yesterday, noted that “market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future.” He said bad financial news has the potential to limit the amount of credit available to households and businesses.
Banking regulators have focused on counterparty risk amid the boom in credit derivatives, instruments whose value depends on the value of some other asset. But they’ve concentrated mainly on banks that service the instruments and on hedge funds that actively trade them — jawboning to try to ensure that trades are properly documented. Few envisioned a little-known bond insurer like ACA causing so much instability.
This market poses challenges for would-be regulators. It isn’t clear, for instance, how securities laws on fraud and insider trading would apply to credit-default swaps, because it’s not clear in what way they are even securities; they are private contracts.
The LTCM Scare
This isn’t the first time the financial world has shuddered at counterparty risk. In the spring of 2005, the downgrading of General Motors Corp. and Ford Motor Co. bonds to “junk” status led to losses for hedge funds that had bought exposure to these bonds through credit-default swaps.
A far bigger problem came in 1998, when the big hedge fund Long Term Capital Management nearly collapsed. Regulators scrambled to arrange an industry bailout, fearing broad damage to the world financial system if LTCM couldn’t make good on billions of dollars of trades with others.
The LTCM crisis involved just one fund, enabling regulators to track its scope quickly. It’s possible that as in the LTCM and auto-bond instances, the markets will soon stabilize without further trouble. But the landscape today is more complex. Traders increasingly sell their credit-risk commitments to other investors in multiple layers, making it difficult to know where the risk ultimately resides.
One hedge-fund manager who has entered into credit-default swaps with 10 brokerage firms says he also has bought such contracts from other market players on the brokerage firms themselves — guarding against the possibility they might not be able to pay.
The market for swaps has grown fivefold just since 2004. It has no publicly posted prices; the contracts are sold privately among dealers. The market began 12 years ago with insurance against defaults on corporate bonds, expanding in 2005 to mortgage securities.
The troubles at ACA show how one spark can set off a brushfire. Launched 11 years ago by H. Russell Fraser, a former chief executive of Fitch Ratings and bond insurer Ambac Assurance, ACA originally set out to provide traditional insurance on municipal bonds.
ACA had just a single-A financial-strength rating — not the top triple-A rating of larger players Ambac and MBIA Inc. — and it insured municipal bonds whose own ratings were even lower. ACA promised to cover these bonds’ interest and principal payments on the off chance that city power authorities, schools and other issuers couldn’t make those payments.
It was a steady business but had limited growth. In 2000, ACA moved into the more lucrative arena known as “structured finance.” Initially, it began pooling highly rated securities into bundles called collateralized debt obligations, and managed them for a fee. ACA later began writing insurance on securities backed by corporate and mortgage debt, by selling credit-default swaps.
Investment banks paid ACA annual fees for bearing the risk in their debt securities. This shielded them from the impact of market-price fluctuations, so the banks didn’t have to reflect such fluctuations in their earnings reports.
As long as ACA kept its single-A rating, the banks didn’t require ACA to post collateral even if the securities it insured slipped in value. It’s different if a hedge fund, which doesn’t have a credit rating, is selling the insurance. In that case, each time the security insured falls in value, the hedge fund may be asked to put up more collateral.
Who Owes What
Sometimes it isn’t clear who owes what. A tiny hedge fund sold a swap to a unit of Wachovia Corp. this spring and faced repeated demands for more collateral as the subprime market slid. The fund, CDO Plus Master Fund Ltd., says in a suit in New York federal court that it insured a $10 million security, but Wachovia eventually demanded more than $10 million of collateral — even as the security’s value dwindled. Wachovia called the suit “without merit.”
Last fall, with the market for low-end subprime mortgages collapsing, investors worried about firms with exposure to them. Analysts zeroed in on ACA and other bond insurers that had assumed the risk on many such securities.
ACA appeared to be in the most precarious position, because its capital of $425 million seemed minuscule compared with the $69 billion of credit protection it had provided on corporate and mortgage debt. ACA had added about $20 billion of that exposure between April and September.
The firm was upbeat. ACA Financial Guaranty “has never been in better financial condition,” said Ted Gilpin, chief financial officer of parent company ACA Capital Holdings Inc., in a Nov. 8 conference call with investors. He cited a 67% year-over-year jump in the unit’s third-quarter net profit.
Still, the parent firm reported an overall net loss of $1 billion because of charges from a drop in market value of the mortgage securities to which it was exposed. CEO Alan Roseman brushed off investor worries about the health of financial guarantors, saying clients “have been overfed with fiction from others,” according to a transcript of the call.
The next day, Standard & Poor’s said it was reviewing ACA’s single-A rating for a possible downgrade because the weak earnings report could make it hard for ACA to win new business. ACA executives realized that if their credit rating was cut, the firm might have to post at least $1.7 billion in collateral to its 29 counterparties — cash it didn’t have. They began talking to these parties about how to address the issue. ACA Capital’s shares, which had traded at $15 in June, sank to 50 cents in mid-December and were delisted by the New York Stock Exchange.
On Dec. 19, S&P slashed ACA’s credit to the deep “junk” rating of triple-C — a rude shock not only to ACA but to its bank counterparties. ACA executives were furious with S&P, whose action effectively is putting the company out of business, according to people familiar with the matter. For the banks, the downgrade made the billions of dollars in insurance contracts ACA had provided all but worthless.
Waiving Collateral Demand
That evening, ACA said it had reached a “forbearance agreement” with counterparties, who temporarily waived their right to demand that it post collateral to its swap contracts. The agreement is set to expire today, but ACA is likely to announce an extension to give it more time to work out arrangements with each party, say people familiar with the matter.
ACA is attempting to unwind its swap agreements in an orderly manner, these people add. One possibility: a rescue plan giving the counterparties stakes in a restructured bond-insurance company. An alternative plan or capital infusion is also being considered, the people add. It’s a tenuous position: ACA needs the cooperation of all counterparties to avoid collapse.
A few of its trading partners — not just Merrill but also Canadian Imperial Bank of Commerce and French securities firm Calyon Securities — recently reported write-downs on the ground that ACA wasn’t likely to be able to continue protecting them from losses on mortgage securities. CIBC’s write-down is $2 billion and Calyon’s is about $1.7 billion. Lehman Brothers Holdings Inc. and Bear Stearns Cos. also have small exposures to ACA.
Merrill CEO John Thain says counterparty risk at his firm is limited to ACA. But ACA isn’t the only insurer with a problem. Last month, Structured Credit Co., a small Dublin insurer, completed a plan that will pay its dozen trading partners just 5% of what they are owed. Its problems leave various financial firms with losses totaling about $250 million.
Investors, banks and regulators are also concerned about bigger bond insurers. Moody’s said this week it may cut the top ratings on MBIA and Ambac.
Bill Gross, chief investment officer at Allianz SE’s Pacific Investment Management Co, or Pimco, recently told investors that if defaults in investment-grade and junk corporate bonds this year approach historical norms of 1.25% (versus a mere 0.5% in 2007), sellers of default insurance on such bonds could face losses of $250 billion on the contracts. That, he said, would equal the losses some expect in the subprime-mortgage arena.
With no central trade processing of credit-default swaps, defining trading-partner risks can be a Herculean task. Mr. Buffett learned the difficulty of unraveling such complex instruments in 2002 when he directed General Re Corp., a reinsurer that had been acquired by his Berkshire Hathaway Inc., to pull back from the business of these swaps and other derivatives. It took General Re four years to whittle the business from 23,218 contracts to 197 by the end of 2006.
Doing so involved tracking down hundreds of counterparties to General Re’s trades, many of which Mr. Buffett and his colleagues had never heard of, he says, including a bank in Finland and a small loan company in Japan, to name just two. One contract, Mr. Buffett says, was designed to run for 100 years. “We lost over $400 million on contracts that were supposedly” safe and properly priced, “and we did it in a leisurely way in a benign market,” Mr. Buffett says. “If we had to unwind it in one month, who knows what would have happened?”