Part 5B. What Happens If Things Go Really Badly? More Things Can Go Badly: Credit Default Swaps, Interest Swaps and Options, Foreign Exchange

"...In our Really Bad scenario, there isn’t enough collateral to cover the gross market values. If collateral was required on all positions of all traders and the market values reached 3x their 2008 values, gross market value would be about $100 trillion dollars. That would exceed all sovereign debt, all corporate debt and all outstanding equities. However, even in a dysfunctional market, there is a lot of netting.

There might not be enough collateral even if netting. In recent years, the ratio of “gross credit exposure” to “gross market value” has been about 14-22% (BIS data). Let’s say that there is a need for a maximum of $20 trillion of collateral given the net positions. While there is probably enough collateral worldwide to cover $20 trillion, it would undoubtedly move market prices for acceptable assets. It would also be difficult to buy or borrow that much in a short time period.

It’s not just collateral. During a crisis, huge amounts of money would be changing hands. Many interest rate and FX contracts would have their scheduled payments.

An estimate of OTC losses.

While this is not a market value estimate like Part 5A, in the Really Bad scenario, defaulted sovereigns, banks, and other counterparties might find themselves unable to make a substantial part of their payments, or provide collateral. The IMF has discussed “the systemic risk associated with cascading counterparty failures” in Making Over-the-Counter Derivatives Safer.

Despite some large efforts by academics, governments, and others to estimate stress case losses, there are a myriad of modeling issues and choices. For the Really Bad scenario, I use a similar assumption to the losses on sovereign bonds. 45% of the counterparties have problems providing collateral or making their derivative payments as due. Losses to their counterparties are 50-69% of what is owed. That results in another $4.5 to $9.0 trillion of losses on interest rates and FX, and $0.5 to 1.0 trillion on CDS. So far, we’re at $12.5 to 20.5 trillion of losses in the Really Bad scenario..."