Shrink wrapped

‘The industrial production series reveals that a recession began in the United States during 1929. By late 1930, the downturn, although serious, was still comparable in magnitude to the recession of 1920-1922. As the decline slowed, it would have been reasonable to expect a brisk recovery, just as in 1922.

With the first banking crisis, however, there came what Friedman and Schwartz called a ‘change in the character of the contraction’. The economy first flattened out, then went into a new tailspin, just as the banks began to fail again in June 1931’.
Ben Bernanke – Essays on the Great Depression

It’s probably history’s greatest example of the fact that two shocks are more than twice as bad as one.

A couple of posts ago, I highlighted my view that we are now faced with five major shocks (see A Bout de Soufflé). I now think we have a sixth shock coming. It’s something Gerard Minack of Morgan Stanley has been talking about – counterparty risk.

A lot of people have exaggerated the monetary impact of the explosion in the global derivatives business. Much of the supposed increase in liquidity is in fact double counting. But what is critical is that it has led to a fantastic increase in counterparty risk. A bit like when you get in longer and longer chains when you’re selling your house; the chance of disruption increases exponentially.

And the biggest counterparty risk right now is the credit, or monoline, insurers.

Now, following the law of unintended consequences, when the regulators tried to reduce risk taking at insurers after the 2001/2 debacle, they effectively forced a reduction in equity exposure, and a rise in credit holdings. But this has likely set up a much greater risk than had the regulators left well alone.

What the regulators did was to insist that insurers discounted future liabilities by the risk adjusted yield on their ‘float’ (The assets they held to back future insurance and pension liabilities). If you put a big discount on your liabilities, your deficit quickly turned to surplus. It was all good.

But the regulators fiddled the risk, putting too high a premium on equities and too low a premium on credit. All in a good cause, of course.

This induced the bean counters at the insurers to hunt for stuff with a high yield and a high credit rating. That kind of product shouldn’t show up too much in an efficient market.

But where there is a will, on Wall Street, oftentimes there is a way.

Enter the monolines. These boys would offer to insure, or wrap-up, a basket of low quality credit in an insurance default wrapper. And immediately, that basket of credits takes on the monolines’ credit rating; AAA.

As if by magic, the insurers got what they wanted; a basket of high yielding credit, with an AAA rating.

This created a relentless institutional dynamic. Once one insurer did it, it gained a major competitive advantage. It reduced its reserve requirements, it cut its cost of capital, it raised its earnings, and it boosted its ratings. Its competitors felt massive pressure to follow suit, and they succumbed to that pressure. And once they were all doing it, there was an escalating motive to do it some more.

This, in turn, created a self-reinforcing bid for credit – especially low quality credit. As the bid rose, yields fell, creating the need among insurers to delve further down the quality spectrum in search of more yield.

Now, this also had a fundamental effect. As companies with poor credit ratings saw their debt being bid (and their yields falling) it reduced their cost of capital. It raised their ratings, and created an inducement to invest to build their own businesses.

Aggregated, this supported benign macro conditions, reduced default risk, it improved balance sheets and the quality of collateral and it raised earnings at financial institutions. It all helped to raise the bid, and reduce the yield on credit once again. Globally, exploding demand for credit insurance and collapsing defaults meant that earnings at the monolines went through the roof, further reinforcing their AAA ratings, and the confidence in their business models.

It is perhaps telling that Bernanke, in his essays on the Great Depression, focuses on the role of assets as collateral for loans. In a boom, it makes lending cheaper and easier, as rising asset prices mean that banks can lend with limited information on the borrower. This is because the rising collateral value is a big incentive not to default, and ample payment to the banks in the case of default. Falling asset prices can freeze the credit markets, because the banks would rather not lend than root out genuinely strong businesses to lend to. In a sense, the ‘information asymmetry’ between borrowers and lenders makes it real hard to lend when assets are depreciating.

So then came the subprime crisis, the disruption in the wholesale banking model and the lurch away from a zero default world.

Last week saw S&P downgrade the monolines from AAA to AA. It followed Fitch, the smaller of the three major ratings agencies. Moody’s will likely follow soon.

And so we will see further significant credit unwinding. In my view, it will end with a bust at the monoline insurers, and major capital raisings at the world’s insurers.

Because, as monolines go to AA, the wrapper round the insurance companies’ credit shrinks to AA. Their deficits rise, their cost of capital jumps, their earnings and ratings drop. There is a lot of pressure to move back up the quality scale. But every step they take, they diminish their own strength – as they raise their deficits and weaken their balance sheets.

So credit spreads widen, the cost of capital at low grade corporates rises, and they tend to invest less in their own businesses. And in aggregate, this weakness turns the macro environment sour – raising defaults. That causes a fundamental deterioration in the balance sheet and earnings prospects of the monolines.

My view; the cut to AA is the first of many. And AA is way too high for businesses with bust business models. Now the ratings agencies have taken the first, most difficult, step, they will find it easier to keep cutting the ratings on the monolines. Ambac and MBIA lost 24% and 21% respectively on the S&P news.

The insurers now have to work out what to do with multi-billions of credit that will lose its insurance wrapper. Just when all credit faces a major increase in defaults from the credit crunch, the global downturn and the widespread resource shortages.

And, as we have now come to expect, the insurers’ risk models are simply not equipped for this. Because, between them, they own the market, they are all way too long, and they will be selling all at the same time.

This is likely to blow a hole in a bunch of insurers’ balance sheets. My bet is that we see capital raising by Christmas.