the next crisis could come from CDS(Mauldin)

Chichilnisky created the term and theory of "Endogenous Uncertainty" about 12 years ago. It is the uncertainty coming from risks that we ourselves create - rather than risks coming from exogenous or outside events (the standard theory of risk management only considers risks that are outside events on which we have no participation in creating). It has to do with risks that we humans ourselves create through our actions, rather than coming from nature. The more the economy is globalized, the larger is human impact globally - the more frequently we will encounter such risks. Now, let's turn to the paper. (I should note that Chichilnisky was one of the creators of the carbon credit markets and is quite involved in the next phase of the Kyoto protocols. This is one very bright lady, with two doctorates in both Mathematics and Economics.)

First, the paper demonstrates that the greater the number of connections within any given economic network, the greater the system is at risk. This is counter-intuitive, but a simplified illustration may help.

Let say I own a $10 million corporate bond from Big Automotive Company (BAC) in my portfolio paying 7%. I can go into the market and purchase a credit default swap (CDS) for (say) 2% of the face value of the bonds from a large investment bank (LIB). Now I am getting a net return of 5%, but my risk is greatly reduced. LIB has insured my risk. Now LIB has a liability of $10,000,000 on its books, which of course reduces its capital. So LIB, clever folks that they are, buy another CDS from someone else on the same bonds for 1%, and thus their books are even. They own both a put and a call on $10 million in BAC bonds, so they take no hit to their capital structure. However, they do make a neat $100,000 (the difference in the buy and sell price) for making a market in BAC credit insurance.

Now, there are hundreds of investment banks and hedge funds making markets in all sorts of credit markets, buying and selling these derivatives to thousands of various investors and funds. It is quite possible that the CDS I bought has been re-shuffled a few times, so that we could have five or ten times the face amount of my bonds in the actual derivatives. I have seen reports that the total amount of CDs written on General Motors bonds are ten time the actual number of bonds.

Why would this be? If a hedge fund or investment bank thinks that default insurance on General Motors is too expensive relative to the risk, they can sell the CDS and hope to make a profit when the cost of insurance goes down. This provides liquidity to the market, but also creates a lot of connections among unrelated parties. By that I mean that I am exposed to the default risk of all the counter-parties of the firm who sold me the original insurance.

How? you might ask. Because if one of LIBs creditors defaults, then that reduces the capital of LIB. Let's say that the $10 billion of total debt in that Big Automotive Company goes bad. I call up LIB and ask for my $10 million. Not a problem, they say. We'll call the person who sold us the protection, who will call the person from whom they bought protection, until we find someone who is "naked long" BAC debt. Then they will pay up. Or we can hope they do.

But if there are several debt events that happen at once, as say generally does happen in a business downturn, there will be funds or banks that may not have enough capital. Why? Because banks and funds do not have to set aside reserve capital for potential losses and can leverage their exposure by a great deal. Technically, they are safe as the assets and liabilities on their books should match. But those assets are only as good as the counter-party who guarantees them.

Thus, we create potential fingers of instability with every new derivative we sell or buy, as we get connected to market players we have never heard of. Let's read the following paragraph from introduction to the Chichilnisky paper:

"Markets can magnify risk. As new assets [like CDS-JFM] are introduced, a creditor who is a victim of default in one transaction is unable to deliver in another, thereby causing default elsewhere. In this manner default by one individual leads, through a web of obligations, to a large number of defaults. Since new instruments create new webs of obligations, financial innovation is the precipitating factor. The transmission of default from one trader to another and from one market to another transmits individual risk and magnifies it into collective risk. Default by one individual leads to a collective risk of widespread default."

And that is what we have seen in the subprime markets. We have taken the risk of a mortgage in California and spread them literally around the world. Now one default or a thousand is no big deal. Those defaults are priced into the bonds. But when we introduce extra risk by inserting mortgages which have little economic rationale (or are outright fraud, as more evidence mounts daily of massive fraudulent activities) then we change the equation of potential systemic risk.

So far, the credit defaults are being handled by the system. That is, banks are writing off large amounts of debt, and I would expect there to be more major write-offs. Soon we will hear of insurance companies that have to take write-downs from the subprime exposure. We have seen several German banks go completely under. A money market pool of various Florida governmental entities (cities, counties, schools) will probably have to take some write-offs. The losses will be spread out and will cause some pain here and there in Florida, but it is highly unlikely that serious damage will be done to any single entity.

In fact, let me sound a note of "optimism." The ever-growing estimates of losses due to subprime may be overstated. According to a study by Goldman Sachs, the ABX indexes suggest about $400 billion in losses. But a $150 billion dollar chunk of that is from AAA rated bonds. They have been marked down an average of 18%. But in order for the AAA tranches to lose money, 50% of the mortgages in the securities would have to go into foreclosure, and those homes would have to drop 50% in value.

So, why the drop in value? Because some of the Residential Mortgage Backed Securities will more than likely face such a serious loss. Others are unlikely to see anywhere close to a 50% foreclosure rate. The problem is that investors cannot figure out which RMBS's are in trouble and which would be good bets. Until there is transparency, it is likely that prices will stay low.

As an aside, if the Bush plan to help out those who cannot make payments because of mortgage resets keeps the market from finding out the true nature of the underlying assets in these RMBS, then that is not a good thing. The devil is in the details.

My thinking is that sometime next year the credit markets start to function, and people will think that things are back to normal. New securitizations and guarantees will be found to allow the placement of debts of all types. We will never face a subprime problem again, as rules will be put in place to avoid such a crisis. The market, like an old general, is pretty good at fighting the last war.

But that does not mean that all will be well. Another conclusion of the Chichilnisky paper is that the more we create new financial instruments, the more likely it is we will have systemic problems. And since we are creating them at an ever faster pace, and tying more and more market players together, we are sowing the seeds for another Black Swan event that will crop up somewhere, leading to yet another crisis.

Does that mean we should stop the train? No, but it does mean that we should be aware of what we are doing. Let's read one last paragraph from the paper:

"The other implication of our results is that they help to formalize a 'multiplier effect' for policy. In a complex economy, financial policies which succeed in preventing default by one agent also prevent, by a chain reaction, a large number of other defaults at no additional cost. Therefore the benefits have a "multiplier effect". Our results provide support for the policy of requiring reserves to enhance financial stability."

I think the next crisis could come from the Credit Default Swaps market. Remember, this is a market which essentially has no reserves to deal with default risk other than the capital accounts of the banks and hedge funds. A worst case scenario would be for the economy to fall into a serious recession next year which would hammer high yield bonds and cause defaults in certain riskier debt, for which CDSs have been bought and sold. With banks having to write down a lot of the mortgage related debt, they would be in poor position to have to handle even greater losses.

The far more likely scenario is that we have a mild recession or slowdown, banks shore up their balance sheets and can deal with a problem in the CDS markets when it happens or with another still hidden black swan of endogenous uncertainty. It would behoove regulators or market participants to figure out how to create more of an exchange type mechanism where there was a central clearing house like the Chicago Board of Trade or NYMEX guaranteeing the CDS rather than a potentially highly leveraged systemic problem. Bank regulators should ask whether to not reserves should be held even for positions which are offset. Yes, that would eat into profits, but I think it is better than the losses which could accrue from another crisis.

But the point is that within a few years there will be yet another crisis. The research shows that the way the system is designed, by connecting ever more participants together in a vast network, practically guarantees another crisis of some kind.

So, what do you do? Pull in your cash and stick it under the mattress? Of course not. Truly diversify your portfolio, use as much hedging possibilities as you can and learn to love the volatility. Make it your friend rather than fight it. Pay more attention to markets where there is irrational behavior. It was easy to discern that there were potential problems in the subprime market a year ago. If you were reading me, you should have checked your portfolio to see if you had exposure and then eliminated it.

These things just don't "happen." We live in a world with "endogenous uncertainty and default." In the future, when you see a problem starting to develop in one part of the world, think about how those problems are connected to the rest of other world. I know I will.