This week look at a short but very important piece by Bill Gross. He has my same concern about credit default swaps, but he puts a number to it. He thinks the cost to the world economic system could be in the $250 billion dollar range. Add that to the $250 billion in losses due to the subprime markets, and you are starting to talk real money. The Shadow Banking System is at the center of the problem. I trust you will find this of interest.
Bill Gross was just named Fixed Income Manager of the Year by Morningstar. He sits on the largest pile of bonds in the world at PIMCO and is their Managing Director.
But before we get to Gross's piece, let's look at these few paragraphs which set the scene for the problem in the CDS market from good friend Michael Lewitt of HCM:
"This brings us to the second and, in our view, greater concern raised by Mr. Seides, which is the financial strength (or weakness) of counterparties and their ability to post additional collateral when their positions move against them. This is undoubtedly going to be a growing concern as mortgage and other credit losses swell in 2008. The dirty little secret in the leveraged finance market is that many participants, including many CDS counterparties, are "weak hands." A "weak hand" is an investor whose capital base is subject to erosion due to losses or investor redemptions, such as a hedge fund. "Weak hands" are usually significant employers of leverage as well.
"It is a widely acknowledged fact that many of the participants in the CDS market are hedge funds whose capital is subject to the whims of performance-chasing investors. As the disappointing performance of some previous top performing hedge funds demonstrated last year, investment banks and other financial institutions that are counting on these counterparties to fulfill their part of the bargain in CDS contracts could be left holding the bag if the current credit environment continues to deteriorate, as many of us expect.
"A case in point was the collapse of Dublin-based Structured Credit Company (SCC) in December 2007, which is seeing its 12 trading partners lose about 95 percent of what they are owed, according to the Financial Times. SCC was just a couple of years old and was one of a new brand of Credit Derivative Product Companies (observation: these companies should use a "skull and crossbones" as their corporate logo). It had no credit rating (although HCM would not have been surprised to see it obtain one since the rating agencies were handing out ratings left and right during this period) and $200 million of capital on top of which it wrote $5 billion of credit default swaps. We will save our readers from doing the math ? that is 25-to-1 leverage (significantly less than many Structured Investment Vehicles, just to place this insanity in some kind of context). Low and behold, when the credit markets collapsed last summer and SCC was required to post additional collateral on its trades, there was ? to quote Gertrude Stein ? "no there there."
"Court documents show that collateral demands rose from $55 million to $438 million, but SCC ran out of funds after managing to post $175 million, and the game was up. Was such an outcome unforeseeable? Only for someone completely ignorant of the last 500 years of economic history, HCM supposes. SCC boasted, of course, that "we have stress-tested our capital to the ?nth' degree and believe that the platform we have is the most flexible and comprehensive you could have." Right. HCM would respectfully suggest that the only ones more misinformed than SCC itself were those who were lured into taking the other side of their trades and are now nursing $250 million of losses (and frankly it's shocking that the losses aren't much larger). Of course, these firms included some of the largest financial institutions in the world, so once again HCM finds itself scratching its head in amazement at the madness of crowds."
25 to 1 leverage and stress testing do not belong in the same sentence or marketing pitch. This type of ending for various funds is going to become all too common.
John Mauldin, Editor
Outside the Box
My college experience dates so far back that it can only be labeled "ancient history." Still, there are a few seminal lessons I learned at Duke University?unfortunately none of them having much to do with the classroom. "Ticket Scalping 101" and "Beginning Blackjack" probably head the list, but not far behind would be "Introduction to Pyramid Schemes." While the first two courses may be rather…