Wednesday, May 13, 2009

Convergence of Geithner, Credit Derivatives, Private Equity and Systemic Risk

An odd convergence of stories occurred today. The headlines include:

1. Treasury Chief Tim Geithner acted on OTC derivatives, which includes credit default swaps. He said they should not cause systemic risk.

2. Private equity underwriters claimed they are not a systemic risk. They offered a study backing up their assertion.

3. Bankrupt General Growth Properties (GGP), a REIT specializing in shopping malls, settled their secured loan value and resulting credit default swap obligations. Secured loans and CDS's split roughly 50/50.

How does this combine for systemic risk? Let me count the ways:

Holders of credit coverage--Debt holders with credit coverage may hold out for bankruptcy, a process that makes them whole. Naked credit default swap holders can impact public confidence in a firm by shorting the company. CDS's can encourage a firm's implosion, rather than stem it.

Suppliers of credit coverage--Due to the unregulated nature of CDS's, firms may have sold credit coverage and not set aside adequate capital in the event of bankruptcy. The CDS writer could go bankrupt, like Syncora Guarantee. This could trigger other credit bets.

Ailing firm unable to refinance debt--GGP needed to refinance billions in debt in 2009. No lending institution stepped up to fill the gaping hole. The REIT declared bankruptcy, triggering CDS's. Their secured loans settled for 50 cents on the dollar. CDS writers must make up the other 50 cents of each dollar. What other firms have bloated asset values on their balance sheet and an immediate need for financing?

The Carlyle Group has major real estate holdings worldwide. It has billions invested via multiple funds. In many deals the firm used significant leverage to drive returns. What happens if they used shorter term debt to finance the deal? Refinancing could trigger default like GGP.

Let's assume Carlyle used longer term debt instruments. As asset values fall, the PEU has to pony up more capital to meet borrowing requirements. The Carlyle Group issued capital calls to pension funds and endowments last fall. What happens when investors say no? It gets worse if investors want to redeem their investment. Then the firm faces a PEU run. Systemic risk.

How can they reduce it? Carlyle can have their distressed debt fund buy CDS coverage on affiliates approaching bankruptcy. While the Carlyle affiliate works to cram down debt holders, a sister fund purchases credit coverage. They don't have to hold the underlying debt. Carlyle can win no matter what. Debt holders cram down, Carlyle wins. Debt holders force bankruptcy, Carlyle's naked CDS's turn to cash.

Tim's announcement provides few mechanisms to reign in any of the above. It will impose record keeping and reporting requirements. Systemic risk remains. The one way for a PEU to reduce it is blatantly unethical.