'Worst-case' systemic risk anchors misleading, says CDR

Credit Derivatives Research has reported that while its Counterparty Risk Index (CRI) is trading back to July 2008 levels (post Bear Stearns), cognitive biases to anchor on the worst case (last September, post Lehman bankruptcy) are misleading as the largest 14 OTC derivative counterparties remain 5-10 times more risky than early 2007.

The CRI is trading 40bp (26% less risky) below 12 September 2008 levels, still above recent tight levels as the average equity price of the CRI components is down over 21% over the same period. CDR says 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 centralised clearing and regulatory pressure to margin more effectively appear closer by the day.

Only two (Citi 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 European and US 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 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 to the most creditworthy balance sheets.

As governments begin to unwind emergency relief measures such as TLGP/QE/POMO, CDR questions where systemic risk will appear next.