Skip to comments.Fed's rescue halted a derivatives Chernobyl
Posted on 03/23/2008 5:49:23 PM PDT by DeaconBenjamin
We may never know for sure whether the Federal Reserve's rescue of Bear Stearns averted a seizure of the $516 trillion derivatives system, the ultimate Chernobyl for global finance.
"If the Fed had not stepped in, we would have had pandemonium," said James Melcher, president of the New York hedge fund Balestra Capital.
"There was the risk of a total meltdown at the beginning of last week. I don't think most people have any idea how bad this chain could have been, and I am still not sure the Fed can maintain the solvency of the US banking system."
All through early March the frontline players had watched in horror as Bear Stearns came under assault and then shrivelled into nothing as its $17bn reserve cushion vanished.
Melcher was already prepared - true to form for a man who made a fabulous return last year betting on the collapse of US mortgage securities. He is now turning his sights on Eastern Europe, the next shoe to drop.
"We've been worried for a long time there would be nobody to pay on the other side of our contracts, so we took profits early and got out of everything. The Greenspan policies that led to this have been the most irresponsible episode the world has ever seen," he said.
Fed chairman Ben Bernanke has moved with breathtaking speed to contain the crisis. Last Sunday night, he resorted to the "nuclear option", invoking a Depression-era clause - Article 13 (3) of the Federal Reserve Act - to be used in "unusual and exigent circumstances".
The emergency vote by five governors allows the Fed to shoulder $30bn of direct credit risk from the Bear Stearns carcass. By taking this course, the Fed has crossed the Rubicon of central banking.
To understand why it has torn up the rule book, take a look at the latest Security and Exchange Commission filing by Bear Stearns. It contains a short table listing the broker's holding of derivatives contracts as of November 30 2007.
Bear Stearns had total positions of $13.4 trillion. This is greater than the US national income, or equal to a quarter of world GDP - at least in "notional" terms. The contracts were described as "swaps", "swaptions", "caps", "collars" and "floors". This heady edifice of new-fangled instruments was built on an asset base of $80bn at best.
On the other side of these contracts are banks, brokers, and hedge funds, linked in destiny by a nexus of interlocking claims. This is counterparty spaghetti. To make matters worse, Lehman Brothers, UBS, and Citigroup were all wobbling on the back foot as the hurricane hit.
"Twenty years ago the Fed would have let Bear Stearns go bust," said Willem Sels, a credit specialist at Dresdner Kleinwort. "Now it is too interlinked to fail."
The International Swaps and Derivatives Association says the vast headline figures in the contracts are meaningless. Positions are off-setting. The actual risk is magnitudes lower.
The Bank for International Settlements uses a concept of "gross market value" to weight the real exposure. This is roughly 2 per cent of the notional level. For Bear Stearns this would be $270bn, or so.
"There is no real way to gauge the market risk," said an official
"We don't know how much is backed by collateral. We don't know what would happen in a crisis, and if we don't know, nobody does," he said.
Under the rescue deal, JP Morgan Chase will take over Bear Stearns' $13.4 trillion contracts - lock, stock, and barrel.
But JP Morgan is already up to its neck in this soup, with $77 trillion of contracts. It will now have $90 trillion on its books, a sixth of the global market.
Risk is being concentrated further. There are echoes of the old reinsurance chains at Lloyd's, but on a vaster scale.
The most neuralgic niche is the $45 trillion market for credit default swaps (CDS). These CDS swaps are a way of betting on the credit quality of companies without having to buy the underlying bonds, which are less liquid. They have long been the bête noire of New York Fed chief Timothy Geithner, alarmed that 10 banks make up 89 per cent of the contracts.
"The same names show up in multiple types of positions. These create the potential for squeezes in cash markets, magnifying the risk of adverse dynamics," he said.
"They could increase systemic risk, by amplifying rather than dampening the movement in asset prices," he said.
This is what happened as the banking crisis gathered pace. The CDS spreads measuring default risk on Bear Stearns debt rocketed from 246 to 792 in a single day on March 13 amid - untrue - rumours that the broker was preparing to invoke bankruptcy protection.
Was it the spike in spreads that set off the panic run on Bear Stearns by New York insiders? Or are the CDS spreads merely serving as a barometer?
In the old days it was hard for speculators to take "short" bets on bonds. Credit derivatives open up a whole new game.
"It is now much easier to short credit, " said James Batterman, a derivatives expert at Fitch Ratings in New York. "CDS swaps can be used for speculation, and that can cause skittish markets to overshoot," he said.
For now the meltdown panic has subsided. Yet the hottest document flying around the City last week was a paper by Barclays Capital probing what might happen in a counterparty default.
It is not for bedtime reading. Direct losses from a CDS breakdown alone could be $80bn, but the potential risks are much greater.
In theory, the contracts are matching. One sides loses, the other gains, operating through a neutral counterparty (ie Bear Stearns). But if the system seizes up, the mechanism is not neutral at all. It becomes viciously one-sided.
"Upon the default of the counterparty, [traded] derivatives would be immediately repriced, with spreads widening dramatically," said the Barclays report.
This is "gap risk", the stuff of trading nightmares. Fortunes can vanish in a moment.
One side would suddenly be trapped with staggering losses on their books. Yet the winners would be unable to collect their prize from the insolvent bank in the middle. It would take years to unravel all the claims in court. By then the financial landscape would be a scene of carnage.
Warren Buffett famously described derivatives as "weapons of mass financial destruction". The analogy is suspect, of course. Allied troops never found the alleged weapons in Iraq.
This time, Washington's pre-emptive shock and awe may have been well-advised.
That’s nice. But if these popcorn fart financial devices aren’t (gasp!) regulated out of existence, it will just happen again. And again. And again.
I've never, ever liked that pompous, arrogant mumbler. Thank God he is out of there.
$13.4 TRILLION??? Uh.. We’re starting to talk, REAL money?
Can some financial wiz please come along and splain to me why this article shouldn’t worry me?? Puh-lease????
"Twenty years ago the Fed would have let Bear Stearns go bust," said Willem Sels, a credit specialist at Dresdner Kleinwort. "Now it is too interlinked to fail."
That's pretty much exactly what you said, Travis.
Can anyone explain what "reinsurance chains" means? And credit default swaps? Good grief, one needs a master's degree just to understand the vocabulary.
Also, aren't derivatives what caused Orange County, CA to go bankrupt way back last century?
Derivatives sound a lot like the modern version of what touched off the Great Depression.
“...$516 trillion derivatives system ...”
What? $516 TRILLION, theres not even that much money on the world.
Are they talking Monoply money? What is this hocus-pocus shnanagins junk?
I think it would be easier to understand the Unified Field Theory then to understand this financial stuff.
You might enjoy this site: http://themessthatgreenspanmade.blogspot.com/
Ask Toddster any questions you might have. He’ll be happy to answer them.
Nice to see a smart money man slam that assclown Greenspan, who should be in Gitmo right now. I am so sick of years of acclaim for the worst Fed chairman in history.
I think that might be the problem.
One problem with this article is that it really does not tell us anything. It could have been written by a reporter with a first grade education. In fact, maybe it was. Recite a few well-known facts, take some quotes out of context, and throw-in some meaningless scare phrases like “the Fed has crossed the Rubicon of central banking,” “resorted to the ‘nuclear option’, “Depression-era clause,” and “the meltdown panic,” and lo and behold a newspaper article appears.
Someone with something to gain likely spurred this “reporter” into writing this gibberish. Likewise, we will eventually likely learn that someone (probably a few hedge-fund managers) with something to gain brought down Bear Stearns (not that the Bear Stearns management doesn’t deserve plenty of blame for putting its organization in a position where those with something to gain could kill it).
Who would have thought that Democrat efforts that began in the 1980s to eliminate so-called redlining in the housing market would lead to this? This is what happens when housing becomes a “right” rather than a responsibility.
LOL! that was mean.
Now, Now, advice is welcome from all angles.
LOL! I guess.
From what I’ve read of his answers, he isn’t keen on sharing knowledge.
They dodged one bullet, with a loaded machine gun still firing.
He is quite agressive but in this market you have to be. Some have nailed it.
Well how can any two parties create a financial agreement over somthing that does not exist? Or couldn’t possibly exist?
"American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage."~~Alan Greenspan, February 22, 2004
The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions.~~Alan Greenspan, May 2005
"We're not about to go into a situation where (real estate) prices will go down. There is no evidence home prices are going to collapse."~~Alan Greenspan, May 21, 2006
The damage from the subprime market has been largely contained. Fortunately, the financial system and the economy are strong enough to weather this storm.~~Richard Fisher, Federal Reserve Bank of Dallas President, Apr 4, 2007
"All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system."~~Fed Chairman Ben Bernanke, May 17, 2007
Hey Travis, I hope everything is good in your corner! Happy Easter to you!
So far so good! Hope yours was nice too.
A “credit default swap” is nothing more than insurance against a borrower going bankrupt (reallly just a guaranty). If I loan you $1,000 and then pay $10 to your Daddy for him to agree to cover the loan if you default, I swapped $10.00 for insurance against the risk of your default. Make it corporations and banks instead of us chickens (and add lots of zwros), and you have “credit default swaps.”
A reinsurance chain is just a series of agreements among insurance companies. If I agree to insure your $300,000 home against fire loss, then get my brother to agree to pick up (or reinsure) $50,000 of the loss if your house burns down, and then my brother gets his girlfriend to agree to pick up $25,000 of his obligation if the house burns down, we have spread around, or diversified, the risk of a fire. Make it corporations and insurance companies instead of us chickens (and add lots of zeros), and you have a “reinsurance chain.”
Your posts prove to take risk in your own hands and quit listening to these hacks.
I enjoy them, actually. The threads would be dull without their input, and would peter out after 20 or so replies.
I hear ya! I just piss everybody off on these threads because my investment rides with people much smarter than me when it comes to the big picture.
I see financial crises as needing three strong elements. The first is vast amounts of leverage. The second is that they must be too swift for efforts to stop them. And the third is that the efforts to stop them are either not done, nor effective.
We have the excessive leverage.
However, everybody is now aware of the problem, and for all of the bearish cheerleaders for recession, there is enough time to act to counter much of the instability. This takes care of the second problem.
This leaves the third element. Will whatever is being done, work? While most eyes are on Bernanke, he is not working alone. In just the US alone, from the Secretary of the Treasury on down, not just in the government, but in business as well, all have irons in the fire. Internationally, the same applies, with the central banks and finance ministers. All with ideas.
Since all the major players are involved, the situation becomes one of confidence. Ironically, while everyone knows that the system is a house of cards, if these leaders believe that the house of cards will continue to stand, it will take away most of the pressure for it to fall.
This creates even more time to act. Eventually, when an adjustment happens to reduce the real problem, it will hopefully be just tying up loose ends.
Every day the crisis doesn’t happen means it is less likely to.
Hedge funds can kiss it!
Sell Investment Bank and Fannie & Freddie stock . . .
And Abolished the Federal Reserve.
Last updated: March 23 2008 22:46
An Anglo-French summit on Thursday will put renewed pressure on banks to agree to full and immediate disclosure of the scale of their bad debts, reflecting heightened political concerns about instability in financial markets.
Gordon Brown, the British prime minister, and Nicolas Sarkozy, Frances president, will make the call for greater bank transparency a central element of their talks in the UK this week. European finance ministers said in January that slow and inconsistent disclosure of bad debts by banks exposed to the subprime market was damaging confidence.
The rest of the article requires membership.
This weekends meeting of four heads of central banks communicates the size of the OTC derivative disaster. It is a system that is broken. A bailout will require the printing of trillions of dollars worth of monetary stimulation making Bernankes helicopter drop look like chump change.
The dollar number of pending derivative bankruptcies is the size of the mountain of garbage paper issued by just those who are to be bailed out. That number is greater than the total world economies.
There simply isnt enough money in the world for central banks to buy up the mountain of worthless paper sold by those who need bailouts; all of which made fortunes for their directors, officers and key people.
When an OTC derivative fails to perform, notional value becomes real value. The notional value of all OTC derivatives exceeds $500 trillion.
Credit default swaps (OTC derivatives) alone account for over $20 trillion dollars of notional value and are failing. Major dealers in these items, Lehman and JP Morgan, had their debt downgraded last week.
Maintaining the AAA rating on debt of public companies primarily issuing default swaps as credit guarantees is a sick joke of fabrication. This is a joke that in all probability will lead to litigation that destroys the rating companies.
You can be absolutely sure that all the biggies have their money out.
No one mentions these firms being bailed out are the ones who created this disaster, making billions for their economic sin. You can be sure the big boys have their money out of the now on-the-rocks international institutions.
No one mentions that bailing out the bankers will leave the average man victimized and paying for the pleasure of the economic rape.
Meanwhile derivative traders (salesmen of perdition, not traders) and their hedge fund managers are all in Greenwich, Connecticut with their hundreds of millions and billions, now retired playing tennis on their indoor courts at their waterfront mansions as the mess deepens.
Litigation against the officers and directors of these international banking firms, both against the biggies personally as well as the company, will make the biggies occupation one of defending against litigation for the rest of their lives.
For those biggies in these companies who trust no one and therefore have wives with no money will lose everything. Some of them I know. What goes around certainly comes around.
Litigation against OTC derivatives are slam-dunk victories for the injured plaintiffs. The biggies will pay.
This is the greatest act in the history of The Public Be Damned and Let them Eat Cake. It will not come about because in the USA it is already the hottest political potato.
The problem is that the plan of the US legislative [branch] is downright stupid. It is an embarrassment that legislators are so publicly moronic when it comes to economics.
The problem that no one is focusing on right now is the tracking of the mortgage itself to the structured product which has broken down. That means in these items many cant connect the underlying mortgage to the structured investment product (derivative).
So far courts have held that the only entity that can foreclose is the entity that actually lent the money. The average guy does not know that with an attorney to protect him he has a free house!
The entity that actually lent the money has sold the mortgage and been paid. Therefore, where is the incentive for the original lender to foreclose? The answer is there is none. Bankers do not help bankers in the same way that sharks do not help sharks.
Travis, I think you have it right.
I agree that full and comprehensive disclosure is essential—but only to top government finance officials. They need this a critical information, to know how bad things really are. Until they know, it is hard to plan.
Once they do know, however, they can take action with a “need to know” basis, to reassure critical players.
I disagree about point two, "too swift for efforts to stop them." I believe we are in a slow motion train wreck that is unstoppable at this point.
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."~~Ludwig von Mises
perhaps of interest.
Iceland shows cracks as the krona crashes
Telegraph (UK) | 11:33pm GMT 23/03/2008 | By Louise Armitstead
Posted on 03/23/2008 5:31:13 PM PDT by DeaconBenjamin
Thanks for posting Sinclair, I missed it today.
He’s on my daily read list, along with Mish Shedlock and some others.
Check out this thread. Especially post #64 and #157.
Let me know if you have any other questions.
From the Financial Times, via Mish Shedlock:
Central banks on both sides of the Atlantic are actively engaged in discussions about the feasibility of mass purchases of mortgage-backed securities as a possible solution to the credit crisis.
Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices and weakening balance sheets.
The Bank of England appears most enthusiastic to explore the idea. The Federal Reserve is open in principle to the possibility that intervention in the MBS market might be justified in certain scenarios, but only as a last resort. The European Central Bank appears least enthusiastic.
Any move to buy mortgage-backed securities would require government involvement because taxpayers would be assuming credit risk. There is no indication as yet that the US administration would favour such moves. In the eurozone it would require agreement from 15 separate governments.
One argument among policymakers and bankers has been that new international rules have exacerbated the credit squeeze by requiring assets to be valued at their current record lows rather than at face value.
Fed officials are monitoring the impact of the latest barrage of Fed liquidity moves and interest rate cuts. They also believe the US has not exhausted all the options short of wholesale public intervention and further intermediate steps are available to them.
These could include still more aggressive use of the Feds own balance sheet to boost liquidity in the markets.
Analysts say the US government also has plenty of scope to boost support for the markets indirectly through the Federal Housing Administration or Fannie Mae and Freddie Mac.
The UK lacks these institutions, which could be one reason why the Bank of England is keenest to explore outright intervention. The UK government has already become heavily involved in buying mortgages since September with the recent nationalisation of Northern Rock, the mortgage lender.
A perfect definition of Crony Capitalism.
I definitely get the feeling that these financial “genuises” has so goobered up the system with these incomprehensible instruments that no one knows what anything is worth anymore. People can understand a share of stock in a real company and a mortgage on a real house. What they can’t understand (or value) is what happens when you lump all these things together every which way. At its core, this is really scary stuff because these derivatives have so permeated our financial system.
And yes, it will keep happening again and again until they are outlawed. This is one huge mess.
It's different this time: this ship is unsinkable! Full speed ahead I say!"
But the notional amounts are great press. Especially for the gold bug doom crowd.
I was reading this and was concerned that it might be a reasoned argument...until the above quote was placed in the article...
The author may be right, but it does seem like he has a bone to pick outside of his discussion of 'economics'.
Tim Bond, head of asset allocation at Barclays Capital, said that U.K. policy makers should copy the Fed's program to inject liquidity into financial markets.
``The Bank of England does not provide the same comprehensive liquidity framework that the Fed has just put in place and such as exists already at the ECB,'' Bond told journalists in London on March 20. ``We need them to provide liquidity to any duration. It would deter the raiders.''
The Fed slashed its benchmark lending rate three-quarters of a point to 2.25 percent on March 18 and implemented a program to swap $200 billion in Treasuries for mortgage-backed securities. The ECB loaned 15 billion euros ($23.2 billion) of funds to meet demand for more cash before the Easter weekend.
The Bank of England lowered its benchmark rate a quarter point in February to 5.25 percent, the second cut of that size in three months.
That's funny. And wrong.