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.
“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.”
Happy thoughts for 1 am on Easter Monday. But, JPMChase bought its rival for a song. Now to squeeze the workers into juice.
According to this , $492.6 billion.
OK. Thanks for talking me down. I was getting worked up there.
How about this tongue twister:
The Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund.
And of course, it failed!
http://www.businessweek.com/magazine/content/07_43/b4055001.htm
Thanks for the links!
That effer Greenspan allowed and approved the explosive growth in derivatives and CMOs and other garbage. Whoever call Greenspan a closet gold advocate is an idiot.....
Though I would not be surprised if he owns lots of AU as a hedge against his moronic policies
Same as Arnold Schwarzenegger -— No way does he manage his money —200 million— recklessly. He saves that for the state of California
Unfortunately, "mark to market" = "what people are willing to pay."
In times of uncertainty like this, the "market value" may be unfairly low (whatever that means); and the greater the pressure to do it, the lower the price is likely to go.
And then, once *anyone* sells at a low price, *everyone* will have their portfolios similarly valued; with the result that everyone will probably face margin calls at the same time, with the result that *everything* goes on a downward spiral at once. This would unwind the excesses all at once. BUT, that can't happen, because so many people are *highly* leveraged, based on the prior assumptios (during the bubble) of monotonically increasing prices, i.e. near zero risk. So even a relatively minor change in the prices downwards will drive many players to bankruptcy at the same time.
Cheers!
And I can just about bet the farm that $10 trillion of the $13.4 is BS funny money just created out of thin air and put on paper.
WTF?
So, who has the money now? And they want the US taxpayer to foot the bill? Give me a break!!!
I’m not speaking of derivative accounts. I’m speaking of normal stock/commodity investment accounts.
Do you understand what notional value is?
Do you understand what "notional value" refers to?
Your memory is failing you.
Read At Home Tonight BUMP!
You disagree with Jim Sinclair (post #35) where he states:
When an OTC derivative fails to perform, notional value becomes real value.
How is he wrong?
Your answer could read: "Yes, Jim Sinclair is wrong, because notional value is actually ...."
How is he wrong?
Here is an old explanation I posted about interest rate swaps, the most common type of derivative.
Say you loaned out $1,000,000 at an adjustable rate, say 3 month Libor plus 2 points. Now want a fixed interest payment every month to meet some of your own obligations. You go to another bank that is willing to pay you 5% fixed for the next 3 years in exchange for your adjustable payment.
On the last day of each month you take the 3 month Libor rate and add 2 points. If the number is above 5%, you owe the bank. If the number is below 5%, the bank owes you.
Say Libor hits 4% and stays there for the entire 3 year term of your swap. Every month you owe the bank 1% on the $1,000,000 swap. That's $10,000 a year. Every month you wire the bank $833.33, but you have a swap for $1,000,000 and the bank has a swap for $1,000,000.
$2,000,000 in swaps! OMG!!! And every month $833.33 changes hands.
Now, if this "OTC derivative fails to perform" (that's a stupid phrase, maybe, "If the counterparty stops paying"?), they aren't sending me $833.33 each month.
How does that make the $2,000,000 in notional value real? I'm losing $10,000 in payments a year, for 3 years. I don't suddenly owe $2,000,000. No one suddenly owes me $2,000,000.
Do you know what notional means?
Do you honestly believe this?
Is this why the Bear Stearns debacle occurred, because of purely imaginary notional funny money? Is this why Bernanke and Paulson are sweating bullets?
Do you honestly believe this?
How does that make the $2,000,000 in notional value real? I'm losing $10,000 in payments a year, for 3 years. I don't suddenly owe $2,000,000. No one suddenly owes me $2,000,000.
I am familiar with loans which provide that, if several payments are missed, the entire loan balance is due at once. Now you did not explain whether any principal is being paid on the loan or not (is it an interest-only loan?).
If both loans have a provision that the remaining balance is due if three payments are missed, and the debtor on your loan defaults, and as a result you default on your loan from the bank, then it would be appropriate for both your balance sheet and the bank's balance sheet to show a loan default in the amount of whatever the balance of the loan would happen to be.
Presumably, your balance sheet would also identify your status of being in default of the loan from the bank.
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