Derivatives Catastrophe: Are We Headed for a "Credit Derivatives Event?"
** “I am concerned about the level of capital” of our competitors “to service the bonds as those portfolios age”
** “Should real estate on the West Coast flatten out, I would be worried about a credit event”
** “There are people that will buy a 100% loan to value (LTV). We do not have that product, we do not believe in it. We want the stated income borrower to actually have some skin in the game”
** We can now offer those products but “We have no intentions of putting those loans in our portfolio….We are going to pass them thru to other investors”
** Question: “And you think that is a good strategy, thinking this is the Perfect Storm you are describing?”
** Answer: “As long as the market is willing to provide that credit…they attempt to deliver the customer as much cash as possible with the least amount of investigation or effort….That’s what drives our customer….In order to get the customers we want, we need to be able to offer those products”
** Question: “Since I have known you, you have been bearish on the industry…now you are saying I want to be more like people offering products that are unsustainable. I am struggling with that”
** Answer: “The only difference is that I do not intend to put those in my portfolio…and the day that I can’t sell these (to someone else) is the day that I stop offering them.”
We also noted that Fannie Mae’s restatement is such a big task that Fannie expects to hire some 1,500 consultants by year’s end to accomplish the mission.
In “Derivatives Cannot Take the Pressure,” Brad DeLong comments on a Financial Times report as follows:
** “The real problem is that the U.S. economy is just too leveraged. Starting with the housing industry, the country is too dependent on derivatives markets to create the illusion that interest rate risk can be conjured away. The technical problems of the 10-year are just another early warning sign of this fundamental weakness.”
As a result of that mishap, CNN Money reports an “Investor Charges PIMCO With Manipulation”:
“An investor has sued money manager Pacific Investment Management Company, claiming the firm manipulated the price of June 10-year Treasury futures contracts on the Chicago Board of Trade…
Derivatives Catastrophe: When Genius Failed
By the spring of 1998, LTCM was losing several hundred million dollars per day. What did LTCM’s brilliant financial models say about all of this? The models recommended waiting out the storm.
By August 1998, LTCM had burned through almost all of its $4 billion in capital. At this point, LTCM tried to exit its trades, but found it impossible, as traders all over the world were trying to exit as well.
With $1.2 trillion at risk, the economy could have been devastated if LTCM’s losses continued to run its course. After much discussion, the Federal Reserve and Wall Street’s largest investment banks decided to rescue Long-Term. The banks ended up losing several hundred million dollars each.
What became of the LTCM founders? They went on to start another hedge fund.
In “Thoughts on Volatility,” we discussed the explosive use of all kinds of credit derivatives including:
** Credit Default Swaps (CDS)
** Collateralized Mortgage Obligations (CMO)
** Collateralized Debt Obligations (CDO)
** Synthetic CDOs.
You might wish to review that article to see just what is being traded and why.
Here is a snippet:
CDOs and synthetic CDOs are among the most complex financial instruments that you can find. They are often cut into custom-tailored slices to suit the “needs” of an individual hedge fund. Obviously, this complexity makes the CDO market very illiquid. Illiquid CDOs may contain illiquid CDSs as part of the structure. Given the party-to-party illiquidity of both the CDS and CDO markets, with one potentially “supporting” another, it is obvious we have an enormous problem should anything go awry.
Given the “obvious benefits” of these “investments,” CDOs and synthetic CDOs have sparked a boom in “credit risk transfer” as hedge funds and banks are all trying to measure and capture anomalies in the spreads between various credit instruments. Let’s flash back to 1998. Attempts to exploit anomalies in credit spreads is essentially what Long-Term Capital Management was trying to do when it collapsed in 1998 and nearly threw the U.S. financial system into a free fall. Lenders organized by Fed, just minutes before an options expirations close, bailed the fund out. The Fed has always stood ready to “bail out” the most stupid investments, and that, of course, has led to even more widespread risk-taking, such as we are currently witnessing.
Of course, CDO activity is far more “sophisticated” today than when LTCM blew up. Whether that is reducing the risks or creating huge new perils is a subject of much debate. Perhaps I mean the subject is debatable until some six sigma event blows it all up. Here is something to ponder in the meantime: Given the explosion in the use of CDOs and CDSs, what will happen if something causes credit spreads to suddenly widen far more than risk models anticipate or anyone expects? I suggest the answer will not be pretty, to say the least. In that regard, I sense a lull before “the big storm,” and that big storm will hit in the form of a housing bust, a junk bond blowup led by GM or Ford, trade wars with China, or something completely off everyone’s radar, including mine. There are indeed numerous potential “tipping points,” and any of them could send us over the edge.
Derivatives Catastrophe: The Russian Crisis
Looking back at the Russian crisis in 1998, the default occurred in August, but the credit market did not feel the full effects until October. On that basis, the true consequences of market-to-market losses from General Motors and Ford debt downgrades, as well as future demand for more corporate junk, may take a few months to become apparent.
Perhaps the following picture, courtesy of Contrary Investor, will help summarize the current situation:
“FHLB-Pittsburgh will restate results for 2001 through 2004 and the first quarter of 2005. The bank’s review of derivatives accounting is ongoing and ‘could result in a material change’ to its estimated earnings drop, the bank said in a statement.”
On Aug. 5, Randall Dodd, director of the Financial Policy Forum, wrote an interesting article on the GM debacle entitled “Credit Derivatives Trigger Near System Meltdown”:
“What is the extent of the fallout? Exact amounts cannot be known with any clarity or certainty. Actual losses at hedge funds and proprietary trading desks are not reported, or at least not reported separately. The change in credit derivatives prices can be estimated from the iTraxx index for credit derivatives; however, there is no reported information on the volume of trades and value of derivative and cash positions. Thus, estimates of gains and losses to individual firms and the market cannot be determined.
“Some anecdotal information can be gleaned from announced hedge fund closings. The well-known Marin Capital hedge fund closed doors after big losses in convertible arbitrage and credit arbitrage, and Aman Capital also closed shop at the end of the midyear. GLG’s Neutral Group, which has credit derivative investments similar to that of Marin Capital, lost $2.5 billion, or 17.2%, in the first half of the year. Cheyne Capital’s hedge fund lost 4.8% in May alone. The huge hedge fund Bailey Coates Cromwell Fund, after being named Hedge Fund of the Year for 2004, announced in early June that it would close down.”
Derivatives Catastrophe: “Fed Summons 14 Banks”
Is LTCM on the Fed’s mind once again? Given some recent near misses with derivatives, and given that no one has a clue with what might be trillions of dollars worth of derivatives at Fannie Mae, the Fed should be concerned. Actually, it should have been concerned long ago, but typically it waits until there is a big problem, and then and only then does it think about addressing it.
At any rate, I am sure LTCM and a derivatives blowup is on the Fed’s mind, since the “Fed Summons 14 Banks to Discuss Credit Derivatives Controls”:
“JP Morgan Chase & Co., Deutsche Bank AG, Goldman Sachs Group Inc., Morgan Stanley, and Merrill Lynch & Co. dominate the credit derivatives market as the five most-cited trading partners, according to Fitch Ratings.”
The Fed’s letter said “a senior business representative and a senior risk management person,” should attend the meeting.
Of course the Fed summons brings to mind some additional questions:
** Was this an “invite” from the Fed or a demand to be there?
** Why is the industry “rife with unconfirmed trades”?
** If there are problems and lawsuits over Treasuries, the most liquid of all futures, what the heck is going on with CDOs, CMOs, and synthetic CDOs?
** If it takes 1,500 consultants a year to straighten out Fannie Mae’s hedge book, how long would a complete audit of JPM’s book take?
** If all JPM’s trades had to be unwound tomorrow, would JPM even be solvent?
I do not see how we can possibly avoid one, but timing it is the problem, since no one knows what event might trigger the cascade.
Mike Shedlock ~ “Mish”
September 12, 2005