Bailout after bailout over the weekend, the UK is considering recapitalising its banks and the money markets are broken.
Why the breakdown?
Panmure Gordon’s Sandy Chen has this to say in a note out today:
We think one of the key drivers has been the tremendous potential demand for cash from counterparties, related to the CDS (credit default swap) payouts on the recent major credit events. To recap, the FNM/FRE CDS settlement auction happens today (6 October), the LEH auction on 10 October (Friday), and WaMu on 23 October. In these settlement auctions, the reference price for the underlying bonds will be set, thus determining the payout levels.
… We think that the CDS payouts related to these credit events will put tremendous strains on the financial counterparties that had written those CDS. We broadly estimate there could be US$50bn of payouts related to FNM/FRE CDS, and US$400bn of payouts related to LEH CDS. We think it highly likely that many counterparties, particularly hedge funds, will not be able to raise the cash to meet their ends of these bargains.
What will this mean? More failures amongst hedge funds, insurance companies and banks, and - given that CDS are largely OTC, meaning that there is limited visibility beyond the immediate counterparty - a lack of trust that translates into money markets remaining effectively shut. And whichever measure of financial stress/lack of liquidity is used - LIBOR-BaseRate gap, TED spread etc - it will remain at elevated levels as long as markets are worried about possible failures of counterparties (or counterparties’ counterparties).
How cheery.
But Chen is making a very good point. Counterparties may have protected themselves from one or two bankruptcies in the system but they would likely not have anticipated failure on the scale seen recently. For instance, if you bought a CDS to protect you on AIG but you bought it from Lehman Brothers, you’re not protected. If you were smart you might have bought protection on Lehman from someone else, but you can’t keep going forever.
As the mystery CDS expert moonlighting at Felix Salmon’s blog notes:
In practice, because multiple counterparties can go bankrupt, you can’t hedge your risks perfectly; the best you can hope for is to minimize them and to understand them.
On the UK banks recapitalisation point, Panmure recommends selling Barclays and RBS on the basis of their 2.4 trillion in credit derivatives notional contracts each at Barclays and RBS (i.e. 1.2 trillion each in credit derivatives bought from counterparties) and possible share dilution from any recap program.
And on a positive note, if all the recent cash-hoarding is in preparation for these few credit events, maybe (a big maybe) money markets will get better soon.
Libor is slightly down today (one month dollar at 4.09 per cent vs 4.11 per cent), presumeably because of Tarp, though the dollar-OIS spread is still out at about 290 — way above historical levels.
