Goldman Sachs reported yesterday that it has sold $142 billion of single-name swaps relating to Greece, Ireland, Italy, Portugal and Spain. Goldman has also purchased $147 billion of (presumably off-setting) contracts on the debt of those companies.
Overall market confidence that the U.S. can somehow navigate through a European financial crisis without significant ill-effects continues to strike me as an almost delusional strain of optimism. Counter-party risk in CDS transactions cannot be ignored, and while many U.S. banks (such as Goldman Sachs) have maintained that the key metric is their net exposure, a prudent consideration of all the risks involved suggests that this is not the case.
Any guesses as to where the counter-parties for some of these off-setting CDS contracts might be located? According to a post by Lisa Pollack of FT Alphaville, a disturbing number of protection sellers are countries based in the country for which they are selling protection. The logic of CDS as a risk management tool breaks down with so little attention paid to the economic exposure of counter-parties to the very events they are selling protection against.
A 2009 working paper by the European Central Bank (“Credit Default Swaps and Counter-Party Risk”) made this key point when discussing counter-party risk:
CDS contracts are commonly regarded as a zero-sum game within the financial system, as there is always a buyer for each seller of CDS contracts, as with all other OTC derivative contracts. The financial turmoil has shown, however, that both buyers and sellers of CDSs may suffer losses if counterparty risks material ise.
Indeed, with CDSs, both parties are exposed to credit risk derived from the counterparty (or “counterparty risk”), which reflects the potential for the counterparty to fail to meet its payment obligations. In other words, counterparty risk reflects the risk of being forced to replace positions in the market, were a counterparty to default.
We have lived through the peak of financial engineering and risk transfer. Sadly, many of the most powerful financial players in the market would like to keep the music going. I suspect that over the coming years we will see the market inflict a series of painful lessons on those who continue to maintain that liquidity triumphs over all, and that risk of a negative credit event can be hedged via a party with direct exposure to that event.
About the author:
David Johnson is a partner with ACM Partners, a boutique financial advisory firm providing due diligence, performance improvement, restructuring and turnaround services to companies and municipalities. He can be reached at 312-505-7238 or at [email protected].
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