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Synthetic CDOs, China and Systemic Risk

September 18, 2005

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I suspect the stock of outstanding synthetic credit derivatives -- $ 1500 b in synthetic CDOs in 2004 v. $300 b or so in 2001, according to Mark Whitehouse of the Wall Street Journal -- is the only thing than has increased more rapidly than China's reserves over the past few years.  China's reserves are probably above $800b now, including the reserves transferred to the state banks, up from $165b in 2000.  El-Erian has a nice graph of China's reserves here.

Though perhaps the percentage increase in total assets under management by hedge funds since 2001 would give Chinese reserves a run for their money ... 

A warning - any post that starts with the "stock of outstanding synthetic credit derivatives" is going to be rather technical in places, and this post is long to boot.   Think of it as a coda to DeLong's take on the hard or soft landing debate, but one that puts more emphasis on financial markets and less on labor markets.

I also suspect the surge in synthetic credit derivatives, the surge in hedge funds and the surge in China's reserves are not entirely unrelated.  Demand for Treasuries from the central bank of China (and other central banks) is one factor that has kept Treasury yields low.   And low Treasury rates have fueled a search for yield that propelled the growth of the CDO (collateralized debt obligations) market and eventually the synthetic CDO market.  A synthetic CDO replaces the package of bonds in a standard CDO with a package of credit derivatives. 

The fact that David Li came up with a clever model for pricing CDOs helped too ...

And I suspect that the three are linked in another way.  All add to the (rising?) risk of a serious systemic crisis.

China looks set to add between $250b and $300b to its reserves this year (taking into account valuation gains and reserves transferred to its state banks).   That amounts to about ½ of the $600 b a year or so that central banks look likely to add to their reserves in 2005.   The willingness of the PBoC to intervene to keep the renminbi from rising/ the dollar from falling (along with similar actions from other central banks) has set a floor under the dollar, and arguably, a ceiling on US interest rates.   Foreign governments - not private investors - are taking the "spare" savings of emerging economies, along with the spare savings that private investors in other countries want to invest in emerging economies, and investing it in the US bond market.

Nouriel and I have hammered on and on about the risks this poses.  Not just because we suspect the risks are larger than the "conventional wisdom" allows, particularly if the Bush Administration makes post-Katrina policy on the assumption the US has an infinite credit line.  But because the willingness of foreign investors to hold dollars despite interest rates that seem to fail to compensate for the risk of future dollar depreciation suggests that the financial system is out of equilibrium in some sense, or in an equilibrium that depends on continued reserve accumulation by central banks willing to ignore future losses.

Joe Gagnon has demonstrated that currency adjustment does not need to be accompanied by a rise in interest rates, at least in industrial countries.  A slowdown in the US could cause the trade deficit to fall, and a weak economy could lead the Fed to lower rates.  Alternatively, fall in the dollar could stimulate the US economy and lead the Fed to push up interest rates - but in this case, the US would continue to grow rapidly, and higher interest rates would just send a signal for resources to shift from interest-sensitive sectors to the now booming export sector.  Read the Economist.

But that doesn't mean that we should not worry about the risk a fall in the dollar that it could be accompanied by a rise in interest rates.  After all, foreign investors hold something like $8 trillion in US dollar denominated debt - not a small sum.   Central banks are sitting on $3 trillion or so of dollars (not all in the US) and that sum, in my judgment, is still rising by $400-500 billion a year.  A portfolio shift out of dollar assets (let alone a full fledged run) could force US interest rates up even as the economy slows.

That is an unpleasant combination - it pushes the economy out of the self-regulating cycle where, in an economy with a credible central bank, a weaker economy leads to lower rates and a stronger economy leads to higher rates.  Think of it as the capital market equivalent of an oil "supply shock."  Its effects would be different than the capital market equivalent of a "demand" shock.

There is a reason why - in FRNBY President Tim Geithner's words - systemic crises tend to emerge when there are large macroeconomic imbalances.

It probably is possible for a country with an exceptionally virtuous fiscal and monetary policy framework to experience a systemic financial crisis. But most financial crises involve a shock whose origins lie in the realm of macroeconomic policy error, often magnified by the toxic combination of poorly designed financial deregulation and an overly generous financial safety net. Probably the most important contribution policy makers can make to financial stability is to avoid large monetary policy mistakes or sustained fiscal and external imbalances that increase the risk of large macroeconomic shocks, and to try to ensure that policy reacts with sufficient speed and force in the face of those shocks we are unable to avoid.

Systemic crises have another fuel -- leverage and the self-reinforcing dynamics created when initial losses lead leveraged players to run for cover, adding to the initial market move, and ultimately, to the leveraged player's losses. 

That leads us me to the latest hedge fund playground: credit derivatives.  I am a little late to this party.

Mark Whitehouse of the Wall Street Journal splashed David Li's concerns about the use of his model for pricing credit derivatives all over the front page last Monday.  (If you do not have an electronic subscription to the Journal, check out Steve Hsu's excerpts.  Steve can also answer any questions about copulas you might have ... ) To quote Li: "the most dangerous part is when investors believe everything coming out of it."  Whitehouse adds: "Investors who put too much trust in it or don't understand all its subtleties may think they have eliminated risks when they haven't."

Both the C section of the Journal and the Business page of the New York Times highlighted recent work from Andrew Lo suggesting that low volatility in hedge fund returns can be a sign of rising, not falling, risk.   Think about Bayou's stable (reported) returns ...

But I am interested in the intersection between the theme of Whitehouse's story and recent comments from the IMF' chief economist Ragu Rajan, who also suggested that the risk of a systemic crises is rising.  Call it the intersection between fancy financial engineering, greed and underestimated "tail risk."

One of the appeals of synthetic CDOs is that they provide a way to juice up returns in a low-yielding world.  Mark Whitehouse:

Because synthetic CDOs don't contain any actual bonds, banks can create them without going to the trouble of purchasing bonds.  And the more synthetic CDOs they create, the more money the banks earn by selling and trading them.  Synthetic CDOs have made the world of corporate credit very sexy - a place of high risk but of high potential return with little money tied up. ... Someone who invests in synthetic CDOs riskiest slice - agreeing to protect the pool against its first $10 million of default losses - might receive an immediate payment of $5 million upfront, plus $500,000 a year, for taking the risk.  He would get this $5 million without investing a dime, just for his pledge to pay in case of default, much like what an insurance company does.

That kind of high-risk/ high return bet may appeal to hedge funds just starting up who need to generate impressive returns fast.  David Himann of Ares: "if you're a new hedge fund starting up, selling protection on the [riskiest] tranche and getting a huge payment upfront is certainly something that would attract your attention."  It also strikes me as the kind of bet that would appeal to a fund gambling for redemption.   The risk managers at the big broker dealers better beware.

It overlaps with a concern Rajan raised - and Lo raised as well. Selling protection against bad outcomes is an easy way to generate stable returns in most states of the world.  But as Rajan notes, it adds to the system's exposure to really bad outcomes.

Taken together, these trends suggest that even though there are far more participants who are able to absorb risk today, the financial risks that are being created by the system are indeed greater. And even though there should theoretically be a diversity of opinion and actions by market participants, and a greater capacity to absorb risk, competition and compensation may induce more correlation in behavior than is desirable. While it is hard to be categorical about anything as complex as the modern financial system, it's possible that these developments are creating more financial-sector induced procyclicality than in the past. They may also create a greater (albeit still small) probability of a catastrophic meltdown.

Unfortunately, we won't know whether these are, in fact, serious worries until the system has been tested. It is true the volatility of growth in industrial countries has been falling, partly as a result of the increasing flexibility of real economies, partly as a result of better policies, partly as a result of increased trade, and partly as a result of better financial markets. But the nature of tail risks, especially those related to credit, is such that we should not be lulled into complacency by a long period of calm. The absence of volatility does not imply the absence of risk, especially when the risk is tail risk.

One potential risk: Leveraged players may have sold protection against really bad outcomes.  Of course, in some really bad states of the world, they just won't pay up, leaving someone else with the risk.  Think Russian banks selling protection v. the risk of a big fall in the ruble - even though there was no way that they could honor those contracts with out help from the Russian central bank.  And that help was least likely in the context where falling central bank reserves led Russia to let the exchange rate float ...  Hedge funds who thought they had a hedge against a falling ruble discovered that they did not.

Another source of risk: the big commercial banks themselves.  According to Rajan, they have become big seller of protection against bad outcomes (emphasis added). 

As traditional risks such as mortgages or loans can be moved off bank balance sheets into the balance sheets of investment managers, banks have an incentive to originate more of these risks. Thus they will tend to feed rather than restrain the appetite for risk. As I argued earlier, however, banks cannot sell all risk. In fact, they often have to bear the most complicated and volatile portion of the risks they originate, so even though some risk has been moved off their balance sheets, they are being reloaded with fresh, more complicated, risks. The data support this assessment-despite a deepening of financial markets, banks in industrial countries may not be any safer than in the past. 

Call the commercial banks too big to fail or too complex to unwind.  Call it a potential problem.

Lots of folks have sold protection of various kinds, though no one seems to have sold as much as JP Morgan.  There are now $2 trillion in synthetic CDOs outstanding.  By comparison, the outstanding stock of US corporate bonds is around $4.9 trillion.  

Another risk: events may not validate the assumptions that went into pricing these synthetic CDOs, or, more precisely, the assumptions used to hedge the risks the banks and hedge funds think they are taking on. 

Remember GM and Ford.  Whitehouse again:

Consider the trade that tripped up some hedge funds during May's turmoil in GM securities.  It involved selling insurance on the riskiest slice of a synthetic CDO and looking to the model for a way to hedge the danger that the default risk would increase.  Using the model, investors calculated that they could offset the danger by buying a double dose of insurance on a more conservative slice.  ... It looked like a great deal .... But the model's hedge assumed only one possible future: one in which the prices of all the credit default swaps in the synthetic CDO moved in sync.  They didn't.  On May 5, while the outlook for most bond issuers stayed about the same, two got slammed: GM and Form Motor Co .... The simultaneous investment in the conservative slice proved an inadequate hedge.  Because only GM and Ford saw their default risk soar, not the rest of the bond world, the pricing of the more conservative slices of the pool did not rise nearly as much as the riskiest slice.  So there wasn't much of an offsetting profit to be made there by reselling that insurance. 

A shock that hit GM and Ford but not other bonds was not all that hard to envision --- model or no model.  A bit of common sense could tell you both are exposed to what might be called "We only make money on SUVs and have more retirees than workers risk."   Both GM and Ford had more exposure to an oil demand shock that pushed up gas prices and thus reduced demand for their most (only?) profitable product than the rest of the market.

Some have been reassured by the system's resilience in the face of the GM/ Ford shock - credit spreads have come back down.  But the fact that such an obvious shock tripped up so many adds to my sense of concern. 

The pricing of credit derivatives seems to assume that the current "credit curves" of various corporate bonds can provide a decent gauge of the correlation between different types of credit risk in the future.  But data from a period where the US consumer has been king, and the US trade deficit has tended to widen over time may not offer the best guide to corporate credit risk in a world where the US trade deficit trends down over time, and the US consumer starts acting like the German consumer.

That brings me back full circle:  no one has any experience with the adjustment process that will ensue when the world's largest economy is also the world's largest debtor, and it alone is absorbing most of the world's spare savings.  No one has any experience with an adjustment process where one rising power - and potential superpower - is on track to be the largest creditor of the world's current superpower.   But it certainly strikes me as an environment ripe with tail risk.  The fact that such an adjustment process will take place in a financial system that some well-informed observers think is taking on ever more tail risk worries me.

Bottom line: I second Buttonwood.

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