Credit Derivatives May Lose $250 Billion, Gross Says
(THIS IS THE NEXT SHOE TO DROP. Kipp)
By Caroline Salas
Jan. 8 (Bloomberg) -- Credit-default swaps, used to help protect against the risk a company won't pay its debt, may cause losses of $250 billion this year, helping send the U.S. economy into a recession as corporate defaults rise, Pacific Investment Management Co.'s Bill Gross said.
``Credit-default swaps are perhaps the most egregious offenders'' in today's banking system, Gross wrote on the company's Web site today. ``Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.''
The Federal Reserve will probably cut its benchmark interest rate to 3 percent by mid-year from 4.25 percent as losses on credit-default swaps contribute to a slowing U.S. economy, wrote Gross, who manages the world's largest bond fund. The market for outstanding credit-default swap contracts grew to $45.5 trillion during the first half of last year from $632 billion at the end of June 2001, according to the International Swaps and Derivatives Association, an industry group.
Goldman Sachs Group Inc. ``estimates that mortgage related losses of $200-$400 billion alone might lead to a pullback of $2 trillion of aggregate lending,'' Gross said. ``Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.''
`Goldman Sachs Wins'
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.
Assuming default rates on corporate bonds reach historical averages of about 1.25 percent, $500 billion of credit-default swap contracts will be triggered, causing losses of $250 billion to sellers of the derivatives after accounting for the recovery value of the securities, Gross said.
``Of course, `buyers of protection' will be on the other `winning' side, but the point is that as capital gains and capital losses slosh from one side of the shadow system's boat to the other, casualties and shipwrecks are the inevitable consequence,'' Gross said. ``Goldman Sachs wins? Fine, but the losers in many cases will not be back for a return match.''
`Held Up Well'
Gross was named fixed-income manager of the year in 2007 by Chicago-based Morningstar Inc. The $112.7 billion Pimco Total Return fund returned 9.07 percent last year, in the 94th percentile, Bloomberg data show.
``Mr. Gross is correct that the market for CDS is large,'' ISDA Chief Executive Officer Robert Pickel said in a statement. ``While adverse price movement undoubtedly pushes bids and offers further apart, as it does in any market, liquidity in, and the mechanics of, the CDS market have held up well in the face of a challenging credit environment.''
The global default rate on high-yield, high-risk bonds will climb more than fivefold by the end of this year to 4.8 percent as the economy weakens, Moody's Investors Service forecast today. High-yield, or junk, bonds are those rated below Baa3 by Moody's and BBB- by Standard & Poor's.
`Shadow Banking'
``The withdrawal of deposits from our new-age shadow banking system has frightening potential consequences,'' Gross said. ``Pyramid schemes and chain letters collapse because there is no more credit to feed them. As the system of modern day levered shadow finance slows to a crawl, or even contracts at the edges, its ability to systematically fertilize economic growth must be called into question.''
Gross has expressed concern in his last four monthly outlooks about the ``shadow banking system,'' which was created by ``the loose regulation and financial innovation of the past 35 years'' and ``where credit is composed on a keyboard as opposed to a printing press,'' he said in his November piece.
Pimco currently has a ``credit-lite'' position and is interested in buying bonds of banks and investment banks that are rated AA or A, and yield about 200 basis points more than similar-maturity Treasuries, Gross wrote in an e-mailed response to questions.
Defaults to Rise
Our position ``assumes that as the year progresses that we re-enter `high-quality corporate markets' at increasingly wider spreads,'' Gross said in the e-mail. ``We will wait to enter lower investment-grade/high-yield markets until recessionary conditions/higher defaults begin to become obvious. We estimate that will be in the second half of the year.''
The extra yield, or spread, investors demand to own the average investment-grade corporate bond instead of Treasuries has more than doubled since 2006 to 211 basis points, according to Merrill Lynch & Co. index data. High-yield spreads have also more than doubled in the same period to 645 basis points, Merrill data show. A basis point is 0.01 percentage point.
U.S. construction companies are ``certainly in danger to a high extent'' as are companies with exposure to the U.S. consumer, Axel Potthof, investment manager at Pimco in Munich, said in an interview today.
