By Robert Cookson, Paul J Davies and Sarah O'Connor
January 11 2008
SourceWhen Ned Bowers jumped ship from US bond insurance group Radian with a plan to clean up in the booming world of credit derivatives in the summer of 2006, he was riding the crest of a market wave.
Little did he or anyone else know that a year later that wave would break violently, all but destroying his Dublin-based venture - and leaving financial players worldwide uncovering huge losses in the wreckage of this corner of the debt markets.
His venture, Structured Credit Company, last month finalised a restructuring that will see its 12 trading partners receive just 5 per cent of what they are owed and so leave the banks, which include Merrill Lynch, Morgan Stanley, Bear Stearns, Deutsche Bank and HSBC, nursing losses of about $250m between them.
While this might not seem huge in the context of the billions of dollars of write-offs many such banks have made against their exposures to complex credit products, SCC's collapse raises important questions about how a company with no credit ratings and just $200m in capital was able to write default protection on $5bn worth of credit risk for the banks involved.
"There were a number of things that should have led the banks to question 'is this an appropriate counterparty?'" says Joe Gavin, head of banking at law firm LK Shields, which acted on behalf of Nomura, one of SCC's creditors. "Has it got deep pockets? If this whole thing is stress-tested, will it crumble? As in fact it did."
It also raises questions about how well counterparty risk - the danger one party to a trade cannot honour their losses - has been understood and monitored by banks and others in complex corners of the exuberant markets of recent years, including credit derivatives.
Andrea Cicione, credit strategist at BNP Paribas, says counterparty risk will be a big theme in 2008 and that losses from market players being unable to honour their derivatives contracts could exceed $150bn.
"We know that in times of distress things typically get much worse than one would rationally anticipate - markets take advantage of forced sellers, banks tighten their lending standards, credit availability evaporates, and so on," he says. "Even under quite conservative assumptions losses suffered by protection buyers due to counterparty risk easily could exceed $60bn."
SCC can be seen as an extreme example of the loosening of practices that came to prevail in the booming $45,000bn world of credit derivatives and other areas of the structured debt markets.
It was designed to be similar to the handful of ventures known as Credit Derivative Product Companies. These exist to be end-of-the-line insurers of credit risk in the derivatives markets. But whereas CDPCs, such as Primus and Athilon, spend years building up their systems and capital bases to win the safest AAA credit ratings, SCC began writing credit protection far more quickly - and without the lower AA-rating it intended to apply for, but never actually achieved.
Andrew Reid, one of the former Radian team who helped found SCC, in 2006 told Euroweek, a trade magazine, that the company's size and low rating target would be no handicap, since "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". However, the quid pro quo in its business model was that the company - unlike similar bearers of credit risk - would have to post collateral against changes in the market value of the protection it had written.
When the credit crunch hit last summer and the market for credit default swaps saw risk premiums or spreads surge, the company found itself unable to afford its counterparties' collateral demands.
Court documents from Nomura's attempts to liquidate the company and SCC's successful response to secure a Chapter 11-style restructuring show that between the end of June and August 16 last year, collateral demands rose from $55m to $438m. SCC managed to put up $175m worth before running out of funds and sparking Nomura's High Court petition to have the firm liquidated.
The ravages wrought by mark-to-market accounting are visible in the tens of billions of losses among investment banks, the collapse of the structured investment vehicle industry and in the ever-more precarious position of the bond insurers.
And yet, credit losses from actual defaults outside of the US subprime mortgage market remain minimal. SCC told the High Court that expected losses over the life of its contracts would be a fraction of the collateral it had to post.
It is a position managers of SIVs in particular would sympathise with. As Satyajit Das, derivatives industry expert, says: "The 2007 credit crash paradoxically may be the first where nobody actually defaults."
SCC will now struggle on under the care of two of its original investors, a US private equity firm called Aquiline and the French investment bank Calyon, which has suffered painful and embarrassing derivatives losses elsewhere and sacked the heads of its structured credit operations. None would comment on the company's future.
The lesson is that as the disruption in credit markets continues and the prospects of a slowing economy and rising defaults increases, banks would do well to triple-check the financial strength of all their counterparties.
As Mr Cicione says, the way market players generally have dealt with each other in the credit markets is "kind of reckless - but that's what's been going on for more or less the last five years".
Copyright The Financial Times Limited 2008