Sad Proof of Europe’s Fallout

That old line from the Marx Brothers came to mind last week as MF Global, the brokerage firm run by Jon S. Corzine, was felled by over-the-top leverage and bad derivative bets on debt-weakened European countries.

Suddenly, all of those claims that American financial institutions have little to no exposure to Europe rang hollow.

You can understand why Wall Street wants to play down the threats from Europe. Its profits depend on the market’s confidence in the products it sells — and on the belief that the firms that sell those products will be around tomorrow.

But MF Global provides two lessons. The first is that our financial institutions are not impervious to Euro-shocks. The second is that when those problems reach our shores, they usually ride in on a wave of derivatives.

“The problems that we’ve had since the inception of the credit derivatives market have never been solved in any meaningful way,” said Janet Tavakoli, president of Tavakoli Structured Finance and an authority on these instruments. “How many times do we want to live through this?”

MF Global’s debacle was a result of complex swaps deals it had struck with trading partners. While those partners owned the underlying assets — in this case, government debt — MF Global held the risk relating to both market price and default.

These arrangements at MF Global underscore two big problems in the credit derivatives market: risks that can be hidden from view, and risks that are not backed by adequate postings of collateral.

These are the same market flaws that helped hide the problems at the American International Group — problems that arose from insurance that A.I.G. had foolishly written on crummy mortgage securities.

Same old, same old...Back in the day on Wall ST, "Portfolio insurance" was the rage. Until it failed to work. All these types of derivatives that purport to hedge, or eliminate risk, are worthless..because when the SHTF, the underlying $$$ isn't there. It's been estimated, deppending on the type of financial instrument involved, that the values of the derivatives can be 100-500x MORE than the value of the underlying investment. So it becomes a question of is the tail actually wagging the dog.

For those who may not understand, let me provide a simple example. Assume a company, ABC, with 100 million shares outstanding, now trading at $20/share. Thus the company has a current market value of $ 2 billion.

However, the value of deriviatives ( called thus because the "derive" their identidy, and value from the underlying entity) such as puts, call, and options, and futures, could be $20 billion, or $100 billion. ( And there are many more exotic derivatives which are also pegged to the underlying stock price.)

In theory, these derivatives are backed by the financial resources of the parties involved, and the exchanges that make sure that those parties do indeed have the requisite capital. EXCEPT WHEN THEY DON'T.

And if the market moves dramatically, well, it's katie bar the door..

From Zero Hedge:

“Olive Oil Crisis” – G-20 Wants Germany to Contribute Gold to the Crisis Fund – Germany Says “Nein!” – ECB Threatens Italy About Lack of Austerity

http://confoundedinterest.wordpress.com/

Good comment.

For those who don’t know what “portfolio insurance” is, http://www.khanacademy.org/video/put-as-insurance?playlist=Finance . The loser in the article was on the other side of the put. He didn’t buy the bonds. He didn’t short the bonds. He shorted the short on the bonds.

This is why BofA dumped one of it’s subsidiaries, laden with derivatives, onto another subsidiary that was FDIC-insured. When the balloon pops - again - look in the mirror to see who pays for that little gem.

BTW, the FDIC folks were dead set against this but the Fed intervened and said it was OK. Hmmmn (NOT!)

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.