by (Originally published 4 March 2009)
Over at Angry Bear, there is a quote that relates to an issue that I find interesting, and where I added the comment that follows.
[Robert Haines, senior insurance analyst at CreditSights] said. “The counterparties on most of the book are (European) banks that would be hammered if the U.S. walked away.”
I’ve seen comments like this a few times now — often attached to complaints about bailing out foreign banks — and there is something about this particular meme that I don’t quite follow. Of course, I’m no economist, so it may be just my own ignorance, and I would very much like to hear an explanation of how my own understanding is faulty.
As I understand it, the issue with AIG is the large number of (unbalanced?) CDSs written by AIG,and the potential danger to AIGs counterparties should those CDSs be erased (via, e.g.: the collapse of AIG).
So, assume that the counterparties to a large number of those CDSs are indeed foreign banks. How do those banks “be hammered” if AIG fails?
If I understand things correctly, a CDS is not a normal asset. Rather, a CDS is, as I have read many times, something like insurance on an asset. An example might be buying some CDO, and then buying a CDS against the potential default or loss of value of that CDO. And a CDS, like an insurance policy, will have some sort of “trigger”; that is, in the case of some event occurring, the seller of the CDS must pay off, while if that event does not occur, the seller does not pay. So, a CDS is not an asset (or at least not a normal asset); rather, it is a hedge used to make other assets less risky than they would otherwise be.
So, if I am a bank, I need to have some percentage of my assets must be low risk (leaving the details of ‘some percentage’ and ‘low risk’ aside for the moment). If I want to increase my yield, I can use CDSs to do so, by buying higher-yielding (but riskier) assets and using CDSs to offset the risk and therefore have those assets fall into the ‘low risk’ category.
This is the way I understand this issue, at least, though I may be horribly mistaken. If I am not, though, then I see a problem with the meme quoted above, in that it is at least overly simplistic.
My reasoning here is based on the nature of CDSs, as “insurance-like” entities. Because a CDS is a hedge on an asset, rather than itself being an asset, a failure of a counterparty doesn’t (necessarily) mean that someone is “hammered”.
The one time that I took out an auto loan, I was required to carry comprehensive insurance on the car until the loan was paid off (presumably for the lender to hedge against the risk of the auto being lost or damaged). Had my insurer failed, neither I nor the bank would have been greatly harmed. Yes, I would have lost the money I paid the insurer, but the bank would then either require that I purchase new insurance or call in the loan. Because the insurance was the hedge and not the asset itself, failure of the insurer causes no immediate harm. There is potential harm only if the insurer fails at or about the same time as the auto is damaged or stolen.
If I understand things, then something similar is true in the case of banks and CDSs. If AIG fails, its CDSs are no longer valid, but the counterparties (at least the banks using the CDSs as hedges) are not (necessarily) greatly harmed. They do have a problem, of course, because they have assets that are now riskier than required. But this means that they must either find some other way to hedge that risk, or sell the ‘too risky’ assets and buy ‘sufficiently safe’ assets instead. There will be a cost to this, of course, either the cost of some additional hedge or the loss of the additional yield on the riskier assets, but this would not qualify as being “hammered”, at least in any normalsituation.
Plainly, we are not now in a “normal situation”, so that qualifier does not apply. Thus, it is possible that banks who are counterparties to AIG CDSs could suffer significant harm should AIG fail. But it seems relevant to be clear about how they would suffer that harm. Presumably, that harm would be suffered because the banks would be forced to sell their ‘too risky’ assets into a depressed market, therefore realizing some significant losses. But it is unlikely that the foreign banks would be the only losers in such a case, as the resulting collapsing prices of what they sold — perhaps such things as US CDOs or other securities — would almost certainly have an effect on other institutions, and quite possibly the US economy as a whole.
All of which means, if my understanding of these matters is correct, that — even if “[t]he counterparties on most of the book are (European) banks”, it does not follow that preventing the collapse of AIG is just bailing out foreign banks.
All that said, I emphasize that I am hardly an expert in such matters, and would welcome additional explanations or corrections.
