Counterparty Risk

July 9, 2007 – Counterparty risk is often ignored and misunderstood. But it can only be ignored at one’s peril, particularly now that the subprime mortgage blow-up is looking more and more like a mushroom-shaped cloud.

The knock-on effect from the initial subprime defaults will I expect lead to more defaults, notwithstanding the Pollyanna’s at the Treasury and the Federal Reserve who say the problem has been “contained”. But then again, what else would you expect them to say? Don’t expect them to highlight the growing counterparty risk that the financial markets are facing.

To understand counterparty risk, it is necessary to first lay out some basic definitions. Indeed, it is first necessary to define that all-important objective we all strive for – wealth. The point is that while wealth comes in many different shapes and sizes, it can be broken down and grouped within basically two generic categories of assets – tangible assets and financial assets.

Tangible assets do not have counterparty risk. Tangible assets are not dependent upon someone’s promise. A tangible asset has a utility inherent within itself, which we value and want to use. We therefore are willing to exchange other wealth for this utility.

For example, a house has value because it provides shelter. That is its utility. And clearly, a house is a tangible asset. The shelter the house provides is not dependent upon someone’s promise, so its utility – i.e., the value of this asset – does not have any counterparty risk. But now compare this form of wealth to any financial asset.

Financial assets are fundamentally different. Their value is always dependent upon some promise. Therefore, financial assets have counterparty risk.

For example, the dollars you have on deposit in a bank are dependent upon the bank’s promise to return that money to you when you ask for it to either spend it or to transfer it to some other bank. Another example of this dependency aspect of financial assets is a government debt instrument like a Treasury bill or note, as these are dependent upon the government’s promise that it has the financial capacity to repay that debt to you when it comes due. The same risk exists with bonds issued by companies.

So when it comes to financial assets, you have to accept someone’s promise. It comes with the territory. That means financial assets always have counterparty risk, but this explanation is a little more complicated than that. There is a little recognized but pernicious form of counterparty risk of which you should be aware.

Here’s an obvious example. Let’s assume you accept a personal check in payment for some good or service that you provide, and the check bounces. You’ve just experienced payment risk.

A less obvious example is the money you have on deposit in a bank. You are accepting the risk that payment will be made to you by the bank.

There are many examples of how payment risk arises, but basically, you have payment risk when delivering an asset in exchange for a liability. In other words, if you accept anything other than a tangible asset in payment, you have payment risk.

As an aside, this reality explains the essential nature of the four US patents that have been awarded to me and now being used by my company, GoldMoney. The background information in them makes interesting reading, and they can be viewed at the following link: GoldMoney. The digital gold currency GoldMoney has created uses a tangible asset (i.e., gold) that can be exchanged online for a good or service, thereby eliminating payment risk in online commerce.

So to get back to the basic point, when you go to your bank and deposit money in it, you are giving the title of your property to the bank. Having given up your property, you then leave the bank with some evidence of its debt to you, typically a bank statement, certificate of deposit, or the like.

The bankers at your bank then can do with your money whatever they want. That means they lend it out to generate interest income, or to highlight the key point I am making, they can use it to buy subprime mortgage debt.

It is important to note that when you make a deposit, you no longer own your money; the bank owns it. You now own a piece of paper that lays out the terms and conditions explaining how and when you get your money back, all of which depend upon the bank’s promise. The bank has created a liability on its balance sheet, and this liability means that your wealth – your financial asset – is now subject to payment risk.

While on the subject, there is another type of risk. It is performance risk, and it can apply to both financial and tangible assets. For example, let’s assume you take your car to the repair shop to have some work done on it. By leaving your car at the shop you have accepted performance risk, namely, that you car will not only be returned to you, but that it will also be repaired. Stocks are an example of performance risk in financial assets because you are reliant upon the management of the company. But other than mentioning that it exists, performance risk is not important to the essential message that I am highlighting by explaining counterparty risk.

Namely, counterparty risk is growing, and there are two excellent articles in the current issue of Barron’s that explain why. They both address the growing subprime mess. Both articles confirm my expectation that subprime mortgages – those home loans made to the riskiest borrowers with questionable credit – will turn into a financial debacle.

The first article by Alan Abelson quotes Stephanie Pomboy, editor of the MacroMavens newsletter. She has calculated that a “stunning $693 billion in mortgage loans are already in the red. Assuming lenders are able to recover 70% of those assets — which seems optimistic given the massive amount of housing inventory yet to be unwound — that means mortgage lenders are already grappling with $210 billion in outright losses.” Abelson then observes: “And that, she points out, is merely the direct hit. Thanks to what she nicely dubs the “divine miracle of leverage,” the total financial exposure to these claims is many multiples of that.”

Abelson then goes on to make the important point relevant to my point about counterparty risk. He says: “What’s more, Stephanie notes, these horrendous losses are coming at a time when the financial sector is “uniquely unprepared to withstand them.” Commercial banks, she points out, have let their loan-loss provisions sink to 20-year lows while increasing their exposure to real estate to record highs. Mortgages, she reckons, account for a tidy 55% of total bank loans — and that doesn’t include the trillion dollars worth of mortgage-backed securities on bank balance sheets .So much for the myth that banks have cleverly “offloaded” their real estate risk.”

In other words, this deterioration in the quality of bank assets means we should be focusing more closely on payment risk, and indeed be taking steps to avoid it. The second article in Barron’s, which was written by Jonathan Laing and entitled “Garbage In, Carnage Out”, makes clear this point about the banking system.

“Far greater troubles await the subprime market in the next two years, when homeowners will face increases of as much as 50% in their monthly payments after their two-year teaser rates expire and convert to materially higher floating interest rates. The period will see some $800 billion in subprime loans reset, according to Deutsche Bank.

For many subprime borrowers, default will be the only viable option, as tighter lending standards slam the refinancing window shut for them. Dwindling or negative equity in homes means they won’t be able to roll into 30-year fixed mortgages, even assuming that they handle the higher monthly payments. Foreclosures are expected to surge.”

Noting candidly that the “subprime problems appear to be metastasizing“, Laing goes on to conclude: “The coming crisis in subprime CDOs is reminiscent of the S&L collapse of the early 1990s; both involved imprudent lending and will be enormously costly. The bill for the earlier fiasco totaled more than $150 billion.”

No one yet knows how big the subprime problem will become. In fact, we really don’t even know for sure how big it is at the moment because accounting sleight of hand has masked much of the problem so far. Nevertheless, given the reckless lending by the banks over the past several years that fueled the housing bubble, it seems to me that it is both safe as well as prudent to assume that the losses will be much bigger than those incurred by the banks during the S&L crisis two decades ago.

The quality of bank assets and those of other financial firms like brokers and finance companies is deteriorating. The capacity of these firms to repay their liabilities depends upon the quality of their assets, and in the case of banks, government insurance of deposits in case the liquidation of their assets erodes a bank’s equity. Those are thin reeds to rely upon in an environment where financial tensions are growing.

So the way to protect your wealth is clear. One should own tangible assets (and near-tangible assets like the equities of mining companies, oil companies and other commodity producers) in preference to financial assets. By following this strategy, you avoid counterparty risk, which will become an increasing threat to the viability of financial assets in the weeks and months ahead.