Guest Post: Lehman Anchoring Belies Systemic Risk
Submitted By Credit Derivatives Research
Counterparty risk is considerably below its peak levels surrounding the September 2008 systemic crisis anxiety. However, while the CDR Counterparty Risk Index (CRI) is trading back to July 2008 levels (post Bear Stearns), cognitive biases to anchor on the worst case are misleading as the largest 14 OTC derivative counterparties remain 5-10 times more risky than early 2007.
The improvement in credit risk perceptions among these most systemically critical financial institutions has been driven by many factors, not the least of which is an availability cascade as implicit Fed/Treasury support combined with CEO/analyst/press comments dragged us from the edge we teetered on again in early March 2009. It is interesting to note that the CRI is trading 40bps (26% less risky) below the 9/12/08 levels, still above recent tight levels as the average equity price of the CRI components is down over 21% over the same period. This seems appropriate in terms of the TLGP/TARP/ZIRP support for the capital structure (senior unsecured outperforming equity). The drop in credit risk for the major CDS dealers has also been driven by counterparties lifting protection measures as centralized clearing and regulatory pressure to margin more effectively appear closer by the day.
Only two (Citigroup and Dresdner Bank) of the CRI members are wider than pre-Lehman levels with Royal Bank of Scotland, Bank of America, and Credit Suisse all practically unchanged since then. US banks (and brokers) outperformed European banks in credit but underperformed in equity as JPMorgan, Merrill Lynch, Morgan Stanley, and Goldman Sachs were the best performing credits of the CRI over the last year.
Dispersion, the range of spreads among the members of the CRI, has been cut in half over the past year indicating much more systemic than idiosyncratic discrimination among these institutions as Europe's spread volatility has been far lower than in the US banks. This relative difference in risk compression and volatility is opposed by the changes in EUR and USA sovereign risk levels.
The systemic risk transfer from corporate/financial balance sheets, as well as currency volatility, has played out aggressively in the sovereign protection markets with the CDR Government Risk Index (GRI) only back to October 2008 levels and 20-25 times higher than the late Great Moderation levels of early 2007. While financial institution risk (as measured by the CRI) is about even with July 2008 levels, major sovereign risk (as measured by the GRI) is almost three-times its July 2008 levels and coupled with the massive derisking seen in the DTCC data for sovereigns, it is apparent that systemic risk remains elevated but has been transferred (rightly or wrongly) to (arguably) the most creditworthy balance sheets. As governments begin to unwind emergency relief measures such as TLGP/QE/POMO, we wonder where systemic risk will appear next and will be looking at credit term structures for signs of weakness, and discount the government-intermediated short-term financing spreads.