Derivatives will collapse the world's financial system

[jeffolie]

Derivatives will collapse the world's financial system when the MBSs, then CDOs default from the housing bust.

I do not see how the Fed can monetize and create enough credit to save the world's $570 TRILLION in derivatives most of which are held outside the Fed's jurisdiction and overseas.

When the housing bust cascades the fall of the derivatives, the Fed will let it happen (it has stated over and over again) and can not avoid the defaults which will hurt the overseas holders of CDOs and derivatives. Let the foreigners sink and collapse having chased the higher yields these instruments get them.

[EJ]

That's the theory... spread the risk far and wide enough and it dissapears. Reminds me of the early days of anti-polution policy where the catchphrase was: "The solution to pollution is dilution." I suspect that the policy of dilution will work about as well to reduce the toxicity of credit risk as it did to make dioxin and DDT go away. The solution is to reduce the output of toxins: stop lending money to people and countries that can't pay it back.

Eric Janszen
Founder, iTulip.com

[jeffolie]

...there is still a backlog of thousands of unconfirmed derivatives trades, and about 40% of new trades are still not matched electronically. There’s still no centralized means of processing trades. Unmatched means:

"...firms were typically assigning trades without the knowledge or consent of the original counterparties. "

From:
New York Federal Reserve President Timothy F. Geithner


The speed with which demand for credit derivatives is growing is creating headaches for the banks, which can't process the deals fast enough.
The New York Federal Reserve in September told the 14 biggest buyers and sellers of credit derivatives to take steps to eliminate a backlog of unsigned order confirmations.


Credit-default swaps were designed to protect creditors against non-payment of debts, and some investors now use them to bet on a company's credit quality. Contract buyers pay an annual fee and receive the full amount insured if a borrower defaults. Under the current system, buyers are obliged to deliver the defaulted loans or bonds to the insurer.

`Lack of Transparency'

The credit-derivatives market, dominated by credit-default swaps, is unregulated, with contracts traded over-the-counter and no requirement for investors to disclose their holdings.

With more credit derivatives being traded than bonds available, a default by GM could spark panic buying of the company's bonds, driving up prices. The contracts would be worthless if prices rose to 100 cents on the dollar because investors would have to pay the same amount for the bonds as they received in payouts.

``The current method has the potential to significantly distort the economics of the trade,'' says James Batterman, an analyst at Fitch Ratings in New York. ``There are no limits on the amount of derivatives exposure vis-a-vis deliverables, and a lack of transparency as to how many contracts there are in existence.''

[EJ]

“A given [derivatives] contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.”
Warren Buffett. March 1, 2006

[jeffolie]

The Fed created a semi-secret fallback bank for the financial collapse.

In case of a T-note crisis …

By Eric Dash
March 2, 2006
A BANK created to provide emergency back-up for the US Treasury market will be ready to operate in the next 18 months, a bond industry group is set to announce today.

The so-called NewBank exists largely on paper, but like a superhero on standby, it can spring into action to stabilise the government securities market if a legal or financial disaster strikes.

The bank is a result of a five-year effort by government and banking officials to draw up plans in the unlikely event that either JP Morgan Chase or the Bank of New York, the only existing clearing banks in the Treasury market, are suddenly unable to operate.

The two banks play an obscure but crucial role in the government securities market, processing more than $US1.9 trillion ($2.6 trillion) of very short-term trades each day between investors who want small but safe returns and dealers who want to finance securities positions. The industry's dependence on just two big institutions has long concerned the Federal Reserve.

"All of a sudden half of the securities would not be able to clear their overnight positions," said Donald Layton, the former vice-chairman of JP Morgan Chase, who will lead the NewBank effort.

[stevenstevensteven]

Can you recommend an article that explains derivatives and summarizes their potential hazards.

[EJ]

The best article I've seen was written in 1999 by Martin Mayer for writing for the Economics Studies section of The Brookings Institution web site. Mayer's background:

Previous Position(s): Columnist, American Banker; Member, President's Panel on Educational Research and Development (Kennedy and Johnson administrations); Member, President's Commission on Housing (1981-82); Consultant, Twentieth Century Fund and Carnegie, Ford, Kettering, and Sloan Foundations (1962-1966); Consultant to the American Council of Learned Societies (1962-1964)

Publications:
The Fed and the Markets (Free Press, 2001)
The Bankers: The Next Generation (Dutton, 1997)
The Greatest-Ever Bank Robbery: The Collapse of the Savings and Loan Industry (C. Scribner's Sons, 1990)
Markets: Who Plays, Who Risks, Who Gains, Who Loses (Norton, 1988)
Making News (1987)
The Money Bazaars: Understanding the Banking Revolution Around Us (Dutton, 1984)
The Diplomats (Doubleday, 1983)
The Met: One Hundred Years of Grand Opera (Simon & Schuster, 1983)
The Fate of the Dollar (Times Books, 1980)
Today and Tomorrow in America (Harper & Row, 1976)
The Bankers (Ballantine Books, 1975)
The Lawyers (Greenwood Press, 1967)

The article:

Somebody Turn on the Lights
Derivatives Strategy, November 1999
Martin Mayer, Guest Scholar, Economic Studies

http://www.brookings.edu/views/artic...yer/199911.htm

The article is long andechnical. If you have questions about it I'd be glad to try to address them. His conclution is easy enough to understand:

"Derivatives markets guarantee a winner for every loser, but they will over time concentrate the losses in vulnerable sectors. Nature obeys Mayer’s Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ain’t got want to get and speculate. The logic behind margin requirements in stock markets and capital requirements in banking also holds in the derivatives markets. Permitting highly leveraged institutions to hold private parties behind closed doors is the political version of selling volatility: the predictable likely gains will one day be overwhelmed by an equally predictable disastrous loss."

[jeffolie]

I KNOW THIS IS EXTREMELY LONG, BUT IT IS WORTH IT !!!

derivative
Definition

A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. Examples of derivatives include futures and options. Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky.


credit derivative
Definition

A contract between two parties that allows for the use of a derivative instrument to transfer credit risk from one party to another. The party transferring risk away has to pay a fee to the party that will take the risk.

February 2006 issue:
Versatility For Long-Term Success
by Howard Schneider

Mortgage lending has become harder for the Fed to manage as lenders have gone from holding loans in portfolio to selling them in the capital markets. Since the Federal Reserve controls the money supply, it also rationed credit when banks could only lend the cash they had collected from depositors. But now lenders can restore their liquidity by securitizing loans. Selling off the debt makes it easier for them to encourage more borrowing, and the Fed can’t do much about it. Right now it’s easier for the Federal Reserve to control mortgage lending through its role as a banking regulator, and to limit credit expansion by curtailing the use of exotic mortgages.


Collateralized debt obligations are securitized interests in pools of—generally non-mortgage—assets. Assets—called collateral—usually comprise loans or debt instruments. A CDO may be called a collateralized loan obligation (CLO) or collateralized bond obligation (CBO) if it holds only loans or bonds, respectively. Investors bear the credit risk of the collateral. Multiple tranches of securities are issued by the CDO, offering investors various maturity and credit risk characteristics. Tranches are categorized as senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults or the CDO's collateral otherwise underperforms, scheduled payments to senior tranches take precedence over those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches. Senior and mezzanine tranches are typically rated, with the former receiving ratings of A to AAA and the latter receiving ratings of B to BBB. The ratings reflect both the credit quality of underlying collateral as well as how much protection a given tranch is afforded by tranches that are subordinate to it.

A CDO has a sponsoring organization, which establishes a special purpose vehicle to hold collateral and issue securities. Sponsors can include banks, other financial institutions or investment managers, as described below. Expenses associated with running the special purpose vehicle are subtracted from cash flows to investors. Often, the sponsoring organization retains the most subordinate equity tranch of a CDO.



The hard landing will be world wide and the Fed will not control it:

"As the delinquencies and losses on mortgages flow through to subordinated mortgage- and asset-backed securities, who will be affected? Who buys these securities? The interesting part about these private label subordinate pieces is that for the most part, they’ve ended up in CDOs [collateralized debt obligations] and have been sold outside the U.S. Subordinated pieces are trading at their most expensive levels ever primarily because of the demand from structured deals—CDOs are underwriting the risk in the mortgage market. The lender (buyer of the CDO) is the person in line to lose money. While CDOs often have higher yields for a given rating level, they also usually have higher risk for a given rating level. Because the investors are CDOs, the bonds are outside the banking system, and the regulatory agencies cannot police the market. That has been a frustration for the regulators—they can’t do as much about the situation as they had hoped."


The whole problem is when the collateral fails through foreclosures and bankruptcy pushing the houses (collateral) into the hands of the GSE's (Freddie and Fannie). This causes the mortgage backed bonds to fail or be seriously impaired. Borrowing against homes added $600 billion to consumers' spending power in 2004, according to research by Federal Reserve Chairman Alan Greenspan.

The whole problem is when the collateral fails through foreclosures and bankruptcy pushing the houses (collateral) into the hands of the GSE's (Freddie and Fannie). This causes the mortgage backed bonds to fail or be seriously impaired. Borrowing against homes added $600 billion to consumers' spending power in 2004, according to research by Federal Reserve Chairman Alan Greenspan.

Banks will fail and cause commercial loans to medium or small businesses to disappear. Credit risk and credit ratings will fall slowing the "velocity" of money and the GDP. The hundred of trillions world wide in derivatives based on mortgaged backed bonds will unwind destroying worldwide liquidity. The feds will step in to salvage and consolidate the surviving banks and thrifts after the collapse as the lender of last resort. The fed will be "pushing on a string", unable to stimulate the world’s economy.

That is the amount of unregulated "credit derivatives" that are known (there may be more) as reported by the WSJ. If the housing bubble bust goes badly (hint - it will go very, very badly), the world goes to hell in a hand basket. Source:

http://prudentbear.com/archive_comm_...tent_idx=51737

http://www.jsmineset.com/

The debt is worldwide not just US. To give you some scale the twin US deficits amount to over $2 trillion. The US GDP is $12 trillion. The derivatives are $570 trillion world wide.

Most of this is overseas. The world is wash in this securitized debt. China, Germany, Europe and Japan all hold this. These are not regulated by the Central Banks including the Fed.

Liquidating the derivatives will collapse the system world wide.

The $570 trillion in derivatives can not be paid. Failure to pay will bring the bankruptcy of the world's financial system. Orange County, California went into bankruptcy in less than a year when their derivative investments went against them. The Fed had to prevent the entire nation's collapse went LTCM went the wrong way on their derivatives trades and collapsed.



Financial markets: Spread of derivatives reshapes markets
By John Authers Tue Jan 24, 1:00 PM ET
Hedge funds account for more than half of the daily volume in the US stock market. Hedge funds can buy or sell the risk of default by a single company or a portfolio of them. Derivatives have been used to create securities that track the credit of hundreds of companies at once, allowing hedge funds to bet either way on the corporate credit market.
The fear is that the sheer pace of the growth in credit derivatives has outstripped both the scope of the existing regulation and the development of infrastructure to manage exposures in the sector. According to the International Swaps and Derivatives Association, the total notional volume of credit default swaps outstanding had reached $12,430bn by the end of June - a growth rate of 48 per cent in six months. The market had scarcely existed in 2000.

NEW YORK FED AFRAID OF DERIVATIVES...TIME BOMB--------------------

Over the past year New York Federal Reserve President Timothy F. Geithner has become increasingly concerned about the use of derivative instruments as outlined in a few of his speeches and a number of largely unnoticed articles buried inside the Wall Street Journal. ...broader financial system from the effects of such a failure…And there are aspects in the latest changes in financial innovation that could increase systemic risk in some circumstances, by amplifying rather than dampening the movement in asset prices, the reduction in market liquidity and the associated damage to financial institutions.”

...there is still a backlog of thousands of unconfirmed trades, and about 40% of new trades are still not matched electronically. There’s still no centralized means of processing trades.

...In our view the derivatives mess described above is another potential time bomb (among many) that could throw the financial markets into a severe crisis.



HeliBen has no where to go to avoid the deflationary collapse. He must raise rates because the economy is relatively strong with lower unemployment. He must raise rates because commodities are going ever skyward. He must raise raise to bust the HOUSING BUBBLE.

As rates rise, the adjustable mortgages ( I/O & ARMs, plus HELOCs) raise monthly mortgage payments and default and foreclosures go up. As houses held by flippers and investors try to liquidate prices decline. As prices decline the MEWs (Mortgage Equity Withdrawals) disappear. Greenspan stated the MEWs added $700 billion to the 2005 economy or 70% of the 2005 growth.

Investors and flippers were 24% of the housing purchases in 2005 nationwide. 50% of mortgages in 2005 were adjustables which will easily be underwater with a 14% decline. The subprime lenders disappear when house owners cannot borrow when they have no equity. No subprime lenders means not MEWs for cars, vacations, educations, etc. As unemployment rises and more houses go into default, the mortgage backed bonds (MBS) default or become impaired. The GSEs (Freddie and Fannie) go from not reporting their earnings to the NYSE. The pools of MBS which become CDOs and become sold outside the Fed's control and regulation as derivatives worldwide in the hundreds of Trillions. HALF THE VOLUME OF THE US STOCK MARK COMES FROM DERIVATIVES. -- end game worldwide.

[jeffolie]

The Fed plans to save the banking system by shedding the coming mortgage defaults to overseas investors in MBSs and derivatives:

"The Fed's fully aware that the deteriorating U.S. housing market and subsequently the sustainability of the U.S. consumers spending spree have raised level of concerns among foreign investors of the U.S. Treasury Bonds. But, that's just part of the grand design. The unloading or the "portfolio-switching" by global bond investors, as so termed in a research paper - International Capital Flows and U.S. Interest Rates - prepared for the Fed in September by Francis & Veronica Warnock, associate professor at the Darden School and assistant professor in the School of Architecture, respectively, has thus far caused the 10-year bond yield to rise 20% since June, 2005."

[stevenstevensteven]

Thank you for posting this information, jeffolie. I'll review over the next few days and get back to you, as I'm sure I'll have question.

I'm very excited to be part of this site, as I'm still in the early stages of my monetary/global economic learning curve and it is great to know that there is a place to go where I can get help with my education.

[jeffolie]

Bank of America is the latest victim of the conceptual incoherence and labyrinthine demands of FAS 133, the U.S. accounting standard for derivatives.

Last year, according to The Wall Street Journal, at least 40 companies had to restate financials because they could not cope with this Byzantine accounting rule.

Warren Buffett has stated that derivatives are weapons of financial mass destruction, due to their incredible leverage. Every year now, we hear of old time banks and new ones going broke in a day or two when a derivatives trade goes south for them. The recent victims are the Chinese petroleum procuring company that lost about $700 million in some air fuel hedges gone wrong. The trader responsible has been arrested, as I recall, and probably going to rot in a Chinese work prison.
I could talk about the Barings collapse, the LTCM collapse, and others.

Credit derivatives rocked by loss at GM finance arm

The discovery of huge hidden losses at General Motors's finance arm have raised fresh fears of bankruptcy at the world's biggest carmaker, sending tremors through the credit derivatives markets. The struggling group asked for a filing delay after admitting to an extra $2bn (£1.1bn) in accounting errors at its finance arm GMAC, raising total losses last year to $10.6bn. The news triggered a sharp spike in the cost of default insurance on GMAC's bonds, rising 75 basis points overnight.

Concern that General Motors may now be sliding towards the brink - linked to an estimated $200bn in credit derivatives - has renewed fears that the over-heated credit swap market could seize up in a crisis.

[blazespinnaker]

These things make sense to me, but yields on long term bonds are suprisingly low.

Any thoughts as to why? Is this merely foreign manipulation of US treasuries or excessive confidence (I find that hard to believe) on the part of Bond Traders?

[jeffolie]

Long Term bonds are used general by large investors to match long term obligations. For example, a pension fund needs to guarantee a return according to its actuarial projects.

Foreign countries park their liquid reserves in T-bonds for many reasons. One reason is that T-bonds count as reserve funds which can be lent out in their fractional banking system.

Another reason to buy T-bonds is if you believe rates on the long bond are going to go down more because of various reasons. For example, if you envision a deflationary period or a increase in the value of the dollar.

on another matter-------------------------------------------------------

Financial Accounting Standard 133, Accounting for Derivative Instruments and Hedging Activities.

FASB 133 is stalking the gold producing companies like a Green Beret that has black parachuted out of the night sky. Special Forces do not divert from their mission to eliminate once focused and mobilized.

It is just that serious as the UNRAVELING has begun.

“Mark to Model” is total CRAP. I honestly believe there are pinheads in high places out there that have no clue what is upon them.

FASB makes the hedger who knows tell. Perhaps the ignorant, thanks to FASB 133, finally discovers the truth concerning real values.

I wager the recent USD$2,000,000,000 loss at GM was derivative related at their mortgage division. I also wager Refco went down for the exact same reason, an internal audit in light of FASB 133.
Gold producers who hedge use derivatives.

FASB is the party pooper that takes the derivatives out of the dark into a light they cannot stand. The company then goes up in flames and no one will speak about it. Did the Fed itself not say no regulations were required? No wonder the secret is kept as the mayhem begins.

What FASB 133 has dragged out of the alley, the OTC derivative, has been described CORRECTLY by Warren Buffet as “Weapons of Financial Mass Destruction. When you try to unravel them they become the equivalent of trying to carry a cat home by its tail.”

The unraveling has begun.

[JC Ernharth]

These things make sense to me, but yields on long term bonds are suprisingly low.

Any thoughts as to why? Is this merely foreign manipulation of US treasuries or excessive confidence (I find that hard to believe) on the part of Bond Traders?

Trade is a big part of it. Most of the foreign demand is confined to foreign central banks.

Part of this is the recycling of trade deficit dollars -- On one hand it is a form of vendor financing.

It also helps their foreign currency maintain parity vs. the dollar. If everyone offloads dollars they earn, the U.S. dollar loses strength, which means the U.S. consumer spends less abroad. The impact would hurt those local economies.

Stay Vigilant!

[jeffolie]

Another reason for the high demand that lowers the rates on T-bonds is the "carry trade" - “the carry trade” is borrowing at a low interest rate to earn a higher return.

When Japanese rates are much lower than U.S. rates, hedge funds borrow money in yen (short yen) and buying U.S. treasuries (long dollar), earning around a 4% spread.