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.
It's not a loan. It is a swap of a stream of interest payments.
One interesting aspect of this mess is that courts are refusing to go along with many foreclosures, because the ownership of the mortgages cannot be accurately determined. The mortgage originator sold it the day after cutting the loan, and that loan has since been sliced and diced and resold in a thousand fragments. So who owns the house? It’s going to get VERY interesting, pulling apart this snake pit.
The Cubs beat the Dodgers yesterday, 4-1. Forbes estimates the Cubs are worth $592 million and the Dodgers are worth $431 million.
You can pretend that a $10 bet on yesterdays game put $1 billion at risk, because the performance of your bet was derived from the performance of $1 billion in underlying assets, but you really know it's only a $10 bet.
I think that the key component is vast misallocation of resources that becomes unsustainable. Leverage is often part of this process, but once someone screams that the emperor has no clothes and everyone has a look for himself and sees the shriveled up assets, you cannot reflate the whole thing. Unfortunately, the Federal Reserve has proven time after time that it will do everything in its power to sustain the unsustainable. Remember Michael Milkin? That was his thesis at Wharton, and he build the junk bond markets on it.
You have the $50M in your pocket which would have made you rich, but now you owe $300 to the Yankees, because the Cubs have defaulted.
That wasn't an analogy, it was a derivative.
A better analogy would be that someone set up a trading company to swap the market value of sports clubs to provide insurance against the drop in the club's value created by winning and losing baseball games.
Okay. let's examine your idea.
The Cubs increasing in value by $300M would offset the Yankees dropping $300M . What if the cubs go into bankruptcy and cannot pay the $300M they owe, and which you owe the Yankees.
Back up. Who is buying this insurance? Who is selling?
The best definition I can come up with would be an example.
The State of North Carolina issues a billion dollar bond. They now have a long term liability of one billion dollars and the interim interest payments thereon.
For whatever reason they choose to swap those fixed interest payments into floating rate payments and they create a transaction with JP Morgan to do that. Now JP Morgan owes a stream of payments to NC and NC owes a stream of payments to JP Morgan and its bondholders. If JP goes out of business the only effect is to the stream of interest payments owed to NC on a billion dollars NOT the billion dollars itself.
The billion dollars is a notional amount defining the agreement between JP and NC. The other billion, the one NC owes to all of the investors that own its bonds is the real deal.
Similarly, the state of California could issue a billion dollars of debt and in the six months leading up to the issue date they could by a "cap" on interest rates from JP Morgan and that cap represents one billion in notional value. Again, if JP goes out of business the only effect is that California has lost its hedge and the "premium" it paid for protection.
Notional amounts are the amounts being hedged. Derivatives going bust on notional amounts don't necessarily have an affect on the underlying amount of the original issue.
Trillions of dollars of interest rate swaps, caps, floors, etc. are NOT necessarily principal that is at risk.
No. I do believe that outrageous claims of hellfire based on notional values is stupid.
Is this why the Bear Stearns debacle occurred, because of purely imaginary notional funny money?
Bear and every other WS denizen is flying on collateralized borrowed money. There's nothing wrong with that until the counter parties freeze up. Why do they freeze up? Because of irrational fear. Once upon a time WS firms didn't have credit departments because it was all repo. Then Drysdale Securities blew up and couldn't make interest payments on its repo book. Now WS has designated credit officers who have to approve repo counter parties - even though each transaction is delivery vs. payment and collateralize with government securities or something equivalent.
BSC is hardly the first debacle. Remember the dot com pop after the Fed started tightening, the Orange County, Cal blow up after the Fed tightened in 1994? The S&L crisis makes all this look like a picnic.
Is this why Bernanke and Paulson are sweating bullets?
Who says they are?
Do you honestly believe this?
What I believe is that the Armagedden idea is an endorphin release for a lot of petty people.
Very interesting response.. Thank you for the effort. But, you didn’t address my question: I wanted reasons why I SHOULDN’T be worried.... You just made me MORE worried. :-)
Many years ago, a good friend told me : When the banking system collapses (and it will) you don’t want to be invested in gold... you want to be invested in, lead. Preferably, the kind in the shape of bullets.
Your scenario makes me want to stock up...
That's what I was wondering: Just how much of these trillions are in positions that off-set one another. Just as.... a Vegas casino can take in $200M in wagers on the Super Bowl, but... not really have anything at risk...since they offer wagers on both sides. Is that how it works on these "hedge positions"?
You never discuss anything. LOL
BSC is solvent and the rest of us are endorphin junkies. Whew. Glad we settled that little issue. Just take a little vacation, relax, detox and the whole problem will be over.
Ah HA! Now, I’m starting to get it. One thing I remember from economics class: When interest rates go UP, tradable bond values go DOWN.
I’ve always understood why bond rates would increase w/o a re-insurer. But, I never really considered what the lost of such would do to those already owning bonds..
And, of course... I understand Mongolian Fluster Clucks...
And depending upon the swap let us say that the stream JPM owed to NC amounts to 20% of the interest that NC owes to the bondholders. Let us suppose further that based on that stream NC took out another bond issue. The taxpayers are now stuck with an extra 20% in interest payments above what the state had budget. Do this a few times and the state is going to have a hard time meeting the payroll for its schools.
“The Producers” comes to mind.
#1 There is no "house" that handles and regulates the derivative bets that hedge funds make or that any financial entity (Bear Stearns for example) makes
#2 With derivatives you have two parties making an elaborate bet based on arcane mathematical formulas as applied to financial instruments such as bonds, CMOs etc
#3 .Worst part is these two parties are betting against each other with lots and lots of borrowed money
#4 To borrow such money from Bear Stearns and others they do have to have some collateral. But lately their collateral seems dubious because it is based on sub prime mortgages and other shaky investments
Actually they do treat it like funny money, monopoly money
I'm sure they have all kinds of insider jokes about how hard it is to respect electronic notations as real money. It's like a woman going on an inane shopping spree with credit cards. The credit card is her funny money. Hard to treat as real money
Also these Wall Street rats are making tens of millions each year on these rackets which is so intoxicating. This makes them loose track of what's real as far as money
Now if you think real hard you can probably come up with another idiotic scenario. How about NC takes the bond proceeds and uses it to margin a billion dollars worth of oil futures?
It's not a loan.
But you start out your example by stating:
Say you loaned out $1,000,000 at an adjustable rate, say 3 month Libor plus 2 points.
Is this a loan?
You proceed to state:
You go to another bank that is willing to pay you 5% fixed for the next 3 years in exchange for your adjustable payment.
Is this a loan? If not, how is this swap structured? Can you walk into a bank and tell them "I'll trade you my income stream lasting 3 years based on 3 month LIBOR plus two percent for a flat 5 percent per month, and the loser pays the difference"?
As much as these doomsayers want for the earth to stop spinning, that won't happen with the traditional derivatives market.
Think of your state government. It could decide to go into the muni market and borrow a billion dollars. But they are worried that interest rates may go up between now and the time it takes to get the muni offering ready. So they call up JP Morgan and buy and interest rate cap. Let's say on a billion dollars the cap costs 100,0000 dollars. If rates go above the cap JP Morgan owes your state money.
Now, in this scenario, the notional amount of the cap (or derivative) is a billion dollars. But if JP Morgan goes out of business in the meantime your state is only out a hundred grand plus any extra interest rate expense caused by the loss of the cap.
And JP Morgan will turn around and hedge the cap, creating another billion in derivatives. (Which means they probably won't go out of business.)
And all these billion dollars are included when the worry warts talk about 400 trillion derivatives.
If not, how is this swap structured?
If one party made a fixed rate loan and the other made an adjustable rate loan, they can swap the payment streams. Or, they can swap a payment stream without actually having loans outstanding.
Can you walk into a bank and tell them
No, you can't. If you worked on a trading desk for JP Morgan you could call Goldman Sachs and set up a swap. If you worked for a hedge fund, you could call an investment bank and set up a swap.
You can build a derivative based on almost anything. A derivative derives its value from something else. An option traded on the CBOE derives its value from the performance of the underlying stock or index.
An interest rate swap derives its value from the performance of some interest rate index. Could be based on the 1 year US T-Bill or Libor or Fed Funds. Some derivatives are pretty commoditized. Some might be one-of-a-kind.
Is that any clearer?
Maybe you could give us an example of this?
Sigh... How sad and true and current financial system indicative of the greatest fleecing of the middle class since the French Revolution.
Because Tim, I am a student of human nature and history. Yes, I am worried for the short-term but I had several months since June studying this, so the fear and anger are gone and now replaced with resolve to come up with solutions and push them to be executed. And if collapse and a global conflict occurs, we will rebuild. History has shown this over and over and those whom are prepared survive. Survival of the fittest applies to every species on earth.
Are you such an idiot that only I can understand the implications of what you just wrote? They only offset if one of them has not defaulted, and you act as though the streams of revenue from a swap do not matter. If they did not then why would anyone do them?
Of course, one trades swaps because the revenue stream DOES matter, and the default on a swap surely matters if someone has a portfolio of offsetting swaps without a lot of actual capital in the game. A default on one side exposes you to the entire downside of the offsetting swap, and your bankruptcy and default could sink the guy on the other end who was trying to hedge the risk that you were supposedly offsetting.
One of these days when you talk down to all the rest of us you will actually show us that you understand the technobabble that you spew forth. So far you haven't.
What you don't point out when you talk down to everyone is that it is not that $400T at risk. It is that small mistakes or market inefficiencies or unanticipated defaults could put 1% of that at risk and 1% is $4T which would go a long way towards tanking our economy and did, on a smaller scale, tank LTCM, requiring another "free to the public" Federal Reserve sponsored emergency rescue effort.
Careful, now. I own the patent, copyright, trademark, and future drilling rights on that phrase. ;-)
When life hands you a lemon, sell lemonade.
When life hands you a Mongolian Cluster, sell condoms.
No. You're such an imbecile that you don't understand what I wrote.
You are such a hoot. Everything is just fine in the world if finance, it's just all that "irrational fear" that's causing the crunchiness. Why, if we'd all just think happy thoughts, it would all go away!
And I say Bernanke and Paulson are sweating bullets, because I've been watching them speaking in public, and they are twitching, stuttering, shaking their heads involuntarily and giving every other known indication that they are indeed sweating bullets.
Maybe you could give us an example of this?
You seem to be in the business
Why don't you explain it
Don't you wish you were able to live in ancient Rome and watch the gladiators die?
Now you're a body language expert. Maybe you should go on O'Reilly.
I'm not in the business. I used to be and it has changed a hell of a lot since then.
I'm not in the habit of explaining posts to those who post them.
I'll assume that your answer means that you don't have any idea what a derivative is but that you are trying to explain it to someone else anyway.
I knew you would not elaborate or explain it better.
#2 With derivatives you have two parties making an elaborate bet based on arcane mathematical formulas as applied to financial instruments such as bonds, CMOs etc
I asked you to give us all an example.
Ever since I asked you that question you have done nothing but plead with ME to explain YOUR post.
Now you are amused that I have refused to explain YOUR post.
Since your post WAS an explanation and since I asked you to give us all an example of what you mean, I can only infer that you have no clue what you are posting yet you post it as something educational.
BTW, I have explained derivatives at least once on this thread in post #124 in language that perhaps even you can grasp. If not may I suggest reading skills rehabilitation?
Blah blah blah but the important part is 124 and I will read it. And thanks. (I mean it)
So sorry... I’ll not make that mistake again...
Just for the record, do you have a patent on ALL types of Fuster Clucks?? Or just the Mongolian kind. What about the Brazilian? Or, closer to home, the famous Cleveland kind?
I am nothing, if not observant of patent law. :-)
“The doom mongers see an article which discusses the notional value of outstanding derivatives and they go into hysterics. They don’t understand the amount at risk is much smaller than the notional value. My example from another thread works. “
This is a real good one! Must be why the world financial system in the shape its in.
We petty folks just sit here tripping on our endorphins as the masters of the universe show us how Armagedden is really done.