Derivatives will collapse the world's financial system

[metalman]

from the itulip site...

The Three Desperados
AO's economic agnostic proposes an explanation of the magic behind low interest rates.

http://www.alwayson-network.com/comm...=P8853_0_4_0_C

The Metalman

[jeffolie]

THE ARTICLE MAKES A GOOD POINT ABOUT THE DANGEROUS BOND DERIVATIVES

Back when I was doing bubble research in 1999, I came upon a scholarly book called Debt and Delusion by Peter Warburton. The book has become something of a cult favorite among professional, contrarian financial analyst types. In fact, if you want to buy a copy today, it will cost you $100 used, because it's out of print and in demand. In Chapter Seven, titled "Risk Markets and the Paradox of Stability," Warburton supplied—six years ago—a framework for understanding the peculiar bond price and interest rate movements that we are seeing today. Warburton explained:

"There is an even more serious dimension to the meteoric rise in the use of financial derivatives; the implicit credit system that operates within it. Quite apart from the inherent gearing of futures and options, relative to trades in the underlying securities, it is possible to use unrealized gains in financial assets (including derivatives contracts) as collateral for future purchases. The persistent upward trend in asset prices has amplified these unrealized gains and has enabled and encouraged the progressive doubling up of "long" positions, particularly in government bond futures. It is easy to envisage how the cumulative actions of a small minority of market participants over a number of years can mature into a significant underlying demand for bonds. While financial commentators are apt to attribute a falling US Treasury bond yield to a lowering of inflation expectations or a new credibility that the federal budget will be balanced, the true explanation may lie in progressive gearing."

If we accept Warburton's thesis of the effect of progressive gearing of bond derivatives on treasury yields, and that this applies to current circumstances—not as a factor of the anomaly of a flattening yield curve as suggested by Gilmore and others, but rather as the primary cause—we're still left wondering how this may be resolved. For an answer we turn to Martin Mayer, writing on the Over the Counter (OTC) derivatives market as a Guest Scholar in Economic Studies at the Brooking Institution in the same year (1999) when Warburton wrote his book:

"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."

Warburton draws similar conclusions: "What is clear is that when the next global bear market in equities and bonds arrives, the unwinding of highly geared derivatives positions will trigger financial explosions in every corner of the developed world."

Back in 1999, many of us thought that the coming pop of the stock market bubble (which finally took place in 2000) was destined to be The Great Crash of our century. But in reality, those of us who worried about a repeat of the fallout of the 1929 equities crash were guilty of fighting the last war. The 1929 crash resulted largely from the unwinding of many years of intertwined, non-transparent and highly leveraged investment vehicles called Investment Trusts, the hedge funds of their day. But the damage to the real economy actually happened later, because the banking system had supplied most of the credit for those leveraged bets, so when the stock market went down it took the banking system with it. The real economy soon followed.

But banks did not participate much in the 1990s stock market bubble, thanks largely to post-Great Depression government regulations that limit banks' exposure to equities. Instead, to generate the profits denied them by regulations and regulators in other markets, today our nation's banks carry the liability of several trillion dollars of replacement value for the modern version of the intertwined, non-transparent and highly leveraged bets of the 1920s, but in the bond markets via OTC derivatives, rather than in the equity markets.

Under the rare anomaly of a flattening yield curve may lurk the seeds of the greatest risk to the financial system and the real economy to be seen since the last time the nation's banks supplied credit for massive, highly leveraged financial bets. AO members are invited to discuss this theory. Let's start with three questions: How might an unwinding of these OTC derivative positions in the bond markets come about? What impact might this unwinding have on the economy? What practical steps can AO members take to prepare?

[blazespinnaker]

"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.'

Sounds like a trigger in Japanese inflation could bring down a lot of these hedge funds.

Do we have any accurate information on how many of these derivatives are rollover / long term?

It seems to me that short to mid term derivatives that do not automatically rollover without some kind of accounting do not pose as much a risk to the economy.

[jeffolie]

Japan's Boom May Explode Yen-Carry Trade: William Pesek Jr.
Feb. 22 (Bloomberg) -- Surprisingly strong growth in Japan is raising many eyebrows, not least those at the central bank anxious to scrap its zero-interest policy.

There can be little doubt 5.5 percent growth between October and December pushed the Bank of Japan further in that direction. Oddly, there are few if any signs global markets are bracing for higher debt yields in Japan.

Why? Japanese rates have been negligible for so long that investors take them for granted. This, after all, is the economy that's cried wolf too many times. The reason investors from New York to Singapore aren't ecstatic about Japan's recovery is the sense we've been here before -- many times.

Yet Japan's latest growth figures should make believers of some of the biggest skeptics. Not only did exports boost the economy in the fourth quarter, so did personal spending -- a sign optimism is spreading to households around the nation.

Rest assured the BOJ is noticing and will soon begin pulling liquidity out of Asia's biggest economy. Once that process begins, there's no telling how aggressive the BOJ will be and what effect it will have on bond yields.

Where Liquidity Begins

There are two reasons Japan's rate outlook is a huge story for global markets. One, yields in the biggest government debt market will head steadily higher for the first time in more than a decade. Two, it may mean the end of the so-called yen-carry trade.

``All liquidity starts in Japan, the world's largest creditor country,'' said Jesper Koll, chief economist for Japan at Merrill Lynch & Co. ``When rates go up here, rates go up everywhere.''

What makes the carry trade so worrisome is that nobody really knows how big it is. For example, the BOJ has no credible intelligence on how many hedge funds, investors and companies have borrowed cheaply in ultra-low-interest-rate yen and re-invested the funds in higher-yielding assets elsewhere.

Nor are the Bank for International Settlements, Federal Reserve Bank of New York or the International Monetary Fund likely to know how much leverage this most popular of trades has enabled banks to build up. Ditto for regulators overseeing the dealings of portfolio mangers around the globe.

Carry-Trade Craze

During the past decade, the yen-carry trade has become a staple for many punters. A popular form of the strategy exploits the gap between U.S. and Japanese yields. Anyone borrowing for next to nothing in yen and parking the funds in U.S. Treasuries received a twofold payoff: the 3-plus percentage-point yield difference and the dollar's rise versus the yen. The latter dynamic boosts profits by the time they're converted back to yen.

Yet as the BOJ raises rates and more investors buy into Japan's revival, the yen is sure to rise, much to the chagrin of carry-trade aficionados. Realization the trade is moving against investors may send shockwaves through global markets.

It would start slowly with speculators suddenly closing positions that are becoming more expensive: dumping Treasuries, gold, Shanghai real estate, shares in Google Inc. or whatever else they used yen borrowings to bet on. The chain reaction would accelerate once the mainstream media jumped on the story.

If all this sounds far-fetched, think back to late 1998, which offers an example of the damage a panic among carry-traders can do.

Remember 1998

In October of that year, Russia's debt default and the implosion of Long-Term Capital Management LP shoulder-checked global markets. The disorienting period culminated in the yen, which had been weakening for years, surging 20 percent in less than two months.

Suddenly, just about anyone who'd borrowed cheaply in yen rushed for the exits. It prompted frantic conference calls among officials in Washington, Tokyo and Frankfurt. Just how big was the yen-carry trade? How much leverage was involved? What could policy makers do, if anything, to regain control?

Since then, the wild days of 1998 have been largely forgotten. And as Japan slid back into recession and deflation, the yen-carry trade was back in favor. Trouble is, just as then, officials have little data to go on to understand the enormity of the risks all this poses.

Clearly, the global financial system is in better shape than it was in 1998. For the first time in a decade, economies in the U.S., Europe and Japan are growing in synch. There's the added benefit of strong growth in China and most of the rest of East Asia. India is also growing rapidly.

A boom in the number of hedge funds globally hasn't destabilized the international financial system as critics expected -- at least not yet. The world economy's resilience in the face of rising terrorist threats and record oil prices also provides some measure of comfort.

Even so, it's not clear investors are taking the risk of rising Japanese bond yields seriously enough. Once the process begins, world markets may be surprised by how quickly Japanese rates shoot higher, taking the yen -- and all those who borrowed in it -- along for the ride.

[jeffolie]

JP Morgan will be the first to fall.

Check out: http://www.occ.treas.gov/ftp/deriv/dq305.pdf

You'll see that the amount of derivatives in "insured" commercial bank portfolios increased by $2.6 trillion in the third quarter of 2005, to a whopping $98.8 trillion. 98% of these are concentrated in 5 banks. Total assets of these top 5 banks is $3.3 trillion if I am reading the chart correctly.

Just look at the charts like the year ends 91-2004 chart (Graph 3) and you'll see a chart shooting straight to the moon.

Maybe these bankers are smarter then me, but this is a house of cards in my book.


NEWBANK TO REPLACE JP MORGAN

JPMorgan and Goldman Sachs are among the biggest buyers and sellers of credit derivatives. Traders of the contracts now include investors ranging from Newport Beach, California-based Pacific Investment Management Co., the world biggest bond fund manager, to Blue Mountain Capital, a New York hedge fund.

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.

The terrorist attacks on September 11, 2001, underscored just how vulnerable the clearing system was: Bank of New York's trade-processing operations were troubled for days, causing problems across the banking system that took months to correct.

Soon after, the Federal Reserve and the Securities and Exchange Commission began raising concerns about what would happen if a clearing bank's activities were severely disrupted again.

JP Morgan and Bank of New York built back-up facilities outside the New York metropolitan area to stay ahead of federal regulators and ensure their clearing operations could never be physically shut down.
The idea of a privately organised "standby bank" emerged from a Federal Reserve working group in 2004. This dormant bank would leap into action only if a credit or legal crisis caused investors and dealers to withdraw their business from either of the two existing banks and if no other qualified buyer bought the clearing operations.

Regulators released plans for the NewBank in December. The Bond Market Association is expected to say today that it will take responsibility for enacting them in the next 12 to 18 months.

The NewBank will have no physical location and no full-time employees. It will be funded with roughly $US500 million from 24 banking industry shareholders so that, if needed, it could immediately have money available to begin clearing trades.

In a crisis, however, the NewBank would take over from the existing clearing bank and replace its top officers with executives from other institutions.

The New York Times

[jeffolie]

Posted On: Monday, March 27, 2006, 3:30:00 PM EST

A Review of the Derivatives Market

Author: Jim Sinclair




To: Gillian Tett, Capital Markets Editor
The Financial Times

Dear Ms. Tett:

I read your review of the derivative market and the champions of it who have experienced the most spectacular growth of any theater of finance.




You made certain key points:

There are only three dealers in this market that can be considered majors.
Among the three there are positions representing 12 of the total 17 Trillion dollars total nominal value.
The champions of this new enterprise are all YOUNG.
The people interviewed generally avoid financial reporters because reporters speak poorly of their products.
You speak of these items as a form of insurance without investigation of the quality of that insurance policy as a financial instrument.


Please consider the following:

None of these instruments are regulated.
None of these instruments are listed on a regulated exchange.
Unregulated areas of finance tend to attract unregulated individuals.
There is no clearing house guarantee of these instruments that would speak to their financial ability to perform.
The financial ability of these instruments to perform are totally founded on the balance sheet of the loser in the transaction.
All these instruments are negotiated special performance agreements.
Almost all of these instruments lack transparency.
Almost every one of these instruments has no standards.
Because there are no standards there can be no bid and ask market. The market is by negotiation only.
These instruments are valued not to market, since there is none, but marked to model. Their value is purely assumption is cyberspace.
The people you spoke to colored over the counter derivatives as the greatest thing since sliced bread; a concept that flowed through the majority of your article.

Respectfully, you have been had.

Sincerely
James E. Sinclair

[blazespinnaker]

This is great stuff, and I think it all makes sense, unfortunately I think one critical component is missing in order to devise an actionable strategy:

A solid survey of the derivatives, their terms, and their securitization (versus their volatility .. presumable that derivatives with greater volatility will require greater securitization..)

Also, to extend that, after getting a sense of the terms we probably might want to measure the total beta, does the total risk compound or cancel?

I think I agree with Buffet and Jeffolie and everyone else that derivatives gone bad pose a certain risk. However, with Enron on the minds I believe there is a probability, not that small, that contracts have been written more carefully.

However without a reliable survey, we are somewhat left out in the cold as to exactly how extended this problem is (or is not) and we can only guess. My suspicion is that the problem is often overblown because of a lack of knowledge .. ignorance very often leads to fear which is never rational.

Who could do such a survey? How could we measure its credibility?

[jeffolie]

NO ONE CAN GET A SURVEY OF DERIVATIVES


...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

By Greg Robb, MarketWatch
Last Update: 10:36 AM ET Mar 16, 2006


`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.''



ANOTHER EXAMPLE OF MILLIONS OF DERIVATIVES TRANSACTIONS

GMAC PIVOTAL
Should a strike be called, GM could be bankrupt by June, Boulanger said. After that any scenario might play out, but the status of GMAC will be crucial.

GMAC has traded at a premium to its parent in the credit markets on hopes a controlling stake will be sold, ring-fencing the company and possibly returning it to investment grade. Yet, despite GM's best efforts, no buyer has emerged.

Further complicating the outlook, if GMAC is not sold, and GM does go bankrupt, it is uncertain GMAC would be consolidated in the filing.
For bond investors, a GM bankruptcy would be hard, but a GMAC bankruptcy would be disastrous. GMAC is home to three quarters of the group's bonds, and is found in a large proportion of outstanding synthetic CDOs.

"The high degree of portfolio overlap between synthetic CDO transactions sets this asset class apart," said Standard & Poor's analyst Andrew South. "A rating action on GM could have a widespread effect on many CDOs."

The complex market in CDO squared, or CDOs of CDOs, also faces significant risk following a GM downgrade, one London-based hedge fund manager said.

"To be blunt -- it would be carnage," he said.

Part of that carnage would be in the back offices of financial institutions, which will have literally millions of transactions to unwind, and banks are already under regulator pressure over backlogs in credit derivatives.

[blazespinnaker]

Well, one possibility is that the Japanese may be aware of the risks and will give lots of lead time for people to unwind their carry trade.

[Will]

I think that a lot of negativity turns into shrill. Some facts to note:

1. Even though the total derivative market may be vaued at $570 trillion, the actual VAR is a small fraction of that. This is because of the way these instruments are valued and booked. So lets look past the headline number please.

2. Every few years, the smart people get a bit too ahead of themselves and the market collapses due to some mistake. But does it bring the whole system down or can it? Not really. Sure, we are due for a rationalization but the fact remains that these instruments are not going away as they provide added liquidity by providing insurance against counterparty risk.

3. Interest Rates: The whole cycle in a way is tied to interest rates. Many of the trades will unravel if yields continue their North path. Sure the MBS market will be hit but because of this securitization, rationalization will be quick in this market. The individual housing market is a different game.

I think globalization is inducing long term changes as the world gets more specialized (as Economists like to point out). But along the way, there will be places of imperfections as the world rationalizes itself to a market spanning the globe. The rationalization in US wealth and technology lead may be overdue (I don't know). But the US has a very strong culture of entrepreneurship. A few years of short term economic pain will be good for the country as a whole in the long term. That allows for the society to get over the hangover and adapt to the new world where corporations no longer have nationalities.

[jeffolie]

The New York Fed may be shrill, but that does mean we should pay attention. These are weapons of mass financial destruction to quote Warren Buffett who recently lost $404million. Derivatives are not counterparty actions.

"...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

[jeffolie]

The Derivative Conundrum
Author: Jim Sinclair

I have constructed the following open letter to Chairman Greenspan.

Dear Chairman Greenspan:

Understanding the mechanics of over-the-counter derivatives is a unique talent. In order to fully grasp what the OTC derivative risk is all about, experience as an owner and risk taker of an arbitrage company is the best prerequisite. Because of this, even a member of the Federal Reserve Board cannot be expected to have all the facts at hand.

Your recent expression of concern over the growth of what you refer to as the “derivative market” is well placed even though you restricted your commentary to a certain group of OTC derivatives and renewed your opinion that NO regulation of these specific performance financial vehicles is required.

You refer to the OTC derivative market which is a significant stretch for the word “market.” I can with authority and experience state that this market is not simply illiquid it simply does not exist.

As a result, there is no one standing ready as a market maker to produce bids and offers as is common to the basic structure of an active equity market. There is not even a computer system linking traders able to match bids and offers.

The non existence of the OTC derivative market is a direct result of the fact that there is no standard form of OTC derivative contracts on more than 95% of the OTC derivatives outstanding. Without standardization, such a December gold contract on the Comex, whereby maturation and specifics of delivery are specified and common, no market can exist.

Your expressed fear is that a mass exit from a certain generic type of OTC derivative could cause a problem is not in a practical sense correct. This is because there is no exit door at all. These instruments are made or unmade by negotiations with an entity that offers its services to so do. In order to close a commitment, an entity holding that commitment must have an entity calling itself a derivative dealer find some fool to take the other side. The chances of that happening in a mass exit situation are non existent unless the holder is willing to take a terrific loss because it will not appear in a fall until the bottom or in a rise until the top. Expressed differently, if an entity is in danger of bankruptcy in OTC derivatives, it is going to experience bankruptcy because there is no exit door.

Regarding the opinion that there is no need for regulation, you might consider the following:

1. OTC derivatives are not transparent.
2. SEC reporting requirements do nothing to provide for transparency of derivatives held by reporting companies.
3. Exchange reporting requirements do nothing to provide for transparency of OTC derivatives held by member companies.
4. OTC derivatives are not listed on any major exchange.
5. OTC derivatives are akin to special performance contracts unfunded and floating within the system as special performance financial obligations which are totally dependent on the balance sheet and liquidity of the party to the agreement that is the loser. This is a fact because unlike the listed derivatives called futures and options there is no clearinghouse guarantee for the performance of the obligation. That means that there is no true accounting or payment by the loser to the winner on any time basis via a clearinghouse. Therefore, the loss builds up to a crescendo until the only option is a complete bailout or bankruptcy.
6. Because there is no open market for these items, evaluation of OTC derivatives is simply a computer calculation made using assumptions of conditions prevailing at an assumed future period. To make these assumptions correctly is quite rare and in fact is almost non existent. If you had that knowledge you would be recruited by the Federal Reserve and in time have the honor of being a governor unless you preferred simply to corner the world’s supply of money.
7. The majority of entities doing the largest business in OTC derivatives are subsidiaries whose parent is usually a well known and internationally respected investment firm or bank. There is no requirement under law for such a parent to guarantee the subsidiary as it pertains to trade debts. There is no way to know the financial condition of these subsidiaries or the degree to which they have extended themselves on these instruments. The reason for that is that these subsidiaries are primarily domiciled in areas where capital requirements for these transactions do not exist..

The following data was reported by the Bank for International Settlements in its 2004 review of derivative activity:

OTC derivatives market activity

Turnover data

Global daily turnover in foreign exchange and interest rate derivatives contracts, including traditional instruments such as outright forwards and foreign exchange swaps, rose by an estimated 74%, to $2.4 trillion, between April 2001 and April 2004. At constant exchange rates the increase is 51%, still considerably higher than the 10% growth recorded in the previous survey.

Daily activity grew in both OTC segments, ie interest rate and currency-related derivatives, up by 110% and 51% to $1,025 billion and $1,292 billion respectively. Over the same period activity in exchange-traded derivatives rose by 114%, to $4.7 trillion. Given that exchange-traded derivatives are composed, for the vast majority, of interest rate related products, the expansion recorded in the two markets, OTC and exchanges, has been comparable.

The growth of business in exchange rate derivatives parallels the 57% expansion in turnover in traditional foreign exchange markets. Higher demand in both the traditional and derivatives segments reflects the greater role of such products as an alternative investment class to equity and fixed income products, as well as the larger role of hedge funds and asset managers. In the interest rate segment, changes in hedging and trading practices in the US market helped boost activity. Business in interest rate derivatives may also have been favoured by an exceptional rise in volatility, especially in the US market.

Trading increased at especially high rates between reporting banks and other financial institutions, mainly hedge funds and insurance companies. Expansion was also strong for activity with non-financial customers, ie firms. London and New York remain the two largest marketplaces.

More...

Conclusion

Therefore I offer the conclusion that OTC derivatives - not exchange listed derivatives with clearing house guarantees - are the greatest risk to the US economy, the world economy, and the US dollar.

This problem will start to show itself the minute that there is a significant change in either the equities market or the market assumptions now in place concerning interest rates.

As far as regulations are concerned, they will come more than likely as a product of a debacle - not before it. In a practical sense, having regulators focusing on this area of financial instruments would cause that debacle when they came to realize what I have defined to you in this letter.

Furthermore, any new laws concerning bankruptcy as they pertain to the entities that present themselves as OTC derivative dealers would favor those dealers and not the system itself. The possibility that legislators understand the mechanics of derivatives is simply not possible in my opinion.

Respectfully,

James E. Sinclair


April 11, 2005