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.
I understand your point of view. The most compelling argument I have heard in opposition was the prospective effect on those who had trading accounts with Bear Stearns. No reason to think that these individual (or corporate) investors deserved to lose their investment capital when Bear Stearns's assets were frozen.
Even a train wreck is better at .001 miles per hour than at 60 mph. It gives you time to unload passengers and cargo, disconnect as many cars as you can, and have the fire department standing by.
I wouldn’t bet on a major collapse of the markets at this point. But at the same time, there is going to be punishment like Bear Sterns. Every day that goes by without it happening is one more day to prepare and mitigate.
My understanding has been that the net effect of the presence of the counterparty, the presence of the insurance, is that the price of the bond, or of the interest rate from the bond, reflects the supposedly lower risk, since the possibility of default (the bond not making regular payments) is covered by the counterparty.
IF the counterparty is insolvent, or is too highly leveraged, such that they *can't* make good on all the bonds they're insuring, that means the price and/or interest in the bonds no longer reflects the *actual* risk present, since there is no longer anyone acting as a backstop against the loss of payments from the bond.
That means that those who are *selling* bonds have to pay higher interest to the bond holders, since the risk of holding said bonds has gone up. And when there is commercial paper based on short term auctions of longer term bonds, there may be a dearth of buyers; and the auction houses no longer have the confidence to buy up the bonds on their own; thus some vultures may sweep in and bid the interest on the bond up to exhorbitant levels, which the bond issuers weren't planning on having to pay.
Both of these in effect depresse he price of the bond; and those holding bonds (if the bonds are listed as collateral for something else) suddenly aren't sufficient, and so "margin calls" against the bond holders may result.
Since all of the swaps, loans, and other paper are held by a relatively small group of players, in a more or less incestuous tangle, the result is potentially a galactic sized Mongolian Flustered Cluck©TM.
Is that more or less a decent layperson's description of it? Please give feedback...
Cheers!
the fed shouldnt have stepped it.
Full disclosure of all liabilities and marking these liabilities to market would do a lot to clear up the markets uncertainties.
Insofar as mortgages are concerned, when a mortgage company sells a mortgage, it assigns it to the buyer. In the Deed of Trust or Mortgage, the Assignee is protected. In the case you are describing, the plaintiff did not bring to court demonstrate chain of ownership of the instrument to foreclose. That is NOT the same as being able to foreclose; the plaintiff did not prepare well. They will from now on.
Going out at $2 a share is a bust.
More shock and awe by using big numbers that nobody understands.
IMHO, if the financial gearheads come up with a scheme that the average person cannot understand, the scheme should either be illegal period or heavily regulated.
I know nothing about derivatives. But I do know that before this is all said and done the government is gonna be sticking it’s hand in my pocket once again.
Thanks for the quotes in #24 Travis. I think we’ve been ripped off big time. These guys have been running this scam for years and making tons of money from it. Not that the jig is up they expect the gov to make it go away. Meanwhile, they’re set for life. Shouldn’t at least part of this be illegal?
No, try $90 Trillion:
‘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.’
To give you an example, let’s say one bank out of this 89% goes insolvent, that would be $8 Trillion dollars. What’s the U.S. total annual GDP? $14 Trillion or so. WHEN one of these banks (counterparties) goes bust, no person, institution entire U.S. people can stop it. The real question is WHEN this will happen and no longer an IF in my mind. When the house of cards falls, we will be eating government wheat & cheese. Do you really think our government needed to fill up it’s strategic reserve to 700 M barrels to bomb Iran, pleeeeease. Countries around the globe know this and are simply waiting for the firesale of our assets to plummet to pennies on the dollar. We’ll default on every promisary note to every U.S. and global investor and citizen alike.
Now here is what we can do to actually survive this intact (we will have pain no matter what):
1) Regulate Hedge Fund Leverage Now, Stop increasing risk
2) Declare National Financial Disaster, Use Executive Orders to de-regulate drilling and I mean ALL areas.
3) Use Treasury to subsidize $300 B into nuclear plants, biodeisel, solar & coal liquification. Lots more trains running biodeisel and repair old rail lines, we’re gonna need them!
4) Part of $300 B, say $50 B provide to SBA (small business administration). Get the service economy to work for the fiscally responsible commercial banks on energy independance that will create highly regulated investment vehicles for domestic investors.
5) Use all prominent Ivvy league business schools graduate students and have people like Buffett drill into the true financials of the subprime pig. Peel the skin back so the market can reach bottom and fiscally responsible Americans can then buy. Overseas buyers will also come in droves.
6) Stop cutting rates, but combat the inflation by creating competing product which will force speculators out of the oil market helping Joe six pack and the entire responsible financial system at the same time.
7) Be prepared for pain and to help out your neighbors as well as family. Also, as time progresses we had best be prepared for some kind of ‘make-good’ on this mess to other allies and trade partners. Nothing like turning allies into enemies and letting them have several years to stew over it. First we’ll fix America which also helps allies. Then we’ll make-good on a portion of money due. Lastly, we’ll be exporters and the global investor will come back to America.
Do this and we will quickly get out of depression and create millions of jobs through innovation. Don’t do it and expect severe depression and another global war.
“No reason to think that these individual (or corporate) investors deserved to lose their investment capital when Bear Stearns’s assets were frozen.”
If they had their funds in derivative accounts let them go down.
Umm and why wouldn’t We the People use our $2 Trillion worth of guns to fix the problem? The 60 million gun owners could then apologize to the world afterward and create innovation such as ENERGY to regain confidence? Why would we continue using public funds to help out the bankers who created this mess while 90% of the U.S. population’s net worth is erased? Am I going to go on John Kipling the 3rd’s yacht whom is laughing enjoying the economic rape while I am eating government cheese and wheat pasta? No wonder they keep bringing up the 2nd Ammendment.
Can some financial wiz please come along and splain to me why this article shouldn’t worry me?? Puh-lease????
I am not a wizard, but it seems that if common sense is forced to prevail, the value of these derivatives bear no true connection to assets. To my mind, these end up being like “side bets” on the creditworthiness of a bond, a bank, some entity. Supposedly, there is some link...notice that the ratio of the value of the derivatives to the underlying asset is about 20:1, just like the reserve ratios for typical retail banks.
But, if you have, for example, off-setting positions that evaporate when they mature, then where is the value linked to the asset? It doesn’t sound to me like it exists anywhere except on paper as something that grossly inflates the true value.
It is the financially self-immolating nature of these credit default swaps and such that are being overlooked until now. It is also becoming a case of the rest of the world looking at these sorts of risks the big banks are taking and asking if the “wizards of wall street” have rocks in their heads. Like so many things, they get so close, so involved, they lose all perspective until the proverbial s**t hits the fan and even then they are not sure what the fuss is really about.
So, while some of these geniuses are complaining, the rest of the system bounces from crisis to crisis until these mistakes are fixed permanently - and a lot of innocent people get hurt in the process.
It could lead to new regulations attempting to fix a problem, but then create additional problems as a result....
“...$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.
To me, it really is “betting beyond your means” and the time value of money run amuk.
When you buy a house, you don’t have all the money to pay for it. Instead, you take a considerable risk that you will pay for it over the next 15-30 years. Typically, it you did not have to spend one dime on living expenses, you could pay for that house in 3 years. But that ain’t real. Reality is more like those 15-30 years.
Similarly, a bank lends out more money than it really has. It is betting they will stay in business so long as people keep paying back those loans over time.
Options and futures - same basic idea.
So, these credit default swaps just follow from the same basic principle. I have to believe that the big banks are seeing this stuff is a mistake and they are going to find ways to cut back. I can only hope.
What does the PRC have in US treasuries futures now? $1+trillion?
Go see http://www.realtytrac.com in your neighborhood and state, then, and tell me all is well.
“Maintaining the AAA rating on debt” of public companies may be one thing, but the US credit rating has now dropped to AA, as of this last week.
People need to understand that what the Banks did here was create a credit system where the lender technically earned a profit the moment the capital was married to a borrower.
Absorb that. The entire credit system was optically rigged to show on paper that the lender would immediately bank a profit from lending. They did it by chopping up the loan into so many different pieces of paper that they could be distributed throughout the PLANET as wealth-generating assets.
Guess what. Finance only generates the printing of more numbers in a situation like this, where computer digits are just recycled back into the financial sector, never ‘realized’ in the real world as some kind of real economic gain.
The sickest part of all this is that real estate is the hard asset that this is ultimately tied too. All this mortgage-backed mumbo jumbo this, bond that, derivitive and security that.
The same way the banking system and all the major financial istitutions, including big parts of the government, wired themselves together in a big risk-elimination web, they’ve also wired mortgages together into the web.
The formula at its most basic is this: COMMERCIAL BANK issues SECURITY based on MORTGAGE to FINANCIAL PLAYERS who sell Mortgage Backed Security to other players who turn the MBS into a million other mediums of paper-based exchange (if it sounds like money, this is why it is often referred to as the ‘shadow banking system’).
The capital generated by FINANCIAL PLAYERS along the way is transformed into CREDIT, which is fed back to the PEOPLE who are having the debt on their homes SOLD ON THE OPEN WORLD MARKET to raise the cash to up their CREDIT CARD LIMITS, finance the AUTO LOAN, etc.
Now, the housing bubble that helped trigger this mess has gone bust, Greenspan’s insane blowing of credit bubbles everywhere when he knew what the banks and the credit markets would do with the new liquidity with commercial banks now in play as securities dealers. The FED has access to every Bank’s full books, part of the FED’s job is to see the big picture and act on it, that’s why they have oversight, just FOR that.
With housing values tanking, the mortgage values serving as a basis of collateral for almost every part of the market that is used to accumulate and disburse credit is going down with the housing market.
Lovely cycle. How do we get out of this?
How?
Options and futures - same basic idea.
Same basic idea as what?
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